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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, 2004

                                       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)

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

                    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. [ ]

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

The aggregate market value of the registrant's Common Stock held by the
registrant's non-affiliates was approximately $36,563,669 on June 30, 2004.

Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date: 15,162,909 shares of Common
Stock were outstanding at February 28, 2005.

                       DOCUMENTS INCORPORATED BY REFERENCE

Part III - Proxy Statement for the Annual Meeting of Stockholders to be held May
5, 2005, 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," "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

ITEM ONE | Business

ALL REFERENCES TO "WE," "US," "OUR," "APPLIED INNOVATION," "AI," OR THE
"COMPANY" IN THIS ANNUAL REPORT ON FORM 10-K MEAN APPLIED INNOVATION INC.

GENERAL

Applied Innovation Inc. 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 Dublin, Ohio, is traded on NASDAQ under the
symbol AINN. The Company's corporate headquarters occupy a 120,000 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 four primary markets in the U.S.
and abroad: 1) telecommunications companies using wireline networks; 2)
telecommunications companies using wireless networks 3) government networks; and
4) international telecommunications service providers who address both wireline
and wireless services in their respective territories. 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.

In all markets, the Company's products and services help operators of large,
complex networks more efficiently and effectively manage their operations and
critical infrastructure.

In the wireless market, the Company's products reside at both the mobile
telephony switching office and cellular sites forming a DCN. The primary
applications for the Company's products are remote site management, wireless
repeater management and radio frequency (RF) performance management. By
strategically positioning the Company's products in the network, a service
provider gains remote access and management capabilities that allow the NOC
personnel to be alerted to network issues, remotely troubleshoot issues and
dispatch qualified personnel to perform repairs on affected NE's from a remote
central location, avoiding site visits and reducing operations costs.

In the wireline market, the Company's products form the backbone of the data
communications network (DCN) which connects network elements (NEs) to operations
support systems (OSSs) across wide area networks (WANs). These products perform
the critical functions of providing the physical connection to the NE, mediating
the differing data communications standards, or protocols, to a common protocol
and transporting the data across the WAN to the network operations center (NOC),
where network operations personnel resolve critical network issues remotely or
dispatch local technicians for repair and maintenance. The Company's products
support the operation of switching, transport, test and access systems and are
critical components of both the traditional voice and next generation data
networks.

In the government market, the Company offers its traditional products and
services. Additionally, the Company is

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addressing the emerging issue of networking chemical, biological, radiological
and nuclear (CBRN) sensors. These sensors are designed to detect the presence of
toxic agents and report information to central data collection devices in order
to alert government personnel and first responders in the event of an
unconventional attack. The Company has adapted technology developed for the
wireline and wireless markets to support the data collection, adaptation and
networking functions required to integrate a diverse set of sensors into an
integrated network.

In international markets, the challenges faced by telecommunications service
providers are generally the same as those faced by domestic network operators.
The Company's wireline and wireless products are designed to operate in
international markets by addressing the appropriate technical features and
certification requirements of the customers in the Company's target geographies.

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 and network elements 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.

AIextend(TM) | AIextend brings intelligence to the network edge and improves OSS
efficiency. A powerful, next-generation application mediation device, AIextend
facilitates rapid integration of network elements with both legacy and
next-generation operations support systems. With it, service providers can
reduce OSS integration costs, gain intelligence at the edge, improve return on
current network investments, increase efficiency of their OSS and gain
flexibility and scalability.

AIconnect(TM) | AIconnect is a multi-purpose line card that provides a highly
integrated, scalable routing solution to support local central office IP
networks. It also provides aggregation to collect and manage remote sites,
allowing the service provider to avoid the complex network deployment or costly
infrastructure and support typically required.

AIfirewall(TM) | AIfirewall is a robust security application that fits
seamlessly into the AIswitch chassis. The product combines best-in-class
firewall technology from Check Point Software Technologies Ltd. with Applied
Innovation's Network Equipment Building Standards (NEBS) 3 compliant design.
AIfirewall allows customers to manage services and network devices located at
the customer premises without compromising the security of the operations
support network. It resides in a central office between the customer access
point and the internal support network, which allows it to pass only authorized
traffic while suppressing any unauthorized access attempts. Network managers
have full visibility into the managed services and devices, while security
personnel can administer pinpoint access rules using Check Point Firewall-1 NG.

AIflex(TM) | AIflex is an optical Ethernet aggregation line card that fits any
of the AIswitch chassis systems. This product allows for local area network
extension beyond the physical boundaries of a central office location over fiber
optics. With AIflex, service providers gain the benefits of an IP network
extension to remote sites without the cost of deploying routers at the edge of
the network.

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.

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AIbadger(TM) XT | AIbadger XT provides a flexible, affordable solution for
intelligent network management of wireless sites. The next generation of the
successful AIbadger product is designed to meet a broad range of operating
environments and security requirements. AIbadger XT provides complete remote
management for the entire cell site. It provides remote access to and
surveillance of equipment for immediate problem correction, troubleshooting,
provisioning and periodic maintenance.

AIbadger(TM)-RFM | AIbadger-RFM provides a flexible, affordable solution for
proactive RF monitoring of remote cell sites. It ensures better management of
base station performance from remote locations by recreating the user experience
at the cell site. Using a proactive approach to managing RF path performance,
troubleshooting of network problems is accelerated and on-site user intervention
is reduced. With AIbadger-RFM, service providers will reduce operating costs,
improve quality of service, enhance network reliability, increase revenue and
lower testing and training costs.

AIremote(TM) | AIremote extends the intelligence of operations supports systems
by enabling them to access out-of-band network management information beyond the
central office - thereby delivering intelligence and control to the edge of the
broadband access network. By providing a flexible, scalable means of managing
and monitoring remote locations, this temperature-hardened device allows service
providers to lower operating costs, reduce maintenance costs, decrease training
costs and lower total cost of ownership.

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, higher switch and transport network
reliability, scalability and simplified deployment.

Sensor Management Unit | AI's sensor management unit offers a unique mix of
sensor physical interfaces, data networking and data processing capabilities in
an integrated, environmentally hardened package. Incorporating best-of-breed
network management and process automation capabilities, AI's sensor management
unit allows network designers to build scalable networks of sensors for
protection of critical infrastructure. The AI sensor management unit is designed
to support a wide range of third-party chemical, radiological, nuclear and
biological sensors, as well as supporting infrastructure.

FINANCIAL DISCLOSURES | Revenues from sales of hardware solutions are included
in Products 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.

NETWORK MANAGEMENT SOFTWARE SOLUTIONS

The Company offers several network management software (NMS) solutions to help
telecommunications service providers manage their data communications networks.

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.

FINANCIAL DISCLOSURES | The Company generates software license fees from the
sale of these NMS solutions. Such license fees and related third-party NMS
equipment revenues are included in Products 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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SERVICES SOLUTIONS

Applied Innovation delivers added value to customers through a robust suite of
service offerings. Leveraging its in-depth knowledge of the telecommunications
industry, enterprise networking, network management systems and operational
support requirements, the Company delivers scalable solutions to fulfill complex
business requirements in innovative ways. Its 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. The Company's 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. The
Company's 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. The
Company also offers an integrated method of deployment that unites customers'
disparate third-party equipment and systems with its own. AI customers gain
significant economies of scale because the Company can provide a large portion
of the installation, cabling and configuration support prior to equipment and
personnel arriving at the customer site.

FINANCIAL DISCLOSURES | 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 and 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

The Company designs all of the printed circuit boards, chassis enclosures and
other hardware used in its products at its Dublin facility. These product
designs are proprietary designs of the Company. Under the supervision of the
Vice President of Operations and Services 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
NEBS and Generic Equipment Requirements guidelines. The Company is International
Standards Organization 9001:2000 (ISO 9001:2000) certified and became TL9000
certified in March 2004.

MARKETING, BUSINESS DEVELOPMENT AND SALES

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 Canada. 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

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maintains a sales office in Denver, Colorado.

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 operations managers, engineers 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 and services 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 sales level achievement.

RESEARCH AND DEVELOPMENT

The Company's research and development (R&D) activities are coordinated with
product management and sales with specific focus on customer and market
requirements. Enhancements to AIswitch are focused on improving the performance
capabilities of the product and adding functionality in its set of line cards,
including AIconnect, AIextend, AIfirewall and AIflex. These feature upgrades
allow a service provider to seamlessly transition to next generation operations
support systems, integrate new elements into their systems more efficiently,
aggregate remote sites over multiple physical media, improve network security
and adapt the information flowing across the product for more rapid
implementation of customer-driven applications. Enhancements to the Company's
AIremote product are also planned to address additional applications with
service providers' outside plant applications, including enhanced networking and
security features.

Additional improvements are planned for the AIbadger product line to expand
network management capabilities, improve service quality and speed the
introduction of new technologies primarily for the wireless market. Enhancements
are in development for the AIbadger-RFM product to provide capability to perform
RF, voice and data network performance monitoring for both CDMA EV-DO and GSM
networks. Additional feature releases are also planned for the recently released
AIbadger XT cellular site management device to enhance both networking and
security functions.

The Company is also planning enhancements and extensions for the new sensor
management unit product for pursuit of networked sensor opportunities with
federal, state and local governments.

The Company spent $5,119,677, $5,575,652 and $7,084,646 on Company-sponsored R&D
during the fiscal years ended December 31, 2004, 2003 and 2002, respectively, or
approximately 16% of annual sales in each of those years. See "Business -
Business Risks - New Products, Research and Development, and Rapid Technological
Change; Need to Manage Product Transitions."

SERVICES, CUSTOMER SERVICE AND WARRANTY

The Company offers its customers a variety of services such as technical
support, project management, training, detail engineering, installation, 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, account managers maintain contact with the customers to ensure
customer satisfaction.

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

The Company designs training programs to educate the customer's system
administration, operations and

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maintenance personnel to operate its products and application solutions. 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 warrants its products for a minimum of one year after the sale.
Customers may also purchase extended maintenance 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 maintenance 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 expenses represented approximately 1.7%, 2.3% and 1.6% of annual sales
in 2004, 2003 and 2002, 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.

Competition for the Company's hardware products arises primarily from the
following equipment suppliers: ADC, Carrier Access Corporation, Cisco Systems,
Datatek Corp., DPS Telecom, Eastern Research and Quest Controls. See "Business -
Business Risks - Competition."

In the areas of sensor networking and management within the government market,
the Company competes primarily against internal solutions from large government
systems integrators, RTI and Sentel Corporation.

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 February 28, 2005, the Company had 103 full-time and part-time employees.
The Company's employees are distributed among the following departments: Sales
and Marketing 24; Research and Development 35; Services 17; Administration 14;
and Operations 13.

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, 2005, 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 2004, 2003 and 2002, sales to the Company's
three largest customers represented approximately 75%, 74% and 75%,
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
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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, may impact the
Company's sales. Additionally, many of the Company's largest customers have
significantly reduced staffing over the last two years, including key customer
personnel involved in purchasing decisions who are knowledgeable about the
Company. The loss of key customer contacts could negatively impact future demand
for the Company's products and services.

Over the last 36 to 48 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 the Company's 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 majority of the Company's total sales in fiscal 2005. Therefore,
the Company's future operating results, particularly in the near term, are
dependent upon the continued market acceptance of these products and
improvements to the product framework. 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 and applications. The life cycles of such
products are difficult to estimate due in large part to 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 could
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
efforts. 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 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 could 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.

<PAGE>

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 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 technology companies 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 could 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. Several of the
Company's products include technology licensed from third parties, including
components of its routing, radio frequency and firewall technologies. The
Company believes that currently there are acceptable alternatives to the
suppliers of raw material and technology used in its products. There can be no
assurance that raw material and technology will continue to be available to the
Company on commercially reasonable terms or at all. If the Company is unable to
procure the necessary raw material or technology, the Company's business,
operating results and financial condition could be materially adversely
affected.

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 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 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

<PAGE>

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 | Historically, the Company has experienced
fluctuations in sales and net income (loss). Any growth rates in prior periods
should not be considered indicative of future growth, if any. There can be no
assurance that the Company's sales 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 that may cause operational 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, 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 the
regulatory environment; changes in pricing policies by the Company or its
competitors; the lengthy sales cycle of the Company's products; increased
competition; 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 has 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 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. The
loss of 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.

