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                                  United States
                       Securities and Exchange Commission
                             Washington, D.C. 20549

                                    FORM 10-K

                                   (Mark One)
            [x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

                                       OR

          [ ]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.
             (Exact name of registrant as specified in its charter)


            DELAWARE                                    31-1177192
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
 incorporation or organization)


                    5800 INNOVATION DRIVE, DUBLIN, OHIO 43016
               (Address of principal executive offices)(Zip Code)

        Registrant's telephone number, including area code: 614-798-2000

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

           Securities registered pursuant to Section 12(g) of the Act:
                     COMMON STOCK, $0.01 PAR VALUE PER SHARE
                                (Title of class)


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 the filing
requirements for at least the past 90 days. YES  X    NO
                                                ---      ---

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

Aggregate market value of voting stock held by non-affiliates of the registrant,
8,473,339 shares, based on the $3.29 closing sale price on March 7, 2003, was
$27,877,285.

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). YES       NO  X
                                       ---      ---

Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date: 14,975,067 shares of Common
Stock were outstanding at March 7, 2003.

                       DOCUMENTS INCORPORATED BY REFERENCE

Part III - Proxy Statement for the Annual Meeting of Stockholders to be held
April 24, 2003, in part, as indicated.


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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," and "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 "Business - Business Risks." The Company undertakes no
obligation to publicly update or revise any forward-looking statements.

PART I

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         ITEM 1   | Business
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GENERAL

Applied Innovation Inc. (Applied Innovation, AI, or the Company) is a network
management solutions company that simplifies and enhances the operation of
complex, distributed voice and data networks. Building on a deep knowledge of
network architecture, elements and management, AI delivers unique hardware,
software and service solutions that provide greater connectivity, visibility and
control of network elements and the systems that support them.

The Company was founded in Columbus, Ohio in 1983 by Gerard Moersdorf, Jr. The
Company has two wholly owned subsidiaries.

Applied Innovation, headquartered in Columbus, Ohio, is traded on NASDAQ under
the symbol AINN. The Company's corporate headquarters occupy a 115,000 square
foot facility located at 5800 Innovation Drive, Dublin, Ohio 43016,
800-247-9482.

THE COMPANY'S MARKETS

Applied Innovation's solutions are targeted to three primary markets in the U.S.
and abroad: 1) telecommunications companies using wireline networks; 2)
telecommunications companies using wireless networks; and 3) government
networks. Synergies within the markets allow the Company to leverage its
knowledge and experience and deliver a common value proposition based on key
competitive differentiators--namely, its extensive knowledge of network
infrastructure, its commitment to vendor neutrality, and its focus on customers.
At the same time, Applied Innovation delivers targeted value to each market by
understanding and meeting its unique demands.

PRODUCTS

HARDWARE SOLUTIONS

AISWITCH(TM) | AIswitch delivers maximum connectivity and mediation for
surveillance networks. This mediation system allows network operators to
maintain correct protocol interaction and communication between operations
support systems (OSSs) and network elements (NEs), and offers increased
flexibility. With AIswitch, service providers can increase network availability,
reduce operational expenses, improve network utilization and gain flexibility in
network architecture in central offices.

AISCOUT(TM) | AIscout streamlines network management and improves visibility at
the network's edge. Simplifying the integration of diverse network elements,
AIscout provides a common point of connectivity. As part of a unified network
management framework, it allows network operators to monitor, control and
analyze faults in a network with a common point of remote and local access. With
AIscout, service providers can improve network manageability, accelerate
troubleshooting, reduce network maintenance costs and improve network
reliability at smaller or remote sites.

AIBADGER(TM) | AIbadger provides a flexible, affordable solution for
intelligent, unified network management of wireless infrastructure. Bringing
network management connectivity, site monitoring and alarm visibility to remote
network sites, AIbadger is designed to meet a broad range of operating and
security requirements. With AIbadger, service providers can lower operating
costs, improve network availability, increase network flexibility and speed
return on investment.

AIVORTEX(TM) | AIvortex is a scalable network bridging solution that allows
service providers to aggregate remote sites without investing in an expensive
router-based network. This compact, high-capacity solution is an effective means
of reaching the outermost edges of a network without the commonly accepted
technical complexities. With AIvortex, organizations gain a cost effective
solution, multi-vendor interoperability, scalability, higher switch & transport
network reliability, and simplified deployment.

Revenues from sales of hardware solutions are included in Products and
Integrations Sales in the Company's consolidated financial statements and are
described as Products Sales in the Company's product-line revenue analysis in
Management's Discussion and Analysis of Financial Condition and Results of
Operations.

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NETWORK MANAGEMENT SOFTWARE SOLUTIONS

The Company offers several network management software (NMS) solutions to help
telecommunications service providers manage their data communications networks.
The Company generates software license fees from the sale of these NMS
solutions.

APPLIEDVIEW(TM) | AppliedView consolidates all Applied Innovation equipment
operations for improved system management. As the element management system for
Applied Innovation equipment, AppliedView is integrated with HP OpenView(R) to
provide an in-depth view of AI equipment and expand the reach of the management
center to every AI network node. Its sophisticated yet easy-to-use graphical
user interface (GUI), inventory control system, comprehensive menu system and
firmware download scheduler provide all the tools necessary to monitor,
provision and maintain installed Applied Innovation equipment. With AppliedView,
service providers can accelerate problem resolution, simplify configuration of
AI equipment, save time and money, speed recovery time in emergency situations
and reduce administrative upgrade costs.

HP OPENVIEW(R) | Applied Innovation maximizes the industry leading HP OpenView
suite to provide comprehensive and complete management solutions. AI combines
its extensive telecom networking and operations expertise with HP's
market-leading OpenView software suite to deliver proven, end-to-end management
solutions. AI's solutions provide a strategic platform that affords the
opportunity to increase strategic market position, maximize revenue, quicken
response time, improve customer satisfaction, streamline operations and gain
flexibility and scalability.

Such license fees and related third-party NMS equipment revenues are included in
Products and Integration Sales in the Company's consolidated financial
statements and are described as Products Sales in the Company's product-line
revenue analysis in Management's Discussion and Analysis of Financial Condition
and Results of Operations.

SERVICES SOLUTIONS

Applied Innovation delivers added value to customers through a robust suite of
service offerings. Leveraging our in-depth knowledge of the telecommunications
industry, enterprise networking, network management systems and operational
support requirements, we deliver scalable solutions to fulfill complex business
requirements in innovative ways. Our comprehensive portfolio of services
includes AI Network Management System Services, AI Deployment Services and other
service offerings.

AI NETWORK MANAGEMENT SYSTEM SERVICES | AI offers a complete suite of
professional services, including detailed design, integration, test,
installation, training and overall program management, that significantly reduce
the complexity, time and cost involved in moving towards new generation systems.
AI's robust service offerings offer modularity, interoperability and openness -
ensuring they are reliable, scalable and deliver a lower total cost of
ownership. Our innovative deployment methods provide customers with integrated,
tested and installed systems that are ready for operation.

AI DEPLOYMENT SERVICES | AI offers extensive Deployment Services, including site
management, detail engineering, furnishing, installation, test and turn-up. Our
roots in the telecommunications industry have yielded a highly trained,
Telcordia(TM)-certified installation staff focused on meeting strict engineering
standards and documentation requirements. It is a disciplined approach that
carries over to every customer, industry and installation. We are also unique in
offering an integrated method of deployment that unites customers' disparate
third-party equipment and systems with our own. AI customers gain significant
economies of scale because we can provide a large portion of the installation,
cabling and configuration support prior to equipment and personnel arriving at
the customer site.

ADDITIONAL SERVICE OFFERINGS | The Company generates services revenue from
customers under contracts and/or purchase orders that define the scope of work
for a given project. The Company generally recognizes services revenue at
project completion. The Company also offers extended maintenance support
agreements. Revenues from such agreements are deferred and recognized
straight-line over the terms of the agreements.

Revenues from service work and maintenance contracts are classified as Services
Sales in the Company's consolidated financial statements and are described as
Services Sales in the Company's product-line revenue analysis in Management's
Discussion and Analysis of Financial Condition and Results of Operations.

MANUFACTURING AND OPERATIONS

All of the printed circuit boards, chassis enclosures and other hardware used in
the Company's products are designed in the Company's Dublin facility and are
proprietary designs of the Company. Under the supervision of the Vice President
of Operations and the Company's Quality Control organization, printed circuit
boards, chassis enclosures and power supplies used in each of the Company's
products are contracted out to third party manufacturing firms for assembly.
These subassemblies are then shipped to the Company for testing and final
assembly. Procurement of materials is driven through an enterprise resource
planning (ERP) system with production forecasts supplied to contract firms for
component ordering from sources supplied and approved by the Company. The
Company maintains and controls all documentation and process requirements for
products manufactured by the contract assembly firms. The Company utilizes
multiple assembly firms and is, therefore, not dependent on any single third
party manufacturer.

The Company performs multiple inspections on its products as well as various
test procedures prior to shipment to customers. These processes are designed to
assure product performance and reliability in the environments in which the
products will be used. The Company has made and continues to make significant
investments to attain quality assurance consistent with stringent industry
standards. The Company develops and manufactures its products in accordance with
Network Equipment Building Standards (NEBS) and Generic Equipment Requirements
guidelines. The Company is International Standards Organization 9001 (ISO 9001)
certified.

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MARKETING, BUSINESS DEVELOPMENT, SALES AND SERVICES

The Company's products and services are sold primarily through its own sales
force, except for independent sales agents and distributors in Australia,
Brazil, Mexico, South Africa, and the United Kingdom. The Company is exploring
alternative distribution channels to allow sales of the Company's products to
markets that are not easily accessible or cost effective for its own sales
force. In addition to the Dublin, Ohio headquarters, the Company maintains sales
offices in Dallas, Denver and Mexico City. During 2002, the Company closed its
Atlanta, Chicago and Pleasanton, CA sales offices.

The Company generates a large portion of its annual revenues from customers with
whom the Company has done business for many years. Company sales personnel work
with network managers and planners to determine network management requirements,
the timing of individual projects, and the customers' funding for such projects.
The Company generally has master purchase agreements with its largest recurring
customers, and receives individual purchase orders from customers as Company
products are required.

For new customers, sales leads are generated through targeted marketing efforts
such as direct mail to telecommunications service providers and through product
advertising and trade shows. Sales leads are followed up by personal contact
from the Company's sales and marketing staff. If sufficient interest exists, an
on-site visit may be scheduled for the purpose of making a sales presentation,
which may include a product demonstration.

The technical complexity of the Company's products and the relative large size
of customers create a long sales cycle for the Company's products. The technical
nature of the products requires a sales force that is highly trained and
technically experienced. The Company's sales force receives incentive
compensation based on increased levels of sales.

RESEARCH AND DEVELOPMENT

The Company's research and development (R&D) activities are coordinated with
product management and sales with specific focus on customer requirements.
Enhancements to AIswitch are focused on enhancing the performance capabilities
of the product and adding functionality. These enhancements allow a service
provider to seamlessly transition to next generation operations support systems,
integrate new elements into their systems more efficiently, consolidate network
management systems and adapt the information flowing across the product for more
rapid implementation of customer-driven applications.

Additional enhancements are in development for the AIbadger product line as well
as producing additional products for the wireless market to enhance network
management capabilities, improve service quality and speed the introduction of
new technologies. Additional investments are being focused on the unique needs
and requirements for international markets to enable further penetration of
targeted countries.

The Company spent $7,084,646, $9,648,898 and $8,176,622 on Company-sponsored R&D
during the fiscal years ended December 31, 2002, 2001 and 2000, respectively.
R&D expenditures represented approximately 16%, 13% and 7% of annual sales in
fiscal 2002, 2001 and 2000, respectively. The Company expects to continue
committing resources and cash to its research and development efforts during
2003, although R&D spending in 2003 is expected to decrease, both in absolute
dollars and as a percentage of sales. See "Business -- Business Risks -- New
Products, Research and Development, and Rapid Technological Change; Need to
Manage Product Transitions."

CUSTOMER SERVICE AND WARRANTY

The Company offers its customers a variety of services such as technical
support, project management, training, detail engineering, installation and test
and turn-up. Project managers interface between the Company and customers for
installation of new products and services and upgrades of existing products. The
project manager is also responsible for assuring that circumstances are
anticipated prior to certifying the system for full operation. Following
installation, the project manager continues to monitor the customer's system to
ensure proper satisfaction.

The Company designs training programs to educate the customer's system
administration, operations and maintenance personnel to operate the system.
Classes are available on-line and at the customer's site or at the Company's
headquarters. Additional training is also offered to the customer during system
upgrades and for new operations personnel.

The Company's field service department provides custom design and installation
services for telecommunications network equipment and software. The Company
believes that its field service department complements and enhances the sale of
its products.

The Company warrants its products for a minimum of one year after the sale.
Customers may also purchase extended warranty contracts with guaranteed
overnight factory replacement service for circuit boards or system modules in
the event of equipment failure. Software revisions to the Company's products are
also available as part of the extended warranty contracts, or may be purchased
by the customer. For an additional charge, on-site spares are available for
those customers who require immediate replacement. For warranty-related issues
and customers with extended maintenance agreements, the Company also provides a
24-hour Service Hotline and web-based support for instant access to its field
service and support departments.

Warranty expense represented approximately 2.8%, 2.1% and 1.5% of annual sales
in 2002, 2001 and 2000, respectively. See "Business -- Business Risks -- Risk of
Product Defects."

COMPETITION

There are numerous manufacturers of data communications equipment. Manufacturers
of these products frequently specialize their products for specific applications
and could enter the Company's target markets. Significant competition exists
from several well-established companies having resources superior to those of
the Company and from other aggressive companies.

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Competition for the Company's hardware products arises primarily from the
following equipment suppliers: Cisco Systems, Datatek Corp., Dantel, DPS
Telecom, Eastern Research, ION Networks and Quest Controls. In some cases, newer
products or redesigned older products from these suppliers compete with the
Company's products. See "Business -- Business Risks -- Competition."

Competition for the Company's service offerings includes internal solutions,
offerings from other HP OpenView resellers and independent software vendors
including Micromuse, Harris Corporation and TTI Telecom.

PERSONNEL

As of March 7, 2003, the Company had 155 full-time and part-time employees. The
Company's employees are distributed among the following departments: Sales and
Marketing 38; Research and Development 45; Services 29; Administration 21; and
Operations 22.

BUSINESS RISKS

The Company desires 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, the Company's actual results and could cause the Company's actual
consolidated results of operations for the year ended December 31, 2003, and
beyond, to differ materially from those expressed in any forward-looking
statements made by, or on behalf of, the Company.

RISKS ASSOCIATED WITH CUSTOMER CONCENTRATION; DEPENDENCE ON TELECOMMUNICATIONS
INDUSTRY | A significant portion of the Company's revenues in each fiscal
quarter since inception has been derived from substantial orders placed by large
organizations, such as the Regional Bell Operating Companies (RBOCs). As a
result, the Company's sales often have been concentrated among a relatively
small number of customers. In fiscal 2002, 2001 and 2000, sales from the
Company's three, four and two largest customers represented approximately 75%,
66% and 61%, respectively, of the Company's total sales. The Company expects
that it will continue to be dependent upon a limited number of customers for a
significant portion of its revenues in future periods. None of the Company's
customers are contractually obligated to license or purchase additional products
or services from the Company. As a result of this customer concentration, the
Company's business, operating results and financial condition could be
materially adversely affected by the failure of anticipated orders to
materialize or by deferrals or cancellations of orders. In addition, there can
be no assurance that revenue from customers that have accounted for significant
sales in past periods, individually or as a group, will continue, or if
continued, will reach or exceed historical levels in any future period.
Furthermore, such customers are concentrated in the telecommunications industry.
Accordingly, the Company's future success depends upon the capital spending
patterns of such customers and the continued demand by such customers for the
Company's products and services. Many of the Company's largest customers
maintain collective bargaining agreements with their employees. Accordingly,
they have been affected by labor strikes in the past and could be affected in
the future. Such labor strikes may impact certain customers' ability to place
orders for Company products, accept shipments or deploy products in their
networks, and therefore, impact the Company's sales. Over the last 24 to 36
months, domestic telecommunications service providers have significantly reduced
spending on new equipment and services and many competitive local exchange
carriers (CLECs) have failed. Additionally, any future mergers and acquisitions
among our customers could impact future orders from such customers. The
Company's operating results may in the future be subject to substantial
period-to-period fluctuations as a consequence of such customer concentration
and factors affecting capital spending in the telecommunications industry.

PRODUCT CONCENTRATION | Revenue from the sale, service and support of the
Company's AIswitch family of products has accounted for a substantial portion of
the Company's sales since inception. The Company believes that revenue from the
sale, service and support of the central office products will continue to
account for a significant portion of the Company's net sales in fiscal 2003.
Therefore, the Company's future operating results, particularly in the near
term, are significantly dependent upon the continued market acceptance of these
products, improvements to the product framework and new and enhanced development
tools and network operations support. There can be no assurance that the
Company's central office products and software will continue to achieve market
acceptance or that the Company will be successful in developing, introducing or
marketing improvements to its products or new or enhanced development tools and
applications. The life cycles of products, including development tools and
applications, are difficult to estimate due in large part to the recent
emergence of many of the Company's markets, the effect of future product
enhancements and competition. A decline in the demand for central office
products as a result of competition, technological change or other factors would
have a material adverse effect on the Company's business, operating results and
financial condition.


