<PAGE>

                                 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, 2003

                                       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
      (State or other jurisdiction of incorporation or                     31-1177192
                       organization)                          (I.R.S. Employer Identification No.)
</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 $29,343,699 on June 30, 2003.

Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date: 15,062,775 shares of Common
Stock were outstanding at February 27, 2004.

                      DOCUMENTS INCORPORATED BY REFERENCE

Part III -- Proxy Statement for the Annual Meeting of Stockholders to be held
April 22, 2004, in part, as indicated.
<PAGE>

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 ONE


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

----------------------------------------------------
THE COMPANY'S MARKETS

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

The Company's products and services help operators of large, complex networks
more efficiently and effectively manage their operations. The products serve
three primary network management applications in data communications networks
(DCNs): mediation, aggregation and adaptation.

Mediation refers to the translation of differing data communications standards,
or protocols, to a common protocol used by the carrier's network. Applied
Innovation's mediation expertise, combined with its network knowledge, vastly
simplifies the carrier's network management activities. The Company does this by
providing seamless connectivity between operations support systems (OSSs),
generally located at a network operations center (NOC), and network elements
(NEs), generally located remotely in a central office (CO) or other network
location.

Aggregation is the process of collecting multiple data streams from multiple
network locations and combining the data streams onto a single data
stream--ultimately the data is connected to a wide area network (WAN). AI's
aggregation products simplify and flatten its customers' networks, thereby
improving efficiency, reducing maintenance costs and eliminating the costs of
overlapping communication lines.

Adaptation simplifies the process of replacing or upgrading OSSs. Often, OSS
migration is a very time-consuming, high-risk and expensive process for the
Company's customers since they not only have to migrate large and complex
software systems, but they also have to modify their very large and complex
DCNs, comprised of thousands of elements. AI's adaptation products solve
mediation and aggregation issues for the customer, eliminating or reducing the
need to modify its DCN.

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

                           Applied Innovation Inc. 1
<PAGE>

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(TM) chassis. The product combines best-in-class firewall
technology from Check Point(TM) Software Technologies with Applied Innovation's
NEBS 3 compliant design. AIfirewall allows its customers to manage services and
network devices located at the customer premises without compromising the
security of the operations support network. It sits in a central office between
the customer access point and the internal support network, which allows it to
pass authorized management 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.

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.

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.

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

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(TM)  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 and Integration Sales in the Company's
consolidated financial statements and are described as Products Sales in the
Company's product-line revenue analysis in Management's Discussion and Analysis
of Financial Condition and Results of Operations.

SERVICES SOLUTIONS

Applied Innovation delivers added value to customers through a robust suite of
service offerings. Leveraging 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

                           Applied Innovation Inc. 2
<PAGE>

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

All of the printed circuit boards, chassis enclosures and other hardware used in
the Company's products are designed in the Company's Dublin facility and are
proprietary designs of the Company. Under the supervision of the Vice President
of Operations and 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
Network Equipment Building Standards (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 maintains sales offices in Dallas,
Denver and Mexico City.

The Company generates a large portion of its annual revenues from customers with
whom the Company has done business for many years. Company sales personnel work
with network managers and planners to determine network management requirements,
the timing of individual projects and the customers' funding for such projects.
The Company generally has master purchase agreements with its largest recurring
customers, and receives individual purchase orders from customers as Company
products 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 requirements.
Enhancements to AIswitch(TM) are focused on enhancing the performance
capabilities of the product and adding functionality in its set of line cards,
including AIconnect(TM), AIextend(TM) and AIfirewall(TM). These enhancements
allow a service provider to seamlessly transition to next generation operations
support systems, integrate new elements into their systems more efficiently,
consolidate network management systems and adapt the

                           Applied Innovation Inc. 3
<PAGE>

information flowing across the product for more rapid implementation of
customer-driven applications.

Additional enhancements are in development for the AIbadger(TM) product line as
well as producing additional products for the wireless market to enhance network
management capabilities, improve service quality and speed the introduction of
new technologies. One such enhancement is in the area of radio frequency (RF)
performance monitoring, where the company is working on an application to allow
its customers to proactively monitor performance.