<PAGE>

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 a company. Such litigation could result in substantial
costs and a diversion of management's attention 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 and executive officers and existing
principal stockholders of the Company beneficially own approximately 41% of the
Company's common stock as of February 15, 2005. 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 and executive officers
of the Company beneficially own approximately 41% of the Company's common stock
as of February 15, 2005. In particular, Gerard B. Moersdorf, Jr. beneficially
owns approximately 39% of the Company's common stock. Mr. Moersdorf's beneficial
ownership includes approximately 14% of the Company's common stock held by Mr.
Moersdorf's former spouse because he has been granted an irrevocable proxy to
vote such shares. As a result, Mr. Moersdorf, Jr. is 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.

Litigation and Other Contingencies | The Company may be party to lawsuits in the
normal course of its business. Litigation can be expensive, lengthy and
disruptive to normal business operations. Moreover, the results of complex legal
proceedings are difficult to predict. An unfavorable resolution of a particular
lawsuit could have a material adverse effect on the Company's business,
operating results or financial condition.

ITEM TWO | Properties

The Company is headquartered in a 120,000 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 some adjacent properties which total approximately 38 acres. In
addition, the Company leases an office facility in Denver, Colorado.

ITEM THREE | Legal Proceedings

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

<PAGE>

ITEM FOUR | Submission of Matters to a Vote of Security Holders

Not applicable.

PART II

ITEM FIVE | 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.

<TABLE>
<CAPTION>
          2004            2003
     -------------   -------------
      High    Low     High    Low
     -----   -----   -----   -----
<S>  <C>     <C>     <C>     <C>
Q1   $8.00   $4.85   $3.55   $2.36
Q2   $5.62   $3.79   $3.73   $2.60
Q3   $4.31   $2.84   $6.50   $3.35
Q4   $4.25   $2.86   $7.35   $5.86
</TABLE>

At February 28, 2005, the Company had 493 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, general
financial condition of the Company and general business conditions.

ITEM SIX | Selected Financial Data

The table below presents selected operating and balance sheet data for the years
ended and as of December 31, 2004, 2003, 2002, 2001 and 2000. The Company
derives the selected financial data for those periods and as of those dates from
its audited financial statements. This selected financial data should be read in
conjunction with "Item Seven. Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Item Eight. Financial Statements and
Supplementary Data."

<PAGE>

                             APPLIED INNOVATION INC.

                      SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                                    Years ended December 31,
                                                              --------------------------------------------------------------------
                                                                  2004          2003          2002          2001          2000
                                                              -----------   -----------   -----------   -----------   ------------
<S>                                                           <C>           <C>           <C>           <C>           <C>
OPERATING DATA:
   Sales                                                      $31,396,937   $33,968,086   $42,961,011   $73,019,150   $116,103,392
   Cost of sales                                               14,524,397    16,353,637    23,556,671    39,251,716     75,906,065
                                                              -----------   -----------   -----------   -----------   ------------
      Gross profit                                             16,872,540    17,614,449    19,404,340    33,767,434     40,197,327

   Selling, general and administrative expenses                13,178,399    13,689,576    18,413,456    22,183,578     18,455,315
   Research and development expenses                            5,119,677     5,575,652     7,084,646     9,648,898      8,176,622
   Restructuring charges                                          605,804       (32,237)    2,890,155       292,330             --
                                                              -----------   -----------   -----------   -----------   ------------
      Total operating expenses                                 18,903,880    19,232,991    28,388,257    32,124,806     26,631,937
                                                              -----------   -----------   -----------   -----------   ------------
      (Loss) income from operations                            (2,031,340)   (1,618,542)   (8,983,917)    1,642,628     13,565,390
                                                              -----------   -----------   -----------   -----------   ------------
   Interest and other income, net                                 451,756       393,057       597,137     1,350,338      1,353,612
                                                              -----------   -----------   -----------   -----------   ------------
      (Loss) income before income taxes                        (1,579,584)   (1,225,485)   (8,386,780)    2,992,966     14,919,002
   Income tax (benefit) expense                                  (787,000)     (690,000)   (3,532,000)      755,000      4,774,000
                                                              -----------   -----------   -----------   -----------   ------------
      Net (loss) income                                       $  (792,584)  $  (535,485)  $(4,854,780)  $ 2,237,966   $ 10,145,002
                                                              ===========   ===========   ===========   ===========   ============
   Basic (loss) earnings per share                            $     (0.05)  $     (0.04)  $     (0.32)  $      0.14   $       0.65
                                                              ===========   ===========   ===========   ===========   ============
   Diluted (loss) earnings per share                          $     (0.05)  $     (0.04)  $     (0.32)  $      0.14   $       0.63
                                                              ===========   ===========   ===========   ===========   ============
   Shares used in computing basic (loss) earnings per share    15,077,118    14,994,924    15,092,328    15,870,492     15,598,723
                                                              ===========   ===========   ===========   ===========   ============
   Shares used in computing diluted (loss) earnings per
      share                                                    15,077,118    14,994,924    15,092,328    16,140,993     16,014,153
                                                              ===========   ===========   ===========   ===========   ============
BALANCE SHEET DATA:
   Cash and short-term and non-current investments            $25,697,634   $27,973,038   $23,964,017   $28,616,130   $ 26,274,009
   Net working capital                                         20,777,822    20,957,201    25,127,859    31,803,653     35,204,228
   Total assets                                                47,397,922    49,882,879    50,384,908    60,847,804     80,668,451
   Stockholders' equity                                        42,939,795    43,476,636    43,299,366    50,903,912     49,991,620
</TABLE>

<PAGE>

ITEM SEVEN | 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. 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. By providing solutions in the areas of network
mediation, aggregation and adaptation, the Company enables its customers to more
effectively and efficiently manage their large, complex networks.

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. By leveraging its extensive knowledge of network infrastructure, its
vendor-neutral methodology and its customer-centric approach, AI provides
solutions which help customers better manage and control both their capital
expenditures and their operating expenditures. Applied Innovation's solutions
are targeted to four primary markets in the U.S. and abroad: 1)
telecommunications companies using wireline networks; 2) telecommunications
companies using wireless networks 3) government networks; and 4) international
telecommunications service providers who address both wireline and wireless
services in their respective territories. Its largest customers are the RBOCs,
domestic wireless service providers and other large domestic and foreign phone
companies.

The telecommunications industry continues to be characterized by a rapidly
changing regulatory and technological environment. Along with regulatory and
technological change, consolidation within the wireline and wireless markets
continues to occur among some of the largest service providers (carriers) in the
industry. Whereas network build-out, capacity growth and aggressive customer
acquisitions were areas of focus in the last several years, the carriers are now
turning their attention more to the issues of differentiated service offerings,
quality of service and network reliability. The Company has responded to these
changing industry conditions and customer needs with new product offerings and
ongoing development projects that provide value to the carriers where they need
it most.

<PAGE>

The downturn in the industry experienced over the past several years appears to
be stabilizing and perhaps beginning to reverse in 2005. The Company has
conservatively managed its business through the downturn and considers itself
well positioned to capitalize on the industry stabilization and predicted
recovery. While enacting a number of cost reduction measures over that period,
the Company has continued its focus on customers, continued its research and
development spending in targeted areas that show promise and continued its
market diversification efforts. The Company looks to the upcoming year with
optimism that the wireless growth of the last two years will continue, wireline
market sales will stabilize, international markets will continue to expand and
government business development efforts will begin contributing to sales and
earnings.

Looking ahead to 2005, the Company is monitoring emerging trends in each of its
markets. The following is an analysis of these trends, the Company's positioning
in each market and growth expectations for each in 2005.

Wireless | With the ongoing proliferation of media-rich wireless services,
wireless service providers continue to deploy additional network capacity and
coverage. The wireless carriers also continue to focus on differentiating their
services based on quality, national network availability and broadband data
applications. At the same time, industry consolidation, the emergence of virtual
network operators and the threat of customer churn have created intense
competition that will continue to limit the service providers' pricing power.
These factors all result in the wireless carriers focusing on projects to
improve network coverage, expand capacity, enable advanced services such as
broadband data and enhance network quality and reliability. All of these trends
suggest the wireless service providers will place increased value on workforce
automation, quality initiatives and consolidation of disparate networks as they
strive for even greater operating efficiencies. AI is well-positioned to
capitalize on these trends with its AIbadger, AIbadger XT and AIbadger-RFM
intelligent network management devices. The introduction of the AIbadger-RFM in
2004 provided customers an affordable on-site solution for monitoring the
performance of the total network, including radio frequency, voice and data.
AIbadger XT is the next generation of the successful AIbadger product and is
designed specifically to address opportunities in outdoor base stations and
smaller cell sites. Wireless sales grew over 140% in 2004, largely due to
continued demand from one large customer. Looking into 2005, the Company plans
to continue broadening its sales penetration in existing wireless accounts, add
additional customers and find new applications and products to address changing
marketplace needs, such as RF repeater monitoring, which brings network
management capabilities to previously isolated coverage extension components of
the wireless network. Double digit sales growth in wireless sales is expected in
2005.

Wireline | After several years of record spending in the late 1990's, followed
by several years of declining capital expenditures, wireline carrier spending
appears to have stabilized and is showing signs of returning to more normalized
levels as a percentage of revenue. Market indicators suggest that capital
expenditures by the largest carriers may show slight to modest growth in 2005.
At the same time, the carriers continue to strive for efficiencies in their
networks to minimize ongoing operating expenses. In response to the changing
industry environment and trends, wireline carriers are focusing on digital
subscriber line (DSL) deployment, Voice over Internet Protocol (VoIP)
initiatives and significantly increased plans for broadband network deployments
utilizing fiber-optics. The Company's objective is to ensure that its remote
site monitoring, security and aggregation products become standard equipment for
these deployments. In 2004, the Company received orders for a variety of
products including AIflex and AIremote as part of a fiber to the premises (FTTP)
deployment at a large wireline customer. The Company expects such order flow to
continue in 2005, as well as orders for AIfirewall, in support of the
aforementioned major carrier initiatives. The Company believes the new products
it has developed over the past several years, such as AIremote, AIfirewall, and
AIextend have the flexibility, adaptability and IP features that provide value
to the carriers as they move towards next-generation networks.

Overall Company sales are heavily concentrated with a few domestic wireline
carriers. Based on historical spending patterns, the carriers' first quarter
spending is usually the lowest of the year, the second quarter increases
sequentially, the third quarter is usually flat to down sequentially and the
fourth quarter is the strongest of the year. In addition to seasonality, factors
such as labor disruptions, reorganizations and mergers can temporarily interrupt
order flow and negatively impact short-term sales. Looking into 2005, the
Company is projecting slightly decreased wireline sales as compared to 2004 as
spending on new initiatives and products has not grown fast enough to offset
sales declines in the Company's more mature products.

International | The business issues faced by foreign service providers are
similar to those faced by domestic service providers as they attempt to roll-out
new services such as DSL and broadband wireless data applications, update legacy
networks to current standards and cut both capital spending and operating
expenses. The Company's products are well-suited to these challenges since AI
has been solving many of these issues

<PAGE>

domestically for years through network mediation, network migration and
workforce automation. In 2004, the Company nearly doubled its international
sales from the prior year as it continued its strong partnerships overseas.
Double digit sales growth is expected in 2005 from international business as
demand from the Company's South African customer remains strong and new
customers are added in new territories.

Government | The U.S. Government has significantly increased its focus on
communication, security and military preparedness over the last several years,
especially in the Department of Defense (DoD), Department of Homeland Security
(DHS) and other security agencies focused on homeland defense initiatives. As a
result of business development efforts in 2004, the Company has narrowed its
focus in this market to the area of networking and managing chemical,
biological, radiological and nuclear sensors. The Company believes that this new
market area provides the greatest potential growth, while at the same time
maximizing the leverage of the Company's core technical capabilities. The
Company expects its investment in government business development to begin to
payoff in 2005 and expects government sales to contribute to sales and earnings
in the coming year.

Sales Cycles, Seasonality, Sales Forecasting | Due to the complexity of the
network management solutions provided, the Company's sales cycle can range from
six months to over two years for new product applications. The sales process
begins with the discovery of complex and unique networking problems within new
or existing customers. AI proposes solutions encompassing a mix of products,
software and services, and then often tests these solutions for months in
customers' test labs or networks. Next, AI provides price quotes; the customer
secures funding and develops deployment plans; and finally begins ordering
product. The time from order to delivery is generally measurable in days or
weeks. Since the sales cycle is long, but delivery time is relatively short, the
Company does not operate with large order backlogs and order forecasting is
somewhat limited. In addition, the Company's customer base is concentrated
heavily among a limited number of large domestic service providers and orders
follow the seasonal pattern described above. The Company attempts to mitigate
uneven order flow from its customers by diversifying the mix of customers,
markets, products, services and software.