NEW PRODUCTS, RESEARCH AND DEVELOPMENT, AND RAPID TECHNOLOGICAL CHANGE; NEED TO
MANAGE PRODUCT TRANSITIONS | The market for the Company's products is
characterized by rapidly changing technologies, evolving industry standards,
frequent new product introductions and rapid changes in customer requirements.
The introduction of products embodying new technologies and the emergence of new
industry standards and practices can render existing products obsolete and
unmarketable. As a result, the life cycles of the Company's products are
difficult to estimate. The Company's future success will depend on its ability
to enhance its existing products and to develop and introduce, on a timely and
cost-effective basis, new products and product features that keep pace with
technological developments and emerging industry standards and address the
increasingly sophisticated needs of its customers. The Company is attempting to
ensure future success by continuing to invest in its research and development
effort. However, there can be no assurance that the Company will be successful
in developing and marketing new products or product features that respond to
technological change or evolving industry standards; that the Company will not
experience difficulties that could delay or prevent the


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successful development, introduction and marketing of these new products and
features; or that its new products or product features will adequately meet the
requirements of the marketplace and achieve market acceptance. If the Company is
unable, for technological or other reasons, to develop and introduce
enhancements of existing products or new products in a timely manner, the
Company's business, operating results and financial condition will be materially
adversely affected.

The introduction or announcement of products by the Company or one or more of
its competitors embodying new technologies, or changes in industry standards or
customer requirements, could render the Company's existing products obsolete or
unmarketable. The introduction of new or enhanced versions of its products
requires the Company to manage the transition from older products in order to
minimize disruption in customer ordering. There can be no assurance that the
introduction or announcement of new product offerings by the Company or one or
more of its competitors will not cause customers to defer purchasing existing
Company products. Such deferment of purchases could have a material adverse
effect on the Company's business, operating results and financial condition.

COMPETITION | There can be no assurance that the Company's current or potential
competitors will not develop products comparable or superior to those developed
by the Company or adapt more quickly than the Company to new technologies,
evolving industry trends or changing customer requirements. There can be no
assurance that the Company will be able to compete successfully against current
and future competitors or that competitive pressures faced by the Company will
not have a material adverse effect on its business, operating results and
financial condition.

DEPENDENCE UPON PROPRIETARY TECHNOLOGY; RISK OF THIRD PARTY CLAIMS OF
INFRINGEMENT | The Company's success and ability to compete are dependent in
part upon its proprietary software technology. The Company relies on a
combination of trade secret, copyright and trademark laws, nondisclosure and
other contractual agreements and technical measures to protect its proprietary
rights. The Company currently has no patents or patent applications pending.
Despite the Company's efforts to protect its proprietary rights, unauthorized
parties may attempt to copy aspects of the Company's products or to obtain and
use information that the Company regards as proprietary. There can be no
assurance that the steps taken by the Company to protect its proprietary
technology will prevent misappropriation of such technology, and such
protections may not preclude competitors from developing products with
functionality or features similar to the Company's products. In addition,
effective copyright and trade secret protection may be unavailable or limited in
certain foreign countries. While the Company believes that its products and
trademarks do not infringe upon the proprietary rights of third parties, there
can be no assurance that the Company will not receive future communications from
third parties asserting that the Company's products infringe, or may infringe,
the proprietary rights of third parties. The Company expects that software
product developers will be increasingly subject to infringement claims as the
number of products and competitors in the Company's industry segment grows and
the functionality of products in different industry segments overlap. Any such
claims, with or without merit, could be time-consuming, result in costly
litigation and diversion of technical and management personnel, cause product
shipment delays or require the Company to develop non-infringing technology or
enter into royalty or licensing agreements. Such royalty or licensing
agreements, if required, may not be available on terms acceptable to the Company
or at all. In the event of a successful claim of product infringement against
the Company and failure or inability of the Company to develop non-infringing
technology or license the infringed or similar technology, the Company's
business, operating results and financial condition could be materially
adversely affected.

The Company relies on certain software that it licenses from third parties,
including software that is integrated with internally developed software and
used in the Company's products to perform key functions. There can be no
assurance that these third party software licenses will continue to be available
to the Company on commercially reasonable terms or at all. Although the Company
believes that alternative software is available from other third-party
suppliers, the loss of or inability to maintain any of these software licenses
or the inability of the third parties to timely and cost-effectively enhance
their products in response to changing customer needs, industry standards or
technological developments could result in delays or reductions in product
shipments by the Company until equivalent software could be developed internally
or identified, licensed and integrated, which would have a material adverse
effect on the Company's business, operating results and financial condition.

RELIANCE ON SUPPLIERS | The Company purchases raw material and licenses
technology from a number of domestic and foreign sources. The Company believes
that currently there are acceptable alternatives to the suppliers of raw
material and technology used in its products which could be substituted for over
time, with the exception of network routing products supplied by Cisco Systems,
Inc. The Company currently purchases network routing products and licenses
technology regarding the same from Cisco Systems, Inc. pursuant to a Technology
Agreement. The term of the Technology Agreement expires on December 31, 2003 and
automatically renews for one year periods, unless either party elects not to
renew. Additionally, the Technology Agreement may be terminated by either party
for any reason upon six months notice. The Company believes that some of its
customers place a high value on the incorporation of network routing products
and technology from Cisco Systems, Inc. into the Company's products. Further,
Cisco can cancel the Technology Agreement if the Company markets its own routing
technology that competes with the technology covered by the Technology
Agreement. While the Company believes that it could obtain similar quality
network routing products and technology from other vendors, the termination of
the Technology Agreement could materially adversely affect the acceptance of the
Company's products, which could have a material adverse effect on the Company's
business, financial condition and results of operations.

FUTURE CAPITAL NEEDS; UNCERTAINTY OF ADDITIONAL FINANCING | The Company
currently anticipates that its existing cash, cash equivalents, investments,
cash to be generated from future operations, available credit facility and funds
which may be obtained from future financing activities will provide sufficient
capital to meet the currently anticipated business needs of the Company. See
"Management's Discussion and Analysis of Financial Condition and the Results of
Operations -- Liquidity and Capital Resources." The Company may need to raise
additional funds through public or private debt or equity financings in order to
take advantage of unanticipated opportunities, including more rapid expansion or
acquisitions of complementary businesses or technologies, or to develop new or
enhanced services and related products or otherwise respond to unanticipated

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competitive pressures. If additional funds are raised through the issuance of
equity securities, the percentage ownership of the then current stockholders of
the Company may be reduced and such equity securities may have rights,
preferences or privileges senior to those of the holders of the Company's common
stock. There can be no assurance that additional financing will be available on
terms favorable to the Company or at all. If adequate funds are not available or
are not available on acceptable terms, the Company may not be able to take
advantage of unanticipated opportunities, develop new or enhanced services and
related products or otherwise respond to unanticipated competitive pressures and
the Company's business, operating results and financial condition could be
materially adversely affected.

FUTURE OPERATING RESULTS UNCERTAIN | Although the Company has previously
experienced growth in revenues and net income, the Company expects that
historical growth rates are not sustainable and such growth rates should not be
considered indicative of future growth, if any. There can be no assurance that
the Company's revenues will grow or be sustained in future periods or that the
Company will be profitable in any future period.

RISK OF PRODUCT DEFECTS | Products as complex as those offered by the Company
may contain defects or failures when introduced or when new versions or
enhancements are released. The Company has in the past discovered defects in
certain of its products. Although the Company has remedied all known material
defects in its products, there can be no assurance that, despite testing by the
Company and its customers, errors will not be found in existing or new products
or releases, resulting in delay or loss of revenue, loss of market share or
failure to achieve market acceptance or substantial warranty expense. Any such
occurrence could have a material adverse effect on the Company's business,
operating results and financial condition.

POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS; SEASONALITY | The Company's
quarterly operating results have in the past and will in the future vary
significantly depending on factors such as the timing of significant orders and
shipments; capital spending patterns of the Company's customers; changes in
pricing policies by the Company or its competitors; the lengthy sales cycle of
the Company's products; increased competition; changes in operating expenses;
mergers and acquisitions among customers; personnel changes; demand for the
Company's products; the number, timing and significance of new product and
product enhancement announcements by the Company and its competitors; the
ability of the Company to develop, introduce and market new and enhanced
versions of its products on a timely basis; and the mix of direct and indirect
sales and general economic factors. A significant portion of the Company's
revenues have been, and will continue to be, derived from substantial orders
placed by large organizations, such as the RBOCs, and the timing of such orders
and their fulfillment has caused and will continue to cause material
fluctuations in the Company's operating results, particularly on a quarterly
basis. Due to the foregoing factors, quarterly net sales and operating results
have been and will continue to be difficult to forecast. Revenues are also
difficult to forecast because the Company's sales cycle, from initial evaluation
to product shipment, varies substantially from customer to customer. For these
and other reasons, the sales cycle associated with the purchase of the Company's
products is typically lengthy and subject to a number of significant risks,
including customers' budgetary constraints and internal acceptance reviews, over
which the Company has little or no control. The Company's expense levels are
based, in part, on its expectations as to future revenue levels. If revenue
levels are below expectations, operating results are likely to be materially
adversely affected. In particular, because only a small portion of the Company's
expenses varies with sales, net income (loss) may be disproportionately affected
by a reduction in sales. The Company's business has experienced and is expected
to continue to experience significant seasonality, in part due to an increase in
capital expenditures by customers in certain quarters. Based upon all of the
foregoing, the Company believes that quarterly sales and operating results are
likely to vary significantly in the future and that period-to-period comparisons
of its results of operations are not necessarily meaningful and should not be
relied upon as indications of future performance. Further, it is likely that in
some future quarter, the Company's sales or operating results will be below the
expectations of public market analysts and investors. In such event, the price
of the Company's common stock could be materially adversely affected.

DEPENDENCE ON KEY PERSONNEL | The Company's success depends to a significant
degree upon the continuing contributions of its key management, sales,
professional services, customer support and product development personnel. In
particular, the Company would be materially adversely affected if it were to
lose the services of Gerard B. Moersdorf, Jr., Chief Executive Officer,
President and Chairman of the Board, who has provided significant leadership and
direction to the Company since its inception. The loss of other key management
or technical personnel could adversely affect the Company. The Company believes
that its future success will depend in large part upon its ability to attract
and retain highly skilled managerial, sales, professional services, customer
support and product development personnel. The Company has at times experienced
and continues to experience challenges in recruiting qualified personnel.
Competition for qualified personnel is intense, and there can be no assurance
that the Company will be successful in attracting and retaining such personnel.
Furthermore, competitors have in the past and may in the future attempt to
recruit the Company's employees. Failure to attract and retain key personnel
could have a material adverse effect on the Company's business, operating
results and financial condition.

LIMITED MARKET; VOLATILITY OF STOCK PRICE | Although the Company is listed on
the Nasdaq National Market, there can be no assurance that an active or liquid
trading market in the Company's common stock will continue. The market price of
the shares of the Company's common stock is likely to be highly volatile and may
be significantly affected by factors such as actual or anticipated fluctuations
in the Company's operating results, announcements of technological innovations,
new products or new contracts by the Company or its competitors, developments
with respect to copyrights or proprietary rights, general market conditions and
other factors. In addition, the stock market has from time to time experienced
significant price and volume fluctuations that have particularly affected the
market prices for the common stocks of technology companies. These types of
broad market fluctuations may adversely affect the market price of the Company's
common stock. In the past, following periods of volatility in the market price
of a company's securities, securities class action litigation has often been
initiated against such company. Such litigation could result in substantial
costs and a diversion of management's attention


--------------------------------------------------------------------------------

                                       7

<PAGE>

--------------------------------------------------------------------------------

and resources, which could have a material adverse effect on the Company's
business, operating results and financial condition.

ANTI-TAKEOVER PROVISIONS; CERTAIN PROVISIONS OF DELAWARE LAW; CERTIFICATE OF
INCORPORATION AND BY-LAWS | Certain provisions of Delaware law and the Company's
Certificate of Incorporation and By-Laws could have the effect of making it more
difficult for a third party to acquire, or of discouraging a third party from
attempting to acquire, control of the Company. The Company's By-Laws provide for
the Board of Directors to be divided into three classes of directors serving
staggered three-year terms. Such classification of the Board of Directors
expands the time required to change the composition of a majority of directors
and may tend to discourage a proxy contest or other takeover bid for the
Company. Additionally, the directors, executive officers and existing principal
stockholders of the Company and their affiliates beneficially own approximately
45.7% of the Company's common stock. Such concentration of ownership may have
the effect of delaying or preventing a change in control of the Company.

CONCENTRATION OF STOCK OWNERSHIP | The present directors, executive officers and
principal stockholders of the Company and their affiliates beneficially own
approximately 45.7% of the Company's common stock. In particular, Gerard B.
Moersdorf, Jr. and his former spouse own approximately 42.7% of the Company's
common stock. In addition, Mr. Moersdorf, Jr. has the right, by agreement, to
vote all of his former spouse's shares. As a result, these stockholders are able
to exercise significant influence over matters requiring stockholder approval,
including the election of directors and approval of significant corporate
transactions. Such concentration of ownership may have the effect of delaying or
preventing a change in control of the Company.

TERRORIST ACTS AND ACTS OF WAR | The terrorist attacks in New York and
Washington D.C. on September 11, 2001 have disrupted commerce throughout the
world and have intensified the uncertainty of the U.S. and global economies. The
long-term effects on the Company's business from these attacks are unknown. The
continued threat of terrorism and heightened security and military action in
response to this threat may cause further disruption to the economy. Any such
disruptions resulting in delays or cancellations of customer orders or the
manufacture or shipment of products could have a material adverse effect on the
Company's business, operating results and financial condition.


--------------------------------------------------------------------------------
         ITEM 2   | Properties
--------------------------------------------------------------------------------

The Company headquarters is a 115,000 square foot modern corporate office and
manufacturing facility in Dublin, Ohio. All of the Company's manufacturing,
administrative and research and development activities and a substantial portion
of its marketing activities are conducted at this location. The Company owns the
building and the approximately 33 acres of land on which it is situated. In
addition, the Company leases sales office facilities in Dallas, Texas; Denver,
Colorado; and Mexico City, Mexico.

--------------------------------------------------------------------------------
         ITEM 3   | Legal Proceedings
--------------------------------------------------------------------------------

The Company has no material legal proceedings against it, other than ordinary
litigation incidental to its business.

--------------------------------------------------------------------------------
         ITEM 4   | Submission of Matters to a Vote of Security Holders
--------------------------------------------------------------------------------

Not applicable.

--------------------------------------------------------------------------------

                                       8


<PAGE>


--------------------------------------------------------------------------------

PART II

--------------------------------------------------------------------------------
         ITEM 5   | Market for Registrant's Common Equity and Related
                    Stockholder Matters
--------------------------------------------------------------------------------

The Company's common stock is traded on the NASDAQ National Market. The
following table sets forth, for the periods indicated, the high and low prices
for the Company's common stock. The prices shown represent quotations between
dealers, without adjustment for retail markups, markdowns or commissions and may
not represent actual transactions.

        -------------------------------------------------------------------
                                      2002                    2001
        -------------------------------------------------------------------
                                  High      Low           High      Low
        -------------------------------------------------------------------
        Q1                       $6.30    $4.35         $15.50    $8.25
        -------------------------------------------------------------------
        Q2                       $5.02    $3.56         $16.74    $7.65
        -------------------------------------------------------------------
        Q3                       $4.40    $2.11         $10.45    $5.35
        -------------------------------------------------------------------
        Q4                       $3.74    $2.20         $ 9.49    $5.10
        -------------------------------------------------------------------

At March 7, 2003, the Company had 502 stockholders of record.

The Company has not paid any cash dividends and presently anticipates that all
of its future earnings will be retained for development of its business. The
Company does not anticipate paying cash dividends on its common stock in the
foreseeable future. The payment of any future dividends would be at the
discretion of the Company's Board of Directors and would depend upon, among
other things, future earnings, operations, capital requirements, the general
financial condition of the Company and general business conditions. In addition,
the Company's $10,000,000 credit facility prohibits the payment of cash
dividends.


--------------------------------------------------------------------------------

                                       9
<PAGE>

--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
         ITEM 6   | Selected Financial Data
--------------------------------------------------------------------------------


APPLIED INNOVATION INC.
SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,                                 2002           2001            2000           1999           1998
--------------------------------------------------------------------------------------------------------------------------
OPERATING DATA:
--------------------------------------------------------------------------------------------------------------------------
<S>                                               <C>            <C>            <C>             <C>            <C>
Sales                                             $42,961,011    $73,019,150    $116,103,392    $49,523,619    $53,627,516
Cost of sales                                      23,556,671     39,251,716      75,906,065     20,917,459     22,236,650
-------------------------------------------------------------    -----------    ------------    -----------    -----------
   Gross profit                                    19,404,340     33,767,434      40,197,327     28,606,160     31,390,866
Selling, general and administrative expenses       18,413,456     22,183,578      18,455,315     11,965,059     14,428,447
Research and development expenses                   7,084,646      9,648,898       8,176,622      7,479,496     11,979,875
Restructuring charges                               2,890,155        292,330              --             --      3,800,000
-------------------------------------------------------------    -----------    ------------    -----------    -----------
   Total operating expenses                        28,388,257     32,124,806      26,631,937     19,444,555     30,208,322
-------------------------------------------------------------    -----------    ------------    -----------    -----------
   Income (loss) from operations                   (8,983,917)     1,642,628      13,565,390      9,161,605      1,182,544
Interest income, net                                  593,290      1,389,517       1,374,546        992,665        614,705
Other income (expense), net                             3,847        (39,179)        (20,934)       (68,189)     1,050,403
-------------------------------------------------------------    -----------    ------------    -----------    -----------
   Total other income, net                            597,137      1,350,338       1,353,612        924,476      1,665,108
-------------------------------------------------------------    -----------    ------------    -----------    -----------
   Income (loss) before income taxes               (8,386,780)     2,992,966      14,919,002     10,086,081      2,847,652
Income taxes                                       (3,532,000)       755,000       4,774,000      3,081,000        538,000
-------------------------------------------------------------    -----------    ------------    -----------    -----------
   Net income (loss)                              $(4,854,780)   $ 2,237,966    $ 10,145,002    $ 7,005,081    $ 2,309,652
=============================================================    ===========    ============    ===========    ===========

Basic earnings (loss) per share                   $     (0.32)   $      0.14    $       0.65    $      0.45    $      0.15
=============================================================    ===========    ============    ===========    ===========
Diluted earnings (loss) per share                 $     (0.32)   $      0.14    $       0.63    $      0.45    $      0.14
=============================================================    ===========    ============    ===========    ===========

Shares used in computing basic earnings
(loss) per share                                   15,092,328     15,870,492      15,598,723     15,598,143     15,804,608
=============================================================    ===========    ============    ===========    ===========
Shares used in computing diluted earnings
(loss) per share                                   15,092,328     16,140,993      16,014,153     15,647,050     15,962,846
=============================================================    ===========    ============    ===========    ===========

--------------------------------------------------------------------------------------------------------------------------
BALANCE SHEET DATA:
--------------------------------------------------------------------------------------------------------------------------
Cash and short-term and non-current investments   $23,964,017    $28,616,130    $ 26,274,009    $19,070,826    $17,211,499
Net working capital                                25,127,859     31,803,653      35,204,228     22,851,872     22,173,337
Total assets                                       50,384,908     60,847,804      80,688,451     44,594,329     39,769,673
Stockholders' equity                               43,299,366     50,903,912      49,991,620     37,087,664     31,642,683
-------------------------------------------------------------    -----------    ------------    -----------    -----------
</TABLE>


See consolidated financial statements included in Item 8:
Financial Statements and Supplementary Data of this Form 10-K.


--------------------------------------------------------------------------------

                                       10

<PAGE>

--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
         ITEM 7   | Management's Discussion and Analysis of Financial Condition
                    and Results of Operations
--------------------------------------------------------------------------------

SAFE HARBOR STATEMENT

This Management's Discussion and Analysis of Financial Condition and Results of
Operations contains various forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended, which are intended to be covered by
the safe harbors created thereby. Those statements include, but are not limited
to, all statements regarding intent, beliefs, expectations, projections,
forecasts and plans of the Company and its management, and include any
statements regarding future sales and other results of operations, the
continuation or changes of historical trends, the sufficiency of Applied
Innovation's cash balances and cash generated from operating activities,
research and development efforts and the future of the telecommunications
industry or Applied Innovation's business. These forward-looking statements
involve numerous risks and uncertainties, including, without limitation,
fluctuations in demand for Applied Innovation's products and services,
competition, economic conditions, the fact that Applied Innovation may decide to
substantially increase research and development expenditures to meet the needs
of its business and customers, currently unforeseen circumstances which could
require the use of capital resources and the various risks inherent in Applied
Innovation's business and other risks and uncertainties detailed from time to
time in Applied Innovation's periodic reports filed with the Securities and
Exchange Commission. One or more of these factors have affected, and could in
the future affect, Applied Innovation's business and financial results in future
periods and could cause actual results to differ materially from plans and
projections. Therefore, there can be no assurance that the forward-looking
statements included herein will prove to be accurate. In light of the
significant uncertainties inherent in the forward-looking statements included
herein, the inclusion of such information should not be regarded as a
representation by Applied Innovation, or any other person, that the objectives
and plans of Applied Innovation will be achieved. All forward-looking statements
made herein are based on information presently available to the management of
Applied Innovation. Applied Innovation assumes no obligation to update any
forward-looking statements.

OVERVIEW

Applied Innovation Inc. (Applied Innovation, AI, or the Company) is a network
management solutions company that simplifies and enhances the operation of
complex, distributed voice and data networks. Building on a deep knowledge of
network architecture, elements and management, AI delivers unique hardware,
software and service solutions that provide greater connectivity, visibility and
control of network elements and the systems that support them. The Company's
largest customers are the four RBOCs, other large domestic and foreign phone
companies and certain CLECs.

The turmoil in the telecommunications market is well into its third year. Facing
declining revenues caused by weak demand for local lines and increased
competition from cable, wireless and satellite, incumbent telecommunications
service providers have repeatedly reduced planned capital spending, have
laid-off workers, and some have gone into bankruptcy proceedings and/or ceased
operations. The spending cutbacks have affected the Company through reduced
product orders, even by our largest and most financially secure RBOC customers.
Likewise, demand for the Company's installation services decreased substantially
during the last year.

Applied Innovation's products and services help its customers to improve network
quality and uptime and, at the same time, reduce network maintenance and repair
costs. As such, the Company's products and services are largely discretionary in
nature and its customers can temporarily postpone purchases. The Company
believes its customers will increase spending on its products and services once
the telecommunications market stabilizes so they can take advantage of the
network quality and cost-saving characteristics of the Company's offerings. The
Company does not believe it has lost any significant market share during the
last two years, despite the reduction in sales it has experienced.

Over the past two years, Applied Innovation responded to declining sales
prospects with a number of cost reduction actions, including a significant staff
reduction in the third quarter of 2002. Overall operating costs were reduced 50%
over the last two years through staffing reductions and other cost-cutting
efforts. As a result, operating costs were reduced to a level appropriate for
near-term sales prospects and, in the fourth quarter, resulted in the Company's
lowest quarterly operating expenses in four years.

Although industry conditions appear more stable than they did at this time last
year, announcements from large domestic service providers indicate that 2003
capital spending will be flat or slightly down compared to 2002. The Company
believes that in the long-term and possibly as early as the end of 2003,
domestic service providers will increase spending on network management
equipment and the Company's product sales will increase. The Company expects to
release new products in late 2003 which will enhance its ability to capitalize
on the eventual recovery in our core market.

To help diversify its customer base and sales prospects, the Company has been
aggressively expanding its international distribution capabilities over the last
two years and in 2001 completed an acquisition targeting the wireless network
management market. Additionally, the Company has modified its service sales
focus, targeting higher margin network management system (NMS) integration
projects, while decreasing its field installation activities. During 2003, the
Company will continue to pursue U.S. Government communication business, an
effort started in 2002 which resulted in several promising field trials in late
2002 and early 2003.

COMPARISON OF 2002 TO 2001

Sales for the year ended December 31, 2002 were $42,961,000, a 41% decrease from
the prior year's sales of $73,019,000. The prior year's sales included
$5,830,000 of integration sales from early 2001 which the Company identified at
the time as non-recurring in nature. Excluding the impact of the non-recurring
integration sales, sales decreased 36% from the previous year. The overall
decrease in sales was primarily attributable to the ongoing capital spending
reductions throughout the

--------------------------------------------------------------------------------


                                       11

<PAGE>

--------------------------------------------------------------------------------

telecommunications industry by the large domestic service providers, including
the RBOCs, who comprise the majority of the Company's sales.

Domestic sales decreased $32,251,000, or 47%, from the prior year and comprised
85% of total sales in 2002 versus 94% in 2001. The Company continued to target
international sales opportunities in 2002, resulting in international sales of
$6,391,000, a 52% increase over the previous year. As a percentage of total
sales, international sales increased to 15% in 2002 versus 6% in 2001.

Gross profit as a percentage of total sales was 45% for the year ended December
31, 2002 as compared to 46% in the prior year. Factors contributing to the
overall decrease were: (i) lower product margins as a result of additional
inventory charges taken during the year; (ii) lower sales volumes resulting in
lower coverage of fixed manufacturing costs; and (iii) changes in product sales
mix. Partially offsetting the decrease in product margins, however, were
increased services margins based primarily on changes in the mix of services
sales. The Company shifted its services focus towards higher margin NMS services
and away from lower margin installation services. Also offsetting the decline in
current year product margins was the lack of low margin integration sales in
2002.

The following table summarizes sales and gross profit for products, integration
and services:

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------
                                        Products     Integration        Services          Total
-----------------------------------------------------------------------------------------------
Year Ended December 31, 2002
-----------------------------------------------------------------------------------------------
<S>                                  <C>               <C>            <C>           <C>
Sales                                $35,992,000              --      $6,969,000    $42,961,000
Gross profit                          16,775,000              --       2,629,000     19,404,000
Gross profit %                               47%              --             38%            45%
------------------------------------------------       ---------     -----------    -----------

-----------------------------------------------------------------------------------------------
Year Ended December 31, 2001
-----------------------------------------------------------------------------------------------
Sales                                $52,841,000      $5,830,000     $14,348,000    $73,019,000
Gross profit                          28,190,000         866,000       4,711,000     33,767,000
Gross profit %                               53%             15%             33%            46%
------------------------------------------------      ----------     -----------    -----------
</TABLE>

Product sales of $35,992,000 were 84% of total sales in 2002, versus product
sales of $52,841,000, or 72%, of total sales in 2001. This represented a 32%
decrease in product sales in 2002 from 2001, due largely to the industry-wide
reduction in capital spending. Product sales include revenues from the sales of
AIswitch(TM), AIscout(TM) and other products, as well as third-party hardware
and software licensing revenues.

Gross profit on product sales was 47% for the year ended December 31, 2002
compared to 53% for the prior year. Product sales margins were negatively
impacted by several factors during 2002. First, overall decreased sales volumes
resulted in lower product margins due to lower absorption of certain fixed
manufacturing costs. Second, product sales in 2002 included increased sales of
third-party equipment associated with NMS deployments. Sales of such third-party
equipment generally yield lower margins than the Company's core products. Third,
the Company recorded inventory charges in excess of $2,000,000 during 2002 which
were charged to cost of goods sold. The charges related primarily to the
Company's discontinuance of its optical transmission product line based on the
lack of investment in new optical network capacity by the major service
providers. The charges also related to potential excess inventory and market
price exposure associated with certain other materials in inventory.

The Company had no integration sales in 2002, compared to $5,830,000, or 8% of
total sales in 2001. The integration sales in 2001, consisting of turnkey
integrated systems and including a significant amount of third-party products
integrated with the Company's products, were attributable to the sale of an
integrated solution to one large customer and were identified as non-recurring
at the time of sale. Since the first quarter of 2001, the Company has had no
additional integration sales.

Services sales of $6,969,000 were 16% of total 2002 sales, versus services sales
of $14,348,000, or 20%, of total 2001 sales. The 51% decrease in services sales
from 2001 was primarily attributable to decreased demand for installation
services, consistent with the overall decrease in product sales from the prior
year and consistent with the overall reduced spending in the industry. The
Company's NMS consulting and services sales increased during the year while
sales from extended maintenance agreements were consistent with the prior year.
Services sales include revenues from network planning and design, installation,
project management, engineering services, training and maintenance.

Gross profit on services sales was 38% for the year ended December 31, 2002
compared to 33% for the prior year. The increase in gross profit on service
sales in 2002 was primarily attributable to the reduction of lower margin
installation work, the reduction in the number of installation technicians as
part of the cost-cutting efforts and an increased mix of higher margin NMS
services sales.

Because of the Company's concentration of sales to RBOCs, long distance phone
companies and large CLECs, a small number of customers have historically
comprised a substantial portion of the Company's sales. Sales to three customers
comprised 75% of sales in 2002, with each contributing between 14% and 31% of
sales. In 2001, sales to four customers comprised 66% of sales. Because of the
direct correlation and relative importance of these significant customers'
capital spending patterns to the Company, deviations from historical spending
levels could significantly impact the Company's future operating results.

Selling, general and administrative (SG&A) expenses decreased to $18,413,000 in
2002 from $22,184,000 in 2001. As a percentage of total sales, this represented
43% in 2002 and 30% in 2001. The decrease in SG&A spending was primarily
attributable to overall reductions in staffing (including the elimination of
five senior management positions), bonuses and

--------------------------------------------------------------------------------

                                       12

<PAGE>

--------------------------------------------------------------------------------

commissions, advertising and trade show expenditures, travel expenses and other
discretionary spending. The increase in SG&A spending as a percentage of total
sales was primarily a result of lower total sales in 2002 than in 2001. The
Company expects total 2003 SG&A expenses to decrease compared to 2002, primarily
as a result of the reduced staffing and other cost-saving measures enacted.
Likewise, SG&A spending as a percentage of total sales is expected to decline in
2003 as compared to 2002.

Research and development (R&D) expenses were $7,085,000 in 2002 and $9,649,000
in 2001. As a percentage of total sales, this represented 16% for 2002 and 13%
for 2001. The decrease in R&D expenses was primarily attributable to decreased
staffing costs and reduced expenditures on hardware, materials and parts, as
well as reductions in other discretionary spending. The Company narrowed its R&D
focus to concentrate more on those projects in its core telecommunications
market with the greatest strategic value and market potential. The increase in
R&D expenses as a percentage of total sales was primarily a result of lower
total sales in 2002 than in 2001. While the Company plans to continue to invest
in product enhancements and new product development, it expects 2003 R&D
spending to decrease compared to 2002, both in absolute dollars and as a
percentage of total sales.

The Company recorded non-recurring charges to operating expenses of $2,890,000
during 2002 to account for total workforce reductions of approximately 150
employees, throughout all departments. The restructuring charges were incurred
as a result of two restructuring events in 2002. The first restructuring,
occurring in the first quarter of 2002, resulted in total charges of $408,000
relating primarily to severance and fringe benefits associated with the
termination of approximately 50 employees. The second restructuring occurred in
the third quarter of 2002 and resulted in total charges of $2,482,000. Those
charges related to severance and fringe benefit costs of terminating
approximately 100 employees, as well as charges related to excess equipment and
leased offices. The restructuring charges are shown as a separate line item on
the consolidated statements of operations. As of December 31, 2002, $583,000 of
such costs remained to be paid. The remaining accrued restructuring costs are
expected to be paid in 2003, with the exception of $65,000 related to lease
payments extending to 2005. In 2001, the Company recorded restructuring charges
of $292,000 related primarily to severance and fringe benefit costs associated
with the termination of approximately 40 employees, throughout all departments.
No additional workforce reductions or other cost reduction actions are currently
planned, however the Company will continue to monitor industry conditions and
will take corrective action as industry conditions change.

As a result of the above factors, the Company recorded a loss from operations of
$8,984,000 in 2002 compared to income from operations of $1,643,000 in 2001.
Loss from operations represented 21% of sales in 2002, compared to income of 2%
of sales in 2001.

Total other income, net decreased to $597,000 in 2002 versus $1,350,000 in 2001.
The overall decrease resulted from lower interest income due to lower cash and
investment balances in 2002 than in 2001, as well as lower average yields on
those balances.

Loss before income taxes in 2002 was $8,387,000, or 20% of sales, compared to
income before income taxes of $2,993,000, or 4% in 2001.

The Company's effective income tax benefit rate was 42% in 2002 compared to an
effective tax expense rate of 25% in 2001. The increase in the effective income
tax benefit rate in 2002 was due primarily to increased benefits associated with
research and experimentation credits, the Company's foreign sales corporation
and state net operating losses.

Net loss was $4,855,000, or $0.32 diluted loss per share, in 2002 versus net
income of $2,238,000, or $0.14 diluted earnings per share, in 2001. The diluted
weighted-average number of shares outstanding was 15,092,000 for 2002 compared
to 16,141,000 for 2001. The decrease in the weighted-average number of shares
outstanding was primarily due to the Company's stock repurchase program. During
the twelve-month program, which ended in September 2002, the Company repurchased
1,011,000 shares of its common stock.

Total assets decreased from $60,848,000 at December 31, 2001 to $50,385,000 at
December 31, 2002, a decrease of $10,463,000. Total cash and investments
decreased $4,652,000 due primarily to funding of operations, which consumed cash
of $948,000, stock repurchases of $2,835,000 and purchases of machinery and
equipment of $961,000. Net accounts receivable decreased $2,457,000 as a result
of overall lower sales volume and increased collection efforts. Net inventory
decreased $3,912,000, relating primarily to inventory charges of over $2,000,000
which the Company recorded in 2002, the Company's efforts to reduce its working
capital investment, as well as overall lower sales volume. Net property plant
and equipment decreased $1,030,000 as a result of current year purchases offset
by depreciation expense and asset disposals. Partially offsetting those
decreases was the increase in income taxes receivable of $2,176,000 due to tax
refunds resulting from the current year operating losses.

Total liabilities decreased from $9,944,000 at December 31, 2001 to $7,086,000
at December 31, 2002. The largest portion of that total decrease of $2,858,000
was attributable to deferred revenue. Deferred revenue decreased $1,588,000 as a
result of the timing of several large customer maintenance and support
agreements entered into in late 2001. Such agreements are initially recorded as
deferred revenue and the corresponding revenue is then recognized over the terms
of the related agreements. Accrued expenses decreased $1,132,000 from the prior
year due primarily to timing considerations and overall lower business volume,
partially offset by increased restructuring accruals.