Looking into the first quarter of 2005, the seasonal pattern described above is
expected to repeat and a sequential decline in sales from the fourth quarter of
2004 to the first quarter of 2005 is likely. Overall for 2005, sales are
expected to remain relatively flat as growth in wireless and international
revenues are expected to largely offset the softness in wireline sales. To
ensure profitability at expected 2005 sales levels, the Company took additional
cost cutting measures in early 2005 by reducing staffing and making further
reductions in discretionary spending.

COMPARISON OF 2004 TO 2003

TOTAL SALES AND GROSS PROFIT

Sales of $31,397,000 for the year ended December 31, 2004 decreased 8% from the
prior year's sales of $33,968,000. Despite continued strength in the wireless
market and growth in sales to the Company's international customers, total sales
decreased primarily as a result of lower domestic wireline sales. Sales of
$7,584,000 to wireless customers in 2004 more than doubled from prior year
wireless sales of $3,130,000. Wireless sales represented 24% of total sales in
2004 compared to 9% in 2003. Primarily resulting from increased spending by the
Company's largest international customer, international sales increased from
$1,043,000 in 2003 to $2,074,000 in 2004, an increase of 99%. International
sales represented 7% of total sales in 2004, increasing from 3% of total sales
in 2003. However, the growth in wireless and international sales was not enough
to overcome the lower wireline sales domestically. As wireline sales decreased
from $29,244,000 in 2003 to $21,615,000 in 2004, total domestic sales dropped
from $32,925,000 in 2003 to $29,323,000 in 2004.

Because of the Company's concentration of sales to a limited customer base, 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 2004,
with each contributing between 18% and 35% of sales. In 2003, sales to three
customers comprised 74% of sales, with each contributing between 11% and 35% 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.

Gross profit as a percentage of total sales was 54% for the year ended December
31, 2004 as compared to 52% in the prior year. A significant increase in service
margins from 2003 to 2004 contributed to the overall increase in gross profit
margins.

<PAGE>

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

<TABLE>
<CAPTION>
                                                                       Gross
                                           Sales      Gross Profit   Profit %
                                        -----------   ------------   --------
<S>                                     <C>           <C>            <C>
For the Year ended December 31, 2004:
Products                                $25,876,000    $13,785,000       53%
Services                                  5,521,000      3,088,000       56%
                                        -----------    -----------
Total                                   $31,397,000    $16,873,000       54%
                                        ===========    ===========

For the Year ended December 31, 2003:
Products                                $27,076,000    $14,664,000       54%
Services                                  6,892,000      2,950,000       43%
                                        -----------    -----------
Total                                   $33,968,000    $17,614,000       52%
                                        ===========    ===========
</TABLE>

PRODUCTS SALES AND GROSS PROFIT

In 2004, product sales of $25,876,000 decreased by $1,200,000, or 4%, from the
prior year. This decrease was due primarily to the decrease in orders from the
Company's domestic wireline customers. As a percentage of total sales, 2004
product sales represented 82% of total sales as compared to 80% in 2003.

Product sales include revenues from the sales of the Company's hardware
products, as well as third-party hardware and software licensing revenues.

Gross profit on product sales was 53% for the year ended December 31, 2004
comparable with 54% for the prior year. The Company expects overall product
gross profit margins in 2005 to be generally consistent with the prior two
years.

SERVICES SALES AND GROSS PROFIT

Services sales of $5,521,000 were 18% of total 2004 sales, versus services sales
of $6,892,000, or 20%, of total 2003 sales. While 2004 sales from extended
maintenance agreements were generally consistent with the prior year, the
decrease in services sales from 2003 was primarily attributable to decreased
installation, custom services and training sales.

Services sales include revenues from network planning and design, installation,
project management, engineering services, training and maintenance.

Gross profit on services sales was 56% for the year ended December 31, 2004
compared to 43% for the prior year. The increase in gross profit on service
sales in 2004 as compared to 2003 was primarily due to high utilization of
services personnel, reduced use of consultants and an increased mix of
relatively higher margin maintenance revenues. In 2005, services gross margins
are expected to be approximately 50%.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative (SG&A) expenses decreased to $13,178,000 in
2004 from $13,690,000 in 2003. As a percentage of total sales, this represented
42% in 2004 and 40% in 2003. The decrease in SG&A spending was primarily
attributable to reductions in bonuses, consulting, relocation, materials,
insurance and taxes other than income taxes. SG&A expenses in 2005 are
anticipated to be lower than 2004 as a result of the Company's continued focus
on cost controls, the full-year benefit in 2005 of the two restructuring plans
enacted in 2004 and an additional restructuring event in early 2005.

RESEARCH AND DEVELOPMENT EXPENSES

Research and development (R&D) expenses decreased from $5,576,000 in 2003 to
$5,120,000 in 2004. As a percentage of total sales, this represented 16% in both
years. The decrease in R&D expenses was primarily attributable to reduced
consulting, less compliance testing and other reductions in discretionary
spending. In 2005, the Company plans to continue to invest in product
enhancements and new product development to support changing industry trends,
customer needs and ongoing diversification efforts. At the same time, however,
the Company expects to benefit from the restructuring events and continued
emphasis on cost controls resulting in lower R&D expenses in 2005 than in 2004.

<PAGE>

RESTRUCTURING CHARGES

In 2004, the Company enacted two restructuring plans resulting in aggregate
restructuring charges of $606,000 related to workforce reductions of
approximately 25 employees throughout all departments. As of December 31, 2004,
the remaining restructuring accrual was $139,000, consisting of employee
separation costs totaling $114,000 related to an October 2004 restructuring
event and lease payments (net of estimated sublease receipts) totaling $25,000
related to an October 2002 restructuring event. Remaining employee separation
costs and lease payments are scheduled to be paid in 2005.

Subsequent to the end of 2004, the Company further reduced its workforce and
recorded restructuring charges of approximately $1,000,000 related to severance
and other fringe benefits in its first quarter 2005 financial statements.
Although the Company currently has no further restructuring or other cost
reductions planned, it will continue to monitor industry and business conditions
and will take further corrective action as necessary.

INTEREST AND OTHER INCOME, NET

Total interest and other income, net increased to $452,000 in 2004 versus
$393,000 in 2003. The overall increase was primarily due to reduced interest
expense and increased realized gains on the sale of investments. The decrease in
interest expense was primarily due to the maturity of the Company's note payable
which came due in August 2004.

INCOME TAXES

The Company's effective income tax benefit rate was 50% in 2004 compared to an
effective tax benefit rate of 56% in 2003. The rates in both years exceeded the
expected statutory rates primarily because of reductions made each year to
certain income tax contingency reserves. Based on corresponding reductions in
the related income tax exposures, the Company reduced such reserves by $379,000
in 2004 and $351,000 in 2003. Relative to the associated pre-tax loss for the
year, the reductions in 2004 had less impact on the effective income tax benefit
rate than the reductions in 2003.

NET LOSS AND LOSS PER SHARE

Net loss for 2004 was $793,000, or $0.05 per share, compared to the net loss of
$535,000, or $0.04 per share, in 2003. The weighted-average number of shares
outstanding was 15,077,000 for 2004 compared to 14,995,000 for 2003.

ASSETS

Total assets decreased $2,485,000 in 2004, from $49,883,000 at December 31, 2003
to $47,398,000 at December 31, 2004. The Company's total cash and investments
decreased $2,275,000 from 2003 to 2004 as a result of operating, investing and
financing activities which consumed $2,257,000 of cash during 2004. Working
capital changes included an increase in accounts receivable of $1,209,000 due to
high sales volume at the end of the year. Net inventory decreased $422,000
primarily as a result of the Company's efforts to reduce its working capital
investment, as well as high December sales volume depleting available inventory.
Other current assets decreased $684,000 due to the receipt of deposit returns
and refunds for insurance. Net property, plant and equipment decreased $519,000
as total purchases of $647,000 for the year were more than offset by
depreciation expense and asset disposals. The other noteworthy change in assets
was the $587,000 increase in deferred income taxes primarily as a result of the
Company generating net operating loss carryforwards.

LIABILITIES AND STOCKHOLDERS' EQUITY

Total liabilities decreased from $6,406,000 at December 31, 2003 to $4,458,000
at December 31, 2004. The total decrease of $1,948,000 was primarily
attributable to decreases in deferred revenue of $1,368,000 and the note payable
of $750,000. Deferred revenue is expected to fluctuate as a result of timing
considerations associated with maintenance and support contracts. Revenue
related to maintenance and support contracts is recognized ratably over the
respective terms of the underlying contracts. In addition, deferred revenue may
also be impacted by customer contracts containing terms that govern the timing
of revenue recognition. At December 31, 2004 and 2003, one such contract
resulted in deferred revenue of $94,000 and $965,000, respectively. The note
payable, relating to a 2001 acquisition, matured and was paid in August 2004.

Total stockholders' equity decreased $537,000 in 2004, from $43,477,000 at
December 31, 2003 to $42,940,000 at December 31, 2004. Partially offsetting the
current year comprehensive loss of $822,000 was an increase of

<PAGE>

$267,000 related to stock option exercises, stock issued under the employee
stock purchase plan and stock issued to non-employees for services rendered.

COMPARISON OF 2003 TO 2002

TOTAL SALES AND GROSS PROFIT

Sales of $33,968,000 for the year ended December 31, 2003 decreased 21% from the
prior year's sales of $42,961,000, due primarily to continued low levels of
capital expenditures throughout the telecommunications industry. Despite
continued strength in the wireless market and growth in sales to the Company's
domestic wireless customers, total sales decreased due to lower domestic
wireline sales and a significant decrease in international sales. Largely due to
decreased spending by the Company's largest international customer,
international sales decreased from $6,391,000 in 2002 to $1,043,000 in 2003, a
decrease of 84%. Whereas international sales represented 15% of total sales in
2002, such sales represented only 3% of total sales in 2003. Domestic sales also
decreased in 2003, despite an increase in wireless sales from $803,000 in 2002
to $3,143,000 in 2003. Domestic sales for the year ended December 31, 2003 were
$32,925,000 compared to $36,570,000 in the prior year. The 10% decrease resulted
primarily from decreased wireline sales, partially offset by the increase in
wireless sales.

Because of the Company's concentration of sales to a limited customer base, a
small number of customers have historically comprised a substantial portion of
the Company's sales. Sales to three customers comprised 74% of sales in 2003,
with each contributing between 11% and 35% of sales. In 2002, sales to three
customers comprised 75% of sales, with each contributing between 14% and 31% 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.

Gross profit as a percentage of total sales was 52% for the year ended December
31, 2003 as compared to 45% in the prior year. Several factors, as further
discussed below, contributed to that overall increase. First, services margins
were significantly higher than last year and services sales represented a higher
proportion of total sales than last year. Second, variations in product sales
mix resulted in higher margins on product sales. Third, the prior year included
much higher inventory charges than the current year due to additional charges
necessary in 2002 for obsolete and potentially excess inventory.

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

<TABLE>
<CAPTION>
                                                                       Gross
                                           Sales      Gross Profit   Profit %
                                        -----------   ------------   --------
<S>                                     <C>           <C>            <C>
For the Year ended December 31, 2003:
Products                                $27,076,000    $14,664,000      54%
Services                                  6,892,000      2,950,000      43%
                                        -----------    -----------
Total                                   $33,968,000    $17,614,000      52%
                                        ===========    ===========

For the Year ended December 31, 2002:
Products                                $36,292,000    $17,047,000      47%
Services                                  6,669,000      2,357,000      35%
                                        -----------   ------------
Total                                   $42,961,000    $19,404,000      45%
                                        ===========   ============
</TABLE>

PRODUCTS SALES AND GROSS PROFIT

In 2003, product sales of $27,076,000 decreased by $9,216,000, or 25%, from the
prior year. As a percentage of total sales, product sales dropped from 84% in
2002 to 80% in 2003. The overall decrease was due largely to the decrease in
orders from the Company's largest international customer as well as ongoing low
levels of capital spending industry-wide.

Product sales include revenues from the sales of the Company's hardware
products, as well as third-party hardware and software licensing revenues.