Total stockholders' equity decreased $7,605,000 primarily as a result of the
current year net loss of $4,855,000 and the Company's repurchase of common stock
in 2002 totaling $2,835,000.

COMPARISON OF 2001 TO 2000

Sales for the year ended December 31, 2001 were $73,019,000, a 37% decrease from
the prior year's sales of $116,103,000. Excluding integration sales of
$5,830,000 in 2001 and $45,644,000 in 2000, which were almost entirely from one
CLEC customer and were identified as non-recurring in nature, annual sales would
have been $67,189,000 and $70,459,000 in 2001 and 2000, respectively. Excluding
the impact of the non-recurring revenue in both years, annual sales in 2001
decreased $3,270,000, or 5%, from the prior year. The decrease in
non-integration sales was due to reduced spending by CLEC customers


--------------------------------------------------------------------------------

                                       13

<PAGE>

--------------------------------------------------------------------------------

throughout the year and reduced spending by larger service providers, including
all of our RBOC customers, in the second half of the year.

Gross profit as a percentage of total sales was 46% for the year ended December
31, 2001 as compared to 35% in the prior year. The overall increase in gross
profit percentage was primarily attributable to a change in the overall sales
mix as integration sales, which carry a lower gross margin than products and
services sales, represented 8% of total sales versus 39% in 2000.

The following table summarizes sales and gross profit for products, integration
and services:

<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------
                                       Products         Integration        Services             Total
-----------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2001
-----------------------------------------------------------------------------------------------------
<S>                                 <C>                 <C>             <C>              <C>
Sales                               $52,841,000         $ 5,830,000     $14,348,000      $ 73,019,000
Gross profit                         28,190,000             866,000       4,711,000        33,767,000
Gross profit %                              53%                 15%             33%               46%
-----------------------------------------------         -----------     -----------      ------------

-----------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2000
-----------------------------------------------------------------------------------------------------
Sales                               $64,030,000         $45,644,000     $ 6,429,000      $116,103,000
Gross profit                         34,740,000           2,682,000       2,775,000        40,197,000
Gross profit %                              54%                  6%             43%               35%
-----------------------------------------------         -----------     -----------      ------------
</TABLE>

Product sales of $52,841,000 were 72% of total sales in 2001, versus product
sales of $64,030,000, or 55%, of total sales in 2000. This represented a 17%
decrease in product sales in 2001 from 2000, due largely to the industry-wide
reduction in capital spending, particularly in the second half of 2001. Product
sales comprised a larger percentage of total sales in 2001 as compared to 2000
because of the significant decrease in integration sales in 2001. Product sales
include revenues from the sales of AIswitch, AIscout and other products, as well
as software licensing revenues.

Gross profit on product sales was 53% for the year ended December 31, 2001
compared to 54% for the prior year. Product sales margins were generally
consistent between years. However, gross profit in 2001 was negatively impacted
by inventory charges relating to the establishment of inventory reserves for
optical and other component inventory. Due to long lead times and high market
demand for optical components, the Company placed orders in late 2000 and early
2001 for optical component inventory to support anticipated sales of
LuxConnect(TM) and other optical products. Given the continued uncertain market
conditions for carriers' deployment of new optical network capacity, as well as
declining market prices for optical and other components, the Company recorded
inventory charges of $1,700,000 during 2001 to cover potential excess inventory
and market price changes. These amounts were charged to cost of goods sold.

Integration sales of $5,830,000 were 8% of total sales in 2001, compared to
$45,644,000, or 39% of total sales in 2000. The integration sales in 2001 and
2000, consisting of turnkey integrated systems and including a significant
amount of third-party products integrated with the Company's products, were
attributable to the sale of an integrated solution to one large customer. Since
the first quarter of 2001, the Company has had no additional integration sales.

Gross profit on integration sales was 15% for the year ended December 31, 2001,
compared to 6% in the prior year. Since the integration sales included a
significant amount of third-party equipment, the gross profit margin was
significantly lower than margins on products or services sales. Gross profit in
2001 was higher than the prior year because 2001 integration sales included a
higher proportion of AI equipment and labor, which yields higher gross margins
than third-party equipment.

Services sales of $14,348,000 were 20% of total 2001 sales, versus services
sales of $6,429,000, or 6% of total 2000 sales. This represented a 123% increase
in services sales from 2000. The increase in services sales was primarily
attributed to the continued expansion of the Company's installation services
compared to the prior year for a number of customers, as well as project
management services for one customer. Services sales include revenues from
network planning and design, installation, project management, engineering
services, training and maintenance.

Gross profit on services sales was 33% for the year ended December 31, 2001
compared to 43% for the prior year. The decrease in gross profit on service
sales in 2001 was primarily attributable to a lower mix of maintenance revenues,
which generally have higher margins than revenues from other services, as well
as decreased utilization of services personnel in the latter half of 2001 as
overall spending in the telecommunications industry slowed.

Because of the Company's concentration of sales to RBOCs, long distance phone
companies and large CLECs, a small number of customers have historically
comprised a substantial portion of the Company's sales. Sales to four customers
comprised 66% of sales in 2001, with each contributing between 13% and 23% of
sales. In 2000, sales to two customers comprised 61% of sales.

SG&A expenses increased to $22,184,000 in 2001 from $18,455,000 in 2000. As a
percentage of total sales, this represented 30% in 2001 and 16% in 2000. The
increase in SG&A spending was primarily attributable to increased staffing,
additional personnel and costs associated with acquisition of certain assets of
the remote network management systems and information collection device business
of Badger Technology, Inc. (Badger), increased international travel and selling
expenses and higher insurance costs. In addition, SG&A expenses as a percentage
of total sales increased due to the decrease in integration sales in the current
year as compared to the prior year.

R&D expenses were $9,649,000 in 2001 and $8,177,000 in 2000. As a percentage of
total sales, this represented 13% for 2001 and 7% for 2000. The increase in R&D
expenses was primarily attributable to increased staffing costs to support
product

--------------------------------------------------------------------------------

                                       14


<PAGE>

--------------------------------------------------------------------------------

development associated with international and wireless opportunities. The
decrease in integration sales in 2001 as compared to 2000 also contributed to
the increase in R&D expenses as a percentage of total sales.

The Company recorded a non-recurring charge to operating expenses of $292,000 in
the second quarter of 2001 to account for an approximate 15% reduction in
workforce, or approximately 40 employees, throughout all departments. This
restructuring charge is separately stated on the consolidated statements of
operations and reflects estimated severance and fringe benefit costs associated
with the termination of employees. The Company paid out all such costs as of
December 31, 2001.

As a result of the above factors, income from operations decreased to $1,643,000
in 2001 from $13,565,000 in 2000. Income from operations represented 2% of sales
in 2001, compared to 12% of sales in 2000.

Income before income taxes in 2001 was $2,993,000, or 4% of sales, compared to
$14,919,000, or 13% in 2000.

The Company's effective income tax rate was 25% in 2001 compared to 32% in 2000.
The decrease in the effective income tax rate in 2001 was due primarily to
research and experimentation credits. The credits had a more significant impact
on the effective income tax rate in 2001 because of decreased income before
income taxes in 2001 as compared to 2000.

Net income was $2,238,000, or $0.14 diluted earnings per share, in 2001 versus
net income of $10,145,000, or $0.63 diluted earnings per share, in 2000. The
diluted weighted-average number of shares outstanding was 16,141,000 for 2001
compared to 16,014,000 for 2000.

LIQUIDITY AND CAPITAL RESOURCES

The Company had $23,964,000 of cash and cash equivalents and short- and
long-term investments at December 31, 2002, a decrease of $4,652,000 from the
December 31, 2001 balance of $28,616,000. Despite the net loss of $4,855,000 in
2002, operating activities used only $948,000 of cash due to certain non-cash
operating expenses and favorable changes in working capital. Operating expenses
not requiring the use of cash included inventory charges of $2,151,000,
depreciation and amortization of $1,925,000 and loss on disposal of assets
primarily related to the restructuring of $242,000. Significant changes in
working capital which provided cash included: decreased accounts receivable of
$2,457,000 and decreased inventory of $1,761,000 (net of non-cash charges),
offset by increased income taxes receivable of $2,176,000; decreased deferred
revenue of $1,588,000; and decreased accrued expenses of $1,186,000. Investing
activities in 2002 used $3,057,000 in cash, including $961,000 for equipment
purchases to support operations and $2,130,000 for investment securities
purchases (net of maturities and sales). Additionally, financing activities used
$2,708,000 of cash in 2002, largely attributable to the Company repurchasing
$2,835,000 of its common stock.

Net working capital was $25,128,000 at December 31, 2002 compared to $31,804,000
at December 31, 2001. At December 31, 2002, the current ratio was 5.0:1 and the
Company's only debt outstanding was a $750,000 note payable issued in
conjunction with the Badger asset acquisition in 2001. The note payable bears
interest at an annual rate of 8%, with interest payments due semi-annually and
principal due at maturity in August 2004.

At the April 25, 2002 Annual Meeting of Stockholders, the Applied Innovation
Inc. Employee Stock Purchase Plan (the ESPP) was approved and adopted. The ESPP
authorizes the Company to issue up to 500,000 shares of common stock to eligible
employees, as defined. The ESPP has semi-annual offering periods commencing
January 1 and July 1. During each offering period, eligible employees may
purchase shares at a price equal to 90% of fair market value on the first or
last business day of the offering period, whichever is lower. As of December 31,
2002, no shares of common stock were issued pursuant to the ESPP. On January 3,
2003, the Company issued 24,318 shares of stock at a price of $2.73 per share
based on employee payroll deductions for the six-month period ending December
31, 2002.

On August 7, 2002, the Company entered into an agreement with The Huntington
National Bank (the Bank) for a credit facility. The term of the credit facility
is 364 days and provides for a line of credit up to $10,000,000, with interest
payable monthly and principal due at maturity. Borrowings on the line are
subject to a borrowing base limited to $5,000,000 on real estate, plus 75% of
eligible accounts receivable and 40% of eligible inventory, as defined in the
agreement. Borrowings bear interest at the London Interbank Offered Rate (LIBOR)
plus 1.65%, or the Bank's Prime Commercial Rate less 1.00%, at the option of the
Company. Borrowings are collateralized by the Company's receivables, inventory,
certain investments, equipment, real estate and general intangibles. The credit
facility contains certain financial covenants, including, but not limited to,
restrictions on the payment of dividends, minimum tangible net worth and a
minimum liquidity ratio. At December 31, 2002, the Company had no outstanding
borrowings under this facility and was in compliance with all covenants.

The Company believes that its existing cash, cash equivalents, investments, cash
to be generated from future operations and available credit facility will
provide sufficient capital to meet the business needs of the Company through the
end of 2003. In addition, the Company believes it could generate additional
funding through issuance of debt or equity or through the sale of land if the
Company's working capital needs significantly increase due to circumstances such
as sustained weakness in the telecommunications industry resulting in decreased
demand for the Company's products and services and operating losses; faster than
expected growth resulting in increased accounts receivable and inventory;
additional investment or acquisition activity; or significant research and
development efforts. However, there can be no assurance that additional
financing will be available on terms favorable to the Company or at all.

APPLICATION OF CRITICAL ACCOUNTING POLICIES

The Company applies certain accounting policies, which are critical in
understanding the Company's results of operations and the information presented
in the consolidated financial statements. Because these policies require
judgment and involve choices among alternatives, reported results could vary
materially if different assumptions or policies were utilized. Critical
accounting policies and estimates include:

REVENUE RECOGNITION | Revenue is generally recognized on product and integration
sales as products are delivered and ownership and risk of loss are transferred.
In certain limited situations, customers may request that products are built and

--------------------------------------------------------------------------------

                                       15

<PAGE>

--------------------------------------------------------------------------------

prepared for shipment but held temporarily by the Company on the customer's
behalf. In those instances, revenue is recognized when all other terms and
obligations of the sale are met, including transfer of ownership and risk of
loss.

The Company also derives revenue from the sale of network management system
projects that may include a combination of the following multiple elements:
internally developed software; resale of third-party software and related
computer equipment; installation, training and consulting services; and
Company-provided and third-party maintenance and support agreements for the
software and equipment. In a multiple element arrangement, revenue from the
individual elements is unbundled based on their relative fair values and
recognized as follows:

     *    Software license fee revenue on internally developed software is
          recognized in accordance with the following four elements of software
          revenue recognition: (1) persuasive evidence of an arrangement exists,
          (2) delivery has occurred, (3) the related fee is fixed and
          determinable, and (4) collectibility is probable. 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 recorded
          upon delivery of the maintenance agreement.

     *    Revenue from installation, training and consulting services is
          recognized as the services are delivered or upon project completion.

     *    Revenue from maintenance and support agreements is recognized
          straight-line over the term of the related agreement.

The Company also generates revenue from the activities of its services division.
Installation service projects are typically short-term projects that are billed
and accepted by the customer on a project-by-project basis, with revenue
recognized upon project completion. Revenues from maintenance contracts are
recognized straight-line over the related maintenance period.

SALES RETURN ALLOWANCES | Other than issues involving warranty claims, customers
generally do not have the right to return products. However, in certain limited
circumstances as defined in contracts, customers are permitted to return
products. The Company establishes a sales return allowance, when necessary,
reflecting its estimate of such product returns. The estimate is based on a
number of factors, including the contract provisions, the Company's
understanding of each customer's forecasted usage of previously purchased
products and the estimated likelihood that customers will return products. At
December 31, 2002 and 2001, the Company has no sales return allowances recorded.

ALLOWANCE FOR DOUBTFUL ACCOUNTS | The Company sells to its customers on credit,
generally requiring payment within thirty days from delivery. Since the
Company's customer base is generally comprised of very large, well-funded
service providers, the Company's historical credit risk has been very low.
However, the Company does establish allowances against accounts receivable for
potentially uncollectible amounts. The Company estimates necessary allowances
based on its analysis of customers' outstanding receivables at the individual
invoice level, the customers' payment history and any other known factors
concerning their current financial condition and ability to pay. After the
Company has exhausted its collection efforts and determined that amounts are
uncollectible at the individual invoice level, such amounts are charged off
against the allowance. To the extent any customers unexpectedly become insolvent
or unable to pay amounts due, the allowance estimates may be incorrect. Over the
last twelve to twenty-four months, many telecommunications service providers,
including some that have historically been customers of the Company, have
experienced financial challenges. The Company did not have any significant
exposure to bankruptcies among our customers. Further, the Company has not
historically provided vendor financing to its customers, and currently has no
plans to do so.

INVENTORY | The Company records inventory utilizing standard costs, which
approximate actual costs on a first-in, first-out basis. Additionally, the
Company carries inventory at the lower of cost or market. The Company
periodically estimates its necessary reserve for inventory obsolescence to
ensure inventory balances are properly stated. Such estimates are based on
inventory quantities on hand, sales forecasts for particular products, overall
industry trends that may affect individual product lines, as well as
fluctuations in component prices from suppliers. Continued weak demand and
falling component prices could impact the valuation of the Company's inventory.

INTANGIBLE ASSETS AND GOODWILL | The Company has certain intangible assets
resulting from business acquisitions that are recorded at cost. These intangible
assets are amortized straight-line over their respective estimated economic
lives, generally up to three years, and are reviewed for impairment under
certain circumstances. Goodwill, representing the excess of purchase price over
the fair value of the net assets acquired, is not subject to periodic
amortization. Goodwill is reviewed for impairment at least annually and may be
reviewed more frequently if certain events occur or circumstances change.

WARRANTY | The Company generally warrants its products for a minimum of one year
after sale. Based primarily on historical experience and any known warranty
issues with existing products, the Company estimates its expected future
warranty costs and accrues such costs at the time of sale. Warranty costs
generally consist of labor and materials to repair defective parts, replacement
parts, shipping costs to replace materials, and labor and travel costs
associated with customer site visits to repair products or correct prior service
work. The Company's overall warranty costs have been decreasing over the past
several years, primarily due to improved product quality. However, as the
Company introduces new products using new technology or if defects are found in
widely distributed products, such costs could increase in the future.

--------------------------------------------------------------------------------

                                       16

<PAGE>

--------------------------------------------------------------------------------

INCOME TAXES | The Company utilizes the asset and liability method in accounting
for income taxes. Deferred tax assets and liabilities are recognized for the
future tax consequences attributable to differences between financial statement
carrying amounts of assets and liabilities and respective tax bases. The
Company's provision for income taxes involves estimates of taxable income for
federal, state and local purposes in various taxing jurisdictions as well as
estimated research and experimentation credits and estimated credits related to
foreign sales, all of which could be subject to change in the event of an audit
by the Internal Revenue Service.

STOCK-BASED COMPENSATION | Under various stock option plans, the Company has
issued stock options to employees and members of the Company's Board of
Directors. The Company applies the intrinsic value-based method of accounting
for its fixed plan stock options and therefore must record compensation expense
for any options granted with an exercise price less than the current market
price at the date of grant. Because the Company has not granted any options with
exercise prices less than market prices at the date of grant, the Company has
not recorded any compensation expense in its consolidated statements of
operations. Had the Company accounted for its stock options using the Black
Scholes option-pricing model, a fair value-based method, rather than an
intrinsic value-based method, the Company would have recognized additional
compensation expense, net of related tax effects, of approximately $1,736,000,
$2,617,000, and $1,297,000 for the years ended December 31, 2002, 2001 and 2000,
respectively.