Gross profit on product sales was 54% for the year ended December 31, 2003
compared to 47% for the prior year. The increase in gross profit percentage is
primarily attributable to several factors: (i) slightly higher margins on core
products; (ii) improved margins on wireless products; (iii) fewer sales of
third-party equipment associated with NMS deployments (such equipment generally
yields lower margins); and (iv) fewer inventory charges in the

<PAGE>

current year as compared to 2002. During 2003, the Company recorded inventory
charges of $551,000 compared to inventory charges in excess of $2,100,000 during
2002, all of which were charged to cost of goods sold. The 2002 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.

SERVICES SALES AND GROSS PROFIT

Services sales of $6,892,000 were 20% of total 2003 sales, versus services sales
of $6,669,000, or 16%, of total 2002 sales. The slight increase in services
sales from 2002 was primarily attributable to the continued demand from wireless
customers for installation services. The increase in installation services sales
was partially offset by decreased NMS consulting and services sales, while sales
from extended maintenance agreements were generally 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 43% for the year ended December 31, 2003
compared to 35% for the prior year. The increase in gross profit on service
sales in 2003 was primarily due to an increase in the volume of installation
service projects resulting in high utilization of services personnel.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative (SG&A) expenses decreased to $13,690,000 in
2003 from $18,413,000 in 2002. As a percentage of total sales, this represented
40% in 2003 and 43% in 2002. The decrease in SG&A spending was primarily
attributable to the significant headcount reductions in sales, marketing and
other administrative functions that occurred in the second half of 2002
(including the elimination of five senior management positions) as well as
reductions in bonuses and commissions, advertising, trade show expenditures,
travel expenses and other discretionary spending. Despite the overall reduction
in SG&A spending, the Company increased spending in sales and marketing to
further develop its wireless and government markets.

RESEARCH AND DEVELOPMENT EXPENSES

Research and development (R&D) expenses were $5,576,000 in 2003 and $7,085,000
in 2002. As a percentage of total sales, this represented 16% for both 2003 and
2002. The decrease in R&D expenses was primarily attributable to reduced
headcount costs, lower materials costs and other reductions in discretionary
spending. During 2002 and 2003, the Company narrowed its R&D focus to
concentrate more on those projects in its current wireline and wireless markets
with the greatest strategic value and market potential.

RESTRUCTURING CHARGES

During 2002, the Company enacted two restructuring plans resulting in aggregate
restructuring charges of $2,890,000 related primarily to workforce reductions of
approximately 150 employees throughout all departments, as well as charges
related to excess equipment and leased offices. During 2003, certain adjustments
totaling $32,000 were made to decrease the restructuring accrual because the
planned headcount reduction was not fully enacted and certain fringe benefit
costs were less than originally estimated. As of December 31, 2003, $44,000 of
the accrued restructuring costs remained to be paid. The remaining accrued
restructuring costs represent lease payments, net of estimated sublease
receipts, extending to 2005.

INTEREST AND OTHER INCOME, NET

Total interest and other income, net decreased to $393,000 in 2003 versus
$597,000 in 2002. The overall decrease resulted from lower interest income due
to lower average yields on cash and investment balances.

INCOME TAXES

The Company's effective income tax benefit rate was 56% in 2003 compared to an
effective tax benefit rate of 42% in 2002. The increase in the effective income
tax benefit rate in 2003 was due primarily to reductions to certain income tax
accruals to correspond with reductions in certain income tax exposures. Based on
an audit conducted by the Internal Revenue Service in 2003 and the Company's
detailed analysis of certain federal and state income tax exposures, the Company
reduced its tax contingency reserves by $351,000 in 2003.

<PAGE>

NET LOSS AND LOSS PER SHARE

Net loss for 2003 was $535,000, or $0.04 per share, compared to the net loss of
$4,855,000, or $0.32 per share, in 2002. The weighted-average number of shares
outstanding was 14,995,000 for 2003 compared to 15,092,000 for 2002.

ASSETS

Total assets decreased $502,000 in 2003, from $50,385,000 at December 31, 2002
to $49,883,000 at December 31, 2003. The Company's operations and working
capital changes resulted in total cash and investments increasing $4,009,000
from 2002 to 2003. Part of the cash and investments increase was attributable to
the $2,811,000 decrease in income taxes receivable as a result of federal income
tax refunds of $3,600,000 which were received in 2003 for amounts refundable for
the 2002 tax filing year. In addition, overall lower sales and increased
collections efforts contributed to the reduction in net accounts receivable of
$1,591,000 between years. Net inventory decreased $595,000 primarily as a result
of the Company's efforts to reduce its working capital investment, as well as
less inventory being required to support overall lower sales. Net property,
plant and equipment decreased $733,000 as total purchases of $480,000 for the
year were more than offset by depreciation expense and asset disposals. The
other noteworthy change in non-current assets was the $1,180,000 increase in
other assets resulting from the $1,224,000 purchase of corporate owned life
insurance on four of the Company's executives, primarily purchased as an
alternative investment vehicle.

LIABILITIES AND STOCKHOLDERS' EQUITY

Total liabilities decreased from $7,086,000 at December 31, 2002 to $6,406,000
at December 31, 2003. The total decrease of $680,000 was primarily attributable
to decreases in accounts payable of $765,000 and accrued restructuring of
$539,000, partially offset by an increase in deferred revenue of $366,000.
Fluctuations in accounts payable are expected, based on the timing of invoices
and check processing, even though the Company generally pays amounts owed within
standard 30 day terms. Accrued restructuring costs were paid down in 2003 as
expected, with only the future lease payments for vacated office space remaining
in the accrual at the end of 2003. Deferred revenue is also expected to
fluctuate over time, depending on the timing of certain maintenance and support
contracts. The related revenue is recognized ratably over the respective terms
of the underlying contracts.

Total stockholders' equity increased $178,000 in 2003 as a result of several
factors. Increasing the stockholders' equity balance was the repayment of a
$383,000 note receivable for common stock, as well as $296,000 related to stock
option exercises and stock issued under the employee stock purchase plan.
Partially offsetting those increases was the current year comprehensive loss of
$501,000.

LIQUIDITY AND CAPITAL RESOURCES

Net working capital was $20,778,000 at December 31, 2004 compared to $20,957,000
at December 31, 2003. At December 31, 2004, the current ratio was 5.7:1 and the
Company had no debt outstanding.

The Company had $25,698,000 of cash and cash equivalents and short- and
long-term investments at December 31, 2004, a decrease of $2,275,000 from the
December 31, 2003 balance of $27,973,000.

OPERATING ACTIVITIES

In 2004, operating activities used cash of $1,131,000. In addition to the
$793,000 net loss, significant components of cash flows from operations
included: non-cash depreciation and amortization expenses of $1,209,000;
non-cash deferred income tax benefit of $569,000; increased accounts receivable
of $1,209,000; and decreased deferred revenue of $1,368,000.

Working capital changes in the opposite direction which provided cash in 2004
included: decreased inventory of $422,000; decreased income taxes receivable of
$629,000 as a result of the receipt of federal tax refunds from the 2003 tax
year; and decreased other current assets of $684,000 resulting from the return
of a deposit and the receipt of an insurance refund.

INVESTING ACTIVITIES

Investing activities in 2004 used $626,000 in cash, including $647,000 for
equipment purchases to support operations partially offset by sales and
maturities of investments (net of purchases).

FINANCING ACTIVITIES

<PAGE>

Financing activities used $499,000 of cash in 2004, resulting from the $750,000
payment of a note payable resulting from a 2001 acquisition partially offset by
proceeds of $251,000 from the issuance of common stock for stock option
exercises, payments to non-employees and purchases under the employee stock
purchase plan.

The Company believes that its existing cash, cash equivalents, investments and
cash to be generated from future operations will provide sufficient capital to
meet the business needs of the Company through the end of 2005. 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 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
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 and hardware; 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:

     -    Revenue on internally developed software and hardware is recognized in
          accordance with the following four elements of revenue recognition:
          (1) persuasive evidence of an arrangement exists, (2) delivery has
          occurred, (3) the related fee is fixed 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 generally
          recorded upon delivery of the maintenance agreement, provided the
          Company has no significant continuing obligation related to the
          maintenance contract.

     -    Revenue from installation, training and consulting services is
          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

<PAGE>

estimated likelihood that customers will return products. At December 31,
2004 and 2003, 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 several years, 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 its 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. As the Company introduces new products using new technology or if defects
are found in widely distributed products, the Company's estimates of future
warranty costs could be inaccurate.

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. Valuation
allowances are recognized if, based on the weight of available evidence, it is
more likely than not that some portion of the deferred tax assets will not be
recognized. 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,
estimated credits related to foreign sales and estimated tax contingency
reserves for any known tax exposures, 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.

Under its employee stock purchase plan, the Company has issued stock to eligible
employees at 90% of fair market value on the first or last business day of the
offering period, whichever is lower. The Company applies the intrinsic
value-based method of accounting for stock purchases under the employee stock
purchase plan. Because the Company's stock purchase plan qualifies under Section
423 of the Internal Revenue Code and is

<PAGE>

considered non-compensatory, the Company has not recorded any compensation
expense in its consolidated statements of operations.

Had the Company accounted for its stock options and stock purchases under its
employee stock purchase plan 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 $1,470,000, $1,320,000 and $1,736,000 for the
years ended December 31, 2004, 2003 and 2002, respectively.

The Company has issued shares of stock to non-employees in exchange for goods or
services. The Company accounts for such transactions based on the fair value of
the stock issued or the goods or services received, whichever is more reliably
measurable. During 2004, the Company recorded expenses of $16,000 as a result of
issuing stock to members of its government Executive Advisory Board in exchange
for services rendered.

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. The Company's experience has indicated
historical estimates have been reasonable and the Company has been able to
reasonably estimate its exposures related to these areas.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

The Company is obligated over the next two years for office space under various
operating leases. Future minimum lease payments, net of estimated sublease
payments under these leases, are $81,000 in 2005 and $29,000 in 2006.

Purchase obligations represent an estimate of open purchase orders in the
ordinary course of business for which the Company had not received the goods or
services as of December 31, 2004.

The following summarizes the Company's contractual obligations at December 31,
2004:

<TABLE>
<CAPTION>
                                                   Payments due by period
                       -----------------------------------------------------------------------------
                         Total    Less than 1 year   1 to 3 years   3 to 5 years   More than 5 years
                       --------   ----------------   ------------   ------------   -----------------
<S>                    <C>        <C>                <C>            <C>            <C>
Operating leases       $110,000       $ 81,000          $29,000          $    --          $    --
Purchase obligations    586,000        586,000               --               --               --
                       --------       --------          -------          -------          -------
Total                  $696,000       $667,000          $29,000          $    --          $    --
                       ========       ========          =======          =======          =======
</TABLE>

IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

In November 2004, the Financial Accounting Standards Board ("FASB") issued
Statement No. 151, "Inventory Costs," an amendment to Accounting Research
Bulletin No. 43, Chapter 4, "Inventory Pricing." This statement clarifies that
abnormal amounts of idle facility expense, freight, handling costs and wasted
material should be recognized as current period charges. The provisions of this
statement become effective for fiscal years beginning after June 15, 2005. The
Statement is not expected to have a material effect on the Company's financial
position, results of operations or cash flows.

In December 2004, the FASB issued Statement No. 123R, "Share Based Payment," a
revision of Statement No. 123, "Accounting for Stock Based Compensation" and
superseding APB Opinion No. 25, "Accounting for Stock Issued to Employees."
Statement 123R requires the Company to expense grants made under the stock
option and employee stock purchase plans. Statement 123R is effective for the
first interim or annual period beginning after June 15, 2005. Upon adoption of
Statement 123R, amounts previously disclosed under Statement No. 123 will be
recorded in the consolidated statement of operations. Consistent with the
provisions of the new standard, the Company intends to adopt Statement 123R in
the third quarter of 2005. The Company currently measures compensation costs
related to

<PAGE>

its share-based awards under APB 25, as allowed by Statement 123. Information
about the fair value of stock options under the Black Scholes model and its pro
forma impact on the Company's net loss and loss per share can be found in Note 1
to the financial statements.

ITEM SEVEN A | 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 and equity obligations, primarily U.S.
government 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.

ITEM EIGHT | Financial Statements and Supplementary Data

             Report of Independent Registered Public Accounting Firm

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, 2004 and 2003, 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, 2004.
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 the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. 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, 2004 and 2003, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2004, in conformity with U.S. generally accepted accounting
principles.


/s/ KPMG LLP
Columbus, Ohio
March 7, 2005

<PAGE>

                             APPLIED INNOVATION INC.
                           Consolidated Balance Sheets

<TABLE>
<CAPTION>
                                                                                   December 31,
                                                                            -------------------------
                                                                                2004          2003
                                                                            -----------   -----------
<S>                                                                         <C>           <C>
Assets
Current assets:
   Cash and cash equivalents                                                $ 9,773,586   $12,030,638
   Short term investments                                                     6,921,644     5,582,325
   Accounts receivable, net of allowance of $115,000 in 2004
      and $140,000 in 2003                                                    4,657,914     3,449,052
   Inventory, net                                                             2,392,379     2,814,442
   Income taxes receivable                                                           --       268,287
   Other current assets                                                         571,426     1,255,700
   Deferred income taxes                                                        919,000     1,963,000
                                                                            -----------   -----------
         Total current assets                                                25,235,949    27,363,444

Property, plant and equipment, net                                            6,540,850     7,060,034
Investments                                                                   9,002,404    10,360,075
Intangible assets, net of accumulated amortization
   of $765,000 in 2004 and $633,750 in 2003                                          --       131,250
Goodwill                                                                      3,525,801     3,525,801
Deferred income taxes                                                         1,758,000       127,000
Other assets                                                                  1,334,918     1,315,275
                                                                            -----------   -----------
                                                                            $47,397,922   $49,882,879
                                                                            ===========   ===========

Liabilities and Stockholders' Equity
Current liabilities:
   Accounts payable                                                         $   853,440   $   790,037
   Accrued expenses:
      Warranty                                                                  425,000       479,062
      Payroll and related expenses                                              810,608       787,819
      Restructuring                                                             139,020        43,825
      Income taxes payable                                                      360,917            --
      Taxes, other than income taxes                                            398,974       563,252
      Other accrued expenses                                                    568,917       723,249
Deferred revenue                                                                901,251     2,268,999
Note payable                                                                         --       750,000
                                                                            -----------   -----------
         Total current liabilities                                            4,458,127     6,406,243

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; issued and
      outstanding 15,107,367 shares in 2004 and 15,033,409 shares in 2003       151,074       150,334
   Additional paid-in capital                                                 6,424,655     6,140,540
   Retained earnings                                                         36,352,868    37,145,452
   Accumulated other comprehensive gain, net                                     11,198        40,310
                                                                            -----------   -----------
         Total stockholders' equity                                          42,939,795    43,476,636
                                                                            -----------   -----------
                                                                            $47,397,922   $49,882,879
                                                                            ===========   ===========
</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

                             APPLIED INNOVATION INC.
                      Consolidated Statements of Operations

<TABLE>
<CAPTION>
                                                  Years ended December 31,
                                          ---------------------------------------
                                              2004          2003          2002
                                          -----------   -----------   -----------
<S>                                       <C>           <C>           <C>
Sales:
   Products                               $25,876,037   $27,076,251   $36,291,838
   Services                                 5,520,900     6,891,835     6,669,173
                                          -----------   -----------   -----------
      Total sales                          31,396,937    33,968,086    42,961,011

Cost of sales:
   Cost of sales - products                12,091,272    12,411,771    19,244,949
   Cost of sales - services                 2,433,125     3,941,866     4,311,722
                                          -----------   -----------   -----------
      Total cost of sales                  14,524,397    16,353,637    23,556,671
                                          -----------   -----------   -----------

      Gross profit                         16,872,540    17,614,449    19,404,340

Operating expenses:
   Selling, general and administrative     13,178,399    13,689,576    18,413,456
   Research and development                 5,119,677     5,575,652     7,084,646
   Restructuring charges                      605,804       (32,237)    2,890,155
                                          -----------   -----------   -----------
      Total operating expenses             18,903,880    19,232,991    28,388,257
                                          -----------   -----------   -----------

      Loss from operations                 (2,031,340)   (1,618,542)   (8,983,917)

Interest and other income, net                451,756       393,057       597,137
                                          -----------   -----------   -----------

      Loss before income taxes             (1,579,584)   (1,225,485)   (8,386,780)
Income tax benefit                           (787,000)     (690,000)   (3,532,000)
                                          -----------   -----------   -----------
      Net loss                            $  (792,584)  $  (535,485)  $(4,854,780)
                                          ===========   ===========   ===========
Loss per share:
      Basic and diluted loss per share    $     (0.05)  $     (0.04)  $     (0.32)
                                          ===========   ===========   ===========
Weighted-average shares outstanding
   for basic and diluted loss per share    15,077,118    14,994,924    15,092,328
                                          ===========   ===========   ===========
</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

                            APPLIED INNOVATION INC.
                 Consolidated Statements of Stockholders' Equity

<TABLE>
<CAPTION>
                                    Common stock
                               ---------------------
                                  Number               Additional                                    Accumulated
                                of shares               paid-in     Note receivable    Retained     other compre-
                               outstanding   Amount     capital    for common stock    earnings   hensive gain, net     Totals
                               -----------  --------  -----------  ----------------  -----------  -----------------  -----------
<S>                            <C>          <C>       <C>          <C>               <C>          <C>                <C>
Balance - 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 - December 31, 2002    14,950,749   $149,507  $ 5,845,740     $(382,783)     $37,680,937      $  5,965       $43,299,366
                               ==========   ========  ===========     =========      ===========      ========       ===========

Comprehensive loss:
   Net loss                            --         --           --            --         (535,485)           --          (535,485)
   Unrealized gain on
      investments, net                 --         --           --            --               --        34,345            34,345
                                                                                                                     -----------
Total comprehensive loss                                                                                                (501,140)
Stock options exercised            37,900        379      151,459            --               --            --           151,838
Stock issued for employee
   stock purchase plan             44,760        448      120,324            --               --            --           120,772
Repayment of note receivable
   for common stock                    --         --           --       382,783               --            --           382,783
Tax benefit associated with
   exercise of stock options           --         --       23,017            --               --            --            23,017
                               ----------   --------  -----------     ---------      -----------      --------       -----------
Balance - December 31, 2003    15,033,409   $150,334  $ 6,140,540     $      --      $37,145,452      $ 40,310       $43,476,636
                               ==========   ========  ===========     =========      ===========      ========       ===========

Comprehensive loss:
   Net loss                            --         --           --            --         (792,584)           --          (792,584)
   Unrealized loss on
      investments, net                 --         --           --            --               --       (29,112)          (29,112)
                                                                                                                     -----------
Total comprehensive loss                                                                                                (821,696)
Stock options exercised            40,600        406      155,330            --               --            --           155,736
Stock issued for employee
   stock purchase plan             28,714        287       94,702            --               --            --            94,989
Stock issued to non-employees       4,644         47       15,953                                                         16,000
Tax benefit associated with
   exercise of stock options           --         --       18,130            --               --            --            18,130
                               ----------   --------  -----------     ---------      -----------      --------       -----------
Balance - December 31, 2004    15,107,367   $151,074  $ 6,424,655     $      --      $36,352,868      $ 11,198       $42,939,795
                               ==========   ========  ===========     =========      ===========      ========       ===========
</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

                             APPLIED INNOVATION INC.
                      Consolidated Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                        Years Ended December 31,
                                                               -----------------------------------------
                                                                   2004          2003           2002
                                                               -----------   ------------   ------------
<S>                                                            <C>           <C>            <C>
Cash flows from operating activities:
   Net loss                                                    $  (792,584)  $   (535,485)  $ (4,854,780)
   Adjustments to reconcile net loss to net cash
      (used in) provided by operating activities:
      Depreciation                                               1,078,128      1,196,697      1,715,261
      Amortization of intangible assets                            131,250        210,000        210,000
      Loss (gain) on disposal of assets                             38,661           (797)       241,914
      Deferred income tax expense (benefit)                       (569,000)       164,000        462,000
      Tax benefit of options exercised                              18,130         23,017            340
      Stock issued to non-employees                                 16,000             --             --
      Effects of change in operating assets and liabilities:
         Accounts receivable                                    (1,208,862)     1,591,353      2,656,598
         Inventory                                                 422,063        595,400      3,912,474
         Income taxes                                              629,204      2,811,247     (2,176,265)
         Other current assets                                      684,274       (386,882)      (238,225)
         Other assets                                              (19,643)    (1,180,248)        34,660
         Accounts payable                                           63,403       (764,835)      (204,814)
         Accrued expenses                                         (254,688)      (329,707)    (1,119,820)
         Deferred revenue                                       (1,367,748)       366,443     (1,587,516)
                                                               -----------   ------------   ------------
      Net cash (used in) provided by operating activities       (1,131,412)     3,760,203       (948,173)

Cash flows from investing activities:
   Purchases of property, plant and equipment                     (646,764)      (479,712)      (961,400)
   Proceeds from sales of property, plant and equipment             26,180         16,792         34,566
   Purchases of investments                                     (7,809,025)   (16,778,379)   (13,870,211)
   Proceeds from maturities of investments                       6,971,705     15,669,233     10,983,967
   Proceeds from sales of investments                              831,539        200,816        756,533
                                                               -----------   ------------   ------------
      Net cash used in investing activities                       (626,365)    (1,371,250)    (3,056,545)

Cash flows from financing activities:
   Payment of note payable related to acquisition                 (750,000)            --             --
   Common stock repurchased                                             --             --     (2,834,891)
   Proceeds from payment on note receivable                             --        382,783        112,088
   Proceeds from issuance of common stock                          250,725        272,610         15,219
                                                               -----------   ------------   ------------
      Net cash (used in) provided by financing activities         (499,275)       655,393     (2,707,584)
                                                               -----------   ------------   ------------

(Decrease) increase in cash and cash equivalents                (2,257,052)     3,044,346     (6,712,302)
Cash and cash equivalents - beginning of year                   12,030,638      8,986,292     15,698,594
                                                               -----------   ------------   ------------

Cash and cash equivalents - end of year                        $ 9,773,586   $ 12,030,638   $  8,986,292
                                                               ===========   ============   ============

SUPPLEMENTAL CASH FLOW DISCLOSURE:
   Income taxes received (paid), net                           $   865,335   $  1,818,737   $ (3,364,427)
                                                               ===========   ============   ============
   Interest paid                                               $   197,163   $      1,228   $     11,553
                                                               ===========   ============   ============
</TABLE>

See accompanying notes to consolidated financial statements.

<PAGE>

(1)  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 four primary markets in the
          U.S. and abroad: 1) telecommunications companies using wireline
          networks; 2) telecommunications companies using wireless networks 3)
          government networks; and 4) international telecommunications service
          providers who address both wireline and wireless services in their
          respective territories. 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
          intercompany 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, 2004 and 2003,
          cash equivalents of $7,505,132 and $10,410,049, respectively, were
          invested in money market funds, corporate notes, commercial paper and
          taxable and tax-exempt bonds.

          INVESTMENTS

          The Company invests in various marketable equity securities and debt
          obligations, primarily U.S. government agency obligations and high
          quality commercial paper, with maturities generally less than three
          years. The Company classifies its securities as "available-for-sale"
          and, accordingly, reports such securities at fair value. The fair
          value of debt and marketable equity 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 (loss) and is reported as unrealized gains
          (losses) as a separate component of stockholders' equity.

<PAGE>

          For any marketable security considered impaired because the
          investment's fair value is less than its cost, the Company assesses
          whether such impairment is other-than-temporary. In making the
          assessment, the Company considers various factors, including: the
          severity of the impairment; the duration of the impairment; the
          financial condition and near-term prospects of the issuer which may
          impact the potential recovery of the fair value of the investment; and
          the Company's ability and intent to hold the investment for a
          reasonable period of time sufficient for the potential recovery of the
          fair value. If the assessment indicates that a decline in value is
          other-than- temporary, the impairment would be included in net income
          (loss) on the consolidated statements of operations. No such
          impairment charges have been recorded in 2004, 2003 or 2002.

          ALLOWANCE FOR DOUBTFUL ACCOUNTS

          The Company grants credit on open account to its customers,
          substantially all of whom are in the 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 revenue from product 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.

          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 and hardware; 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:

               -    Revenue on internally developed software and hardware is
                    recognized in accordance with the following four elements of
                    revenue recognition: (1) persuasive evidence of an
                    arrangement exists, (2) delivery has occurred, (3) the
                    related fee is fixed 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

<PAGE>

                    contracts is generally recorded upon delivery of the
                    maintenance agreement, provided the Company has no
                    significant continuing obligation related to the maintenance
                    contract.