USE OF ESTIMATES | In addition to the above critical accounting policies, the
Company utilizes certain estimates in preparing its consolidated financial
statements. Because these estimates are inherently subjective and affect the
reported amounts of assets and liabilities as well as contingent assets and
liabilities, different estimates would yield different results as reported in
the consolidated financial statements. Areas that involve utilization of
significant estimates include accounting for doubtful accounts, inventory
obsolescence, estimated useful lives of property, plant and equipment and
intangible assets, depreciation and amortization, sales returns, warranty costs,
income taxes and contingencies.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

The Company is obligated over the next four years for office space under various
operating leases. Future minimum lease payments, net of estimated sublease
payments under these leases, are $143,000 in 2003, $78,000 in 2004, $75,000 in
2005 and $23,000 in 2006.

The Company's note payable of $750,000 is due in August 2004. Also, related to
the Badger acquisition, the Company may make contingent payments of up to
$750,000 based on certain product sales over the next two years.

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

In June 2001, the Financial Accounting Standards Board issued Statement No. 143,
"Accounting for Asset Retirement Obligations." Statement 143 requires the
Company to record the fair value of an asset retirement obligation as a
liability in the period in which it incurs a legal obligation associated with
the retirement of tangible long lived assets that result from the acquisition,
construction, development, and/or normal use of the assets. The Company also
records a corresponding asset that is depreciated over the life of the asset.
Subsequent to the initial measurement of the asset retirement obligation, the
obligation will be adjusted at the end of each period to reflect the passage of
time and changes in the estimated future cash flows underlying the obligation.
The Company adopted Statement 143 on January 1, 2003. Statement 143 is not
expected to have a material effect on the Company's financial position, results
of operations or cash flows.

In June 2002, the Financial Accounting Standards Board issued Statement No. 146,
"Accounting for Costs Associated with Exit or Disposal Activities." Statement
146 addresses financial accounting and reporting for costs associated with exit
or disposal activities by requiring that expenses related to the exit of an
activity or disposal of long-lived assets will be recorded when they are
incurred and measurable. Prior to Statement 146, these charges were accrued at
the time of commitment to exit or dispose of an activity. The Company adopted
Statement No. 146 on January 1, 2003, and it is not expected to have a material
effect on the Company's financial position, results of operations or cash flows.


--------------------------------------------------------------------------------
        ITEM 7A   | Quantitative and Qualitative Disclosures About Market Risk
--------------------------------------------------------------------------------

The Company does not have any material exposure to interest rate changes,
commodity price changes, foreign currency fluctuations, or similar market risks.
The Company invests in various debt obligations, primarily U.S. government and
agency obligations and high quality commercial paper, with maturities generally
less than three years. Although the yields on such investments are subject to
changes in interest rates, the potential impact to the Company and its future
earnings as a result of customary interest rate fluctuations is immaterial.
Furthermore, the Company has not entered into any derivative contracts. Related
to the Badger acquisition, the Company has a $750,000 note payable, bearing
interest at a fixed rate of 8% annually and due in August 2004.

--------------------------------------------------------------------------------

                                       17

<PAGE>

--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
         ITEM 8   | Financial Statements and Supplementary Data
--------------------------------------------------------------------------------

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Applied Innovation Inc.:

We have audited the accompanying consolidated balance sheets of Applied
Innovation Inc. and subsidiaries as of December 31, 2002 and 2001, and the
related consolidated statements of operations, stockholders' equity, and cash
flows for each of the years in the three-year period ended December 31, 2002.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audits to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Applied Innovation
Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2002, in conformity with accounting principles generally
accepted in the United States of America.



/s/ KPMG LLP

Columbus, Ohio
January 24, 2003

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                                       18

<PAGE>

--------------------------------------------------------------------------------


APPLIED INNOVATION INC.
CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
DECEMBER 31,                                                                                         2002             2001
--------------------------------------------------------------------------------------------------------------------------
ASSETS
--------------------------------------------------------------------------------------------------------------------------
<S>                                                                                           <C>              <C>
Current assets:
  Cash and cash equivalents                                                                   $ 8,986,292      $15,698,594
  Short term investments                                                                        8,028,510        6,067,770
  Accounts receivable, net of allowance of $430,000 in 2002 and $475,000 in 2001                5,240,248        7,697,003
  Inventory, net                                                                                3,409,842        7,322,316
  Income taxes receivable                                                                       3,079,534          903,269
  Other current assets                                                                            668,975          630,593
  Deferred income taxes                                                                         2,050,000        2,678,000
---------------------------------------------------------------------------------------------------------      -----------
        Total current assets                                                                   31,463,401       40,997,545
Property, plant and equipment, net                                                              7,793,014        8,823,355
Investments                                                                                     6,949,215        6,849,766
Intangible assets, net of accumulated amortization of $423,750 in 2002 and $213,750 in 2001       341,250          551,250
Goodwill                                                                                        3,477,001        3,423,201
Deferred income taxes                                                                             226,000           33,000
Other assets                                                                                      135,027          169,687
---------------------------------------------------------------------------------------------------------      -----------
                                                                                              $50,384,908      $60,847,804
=========================================================================================================      ===========

--------------------------------------------------------------------------------------------------------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
--------------------------------------------------------------------------------------------------------------------------
Current liabilities:
  Accounts payable                                                                            $ 1,621,148      $ 1,759,686
  Accrued expenses:
     Warranty                                                                                     542,651          819,166
     Payroll and related expenses                                                                 647,149        1,512,229
     Restructuring                                                                                582,811            6,696
     Other accrued expenses                                                                     1,039,227        1,606,043
  Deferred revenue                                                                              1,902,556        3,490,072
-----------------------------------------------------------------------------------------------------------    -----------
        Total current liabilities                                                               6,335,542        9,193,892
Note payable                                                                                      750,000          750,000
-----------------------------------------------------------------------------------------------------------    -----------
        Total liabilities                                                                       7,085,542        9,943,892
-----------------------------------------------------------------------------------------------------------    -----------

--------------------------------------------------------------------------------------------------------------------------
STOCKHOLDERS' 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;                                     149,507          155,129
  issued and outstanding 14,950,749 shares in 2002 and 15,512,899 shares in 2001
  Additional paid-in capital                                                                    5,845,740        8,659,450
  Note receivable for common stock                                                               (382,783)        (494,871)
  Retained earnings                                                                            37,680,937       42,535,717
  Accumulated other comprehensive gain, net                                                         5,965           48,487
---------------------------------------------------------------------------------------------------------      -----------
        Total stockholders' equity                                                             43,299,366       50,903,912
---------------------------------------------------------------------------------------------------------      -----------
                                                                                              $50,384,908      $60,847,804
=========================================================================================================      ===========
</TABLE>

See accompanying notes to consolidated financial statements.

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                                       19

<PAGE>

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APPLIED INNOVATION INC.
CONSOLIDATED STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
-----------------------------------------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31,                                                       2002          2001            2000
-----------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>           <C>            <C>
Sales:
  Products and integration                                              $35,992,455   $58,670,859    $109,673,655
  Services                                                                6,968,556    14,348,291       6,429,737
-----------------------------------------------------------------------------------   -----------    ------------
  Total sales                                                            42,961,011    73,019,150    $116,103,392
-----------------------------------------------------------------------------------   -----------    ------------
Cost of sales:
  Cost of sales - products and integration                               19,216,831    29,614,268      72,252,187
  Cost of sales - services                                                4,339,840     9,637,448       3,653,878
-----------------------------------------------------------------------------------   -----------    ------------
  Total cost of sales                                                    23,556,671    39,251,716      75,906,065
-----------------------------------------------------------------------------------   -----------    ------------
  Gross profit                                                           19,404,340    33,767,434      40,197,327
Operating expenses:
  Selling, general and administrative                                    18,413,456    22,183,578      18,455,315
  Research and development                                                7,084,646     9,648,898       8,176,622
  Restructuring charges                                                   2,890,155       292,330               -
-----------------------------------------------------------------------------------   -----------    ------------
  Total operating expenses                                               28,388,257    32,124,806      26,631,937
-----------------------------------------------------------------------------------   -----------    ------------
  (Loss) income from operations                                          (8,983,917)    1,642,628      13,565,390
Other income (expense):
  Interest income, net                                                      593,290     1,389,517       1,374,546
  Other income (expense), net                                                 3,847       (39,179)        (20,934)
-----------------------------------------------------------------------------------   -----------    ------------
  Total other income, net                                                   597,137     1,350,338       1,353,612
-----------------------------------------------------------------------------------   -----------    ------------
  (Loss) income before income taxes                                      (8,386,780)    2,992,966      14,919,002
Income taxes                                                             (3,532,000)      755,000       4,774,000
-----------------------------------------------------------------------------------   -----------    ------------
  Net (loss) income                                                     $(4,854,780)  $ 2,237,966    $ 10,145,002
===================================================================================   ===========    ============

-----------------------------------------------------------------------------------   -----------    ------------
(Loss) earnings per share:
  Basic (loss) earnings per share                                       $     (0.32)  $      0.14    $       0.65
  Diluted (loss) earnings per share                                     $     (0.32)  $      0.14    $       0.63
-----------------------------------------------------------------------------------   -----------    ------------

-----------------------------------------------------------------------------------   -----------    ------------
Weighted-average shares outstanding for basic (loss) earnings
per share                                                                15,092,328    15,870,492      15,598,723
-----------------------------------------------------------------------------------   -----------    ------------

-----------------------------------------------------------------------------------   -----------    ------------
Weighted-average shares outstanding for diluted (loss) earnings
per share                                                                15,092,328    16,140,993      16,014,153
-----------------------------------------------------------------------------------   -----------    ------------
</TABLE>


See accompanying notes to consolidated financial statements.

--------------------------------------------------------------------------------

                                       20

<PAGE>

--------------------------------------------------------------------------------


APPLIED INNOVATION INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

<Table>
<Caption>
-----------------------------------------------------------------------------------------------------------------------
                            |- - - Common stock - - -|
                                                                                              Accumulated
                                                                          Note                      Other
                                  Number               Additional   Receivable              Comprehensive
                               of Shares                  Paid in   for Common     Retained          Gain
                             Outstanding      Amount      Capital        Stock     Earnings   (Loss), Net        Totals
-----------------------------------------------------------------------------------------------------------------------
<S>                            <C>          <C>        <C>          <C>         <C>              <C>        <C>
BALANCE AT
DECEMBER 31, 1999              15,371,932   $153,719   $ 6,801,476  $      --   $30,152,749      $(20,280)  $37,087,664
-----------------------------------------------------------------------------------------------------------------------
Comprehensive income:
  Net income                           --         --            --         --    10,145,002            --    10,145,002
  Unrealized gain on
  investments, net                     --         --            --         --            --        74,128        74,128
                                                                                                            -----------
Total comprehensive income                                                                                   10,219,130
Stock options exercised           336,547      3,366     1,670,573         --            --            --     1,673,939
Sale of stock to officer          100,000      1,000     1,199,000   (600,000)           --            --       600,000
Tax benefit associated with
exercise of stock options              --         --       410,887         --            --            --       410,887
-----------------------------------------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 2000              15,808,479   $158,085   $10,081,936  $(600,000)  $40,297,751      $ 53,848   $49,991,620
-----------------------------------------------------------------------------------------------------------------------
Comprehensive income:
  Net income                           --         --            --         --     2,237,966            --     2,237,966
  Unrealized loss on
  investments, net                     --         --            --         --            --        (5,361)       (5,361)
                                                                                                            -----------
Total comprehensive income                                                                                    2,232,605
Stock options exercised            99,720        997       479,513         --            --            --       480,510
Sale of stock to officer           50,000        500       427,625         --            --            --       428,125
Common stock repurchased         (445,300)    (4,453)   (3,023,674)        --            --            --    (3,028,127)
Repayment of note receivable
for common stock                       --         --            --    105,129            --            --       105,129
Tax benefit associated with
exercise of stock options              --         --       694,050         --            --            --       694,050
-----------------------------------------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 2001              15,512,899   $155,129   $ 8,659,450  $(494,871)  $42,535,717      $ 48,487   $50,903,912
-----------------------------------------------------------------------------------------------------------------------
Comprehensive loss:
  Net loss                             --         --            --         --    (4,854,780)           --    (4,854,780)
  Unrealized loss on
  investments, net                     --         --            --         --            --       (42,522)      (42,522)
                                                                                                            -----------
Total comprehensive loss                                                                                     (4,897,302)
Stock options exercised             4,000         40        15,179         --            --            --        15,219
Common stock repurchased         (566,150)    (5,662)   (2,829,229)        --            --            --    (2,834,891)
Repayment of note receivable
for common stock                       --         --            --    112,088            --            --       112,088
Tax benefit associated with
exercise of stock options              --         --           340         --            --            --           340
-----------------------------------------------------------------------------------------------------------------------
BALANCE AT
DECEMBER 31, 2002              14,950,749   $149,507   $ 5,845,740  $(382,783)  $37,680,937      $  5,965   $43,299,366
-----------------------------------------------------------------------------------------------------------------------
</TABLE>


See accompanying notes to consolidated financial statements.

--------------------------------------------------------------------------------

                                       21

<PAGE>

--------------------------------------------------------------------------------

APPLIED INNOVATION INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE>
<CAPTION>
----------------------------------------------------------------------------------------------------------------------------
Years Ended December 31,                                                        2002                2001                2000
----------------------------------------------------------------------------------------------------------------------------
<S>                                                                     <C>                 <C>                 <C>
Cash flows from operating activities:
  Net (loss) income                                                     $ (4,854,780)       $  2,237,966        $ 10,145,002
  Adjustments to reconcile net income (loss) to net cash
  (used in) provided by operating activities:
     Depreciation                                                          1,715,261           1,721,061           1,633,729
     Amortization of intangible assets                                       210,000             213,750                  --
     Provision for doubtful accounts                                         114,596             443,527             464,548
     Loss (gain) on disposal of assets                                       241,914             (12,714)             17,080
     Deferred income tax expense (benefit)                                   462,000             (33,000)         (1,442,000)
     Tax benefit of options exercised                                            340             694,050             410,887
     Effects of change in operating assets and liabilities,
     net of assets acquired and liabilities assumed in
     acquisition:
        Accounts receivable                                                2,342,159          22,017,975         (19,465,222)
        Inventory                                                          3,912,474           5,015,679          (8,095,628)
        Income taxes receivable                                           (2,176,265)         (3,294,671)            986,392
        Other current assets                                                 (38,382)            222,391            (352,352)
        Other assets                                                          34,660              71,354             (30,694)
        Accounts payable                                                    (138,538)        (17,280,850)         17,277,536
        Accrued expenses                                                  (1,186,096)         (1,398,102)          1,318,863
        Deferred revenue                                                  (1,587,516)           (450,985)          3,607,375
------------------------------------------------------------------------------------        ------------        ------------
    Net cash (used in) provided by operating activities                     (948,173)         10,167,431           6,475,516

Cash flows from investing activities:
  Purchases of property, plant and equipment                                (961,400)         (1,825,076)         (1,626,559)
  Payment for business acquisition                                                --          (4,044,969)                 --
  Purchases of investments                                               (13,870,211)        (23,108,753)         (8,885,238)
  Maturities of investments                                               10,983,967          15,598,693           3,171,770
  Sales of investments                                                       756,533           6,871,092             675,624
  Proceeds from sales of property, plant and equipment                        34,566              34,459               6,160
------------------------------------------------------------------------------------        ------------        ------------
    Net cash used in investing activities                                 (3,056,545)         (6,474,554)         (6,658,243)

Cash flows from financing activities:
  Common stock repurchased                                                (2,834,891)         (3,028,127)                 --
  Proceeds from payment on note receivable                                   112,088             105,129                  --
  Proceeds from issuance of common stock                                      15,219             908,635           2,273,939
------------------------------------------------------------------------------------        ------------        ------------
    Net cash (used in) provided by financing activities                  (2,707,584)         (2,014,363)           2,273,939
------------------------------------------------------------------------------------        ------------        ------------
(Decrease) increase in cash and cash equivalents                          (6,712,302)          1,678,514           2,091,212
Cash and cash equivalents - beginning of year                             15,698,594          14,020,080          11,928,868
------------------------------------------------------------------------------------        ------------        ------------
Cash and cash equivalents - end of year                                 $  8,986,292        $ 15,698,594        $ 14,020,080
====================================================================================        ============        ============

------------------------------------------------------------------------------------        ------------        ------------
Supplemental cash flow disclosure:
  Income taxes (received) paid, net                                     $ (1,818,737)       $  3,364,427        $  4,818,722
------------------------------------------------------------------------------------        ------------        ------------
</TABLE>

See accompanying notes to consolidated financial statements


--------------------------------------------------------------------------------

                                       22
<PAGE>

--------------------------------------------------------------------------------

APPLIED INNOVATION INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

--------------------------------------------------------------------------------
      FOOTNOTE 1 | DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT
                   ACCOUNTING POLICIES
--------------------------------------------------------------------------------



The following accounting principles and practices of Applied Innovation Inc. and
subsidiaries ("the Company") are set forth to facilitate the understanding of
data presented in the consolidated financial statements:


DESCRIPTION OF BUSINESS ACTIVITY

The Company is a network management solutions company that simplifies and
enhances the operation of complex, distributed voice and data networks. Building
on a deep knowledge of network architecture, elements and management, the
Company delivers unique hardware, software and service solutions that provide
greater connectivity, visibility and control of network elements and the systems
that support them.