               -    Revenue from installation, training and consulting services
                    is generally recognized 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.

          SERVICE SALES Installation service projects are generally short-term
          in nature and are billed by the Company and accepted by the customer
          on a project-by-project basis. The Company generally 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:

<TABLE>
<CAPTION>
                      Lives (in years)
                      ----------------
<S>                   <C>
          Building           40
          Equipment          3-5
          Furniture           7
</TABLE>

          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
          recorded 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, 2004, 2003 and
          2002 was $131,250, $210,000 and $210,000, respectively. At December
          31, 2004, the assets were fully amortized.

          Goodwill, representing the excess of purchase price over the fair
          value of the net assets acquired, is not amortized but instead is
          tested for impairment at least annually. During 2004 and 2003, the
          Company completed its annual impairment tests using established
          valuation techniques and determined that no impairment charges were
          necessary.

          OTHER ASSETS

          Other assets includes corporate-owned life insurance policies, which
          are recorded at their corresponding cash surrender values. At December
          31, 2004 and 2003, other assets included $1,293,677 and $1,241,361,
          respectively, of cash surrender value associated with these policies.

          WARRANTY

          The Company warrants its products for a minimum of one year after
          sale. Accordingly, the Company

<PAGE>

          accrues the estimated costs of such warranties at the time of sale,
          based on historical experience and known warranty issues with existing
          products. Actual warranty costs are accumulated and charged against
          the warranty accrual.

          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 carryforwards. 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. Valuation allowances are
          recorded when, based on the weight of available evidence, it is more
          likely than not that some portion of the deferred tax assets will not
          be realized.

          STOCK-BASED COMPENSATION PLANS

          The Company accounts for employee and director stock option grants
          under its stock option plans and for stock purchases under its
          employee stock purchase plan in accordance with 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. Under APB Opinion No. 25, no
          compensation cost has been recognized in the consolidated financial
          statements for stock option grants or for shares purchased under the
          employee stock purchase plan.

          The following table illustrates the effect on net loss and 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 model:

<TABLE>
<CAPTION>
                                                         Years ended December 31,
                                                 ---------------------------------------
                                                     2004          2003          2002
                                                 -----------   -----------   -----------
<S>                                              <C>           <C>           <C>
     Net loss, as reported                       $  (792,584)  $  (535,485)  $(4,854,780)
     Deduct: Total stock-based employee
        compensation expense determined
        under fair value-based method for
        all awards, net of related tax effects    (1,470,146)   (1,319,659)   (1,736,080)
                                                 -----------   -----------   -----------

     Pro forma net loss                          $(2,262,730)  $(1,855,144)  $(6,590,860)
                                                 ===========   ===========   ===========

     Loss per share:
        Basic and diluted - as reported          $     (0.05)  $     (0.04)  $     (0.32)
        Basic and diluted - pro forma                  (0.15)        (0.12)        (0.44)
</TABLE>

          The Company accounts for equity instruments granted to non-employees
          in accordance with the provisions of SFAS No. 123 and Emerging Issues
          Task Force Issue No. 96-18, "Accounting for Equity Instruments that
          are Issued to Other Than Employees for Acquiring, or in Conjunction
          with Selling, Goods or Services." In instances where equity
          instruments are issued in exchange for goods or services, the Company
          accounts for the transaction based on the fair value of the equity
          instruments issued or the goods or services received, whichever is
          more reliably measured.

<PAGE>

          RESEARCH AND DEVELOPMENT

          Research and development costs are expensed when incurred.

          GENERAL CREDIT RISK

          The Company grants credit on open account to its customers,
          substantially all of whom are in the telecommunications industry. The
          Company performs credit evaluations of its customers' financial
          condition and extends credit based on the result of the evaluations.
          To date, the Company has not provided extended payment terms under any
          type of vendor financing agreements.

          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.

          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. The Company had no such assets at December 31,
          2004 or 2003.

          RECLASSIFICATIONS

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

(2)  INVENTORY

     Major classes of inventory at December 31, 2004 and 2003 are summarized
     below:

<TABLE>
<CAPTION>
                                   2004         2003
                                ----------   ----------
<S>                             <C>          <C>
     Raw materials              $2,098,741   $1,516,034
     Work-in-process                 1,461      134,874
     Finished goods                455,177    1,597,534
                                ----------   ----------
                                 2,555,379    3,248,442
     Reserve for obsolescence     (163,000)    (434,000)
                                ----------   ----------
                                $2,392,379   $2,814,442
                                ==========   ==========
</TABLE>

<PAGE>

     During 2004 and 2003, the Company recorded inventory charges of $146,000
     and $551,000, respectively, to cost of goods sold, primarily related to
     certain potential excess and obsolete inventory.

(3)  INVESTMENTS AND FINANCIAL INSTRUMENTS

     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:

<TABLE>
<CAPTION>
                                                           Gross        Gross
                                           Amortized    unrealized   unrealized       Fair
              December 31, 2004               cost         gains       losses        value
              -----------------           -----------   ----------   ----------   -----------
<S>                                       <C>           <C>          <C>          <C>
     Certificates of deposit              $ 1,023,168    $     80    $  (8,387)   $ 1,014,861
     Corporate obligations                  4,513,044          --      (36,628)     4,476,416
     Marketable equity securities             802,339     151,402      (16,067)       937,674
     Mutual funds                              93,594       1,180       (7,888)        86,886
     U.S. government agency obligations     9,473,705       1,061      (66,555)     9,408,211
                                          -----------    --------    ---------    -----------
     Total                                $15,905,850    $153,723    $(135,525)   $15,924,048
                                          ===========    ========    =========    ===========

     Reported as:
     Short-term investments                                                       $ 6,921,644
     Investments                                                                    9,002,404
                                                                                  -----------
     Total                                                                        $15,924,048
                                                                                  ===========
</TABLE>

<TABLE>
<CAPTION>
                                                           Gross        Gross
                                           Amortized    unrealized   unrealized       Fair
              December 31, 2003               cost         gains       losses        value
              -----------------           -----------   ----------   ----------   -----------
<S>                                       <C>           <C>          <C>          <C>
     Certificates of deposit              $   769,198     $ 1,209     $ (3,646)   $   766,761
     Corporate obligations                  6,844,627      17,896      (10,169)     6,852,354
     Marketable equity securities             489,059      71,967       (1,285)       559,741
     Mutual funds                              92,910       2,160         (787)        94,283
     U.S. government agency obligations     7,681,298       6,120      (18,157)     7,669,261
                                          -----------     -------     --------    -----------
     Total                                $15,877,092     $99,352     $(34,044)   $15,942,400
                                          ===========     =======     ========    ===========

     Reported as:
     Short-term investments                                                       $ 5,582,325
     Investments                                                                   10,360,075
                                                                                  -----------
     Total                                                                        $15,942,400
                                                                                  ===========
</TABLE>

     Proceeds from the sales of investment securities available for sale were
     $831,539, $200,816 and $756,533 in 2004, 2003 and 2002, respectively. Gross
     realized gains included in income in 2004, 2003 and 2002 were $40,521,
     $5,523 and $22,306, respectively, and gross realized losses included in
     income in 2004, 2003 and 2002 were $17,543, $4,545 and $117,507,
     respectively. Realized gains and losses are determined by specific
     identification.

<PAGE>

     Gross unrealized losses on investment securities and the fair value of the
     related securities, aggregated by investment category and length of time
     that individual securities have been in a continuous unrealized loss
     position at December 31, 2004 were as follows:

<TABLE>
<CAPTION>
                                             Less than 12 months         12 months or more               Total
                                          ------------------------   -----------------------   ------------------------
                                                        Unrealized                Unrealized                 Unrealized
                                          Fair value      losses     Fair value     losses      Fair value     losses
                                          -----------   ----------   ----------   ----------   -----------   ----------
<S>                                       <C>           <C>          <C>          <C>          <C>           <C>
     Certificates of deposit              $   696,183     $ 6,105    $  268,841     $ 2,282    $   965,024    $  8,387
     Corporate obligations                  3,413,935      12,312       402,479      24,316      3,816,414      36,628
     Marketable equity securities              87,468      10,901         9,320       5,166         96,788      16,067
     Mutual funds                              42,729       7,266        26,696         622         69,425       7,888
     U.S. government agency obligations     6,595,472      49,891     2,264,298      16,664      8,859,770      66,555
                                          -----------     -------    ----------     -------    -----------    --------
     Total                                $10,835,787     $86,475    $2,971,634     $49,050    $13,807,421    $135,525
                                          ===========     =======    ==========     =======    ===========    ========
</TABLE>

     The unrealized losses on investments were primarily related to U.S.
     government agency obligations, corporate obligations and marketable equity
     securities. These losses were primarily caused by interest rate increases
     and market volatility. Based on the Company's assessment of the unrealized
     losses, these investments are not considered other-than-temporarily
     impaired and no impairment charges have been recorded in the consolidated
     statements of operations in 2004, 2003 or 2002.

     Interest income, primarily from investments, was $461,325, $467,738 and
     $665,343 in 2004, 2003 and 2002, respectively.

     The Company's December 31, 2004 debt securities at fair market value mature
     as follows: $6,921,644 in less than one year, $7,404,730 after one year but
     less than five years and $660,000 in five or more years.

(4)  PROPERTY, PLANT AND EQUIPMENT

     Property, plant and equipment at December 31, 2004 and 2003 are summarized
     below:

<TABLE>
<CAPTION>
                                    2004           2003
                                -----------   ------------
<S>                             <C>           <C>
     Land                       $ 1,639,303   $  1,639,303
     Building                     5,086,561      5,109,087
     Equipment                    7,637,210      8,381,748
     Furniture                    2,022,578      2,030,209
                                -----------   ------------
                                 16,385,652     17,160,347
     Accumulated depreciation    (9,844,802)   (10,100,313)
                                -----------   ------------
                                $ 6,540,850   $  7,060,034
                                ===========   ============
</TABLE>

<PAGE>

(5)  WARRANTY

     During the year ended December 31, 2003, the Company initiated a product
     recall after a manufacturing defect was identified in a power supply
     component that was purchased from a third party manufacturer, integrated
     into the Company's products and shipped to customers in 1997 and 1998. The
     Company estimated the number of units that it expected customers to return
     in the recall and recorded the associated costs of $450,000 in the first
     quarter of 2003 to recall and replace those units. During 2003, the Company
     recorded an adjustment of $179,000 to decrease the reserve balance based on
     revisions to the estimated number of units to be returned and the
     associated costs. In addition, costs associated with the product recall
     totaling $210,000 were recorded against the reserve in 2003. At December
     31, 2003, the remaining reserve balance associated with the product recall
     was $61,000.

     During the year ended December 31, 2004, costs associated with the product
     recall totaling $29,000 were recorded against the reserve and further
     adjustments of $32,000 were recorded, decreasing the reserve balance to $0
     at December 31, 2004.

     The Company's warranty activity is summarized below:

<TABLE>
<CAPTION>
                               Years ended December 31,
                               ------------------------
                                    2004        2003
                                 ---------   ---------
<S>                            <C>           <C>
     Beginning balance           $ 479,062   $ 542,651
     Warranty provision            543,738     793,923
     Warranty costs incurred      (597,800)   (857,512)
                                 ---------   ---------
     Ending balance              $ 425,000   $ 479,062
                                 =========   =========
</TABLE>

(6)  MAJOR CUSTOMERS AND GEOGRAPHIC DATA

     Revenues from major customers represented 75%, 74% and 75% of net sales for
     2004, 2003 and 2002, respectively. The number of major customers previously
     referred to was three in each of the years, with trade accounts receivable
     balances of $3,827,469 and $1,925,468 at December 31, 2004 and 2003,
     respectively.

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

<TABLE>
<CAPTION>
                             Years ended December 31,
                     ---------------------------------------
                         2004          2003          2002
                     -----------   -----------   -----------
<S>                  <C>           <C>           <C>
     United States   $29,322,593   $32,924,985   $36,569,783
     International     2,074,344     1,043,101     6,391,228
                     -----------   -----------   -----------
                     $31,396,937   $33,968,086   $42,961,011
                     ===========   ===========   ===========
</TABLE>

(7)  LOSS PER SHARE

     The calculations of loss per share for the years ended December 31, 2004,
     2003 and 2002, 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. The calculation of basic and
     diluted loss per share follows:

<PAGE>

<TABLE>
<CAPTION>
                                                                       Years ended December 31,
                                                               ---------------------------------------
                                                                   2004          2003          2002
                                                               -----------   -----------   -----------
<S>                                                            <C>           <C>           <C>
     Net loss available to common stockholders                 $  (792,584)  $  (535,485)  $(4,854,780)
                                                               ===========   ===========   ===========
     Weighted average shares outstanding - basic and diluted    15,077,118    14,994,924    15,092,328
                                                               ===========   ===========   ===========
     Basic and diluted loss per share                          $     (0.05)  $     (0.04)  $     (0.32)
                                                               ===========   ===========   ===========
</TABLE>

     Due to the Company's net loss for the years ended December 31, 2004, 2003
     and 2002, no common equivalent shares were included in the calculation of
     diluted loss per share for those years 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 years ended
     December 31, 2004, 2003 and 2002 were 466,728, 557,192 and 159,098,
     respectively.

     Stock options which are anti-dilutive under the treasury stock method
     because they are out-of-the-money have been excluded from the above
     earnings per share calculations. The Company's stock options outstanding at
     December 31, 2004, 2003 and 2002 which were excluded from the earnings per
     share calculations because they were out-of-the-money were 1,415,420,
     1,263,720 and 1,670,100, respectively.

(8)  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 under the 2001 Plan. Options granted
     under the 2001 Plan may be either incentive stock options or nonstatutory
     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. Except for options granted to
     the Board of Directors which generally vest immediately and become
     exercisable one year from issuance, options granted under the 2001 Plan
     generally vest over five years.

     Previously, the Company had adopted the 1996 Stock Option Plan ("the 1996
     Plan") with 2,000,000 shares of common stock reserved for issuance under
     the 1996 Plan. Options granted under the 1996 Plan 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. Except for options granted to the Board of Directors which generally
     vest immediately and become exercisable one year from issuance, options
     granted under the 1996 Plan generally vest over five years.

     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, 2004, there were 624,750 additional shares available for
     grant under the 2001 Plan and 1,203,940 additional shares available for
     grant under the 1996 Plan. The per share weighted-average fair value of
     stock options granted during 2004, 2003 and 2002 was $4.07, $2.35 and
     $3.65, 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, 2004, 2003 and 2002, respectively:

<PAGE>

     dividend yield of 0% for all years; expected volatility of 87%, 90% and
     90%; risk-free interest rate of 3.1%, 3.0% and 4.3%; and expected life of
     5.4, 5.6 and 5.6 years.

A summary of stock option activity follows:

<TABLE>
<CAPTION>
                                     Number of   Weighted-average
                                      shares      exercise price
                                    ----------   ----------------
<S>                                 <C>          <C>
     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
        Granted                        457,500          3.31
        Exercised                      (37,900)         4.01
        Canceled/expired              (442,630)         7.41
                                    ----------
     Balance at December 31, 2003    1,798,270        $ 6.65
        Granted                        462,000          5.92
        Exercised                      (40,600)         3.84
        Canceled/expired              (355,300)         6.63
                                    ----------
     Balance at December 31, 2004    1,864,370        $ 6.53
                                    ==========
</TABLE>

<PAGE>

The following table summarizes information about options outstanding at December
31, 2004:

<TABLE>
<CAPTION>
                               Options outstanding
                       -----------------------------------    Options exercisable
                                    Weighted-                ---------------------
                                     average     Weighted-               Weighted-
                                    remaining     average                 average
         Range of      Number of   contractual    exercise   Number of    exercise
     exercise prices     shares        life        price       shares      price
     ---------------   ---------   -----------   ---------   ---------   ---------
<S>                    <C>         <C>           <C>         <C>         <C>
      $  2.85 - 3.03     355,550       8.22        $ 3.03     110,350      $ 3.03
      $  3.06 - 4.63     201,900       5.06          3.95     126,300        4.02
      $  4.81 - 5.89     389,270       7.11          5.20     174,820        5.18
      $  6.03 - 7.99     384,450       8.33          6.80      55,050        7.23
      $  8.11 - 9.88     198,350       5.31          8.35     163,800        8.34
      $10.13 - 11.70     262,300       6.10         11.51     188,600       11.53
      $12.13 - 17.38      72,550       5.65         13.72      55,750       13.71
                       ---------                              -------
                       1,864,370       6.96          6.53     874,670        7.38
                       =========                              =======
</TABLE>

(9)  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.

     During the year ended December 31, 2004, 28,714 shares of common stock at
     an average price of $3.31 were issued pursuant to the ESPP. During the year
     ended December 31, 2003, 44,760 shares of common stock at an average price
     of $2.70 were issued pursuant to the ESPP. Additionally, on January 5, 2005
     the Company issued 16,856 shares of common stock at a price of $3.12 per
     share based on employee payroll deductions for the six-month offering
     period ending December 31, 2004.

(10) DEFINED CONTRIBUTION PLAN

     The Company sponsors a defined contribution 401(k) and profit sharing plan
     that covers all eligible employees. The Company is authorized to make
     discretionary 401(k) matching contributions on behalf of each participant.
     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. No such contributions were made in 2004, 2003 or 2002. For 2004,
     2003 and 2002, the total expense related to the plan was $214,359, $195,294
     and $260,531, respectively.

<PAGE>

(11) INCOME TAXES

Income tax expense (benefit) consists of:

<TABLE>
<CAPTION>
                                                 Current      Deferred      Total
                                               -----------   ---------   -----------
<S>                                            <C>           <C>         <C>
     Year ended December 31, 2004:
        Federal                                $  (310,000)  $(575,000)  $  (885,000)
        State and local                             74,000      24,000        98,000
                                               -----------   ---------   -----------
                                               $  (236,000)  $(551,000)  $  (787,000)
                                               ===========   =========   ===========
     Year ended December 31, 2003:
        Federal                                $  (930,000)  $ 171,000   $  (759,000)
        State and local                             76,000      (7,000)       69,000
                                               -----------   ---------   -----------
                                               $  (854,000)  $ 164,000   $  (690,000)
                                               ===========   =========   ===========
     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)
                                               ===========   =========   ===========
</TABLE>

<PAGE>

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

<TABLE>
<CAPTION>
                                                   2004        2003         2002
                                                ---------   ---------   -----------
<S>                                             <C>         <C>         <C>
     Computed tax at the expected federal
        statutory rate                          $(537,000)  $(417,000)  $(2,852,000)
     State and local income taxes, net of
        federal income tax effect                 (39,000)    (40,000)     (457,000)
     Change in the valuation allowance            112,000      83,000       309,000
     Meals and entertainment expenses              40,000      42,000        62,000
     Research and experimentation credit           37,000     (24,000)     (467,000)
     Tax contingency reserve adjustment          (379,000)   (351,000)           --
     Dividends from foreign sales corporation          --          --      (101,000)
     Tax-exempt interest income                   (20,000)    (20,000)      (22,000)
     Other                                         (1,000)     37,000        (4,000)
                                                ---------   ---------   -----------
                                                $(787,000)  $(690,000)  $(3,532,000)
                                                =========   =========   ===========
</TABLE>

     The Company has reserves for federal or state taxes that may become payable
     in future years as a result of potentially under-reported income. The tax
     reserves are reviewed as circumstances warrant and adjusted as events occur
     that affect the Company's potential liability for additional taxes, such as
     lapsing of applicable statutes of limitations, conclusion of tax audits or
     a change in exposures based on current calculations.

     The tax effects of temporary differences that give rise to significant
     portions of the deferred tax assets and deferred tax liabilities at
     December 31, 2004 and 2003 are presented below:

<TABLE>
<CAPTION>
                                                        2004         2003
                                                     ----------   ----------
<S>                                                  <C>          <C>
     Deferred tax assets:
        Accounts receivable allowance                $   44,000   $   54,000
        Inventory, principally due to obsolescence
           reserve and additional costs
           inventoried for tax purposes                 140,000      350,000
        Warranty reserve                                164,000      184,000
        Restructuring costs                              21,000       17,000
        Other accrued expenses                          121,000      129,000
        Deferred revenue                                347,000      874,000
        Federal tax net operating loss
           carryforwards                              1,362,000           --
        State tax net operating loss carryforwards      780,000      593,000
        Research and experimentation credit
           carryforwards                                263,000      299,000
        Other                                            88,000       81,000
                                                     ----------   ----------
                                                      3,330,000    2,581,000

     Valuation allowance                               (504,000)    (392,000)
                                                     ----------   ----------
     Net deferred tax assets                         $2,826,000   $2,189,000
                                                     ==========   ==========

     Deferred tax liabilities:
        Unrealized gain on investments               $    7,000   $   25,000
        Depreciation and amortization                   115,000       68,000
        Deferred interest                                27,000        6,000
                                                     ----------   ----------
                                                     $  149,000   $   99,000
                                                     ==========   ==========
</TABLE>

<PAGE>

     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 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 projections for future taxable income from
     operations over the periods in which the deferred tax assets are deductible
     and based on certain tax planning strategies, management believes that it
     is more likely than not the Company will realize the benefits of the
     federal deductible differences and, therefore, no federal valuation
     allowance has been provided. At December 31, 2004 and 2003, the Company had
     a valuation allowance totaling $504,000 and $392,000, respectively, related
     to certain state net operating loss carryforwards that expire from 2007
     through 2024. Federal net operating loss carryforwards expire in 2023 and
     2024, while research and experimentation credit carryforwards expire in
     2022, 2023 and 2024.

(12) LEASE COMMITMENTS

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

     Future minimum lease payments and estimated sublease receipts under the
     operating leases as of December 31, 2004 are:

<TABLE>
<CAPTION>
                                      Lease    Sublease
                                    payments   receipts
                                    --------   --------
<S>                                 <C>        <C>
     Years ending December 31,
        2005                        $101,662   $(20,984)
        2006                          29,154         --
                                    --------   --------
     Total minimum lease payments   $130,816   $(20,984)
                                    ========   ========
</TABLE>

     Total rent expense, net of related sublease rental income, in 2004, 2003
     and 2002 was $160,233, $91,463 and $276,850, respectively. In 2004, the
     Company vacated its office space in Texas and accrued rent expense charges
     of $68,100 for the lease payments due over the remaining term of the lease.
     In 2002, the Company's restructuring charges included $184,977 for future
     lease payments, net of estimated sublease rental income, for office leases
     in Georgia, Illinois and California.

(13) EQUITY

     During 2004, the Company issued 4,644 shares of stock to members of its
     government Executive Advisory Board for services rendered throughout the
     year, resulting in consulting expense of $16,000.

     On April 22, 2004, the Company's Board of Directors authorized a
     twelve-month stock repurchase program under which the Company was
     authorized to purchase up to 1,000,000 shares of common stock through April
     21, 2005. As of December 31, 2004, the Company had not purchased any shares
     of stock under the program.

     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
     twelve months of the repurchase program, the Company paid $5,863,018 to
     repurchase 1,011,450 shares.

<PAGE>

     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. In 2003, the remaining balance on the
     note was received in full.

<PAGE>

(14) RESTRUCTURING CHARGES

     In 2002, the Company enacted two restructuring plans 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. In 2003,
     certain adjustments totaling $32,237 were made to decrease the accrual
     because the planned headcount reduction was not fully enacted and certain
     fringe benefit costs were less than originally estimated.

     In 2004, the Company enacted two restructuring plans resulting in aggregate
     restructuring charges of $615,840 related to workforce reductions of
     approximately 25 employees throughout all departments. During the year,
     certain adjustments totaling $10,036 were made to decrease the accrual
     related to the May 2004 event because certain fringe benefit costs were
     less than originally estimated. The charges and adjustments are aggregated
     as a separate line item on the consolidated statement of operations.

     As of December 31, 2004 and 2003, the remaining accrual related to the 2002
     restructuring events was $25,469 and $43,825, respectively. The accrued
     restructuring costs remaining at December 31, 2004 represent lease payments
     (net of sublease receipts) extending to 2005. As of December 31, 2004, the
     remaining restructuring accrual related to the plans enacted during 2004
     was $113,551, consisting of employee separation costs. All remaining
     employee separation costs are expected to be paid in 2005.