The Company's solutions are targeted to three primary markets in the U.S. and
abroad: 1) telecommunications companies using wireline networks; 2)
telecommunications companies using wireless networks; and 3) government
networks. Synergies within the markets allow the Company to leverage its
knowledge and experience and deliver a common value proposition based on key
competitive differentiators--namely, its extensive knowledge of network
infrastructure, its commitment to vendor neutrality, and its focus on customers.
At the same time, the Company delivers targeted value to each market by
understanding and meeting their unique demands.

The Company was founded in Columbus, Ohio in 1983 and has two wholly owned
subsidiaries.



PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of Applied Innovation
Inc. and its wholly owned subsidiaries. All significant inter-company balances
and transactions have been eliminated in consolidation.



CASH EQUIVALENTS

Cash equivalents represent short-term investments with original maturities of
three months or less. At December 31, 2002 and 2001, cash equivalents of
$7,139,654 and $14,122,256, respectively, were invested in money markets,
corporate notes, commercial paper and taxable and tax-exempt bonds.



INVESTMENTS

The Company invests in various debt obligations, primarily U.S. government and
agency obligations and high quality commercial paper, with maturities generally
less than three years. Since the Company does not intend to hold its investments
in debt securities until maturity and does not actively trade the securities to
maximize trading gains, the Company classifies these securities as
"available-for-sale" and, accordingly, reports such securities at fair value
plus accrued interest. The fair value of debt securities is determined from
public quotations for such securities as of the reporting date. Any temporary
excess (deficiency) of fair value over (under) the underlying cost of the
investment, net of taxes, is excluded from current period earnings and is
reported as unrealized gains (losses) as a separate component of stockholders'
equity.



ALLOWANCE FOR DOUBTFUL ACCOUNTS

The Company grants credit on open account to its customers, substantially all of
whom are in telecommunications industry. Due to the nature of its customer base,
the Company's historical credit risk has been low. The Company generally
requires payment within thirty days from delivery and has not provided extended
payment terms under any type of vendor financing arrangements. However, the
Company does establish allowances against accounts receivable for potentially
uncollectible amounts. The Company estimates necessary allowances based on its
analysis of customers' outstanding receivables at the individual invoice level,
the customers' payment history and any other known factors concerning their
current financial condition and ability to pay. After the Company has exhausted
its collection efforts and determined that amounts are uncollectible at the
individual invoice level, such amounts are charged off against the allowance.



REVENUE RECOGNITION

PRODUCT SALES | The Company recognizes product and integration sales when
products are delivered and ownership and risk of loss are transferred.
Alternatively, in certain limited circumstances, a customer's order may direct
the Company to build products and prepare them for shipment, but hold such
products temporarily on the customer's behalf. In such situations, revenue is
recognized when all other terms and obligations of the sale are met, including
transfer of ownership and risk of loss.


--------------------------------------------------------------------------------

                                       23

<PAGE>

--------------------------------------------------------------------------------

NETWORK MANAGEMENT SYSTEM SALES | Revenue from the sale of network management
system projects may include a combination of the following multiple elements:
internally developed software; resale of third-party software and related
computer equipment; installation, training and consulting services; and
Company-provided and third-party maintenance and support agreements for the
software and equipment. In a multiple element arrangement, revenue from the
individual elements is unbundled based on their relative fair values and
recognized as follows:

     *   Software license fee revenue on internally developed software is
         recognized in accordance with the following four elements of software
         revenue recognition: (1) persuasive evidence of an arrangement exists,
         (2) delivery has occurred, (3) the related fee is fixed and
         determinable, and (4) collectibility is probable. 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 recorded upon
         delivery of the maintenance agreement.

     *   Revenue from installation, training and consulting services is
         recognized as the services are delivered or upon project completion.

     *   Revenue from maintenance and support agreements is recognized
         straight-line over the term of the related agreement.



SERVICES SALES | Installation service projects are generally short-term in
nature and are accepted by the customer and billed by the Company on a
project-by-project basis. The Company recognizes installation service revenue at
the completion of the project. Revenues from maintenance agreements are billed
periodically, deferred and recognized straight-line over the terms of the
agreements.



INVENTORY

Inventory is stated at the lower of cost or market. Cost is computed using
standard cost, which approximates actual cost on the first-in, first-out basis.



PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment are recorded at cost. Depreciation is provided
using the straight-line method over the estimated useful lives as follows:

        ----------------------------------------------------------------
                                                        LIVES (IN YEARS)
        ----------------------------------------------------------------
        Building                                                     40
        Equipment                                                   3-5
        Furniture                                                     7
        ----------------------------------------------------------------


INTANGIBLE ASSETS AND GOODWILL

Purchased intangible assets resulting from business acquisitions, primarily
intellectual property and non-compete agreements, are carried at cost less
accumulated amortization. Amortization is provided using the straight-line
method over the estimated economic lives of the respective assets, generally up
to three years. Amortization expense for the years ended December 31, 2002, 2001
and 2000 was $210,000, $213,750 and $0, respectively. Future estimated
amortization expense for the years ended December 31, 2003 and 2004 is $210,000
and $131,250, respectively.

Goodwill represents the excess of purchase price over the fair value of the net
assets acquired. Effective January 1, 2002, the Company adopted the provisions
of Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and
Other Intangible Assets." SFAS No. 142 requires that goodwill and intangible
assets with indefinite useful lives no longer be amortized, but instead be
tested for impairment at least annually in accordance with the provisions of
SFAS No. 142. It also requires that the Company complete a transitional goodwill
impairment test within six months from the date of adoption and reassess the
useful lives of other intangible assets within the first interim quarter after
adoption. Any impairment losses that arise due to the initial adoption of the
standard must be reported as a cumulative effect of a change in accounting
principle.

The Company had no previously recorded goodwill or other intangible assets
accounted for under standards other than SFAS No. 142. In accordance with SFAS
No. 142, the Company completed the transitional goodwill impairment test during
the second quarter of 2002 and the annual impairment test during the third
quarter of 2002 and determined that no impairment charges were necessary.


--------------------------------------------------------------------------------

                                       24
<PAGE>

--------------------------------------------------------------------------------

WARRANTY

The Company warrants its products for a minimum of one year after sale.
Accordingly, the Company accrues the estimated costs of such warranties at the
time of sale, based on historical experience and known warranty issues with
existing products.



INCOME TAXES

Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases as well as net
operating loss and tax credit carry-forwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.



STOCK OPTION PLANS

The Company accounts for its fixed plan stock options under the intrinsic
value-based method of accounting prescribed by Accounting Principles Board (APB)
Opinion No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. As such, compensation expense would be recorded on the date of
grant and amortized over the period of service only if the current market value
of the underlying stock exceeded the exercise price. No stock-based employee
compensation cost is reflected in net income (loss), as all options granted
under those plans had an exercise price equal to the market value of the
underlying common stock on the date of grant.

The following table illustrates the effect on net income (loss) and earnings
(loss) per share if the Company had applied the fair value recognition
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to
stock-based employee compensation using the Black Scholes option-pricing model
and including straight-line recognition of compensation cost over the related
vesting periods for fixed awards:


<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31,                                                     2002            2001             2000
------------------------------------------------------------------------------------------------------------------
<S>                                                                   <C>             <C>              <C>
Net (loss) income, as reported                                        $(4,854,780)    $ 2,237,966      $10,145,002
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects                                             (1,736,080)     (2,616,657)      (1,296,537)
---------------------------------------------------------------------------------     -----------      -----------
Pro forma net (loss) income                                           $(6,590,860)    $  (378,691)     $ 8,848,465
=================================================================================     ===========      ===========

---------------------------------------------------------------------------------     -----------      -----------
(Loss) earnings per share:
    Basic - as reported                                               $     (0.32)    $      0.14      $      0.65
    Basic - pro forma                                                       (0.44)          (0.02)            0.57
    Diluted - as reported                                             $     (0.32)    $      0.14      $      0.63
    Diluted - pro forma                                                     (0.44)          (0.02)            0.55
---------------------------------------------------------------------------------     -----------      -----------
</TABLE>



RESEARCH AND DEVELOPMENT

Research and development costs are expensed when incurred.



USE OF ESTIMATES

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reporting period.
Estimates are used for, but not limited to, the accounting for doubtful
accounts, inventory obsolescence, depreciation and amortization, sales returns,
warranty costs, taxes, and contingencies. Actual results could differ from these
estimates.

--------------------------------------------------------------------------------

                                       25
<PAGE>

--------------------------------------------------------------------------------

IMPAIRMENT OF LONG-LIVED ASSETS

Long-lived assets and certain intangible assets to be held and used are reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of such assets may not be recoverable. Determination of
recoverability is based on an estimate of undiscounted future cash flows
resulting from the use of the asset and its eventual disposition. Measurement of
an impairment loss for long-lived assets and certain intangible assets that the
Company expects to hold and use is based on the fair value of the asset.
Long-lived assets and certain identifiable intangible assets to be disposed of
are reported at the lower of carrying amount or fair value less costs to sell.



RECLASSIFICATIONS

Certain amounts in the prior year financial statements have been reclassified to
conform to the current year presentation.




--------------------------------------------------------------------------------
      FOOTNOTE 2   |    INVENTORY
--------------------------------------------------------------------------------

Major classes of inventory at December 31, 2002 and 2001 are summarized below:


----------------------------------------------------------------------------
                                                      2002              2001
----------------------------------------------------------------------------
Raw materials                                  $ 3,508,806       $ 7,104,242
Work-in-process                                     15,004           181,552
Finished goods                                     993,191         1,806,808
----------------------------------------------------------------------------
                                                 4,517,001         9,092,602
Reserve for obsolescence                        (1,107,159)       (1,770,286)
----------------------------------------------------------------------------
                                               $ 3,409,842       $ 7,322,316
============================================================================

In 2002, the Company recorded $2,151,811 of inventory charges to cost of goods
sold, primarily related to discontinuance of its optical transmission product
line and potential excess inventory and market price exposure associated with
certain other materials in inventory. In 2001, the Company recorded inventory
charges of $1,700,000 to cost of goods sold to cover potential excess inventory
and market price fluctuations, also associated primarily with its optical
inventory as well as certain other components in inventory.

--------------------------------------------------------------------------------

                                       26
<PAGE>

--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
      FOOTNOTE 3   |    INVESTMENTS
--------------------------------------------------------------------------------

The fair values of all financial instruments, excluding investments, approximate
carrying values because of the short maturities of those instruments.

The following summarizes the Company's investments in securities:



<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------------
                                                                         Gross            Gross
                                                     Amortized      Unrealized       Unrealized
DECEMBER 31, 2002                                         Cost           Gains           Losses      Fair Value
---------------------------------------------------------------------------------------------------------------
<S>                                                 <C>               <C>             <C>            <C>
U.S. government agency obligations                  $6,541,165        $ 29,255        $(20,517)     $ 6,549,903
Certificates of deposit                                126,582               7          (1,425)         125,164
U.S. government obligations                            102,619          21,053              --          123,672
Corporate obligations                                8,198,395          21,049         (40,458)       8,178,986
--------------------------------------------------------------        --------        --------      -----------
Total                                              $14,968,761        $ 71,364        $(62,400)     $14,977,725
==============================================================        ========        ========      ===========
Reported as:
  Short-term investments                                                                            $ 8,028,510
  Investments                                                                                         6,949,215
--------------------------------------------------------------        --------        --------      -----------
Total                                                                                               $14,977,725
==============================================================        ========        ========      ===========

<CAPTION>
---------------------------------------------------------------------------------------------------------------
                                                                         Gross            Gross
                                                     Amortized      Unrealized       Unrealized
DECEMBER 31, 2001                                         Cost           Gains           Losses      Fair Value
---------------------------------------------------------------------------------------------------------------
<S>                                                <C>               <C>              <C>           <C>
U.S. government agency obligations                 $ 4,705,286        $ 76,451        $ (1,806)     $ 4,779,931
U.S. government obligations                            102,619          15,631              --          118,250
Corporate obligations                                8,030,791          29,462         (40,898)       8,019,355
--------------------------------------------------------------        --------        --------      -----------
Total                                              $12,838,696        $121,544        $(42,704)     $12,917,536
==============================================================        ========        ========      ===========
Reported as:
  Short-term investments                                                                            $ 6,067,770
  Investments                                                                                         6,849,766
--------------------------------------------------------------        --------        --------      -----------
Total                                                                                               $12,917,536
==============================================================        ========        ========      ===========
</TABLE>

Gross realized gains included in income in 2002, 2001 and 2000 were $22,306,
$27,536 and $13,237, respectively, and gross realized losses included in income
in 2002, 2001 and 2000 were $117,507, $45,485 and $9,179, respectively. Realized
gains and losses are determined by specific identification.

The Company's December 31, 2002 debt securities at fair market value mature as
follows: $8,028,510 in less than one year, $6,258,888 after one year but less
than five years and $690,327 in five or more years.


--------------------------------------------------------------------------------

                                       27

<PAGE>
-------------------------------------------------------------------------------

-------------------------------------------------------------------------------
      FOOTNOTE 4   |    PROPERTY, PLANT AND EQUIPMENT
-------------------------------------------------------------------------------

Property, plant and equipment at December 31, 2002 and 2001 are summarized
below:

-------------------------------------------------------------------------------
                                                            2002           2001
-------------------------------------------------------------------------------
Land                                                 $ 1,639,303    $ 1,639,303
Building                                               5,109,087      5,091,607
Equipment                                              8,015,609      8,265,643
Furniture                                              2,018,457      2,031,075
----------------------------------------------------------------     ----------
                                                      16,782,456     17,027,628
Accumulated depreciation                              (8,989,442)    (8,204,273)
----------------------------------------------------------------    -----------
                                                     $ 7,793,014    $ 8,823,355
================================================================    ===========


-------------------------------------------------------------------------------
      FOOTNOTE 5   |    WARRANTY
-------------------------------------------------------------------------------

The Company's warranty activity is summarized below:

-------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31,                                    2002           2001
-------------------------------------------------------------------------------
Beginning balance                                    $   819,166    $ 1,334,786
Warranty provision                                     1,209,970      1,509,164
Warranty costs incurred                               (1,486,485)    (2,024,784)
----------------------------------------------------------------    -----------
Ending balance                                       $   542,651    $   819,166
================================================================    ===========


--------------------------------------------------------------------------------

                                       28


<PAGE>

--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
     FOOTNOTE 6   |    ACQUISITION AND NOTE PAYABLE
--------------------------------------------------------------------------------

On August 15, 2001, the Company acquired certain assets of the remote network
management systems and information collection device business of Badger
Technology, Inc. (Badger). The results of Badger's operations have been included
in the Company's consolidated financial results since the date of acquisition.
Badger, a privately held company located in California, primarily targeted the
wireless telecommunications market with its remote network management products.
As a result of the acquisition, the Company intends to further penetrate the
wireless telecommunications market by leveraging Badger's products targeting
cell site remote management with the Company's larger sales force and service
capabilities.

The acquisition was accounted for in accordance with the purchase method of
accounting. The purchase price included cash payments of $3,955,044 and a note
payable of $750,000. There was also a contingent payment of up to $750,000 based
on certain product sales over the two years subsequent to the acquisition date.
The note payable bears an 8% annual interest rate, with interest payable
semi-annually and principal due in August 2004. The purchase price and
acquisition costs of $89,925 were allocated to assets acquired based on
estimated fair market values at the acquisition date, with the balance recorded
as goodwill.

The following table summarizes the estimated fair values of the assets acquired
at the acquisition date:

------------------------------------------------------------------------------
Accounts receivable                                                 $  167,806
Inventory                                                              328,935
Property, plant and equipment                                          128,427
Intangible assets                                                      765,000
Goodwill                                                             3,404,801
------------------------------------------------------------------------------
TOTAL ASSETS ACQUIRED                                               $4,794,969
==============================================================================

The Company records contingent consideration as additional goodwill as the
contingencies are resolved. Of the total $750,000 contingent payment, $72,200
and $18,400 were recorded as additional goodwill at December 31, 2002 and 2001,
respectively. Goodwill is expected to be fully deductible for tax purposes.


--------------------------------------------------------------------------------
     FOOTNOTE 7   |    MAJOR CUSTOMERS AND GEOGRAPHIC DATA
--------------------------------------------------------------------------------

Revenues to major customers represented 75%, 66%, and 61% of net sales for 2002,
2001 and 2000, respectively. The number of major customers previously referred
to were three, four and two for 2002, 2001 and 2000, respectively, with trade
accounts receivable balances of $3,566,498 and $4,567,446 at December 31, 2002
and 2001, respectively.

The Company's sales by geographic areas were as follows:

--------------------------------------------------------------------------------
YEARS ENDED DECEMBER 31,                    2002            2001            2000
--------------------------------------------------------------------------------
United States                        $36,569,783     $68,820,616    $114,883,136
International                          6,391,228       4,198,534       1,220,256
------------------------------------------------     -----------    ------------
                                     $42,961,011     $73,019,150    $116,103,392
================================================     ===========    ============


--------------------------------------------------------------------------------

                                       29
<PAGE>
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
     FOOTNOTE 8   |    EARNINGS (LOSS) PER SHARE
--------------------------------------------------------------------------------

The calculations of earnings (loss) per share for the years ended December 31,
2002, 2001, and 2000, are based upon the weighted-average shares outstanding
during the periods and, when applicable, those stock options that are dilutive,
using the treasury stock method. Reconciliations of the numerators and
denominators of the basic and diluted earnings (loss) per share calculations
follow:

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------
                                                            Income           Shares     Per Share
                                                       (Numerator)    (Denominator)        Amount
-------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2002
-------------------------------------------------------------------------------------------------
<S>                                                    <C>               <C>               <C>
Basic loss per share-
  Net loss available to common stockholders            $(4,854,780)      15,092,328        $(0.32)
                                                                                           ======
Effect of dilutive securities-
  Stock options                                                 --               --
                                                       -----------       ----------
Diluted loss per share-
  Net loss available to common stockholders
  including assumed conversions                        $(4,854,780)      15,092,328        $(0.32)
==================================================================       ==========        ======

-------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2001
-------------------------------------------------------------------------------------------------
Basic earnings per share-
  Net income available to common stockholders          $ 2,237,966       15,870,492        $ 0.14
                                                                                           ======
Effect of dilutive securities-
  Stock options                                                 --          270,501
                                                       -----------       ----------
Diluted earnings per share-
  Net income available to common stockholders
  including assumed conversions                        $ 2,237,966       16,140,993        $ 0.14
==================================================================       ==========        ======

-------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2000
-------------------------------------------------------------------------------------------------
Basic earnings per share-
  Net income available to common stockholders          $10,145,002       15,598,723        $ 0.65
                                                                                           ======
Effect of dilutive securities-
  Stock options                                                 --          415,430
                                                       -----------       ----------
Diluted earnings per share-
  Net income available to common stockholders
  including assumed conversions                        $10,145,002       16,014,153        $ 0.63
==================================================================       ==========        ======
</TABLE>

Due to the Company's net loss for the year ended December 31, 2002, no common
equivalent shares were included in the calculation of diluted loss per share for
that year because their effect would have been anti-dilutive. The Company's
weighted-average number of options which were in-the-money and, therefore,
potentially dilutive for the year ended December 31, 2002 was 159,098.

Stock options which are out-of-the-money and, therefore, are anti-dilutive under
the treasury stock method have been excluded from the above earnings per share
calculations. The Company's stock options outstanding at December 31, 2002, 2001
and 2000 which were excluded from the earnings per share calculations because
they were out-of-the-money were 1,670,100, 1,215,350 and 676,750, respectively.

--------------------------------------------------------------------------------

                                       30
<PAGE>
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
     FOOTNOTE 9   |    STOCK OPTION PLANS
--------------------------------------------------------------------------------

The Company's 2001 Stock Incentive Plan (the 2001 Plan) was adopted by the Board
of Directors on February 27, 2001 and approved by the stockholders of the
Company as of April 26, 2001, with 2,000,000 shares of common stock reserved for
issuance. Options granted under the 2001 Plan may be either incentive stock
options or non-statutory stock options, with maximum terms of ten years. The
exercise price of each incentive stock option must be at least 100% of the fair
market value per share of the Company's common stock as determined by the Stock
Option and Compensation Committee on the date of grant.

Previously, the Company had adopted the 1996 Stock Option Plan (the 1996 Plan),
the 1986 Incentive Stock Option Plan and the 1986 Non-statutory Stock Option
Plan (the 1986 Plans). Options granted under the 1996 Plan and the 1986 Plans
have maximum terms of ten years. The exercise price of each incentive stock
option must be at least 100% of the fair market value per share of the Company's
common stock as determined by the Stock Option and Compensation Committee on the
date of grant.

Tax benefits realized by the Company for deductions in excess of compensation
expense under these plans are credited to additional paid-in capital.

At December 31, 2002, there were 1,173,150 additional shares available for grant
under the 2001 Plan and 777,110 additional shares available for grant under the
1996 Plan. The per share weighted-average fair value of stock options granted
during 2002, 2001 and 2000 was $3.65, $7.27 and $6.41, respectively, on the date
of grant using the Black Scholes option-pricing model with the following
assumptions used for grants in the years ended December 31, 2002, 2001 and 2000,
respectively: dividend yield of 0% for all years; expected volatility of 90%,
93% and 77%; risk-free interest rate of 4.3%, 4.5% and 6%; and expected life of
5.6, 5 and 4.2 years.

A summary of stock option activity follows:

----------------------------------------------------------------------------
                                                Number of   Weighted-Average
                                                   Shares     Exercise Price
----------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 1999                    1,105,300             $ 4.82
----------------------------------------------------------------------------
  Granted                                       1,117,450              13.21
  Exercised                                      (336,547)              4.97
  Canceled/expired                               (109,223)              6.25
----------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2000                    1,776,980             $ 8.66
----------------------------------------------------------------------------
  Granted                                       1,082,000              10.99
  Exercised                                       (99,720)              4.82
  Canceled/expired                               (392,430)             11.30
----------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2001                    2,366,830             $10.55
----------------------------------------------------------------------------
  Granted                                         619,500               5.13
  Exercised                                        (4,000)              3.80
  Canceled/expired                             (1,161,030)             12.17
----------------------------------------------------------------------------
BALANCE AT DECEMBER 31, 2002                    1,821,300             $ 7.62
----------------------------------------------------------------------------

The following table summarizes information about options outstanding at December
31, 2002:

<TABLE>
<CAPTION>
                         ------------------------------------------------     -------------------------------
                                     Options Outstanding                            Options Exercisable
                         ------------------------------------------------     -------------------------------
                                             Weighted-
                                               Average
Range of                    Number           Remaining   Weighted-Average        Number      Weighted-Average
Exercise Prices          of Shares    Contractual Life     Exercise Price     of Shares        Exercise Price
---------------          ------------------------------------------------     -------------------------------
<S>                      <C>                      <C>              <C>          <C>                    <C>
$ 2.95 -  4.31             188,200                4.85             $ 3.61        99,700                $ 3.46
$ 4.37 -  6.05             614,750                7.26               5.16       145,900                  5.06
$ 6.63 -  9.00             543,300                6.48               7.81       273,950                  7.70
$ 9.66 - 13.25             417,700                8.00              11.66       155,750                 11.73
$13.38 - 17.38              57,350                7.84              15.84        18,950                 16.11
                         ---------                                              -------
                         1,821,300                6.97             $ 7.62       694,250                $ 7.67
                         =========                                              =======
</TABLE>

--------------------------------------------------------------------------------

                                       31
<PAGE>
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
    FOOTNOTE 10   |    EMPLOYEE STOCK PURCHASE PLAN
--------------------------------------------------------------------------------

At the April 25, 2002 Annual Meeting of Stockholders, the Applied Innovation
Inc. Employee Stock Purchase Plan (the ESPP) was approved and adopted. The ESPP
authorizes the Company to issue up to 500,000 shares of common stock to eligible
employees, as defined. The ESPP has semi-annual offering periods commencing
January 1 and July 1. During each offering period, eligible employees may
purchase shares at a price equal to 90% of fair market value on the first or
last business day of the offering period, whichever is lower.

As of December 31, 2002, no shares of common stock were issued pursuant to the
ESPP. On January 3, 2003, the Company issued 24,318 shares of stock at a price
of $2.73 per share based on employee payroll deductions for the six-month
offering period ending December 31, 2002.


--------------------------------------------------------------------------------
    FOOTNOTE 11   |    DEFINED CONTRIBUTION PLAN
--------------------------------------------------------------------------------

The Company sponsors a defined contribution 401(k) and profit sharing plan that
covers all eligible employees. Since October 1, 1999, the Company matched 50% of
each participant's contribution, up to 6% of that participant's contribution.
The Company may also make profit sharing contributions at the discretion of the
Board of Directors. For 2002, 2001 and 2000, the discretionary profit sharing
contribution was $0, $0 and $400,000, respectively, and the total expense
related to the plan was $253,537, $458,082 and $762,745, respectively.


--------------------------------------------------------------------------------
    FOOTNOTE 12   |    INCOME TAXES
--------------------------------------------------------------------------------

Income tax expense (benefit) consists of:

                                          Current       Deferred          Total
-------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2002
-------------------------------------------------------------------------------
Federal                               $(3,917,000)   $   559,000    $(3,358,000)
State and local                           (77,000)       (97,000)      (174,000)
-------------------------------------------------    -----------    -----------

                                      $(3,994,000)   $   462,000    $(3,532,000)
=================================================    ===========    ===========

-------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2001
-------------------------------------------------------------------------------
Federal                               $   568,000    $   (29,000)   $   539,000
State and local                           220,000         (4,000)       216,000
-------------------------------------------------    -----------    -----------
                                      $   788,000    $   (33,000)   $   755,000
=================================================    ===========    ===========

-------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2000
-------------------------------------------------------------------------------
Federal                               $ 5,440,000    $(1,273,000)   $ 4,167,000
State and local                           776,000       (169,000)       607,000
-------------------------------------------------    -----------    -----------
                                      $ 6,216,000    $(1,442,000)   $ 4,774,000
=================================================    ===========    ===========


--------------------------------------------------------------------------------

                                       32
<PAGE>

--------------------------------------------------------------------------------

A reconciliation of income tax expense (benefit) at the expected federal
statutory rate (34%) to income tax expense (benefit) at the Company's effective
rates is as follows:

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------------
                                                                                 2002              2001              2000
-------------------------------------------------------------------------------------------------------------------------
<S>                                                                       <C>                <C>               <C>
Computed tax at the expected federal statutory rate                       $(2,852,000)       $1,018,000        $5,072,000
State and local income taxes, net of federal income tax effect               (148,000)          141,000           350,000
Change in state rate applied to deferred tax assets                                --                --           (51,000)
Meals and entertainment expenses                                               62,000            88,000           110,000
Research and experimentation credit                                          (467,000)         (365,000)         (624,000)
Dividends from foreign sales corporation                                     (101,000)          (55,000)          (37,000)
Tax-exempt interest income                                                    (22,000)          (85,000)          (68,000)
Other                                                                          (4,000)           13,000            22,000
-------------------------------------------------------------------------------------        ----------        ----------
                                                                          $(3,532,000)       $  755,000        $4,774,000
=====================================================================================        ==========        ==========
</TABLE>

The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and deferred tax liabilities at December 31, 2002 and
2001 are presented below:

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------
                                                                                 2002              2001
-------------------------------------------------------------------------------------------------------
<S>                                                                        <C>               <C>
Deferred tax assets:
  Warranty reserve                                                         $  209,000        $  315,000
  Accounts receivable allowance                                               166,000           183,000
  Inventory, principally due to obsolescence reserve and
  additional costs inventoried for tax purposes                               609,000           864,000
  Deferred revenue                                                            732,000         1,343,000
  Restructuring costs                                                         224,000             3,000
  State tax net operating loss carryforwards                                  171,000                --
  Other                                                                       168,000            41,000
-------------------------------------------------------------------------------------        ----------
                                                                           $2,279,000        $2,749,000
=====================================================================================        ==========

-------------------------------------------------------------------------------------        ----------
Deferred tax liabilities:
  Unrealized gain on investments                                           $    3,000        $   30,000
  Other                                                                            --             8,000
-------------------------------------------------------------------------------------        ----------
                                                                           $    3,000        $   38,000
=====================================================================================        ==========
</TABLE>

In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will not be realized. The ultimate realization of deferred tax assets is
dependent upon the utilization of loss carry-backs or the generation of future
taxable income during the periods in which those temporary differences become
deductible. Management considers the scheduled reversal of deferred tax
liabilities, projected future taxable income, and tax planning strategies in
making this assessment. Based upon the level of historical taxable income and
projections for future taxable income over the periods in which the deferred tax
assets are deductible, management believes that it is more likely than not the
Company will realize the benefits of these deductible differences and,
therefore, no valuation allowance has been provided.

--------------------------------------------------------------------------------

                                       33
<PAGE>
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
    FOOTNOTE 13   |    LEASE COMMITMENTS
--------------------------------------------------------------------------------

The Company is obligated for office space in Colorado, Georgia, Illinois, Texas,
California and Mexico under various operating leases, which expire over the next
four years. The Company's California property is sublet through the term of the
lease.

Future minimum lease payments and estimated sublease receipts under the
operating leases as of December 31, 2002 are:

-------------------------------------------------------------------------------
YEARS ENDING DECEMBER 31,                   Lease Payments    Sublease Receipts
-------------------------------------------------------------------------------
2003                                              $197,442            $ (54,208)
2004                                               124,304              (46,538)
2005                                                74,678                   --
2006                                                23,154                   --
----------------------------------------------------------            ---------
Total minimum lease payments                      $419,578            $(100,746)
==========================================================            =========

Total rent expense, net of related sublease rental income, in 2002, 2001 and
2000 was $276,850, $3,856, and $156,746, respectively. In 2002, the Company's
restructuring charges included $184,977 for future lease payments, net of
estimated sublease rental income, for the Georgia, Illinois and California
office leases.

--------------------------------------------------------------------------------
    FOOTNOTE 14   |    EQUITY
--------------------------------------------------------------------------------

On September 14, 2001, the Company's Board of Directors authorized a
twelve-month stock repurchase program under which the Company was authorized to
purchase up to 1,500,000 shares of common stock. During the year ended December
31, 2002, the Company paid $2,834,891 to repurchase 566,150 shares under this
program. For the twelve months since inception of the repurchase program, the
Company paid $5,863,018 to repurchase 1,011,450 shares.

As part of an employment agreement dated July 13, 2000 with its previous
President and Chief Executive Officer, the Company sold 100,000 unregistered
shares of its common stock at $12 per share, the closing market price on the
date of the agreement. In exchange for the stock, the Company received $600,000
of cash and a $600,000 five year note, bearing interest at 6.62%, payable in
five annual installments of principal and interest commencing July 13, 2001. The
note receivable is reflected in the stockholders' equity section of the
accompanying consolidated balance sheets.

--------------------------------------------------------------------------------
    FOOTNOTE 15   |    RESTRUCTURING CHARGES
--------------------------------------------------------------------------------

The Company enacted restructuring plans in February and August 2002, resulting
in aggregate restructuring charges of $2,890,155 related primarily to workforce
reductions of approximately 150 employees throughout all departments, as well as
charges related to excess equipment and leased offices. As of December 31, 2002,
the remaining restructuring accrual was $582,811. With the exception of $65,276
related to lease payments (net of estimated sublease receipts) extending to
2005, the remaining accrued restructuring costs are expected to be paid in 2003.

In June 2001, the Company announced a reduction in workforce of approximately 40
employees throughout all departments. The Company recorded a restructuring
charge of approximately $292,330 related primarily to severance and fringe
benefits. As of December 31, 2002, the Company had paid out all such costs.

<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------------------
                                                        2002           Cash      Non-Cash    December 31,
                                                     Charges     Deductions     Deduction    2002 Accrual
---------------------------------------------------------------------------------------------------------
<S>                            <C>                <C>            <C>             <C>             <C>
Employee separations, February 2002               $  407,730     $  407,730      $     --        $     --
Employee separations, August 2002                  2,105,375      1,647,354            --         458,021
Lease commitments, net of sublease                   184,977         60,187            --         124,790
Equipment disposals                                  192,073             --       192,073              --
------------------------------------------------------------     ----------      --------        --------
                                                  $2,890,155     $2,115,271      $192,073        $582,811
============================================================     ==========      ========        ========
</TABLE>

--------------------------------------------------------------------------------

                                       34
<PAGE>
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
    FOOTNOTE 16   |    CREDIT FACILITY
--------------------------------------------------------------------------------


On August 7, 2002, the Company entered into an agreement with The Huntington
National Bank (the Bank) for a credit facility. The term of the credit facility
is 364 days and provides for a line of credit up to $10,000,000, with interest
payable monthly and principal due at maturity. Borrowings on the line are
subject to a borrowing base limited to $5,000,000 on real estate, plus 75% of
eligible accounts receivable and 40% of eligible inventory, as defined in the
agreement. Borrowings bear interest at the London Interbank Offered Rate (LIBOR)
plus 1.65%, or the Bank's Prime Commercial Rate less 1.00%, at the option of the
Company. Borrowings are collateralized by the Company's receivables, inventory,
certain investments, equipment, real estate and general intangibles. The credit
facility contains certain financial covenants, including, but not limited to,
restrictions on the payment of dividends, minimum tangible net worth and a
minimum liquidity ratio. At December 31, 2002, the Company had no outstanding
borrowings under this facility and was in compliance with all covenants.

--------------------------------------------------------------------------------
    FOOTNOTE 17   |    CONTINGENCIES
--------------------------------------------------------------------------------

The Company is subject to certain legal proceedings and claims which arise in
the ordinary course of its business. Although the outcomes of such matters
cannot be predicted with certainty, the Company believes the final disposition
of such matters will not have a material adverse effect on its financial
position, results of operations or liquidity.