<TABLE>
<CAPTION>
                                                Lease          Employee       Employee       Employee
                                             commitments,    separations,   separations,   separations,
                                           net of sublease    August 2002     May 2004     October 2004     Total
                                           ---------------   ------------   ------------   ------------   ---------
<S>                                        <C>               <C>            <C>            <C>            <C>
     Accrual balance - December 31, 2002       $124,790       $ 458,021      $      --      $      --     $ 582,811
                                               ========       =========      =========      =========     =========
     Cash deductions                            (80,965)       (425,784)            --             --      (506,749)
     Non-cash adjustments                            --         (32,237)            --             --       (32,237)
                                               --------       ---------      ---------      ---------     ---------
     Accrual balance - December 31, 2003       $ 43,825       $      --      $      --      $      --     $  43,825
                                               ========       =========      =========      =========     =========
     Restructuring event                             --              --        227,689        388,151       615,840
     Cash deductions                            (18,356)             --       (217,653)      (274,600)     (510,609)
     Non-cash adjustments                            --              --        (10,036)            --       (10,036)
                                               --------       ---------      ---------      ---------     ---------
     Accrual balance - December 31, 2004       $ 25,469       $      --      $      --      $ 113,551     $ 139,020
                                               ========       =========      =========      =========     =========
</TABLE>

(15) 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.

(16) SUBSEQUENT EVENT

     In the first quarter of 2005, the Company enacted a restructuring plan,
     including management changes and a reduction in workforce of approximately
     16 employees throughout all departments. Management changes included the
     resignations of Gerard B. Moersdorf, Jr. as President and Chief Executive
     Officer and Michael P. Keegan as Executive Vice President and Chief
     Operating Officer. Mr. Moersdorf, Jr. retains his position as Chairman of
     the Board of Directors. As a result of the restructuring plan, the Company
     will record charges of approximately $1,000,000 during the first quarter of
     2005, relating primarily to severance and other fringe benefits for the
     affected employees. The Company expects to

<PAGE>

     pay out all costs during 2005 with the exception of approximately $25,000
     that will be paid out in the first quarter of 2006.

(17) QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

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

<TABLE>
<CAPTION>
     2004                                            Q1        Q2       Q3       Q4
     ----                                         -------   -------   ------   ------
<S>                                               <C>       <C>       <C>      <C>
     Net sales                                    $ 5,848   $ 5,717   $9,873   $9,959
     Gross profit                                   2,959     2,937    5,496    5,481
     (Loss) income before income taxes             (1,772)   (1,863)     872    1,184
     Net (loss) income                             (1,134)   (1,192)     806      728
     Basic net (loss) income per share              (0.08)    (0.08)    0.05     0.05
     Diluted net (loss) income per share            (0.08)    (0.08)    0.05     0.05
</TABLE>

<TABLE>
<CAPTION>
     2003                                            Q1        Q2       Q3       Q4
     ----                                         -------   -------   ------   ------
<S>                                               <C>       <C>       <C>      <C>
     Net sales                                    $ 5,609    $9,512   $9,960   $8,887
     Gross profit                                   2,356     5,160    5,225    4,874
     (Loss) income before income taxes             (2,520)      259      562      474
     Net (loss) income                             (2,016)      207      584      690
     Basic net (loss) income per share              (0.13)     0.01     0.04     0.05
     Diluted net (loss) income per share            (0.13)     0.01     0.04     0.05
</TABLE>

<PAGE>

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

None.

ITEM NINE A | Controls and Procedures

As of the end of the period covered by this report, the Company's management
carried out an evaluation, with the participation of the Company's principal
executive officer and principal financial officer, of the effectiveness of the
Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and
15d-15(e) promulgated under the Securities Exchange Act of 1934). Based upon
that evaluation, the Company's principal executive officer and principal
financial officer concluded that the Company's disclosure controls and
procedures were effective as of the end of the period covered by this report. 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.

There were no changes in the Company's internal controls over financial
reporting that occurred during the Company's most recent fiscal quarter that
have materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.

PART III

ITEM TEN | Directors and Executive Officers of the Registrant

The information required by this item is included under the caption "ELECTION OF
DIRECTORS" of the Company's Proxy Statement relating to the Company's Annual
Meeting of Stockholders to be held on May 5, 2005 (the Proxy Statement), and
under the caption "SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE" of
the Proxy Statement and is incorporated herein by reference.

CODE OF ETHICS

The Company has adopted a code of ethics that applies to its directors, officers
and all employees. The code of ethics is posted on the Company's website at
www.AppliedInnovation.com and can be accessed from the home page by clicking on
"Investors" and then "Governance".

The Company intends to satisfy the disclosure requirement under Item 5.05 of
Form 8-K regarding any amendment to, or waiver of, any provision of this code of
ethics by posting such information on the website at the address and location
specified above.

ITEM ELEVEN | Executive Compensation

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

ITEM TWELVE | 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," under the caption "SECURITY
OWNERSHIP OF MANAGEMENT," and under the caption "EQUITY COMPENSATION PLAN
INFORMATION" of the Proxy Statement, and is incorporated herein by reference.

<PAGE>

ITEM THIRTEEN | Certain Relationships and Related Transactions

The information required by this item is included under the caption "RELATED
PARTY TRANSACTIONS" of the Proxy Statement and is incorporated herein by
reference.

ITEM FOURTEEN | Principal Accountant Fees and Services

The information required by this item is included under the caption "INDEPENDENT
ACCOUNTANT FEES" of the Proxy Statement and is incorporated herein by reference.

PART IV

ITEM FIFTEEN | Exhibits and Financial Statement Schedules

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

     -    Report of Independent Registered Public Accounting Firm

     -    Consolidated Balance Sheets as of December 31, 2004 and 2003

     -    Consolidated Statements of Operations for the years ended December 31,
          2004, 2003 and 2002

     -    Consolidated Statements of Stockholders' Equity for the years ended
          December 31, 2004, 2003 and 2002

     -    Consolidated Statements of Cash Flows for the years ended December 31,
          2004, 2003 and 2002

     -    Notes to Consolidated Financial Statements

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

     -    Report of Independent Registered Public Accounting Firm

     -    Schedule II (Valuation and Qualifying Accounts)

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

<TABLE>
<CAPTION>
EXHIBIT NO.                               DESCRIPTION
-----------                               -----------
<S>           <C>
     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
</TABLE>

<PAGE>

<TABLE>
<S>           <C>
              March 10, 1993, and incorporated herein by reference).

    10.1      Form of Indemnification Agreement between the Company and officers
              and directors. (Reference is made to Exhibit 10.8 to the Company's
              Annual Report on Form 10-K, filed with the Securities and Exchange
              Commission on March 31, 1994, and incorporated herein by
              reference).

    10.2*     Schedule of Indemnification Agreements.

    10.3      Company's Amended and Restated 1996 Stock Option Plan. (Reference
              is made to Exhibit 10.11 to the Company's Annual Report on Form
              10-K, filed with the Securities and Exchange Commission on March
              30, 2000, and incorporated herein by reference).

    10.4      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).

    10.5      Employment Agreement between the Company and Michael P. Keegan.
              (Reference is made to Exhibit 10.1 to the Company's Quarterly
              Report on Form 10-Q, filed with the Securities and Exchange
              Commission on May 12, 2004, and incorporated herein by reference).

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

    10.7      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).

    10.8      Form of Option Agreement under the Company's 2001 Stock Incentive
              Plan (Reference is made to Exhibit 10.1 to the Company's Current
              Report on Form 8-K filed with the Securities and Exchange
              Commission on January 5, 2005, and incorporated herein by
              reference).

    10.9      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).

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

   10.11      Employment Agreement between the Company and Thomas R. Kuchler.
              (Reference is made to Exhibit 10.12 to the Company's Annual Report
              on Form 10-K, filed with the Securities and Exchange Commission on
              March 8, 2004, and incorporated herein by reference).

   10.12      Employment Agreement between the Company and Andrew J. Dosch.
              (Reference is made to Exhibit 10.1 to the Company's Quarterly
              Report on Form 10-Q, filed with the Securities and Exchange
              Commission on May 12, 2004, and incorporated herein by reference).

   10.13      Employment Agreement between the Company and Angela R. Pinette.
              (Reference is made to Exhibit 10.1 to the Company's Current Report
              on Form 8-K, filed with the Securities and Exchange Commission on
              October 4, 2004, and incorporated herein by reference).

   10.14*     Letter Agreement between the Company and Michael P. Keegan.

   10.15*     Letter Agreement between the Company and Gerard B. Moersdorf, Jr.

   10.16      Material Terms of the Consulting Arrangement between the Company
              and Gerard B. Moersdorf, Jr. (Reference is made to Exhibit 10.1 to
              the Company's Current Report on Form 8-K, filed with the
              Securities and Exchange Commission on February 11, 2005, and
              incorporated herein by reference).

   10.17      Employment Agreement between the Company and William H. Largent.
              (Reference is made to Exhibit 10.1 to the Company's Current Report
              on Form 8-K/A, filed with the Securities and
</TABLE>

<PAGE>

<TABLE>
<S>           <C>
              Exchange Commission on February 11, 2005, and incorporated herein
              by reference).

      23*     Consent of KPMG LLP.

      24*     Power of Attorney.

   31.1*      Rule 13a-14(a) Certification of Principal Executive Officer.

   31.2*      Rule 13a-14(a) Certification of Principal Financial Officer.

   32.1**     Section 1350 Certification of Principal Executive Officer.

   32.2**     Section 1350 Certification of Principal Financial Officer.
</TABLE>

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

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

(b)  Exhibits - The exhibits to this report follow the financial statement
     schedule and the independent registered public accounting firm's report
     thereon.

(c)  Financial Statement Schedule - The financial statement schedule and the
     independent registered public accounting firm's report thereon follow the
     signature page.

<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 7, 2005              By: /s/ William H. Largent
                                     -------------------------------------------
                                 William H. Largent
                                 President, Chief Executive Officer and Director

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/ William H. Largent           William H. Largent
------------------------------   President, Chief Executive Officer and Director
                                 (Principal Executive Officer)
                                 March 7, 2005


 /s/ Andrew J. Dosch             Andrew J. Dosch
------------------------------   Vice President, Chief Financial Officer and
                                 Treasurer (Principal Financial and Principal
                                 Accounting Officer)
                                 March 7, 2005


* Gerard B. Moersdorf, Jr.       Gerard B. Moersdorf, Jr. | Chairman of the
------------------------------   Board | March 7, 2005


* Thomas W. Huseby               Thomas W. Huseby | Director | March 7, 2005
------------------------------


* Kenneth E. Jones               Kenneth E. Jones | Director | March 7, 2005
------------------------------


* Curtis A. Loveland             Curtis A. Loveland | Director | March 7, 2005
------------------------------


* Richard W. Oliver              Richard W. Oliver | Director | March 7, 2005
------------------------------


* John D. Riedel                 John D. Riedel | Director | March 7, 2005
------------------------------


* Alexander B. Trevor            Alexander B. Trevor | Director | March 7, 2005
------------------------------


*By: /s/ William H. Largent      William H. Largent (Attorney-in-Fact)
     -------------------------
</TABLE>

<PAGE>

             Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
Applied Innovation Inc.:

Under date of March 7, 2005, we reported on the consolidated balance sheets of
Applied Innovation Inc. and subsidiaries as of December 31, 2004 and 2003, 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,
2004, 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
March 7, 2005

APPLIED INNOVATION INC.

Schedule II - Valuation and Qualifying Accounts
For the Years Ended December 31, 2004, 2003 and 2002

<TABLE>
<CAPTION>
Column A                                Column B             Column C           Column D       Column E
--------                                --------             --------           --------       --------
                                                     /------Additions------/
                                                     -----------------------
                                       Balance at    Charged to   Charged to
                                      beginning of    costs and      other                   Balance at
Description                              period        expense     accounts    Deductions   end of period
-----------                           ------------   ----------   ----------   ----------   -------------
<S>                                   <C>            <C>          <C>          <C>          <C>
YEAR ENDED DECEMBER 31, 2004
   Allowance for doubtful accounts     $  140,000    $   18,170       $--      $   43,170     $  115,000
   Allowance for obsolete inventory       434,000       146,000        --         417,000        163,000
   Warranty provision                     479,062       543,738        --         597,800        425,000

YEAR ENDED DECEMBER 31, 2003:
   Allowance for doubtful accounts     $  430,000    $  (73,342)      $--      $  216,658     $  140,000
   Allowance for obsolete inventory     1,107,159       551,000        --       1,224,159        434,000
   Warranty provision                     542,651       793,923        --         857,512        479,062

YEAR ENDED DECEMBER 31, 2002:
   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       697,604        --         974,119        542,651
</TABLE>