--------------------------------------------------------------------------------
    FOOTNOTE 18   |    QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
--------------------------------------------------------------------------------

A summary of quarterly financial information follows (in thousands, except per
share amounts):

<TABLE>
<CAPTION>
---------------------------------------------------------------------------------------------
2002                                                  Q1          Q2           Q3          Q4
---------------------------------------------------------------------------------------------
<S>                                              <C>         <C>          <C>         <C>
Net sales                                        $ 9,483     $16,451      $ 7,247     $ 9,781
Gross profit                                       4,058       6,949        2,666       5,730
Income (loss) before income taxes                 (4,106)        116       (5,592)      1,195
Net income (loss)                                 (2,874)         81       (3,148)      1,086
Basic net income (loss) per share                  (0.19)       0.01        (0.21)       0.07
Diluted net income (loss) per share                (0.19)       0.01        (0.21)       0.07
--------------------------------------------------------     -------      -------     -------

---------------------------------------------------------------------------------------------
2001                                                  Q1          Q2           Q3          Q4
---------------------------------------------------------------------------------------------
Net sales                                        $25,639     $16,991      $19,635     $10,754
Gross profit                                      11,628       8,358       10,510       3,271
Income (loss) before income taxes                  3,397         617        2,686      (3,707)
Net income (loss)                                  2,242         408        1,772      (2,184)
Basic net income (loss) per share                   0.14        0.03         0.11       (0.14)
Diluted net income (loss) per share                 0.14        0.03         0.11       (0.14)
--------------------------------------------------------     -------      -------     -------
</TABLE>

--------------------------------------------------------------------------------
         ITEM 9   | Changes in and Disagreements with Accountants on Accounting
                    and Financial Disclosure
--------------------------------------------------------------------------------

None.

--------------------------------------------------------------------------------

                                       35

<PAGE>

--------------------------------------------------------------------------------

PART III

--------------------------------------------------------------------------------
        ITEM 10   | Directors and Executive Officers of the Registrant
--------------------------------------------------------------------------------

The information required by this item is included under the caption "ELECTION OF
DIRECTORS" on pages 4 through 7 of the Company's Proxy Statement relating to the
Company's Annual Meeting of Stockholders to be held on April 24, 2003 (the Proxy
Statement), and under the caption "SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING
COMPLIANCE" on page 18 of the Proxy Statement and is incorporated herein by
reference.

--------------------------------------------------------------------------------
        ITEM 11   | Executive Compensation
--------------------------------------------------------------------------------

The information required by this item is included under the caption "ELECTION OF
DIRECTORS" on pages 8 through 15 of the Proxy Statement and is incorporated
herein by reference.

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

The information required by this item is included under the caption "OWNERSHIP
OF COMMON STOCK BY PRINCIPAL STOCKHOLDERS" on page 2, under the caption
"SECURITY OWNERSHIP OF MANAGEMENT" on pages 3 through 4, and under the caption
"EQUITY COMPENSATION PLAN INFORMATION" on pages 12 through 13 of the Proxy
Statement, and is incorporated herein by reference.

--------------------------------------------------------------------------------
        ITEM 13   | Certain Relationships and Related Transactions
--------------------------------------------------------------------------------

The information required by this item is included under the caption "Related
Party Transactions" on page 13 of the Proxy Statement and is incorporated herein
by reference.

--------------------------------------------------------------------------------
        ITEM 14   | Controls and Procedures
--------------------------------------------------------------------------------

Within the 90 days prior to the date of this report, we carried out an
evaluation, under the supervision and with the participation of our management,
including our Chief Executive Officer along with our Chief Financial Officer, of
the effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Rule 13a-14 under the Securities Exchange Act of 1934, as
amended. Based upon that evaluation, our Chief Executive Officer along with our
Chief Financial Officer concluded that our disclosure controls and procedures
are effective in timely alerting them to material information relating to us
(including our consolidated subsidiaries) required to be included in our
periodic SEC filings. It should be noted that the design of any system of
controls is based in part upon certain assumptions about the likelihood of
future events, and there can be no assurance that any design will succeed in
achieving its stated goals under all potential future conditions, regardless of
how remote.

Since the date of our evaluation to the filing date of this Annual Report, there
have been no significant changes in our internal controls or in other factors
that could significantly affect internal controls subsequent to the date we
carried out this evaluation.

--------------------------------------------------------------------------------

                                       36
<PAGE>
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
        ITEM 15   | Exhibits, Financial Statement Schedules and Reports
                    on Form 8-K
--------------------------------------------------------------------------------

(a)(1)   The following documents are filed as part of this report:

            *   Independent Auditors' Report

            *   Consolidated Balance Sheets as of December 31, 2002 and 2001.

            *   Consolidated Statements of Operations for the years ended
                December 31, 2002, 2001, and 2000.

            *   Consolidated Statements of Stockholders' Equity for the years
                ended December 31, 2002, 2001 and 2000.

            *   Consolidated Statements of Cash Flows for the years ended
                December 31, 2002, 2001 and 2000.

            *   Notes to Consolidated Financial Statements.

(a)(2)   The following documents are filed as part of this report:

            *   Independent Auditors' Report

            *   Schedule II (Valuation and Qualifying Accounts)

(a)(3)   Exhibits: The following exhibits are filed as part of this report:


  EXHIBIT NO.                            DESCRIPTION

          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     Company's Amended and Restated 1986 Incentive Stock Option
                  Plan, including form of Stock Option Agreement. (Reference is
                  made to Exhibit 10.1 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).

         10.2     Company's 1986 Amended and Restated Non-Statutory Stock Option
                  Plan, including form of Stock Option Agreement. (Reference is
                  made to Exhibit 10.2 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).

         10.3     Form of Confidentiality, Assignment and Non-Competition
                  Agreement between he Company and employee officers. (Reference
                  is made to Exhibit 10.3 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).

         10.4     Technology Agreement, dated November 12, 1996, between the
                  Company and Cisco Systems, Inc. (Reference is made to Exhibit
                  10.4 to the Company's Annual Report on Form 10-K, filed with
                  the Securities and Exchange Commission on March 31, 1998, and
                  incorporated herein by reference).

         10.5     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).

         10.6     Schedule of Indemnification Agreements. (Reference is made to
                  Exhibit 10.7 in the Company's Annual Report on Form 10-K,
                  filed with the Securities and Exchange Commission on March 27,
                  2001, and incorporated herein by reference).

         10.7     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).

         10.8     Employment Agreement between the Company and Gerard B.
                  Moersdorf, Jr. (Reference is made to Exhibit 10.10 to the
                  Company's Annual Report on Form 10-K, filed with the
                  Securities and Exchange Commission on March 27, 2001, and
                  incorporated herein by reference).

         10.9     Employment Agreement between the Company and Michael P.
                  Keegan. (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 27, 2001, and incorporated
                  herein by reference).

--------------------------------------------------------------------------------

                                       37
<PAGE>
--------------------------------------------------------------------------------

         10.10    Employment Agreement between the Company and Matthew P.
                  Bruening. (Reference is made to Exhibit 10.1 to the Company's
                  Quarterly Statement on Form 10-Q, filed with the Securities
                  and Exchange Commission on August 9, 2001, and incorporated
                  herein by reference).

         10.11    Employment Agreement between the Company and Eric W. Langille.
                  (Reference is made to Exhibit 10.2 to the Company's Quarterly
                  Statement on Form 10-Q, filed with the Securities and Exchange
                  Commission on November 14, 2001, and incorporated herein by
                  reference).

         10.12    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).

         10.13    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).

         10.14    Employment Agreement between the Company and John F. Petro.
                  (Reference is made to Exhibit 10.1 to the Company's Quarterly
                  Statement on Form 10-Q, filed with the Securities and Exchange
                  Commission on August 14, 2002, and incorporated herein by
                  reference).

         10.15    Loan and Security Agreement by and between Applied Innovation
                  Inc., as Borrower, and Huntington National Bank, as Lender,
                  dated August 7, 2002. (Reference is made to Exhibit 10.1 to
                  the Company's Quarterly Statement on Form 10-Q, filed with the
                  Securities and Exchange Commission on November 13, 2002, and
                  incorporated herein by reference).

         23*      Consent of KPMG LLP.

         24*      Power of Attorney.

----------------

          * Filed with this Annual Report on Form 10-K.

(b)  Reports on Form 8-K - None.

(c)  Exhibits - The exhibits to this report follow the financial statement
     schedule and the independent auditors' report thereon.

(d)  Financial Statement Schedules - The financial statement schedule and the
     independent auditors' report thereon follow the certifications.


--------------------------------------------------------------------------------

                                       38


<PAGE>
--------------------------------------------------------------------------------

SIGNATURES

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




APPLIED INNOVATION INC.



Date: March 21, 2003                     By: /s/ Gerard B. Moersdorf, Jr.
                                             -------------------------------
                                             Gerard B. Moersdorf, Jr.
                                             Chairman, President and
                                               Chief Executive Officer



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


<TABLE>
<CAPTION>
Signature                               Title
---------                               -----

<S>                                     <C>
/s/ Gerard B. Moersdorf, Jr.            Gerard B. Moersdorf, Jr.
--------------------------------        Chairman, President & Chief Executive Officer
                                        (Principal Executive Officer)
                                        March 21, 2003


/s/ Michael P. Keegan                   Michael P. Keegan
--------------------------------        Vice President, Chief Financial Officer & Treasurer
                                        (Principal Financial & Principal Accounting Officer)
                                        March 21, 2003


* Michael J. Endres                     Michael J. Endres | Director | March 21, 2003
---------------------------------


* Curtis A. Loveland                    Curtis A. Loveland | Director | March 21, 2003
---------------------------------


* Gerard B. Moersdorf, Sr.              Gerard B. Moersdorf, Sr. | Director | March 21, 2003
---------------------------------


* Richard W. Oliver                     Richard W. Oliver | Director | March 21, 2003
---------------------------------


* Thomas W. Huseby                      Thomas W. Huseby | Director | March 21, 2003
---------------------------------


* Alexander B. Trevor                   Alexander B. Trevor | Director | March 21, 2003
----------------------------------


* William H. Largent                    William H. Largent | Director | March 21, 2003
----------------------------------


*By: /s/ Gerard B. Moersdorf, Jr.       Gerard B. Moersdorf, Jr. (Attorney-in-Fact)
     -----------------------------
</TABLE>

--------------------------------------------------------------------------------

                                       39
<PAGE>
--------------------------------------------------------------------------------

CERTIFICATION

I, Gerard B. Moersdorf, Jr., certify that:

         1.       I have reviewed this annual report on Form 10-K of Applied
                  Innovation Inc.;

         2.       Based on my knowledge, this annual report does not contain any
                  untrue statement of a material fact or omit to state a
                  material fact necessary to make the statements made, in light
                  of the circumstances under which such statements were made,
                  not misleading with respect to the period covered by this
                  annual report;

         3.       Based on my knowledge, the financial statements, and other
                  financial information included in this annual report, fairly
                  present in all material respects the financial condition,
                  results of operations and cash flows of the registrant as of,
                  and for, the periods presented in this annual report;

         4.       The registrant's other certifying officer and I are
                  responsible for establishing and maintaining disclosure
                  controls and procedures (as defined in Exchange Act Rules
                  13a-14 and 15d-14) for the registrant and we have:

                  a)       designed such disclosure controls and procedures to
                           ensure that material information relating to the
                           registrant, including its consolidated subsidiaries,
                           is made known to us by others within those entities,
                           particularly during the period in which this annual
                           report is being prepared;

                  b)       evaluated the effectiveness of the registrant's
                           disclosure controls and procedures as of a date
                           within 90 days prior to the filing date of this
                           annual report (the "Evaluation Date"); and

                  c)       presented in this annual report our conclusions about
                           the effectiveness of the disclosure controls and
                           procedures based on our evaluation as of the
                           Evaluation Date;

         5.       The registrant's other certifying officer and I have
                  disclosed, based on our most recent evaluation, to the
                  registrant's auditors and the audit committee of registrant's
                  board of directors (or persons performing the equivalent
                  function):

                  a)       all significant deficiencies in the design or
                           operation of internal controls which could adversely
                           affect the registrant's ability to record, process,
                           summarize and report financial data and have
                           identified for the registrant's auditors any material
                           weaknesses in internal controls; and

                  b)       any fraud, whether or not material, that involves
                           management or other employees who have a significant
                           role in the registrant's internal controls; and

         6.       The registrant's other certifying officer and I have indicated
                  in this annual report whether or not there were significant
                  changes in internal controls or in other factors that could
                  significantly affect internal controls subsequent to the date
                  of our most recent evaluation, including any corrective
                  actions with regard to significant deficiencies and material
                  weaknesses.


Date: March 21, 2003



                                 /s/ Gerard B. Moersdorf, Jr.
                                 -----------------------------------------------
                                 Gerard B. Moersdorf, Jr.
                                 Chairman, President and Chief Executive Officer




--------------------------------------------------------------------------------

                                       40


<PAGE>
--------------------------------------------------------------------------------

CERTIFICATION

I, Michael P. Keegan, certify that:

         1.       I have reviewed this annual report on Form 10-K of Applied
                  Innovation Inc.;

         2.       Based on my knowledge, this annual report does not contain any
                  untrue statement of a material fact or omit to state a
                  material fact necessary to make the statements made, in light
                  of the circumstances under which such statements were made,
                  not misleading with respect to the period covered by this
                  annual report;

         3.       Based on my knowledge, the financial statements, and other
                  financial information included in this annual report, fairly
                  present in all material respects the financial condition,
                  results of operations and cash flows of the registrant as of,
                  and for, the periods presented in this annual report;

         4.       The registrant's other certifying officer and I are
                  responsible for establishing and maintaining disclosure
                  controls and procedures (as defined in Exchange Act Rules
                  13a-14 and 15d-14) for the registrant and we have:

                  a)       designed such disclosure controls and procedures to
                           ensure that material information relating to the
                           registrant, including its consolidated subsidiaries,
                           is made known to us by others within those entities,
                           particularly during the period in which this annual
                           report is being prepared;

                  b)       evaluated the effectiveness of the registrant's
                           disclosure controls and procedures as of a date
                           within 90 days prior to the filing date of this
                           annual report (the "Evaluation Date"); and

                  c)       presented in this annual report our conclusions about
                           the effectiveness of the disclosure controls and
                           procedures based on our evaluation as of the
                           Evaluation Date;

         5.       The registrant's other certifying officer and I have
                  disclosed, based on our most recent evaluation, to the
                  registrant's auditors and the audit committee of registrant's
                  board of directors (or persons performing the equivalent
                  function):

                  a)       all significant deficiencies in the design or
                           operation of internal controls which could adversely
                           affect the registrant's ability to record, process,
                           summarize and report financial data and have
                           identified for the registrant's auditors any material
                           weaknesses in internal controls; and

                  b)       any fraud, whether or not material, that involves
                           management or other employees who have a significant
                           role in the registrant's internal controls; and

         6.       The registrant's other certifying officer and I have indicated
                  in this annual report whether or not there were significant
                  changes in internal controls or in other factors that could
                  significantly affect internal controls subsequent to the date
                  of our most recent evaluation, including any corrective
                  actions with regard to significant deficiencies and material
                  weaknesses.



Date: March 21, 2003


                                 /s/ Michael P. Keegan
                                 -----------------------------------------------
                                 Michael P. Keegan
                                 Vice President, Chief Financial Officer and
                                   Treasurer




--------------------------------------------------------------------------------

                                       41

<PAGE>

--------------------------------------------------------------------------------


INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Applied Innovation Inc.:

Under date of January 24, 2003, we reported on the consolidated balance sheets
of Applied Innovation Inc. and subsidiaries as of December 31, 2002 and 2001,
and the related consolidated statements of operations, stockholders' equity, and
cash flows for each of the years in the three-year period ended December 31,
2002, which are included herein. In connection with our audits of the
aforementioned consolidated financial statements, we also audited the related
financial statement schedule of valuation and qualifying accounts. This
financial statement schedule is the responsibility of the Company's management.
Our responsibility is to express an opinion on this financial statement schedule
based on our audits.

In our opinion, such financial statement schedule, when considered in relation
to the basic consolidated financial statements taken as a whole, presents
fairly, in all material respects, the information set forth therein.



/s/ KPMG LLP

Columbus, Ohio
January 24, 2003


--------------------------------------------------------------------------------

APPLIED INNOVATION INC.

SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 and 2000

<TABLE>
<CAPTION>
-------------------------------------------------------------------------------------------------------------------------
COLUMN A                                     COLUMN B       | - - - - COLUMN C  - - - - |         COLUMN D       COLUMN E
-------------------------------------------------------------------------------------------------------------------------
Description                                Balance at       Charged to           Charged                          Balance
                                            Beginning        Costs and          to Other                           at End
                                            of Period          Expense          Accounts        Deductions      of Period
-------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2002
-------------------------------------------------------------------------------------------------------------------------
<S>                                        <C>              <C>                   <C>           <C>            <C>
Allowance for doubtful accounts            $  475,000       $  114,596            $ --          $  159,596     $  430,000
Allowance for obsolete inventory            1,770,286        2,150,811              --           2,813,938      1,107,159
Warranty provision                            819,166        1,209,970              --           1,486,485        542,651
-----------------------------------------------------       ----------            ----          ----------     ----------

-------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2001
-------------------------------------------------------------------------------------------------------------------------
Allowance for doubtful accounts            $  690,602       $  443,527            $ --          $  659,129     $  475,000
Allowance for obsolete inventory              190,000        1,700,000              --             119,714      1,770,286
Warranty provision                          1,334,786        1,509,164              --           2,024,784        819,166
-----------------------------------------------------       ----------            ----          ----------     ----------

-------------------------------------------------------------------------------------------------------------------------
YEAR ENDED DECEMBER 31, 2000
-------------------------------------------------------------------------------------------------------------------------
Allowance for doubtful accounts            $  317,547       $  464,548            $ --          $   91,493     $  690,602
Allowance for obsolete inventory              160,000           30,000              --                  --        190,000
Warranty provision                          1,877,731        1,975,811              --           2,518,756      1,334,786
-----------------------------------------------------       ----------            ----          ----------     ----------
</TABLE>

--------------------------------------------------------------------------------

                                       42