Enhancements to the Company's new AIremote(TM) product are also planned to
address additional applications with service providers' outside plant
applications, including enhanced networking and security features. Additional
enhancements are also planned to meet specific government market requirements.

The Company spent $5,575,652, $7,084,646 and $9,648,898 on Company-sponsored R&D
during the fiscal years ended December 31, 2003, 2002 and 2001, respectively.
R&D expenditures represented approximately 16%, 16% and 13% of annual sales in
fiscal 2003, 2002 and 2001, respectively. During 2004, the Company expects to
continue committing resources and cash to its research and development efforts
at a rate generally consistent with 2003 spending. 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 designs training programs to educate the customer's system
administration, operations and maintenance personnel to operate the system.
Classes are available on-line and at the customer's site or at the Company's
headquarters. Additional training is also offered to the customer during system
upgrades and for new operations personnel.

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

Warranty expenses represented approximately 2.7%, 2.3% and 2.1% of annual sales
in 2003, 2002 and 2001, 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."

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 27, 2004, the Company had 154 full-time and part-time employees.
The Company's employees are distributed among the following departments: Sales
and Marketing 37; Research and Development 46; Services 28; Administration 23;
and Operations 20.

----------------------------------------------------
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, 2004, 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

                           Applied Innovation Inc. 4
<PAGE>

customers. In fiscal 2003, 2002 and 2001, sales to the Company's three, three
and four largest customers represented approximately 74%, 75% and 66%,
respectively, of the Company's total sales. The Company expects that it will
continue to be dependent upon a limited number of customers for a significant
portion of its revenues in future periods. None of the Company's customers are
contractually obligated to license or purchase additional products or services
from the Company. As a result of this customer concentration, the Company's
business, operating results and financial condition could be materially
adversely affected by the failure of anticipated orders to materialize or by
deferrals or cancellations of orders. In addition, there can be no assurance
that revenue from customers that have accounted for significant sales in past
periods, individually or as a group, will continue, or if continued, will reach
or exceed historical levels in any future period. Furthermore, such customers
are concentrated in the telecommunications industry. Accordingly, the Company's
future success depends upon the capital spending patterns of such customers and
the continued demand by such customers for the Company's products and services.

Many of the Company's largest customers maintain collective bargaining
agreements with their employees. Accordingly, they have been affected by labor
strikes in the past and could be affected in the future. Such labor strikes may
impact certain customers' ability to place orders for Company products, accept
shipments or deploy products in their networks, and therefore, 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. The uncertainty
regarding the regulatory environment, specifically regarding final guidance on
Voice over Internet Protocol (VoIP) tariffs and taxes, could also impact timing
and/or investments by domestic service providers in the new technology and the
related equipment they would need to manage and monitor these new additions to
their networks. 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(TM) family of products has accounted for a substantial
portion of the Company's sales since inception. The Company believes that
revenue from the sale, service and support of the central office products will
continue to account for a significant portion of the Company's total sales in
fiscal 2004. Therefore, the Company's future operating results, particularly in
the near term, are significantly dependent upon the continued market acceptance
of these products, improvements to the product framework. 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 would have a material adverse effect on
the Company's business, operating results and financial condition.

New Products, Research and Development, and Rapid Technological Change; Need to
Manage Product Transitions  The market for the Company's products is
characterized by rapidly changing technologies, evolving industry standards,
frequent new product introductions and rapid changes in customer requirements.
The introduction of products embodying new technologies and the emergence of new
industry standards and practices can render existing products obsolete and
unmarketable. As a result, the life cycles of the Company's products are
difficult to estimate. The Company's future success will depend on its ability
to enhance its existing products and to develop and introduce, on a timely and
cost-effective basis, new products and product features that keep pace with
technological developments and emerging industry standards and address the
increasingly sophisticated needs of its customers. The Company is attempting to
ensure future success by continuing to invest in its research and development
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 will be materially adversely affected.

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

                           Applied Innovation Inc. 5
<PAGE>

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

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

Dependence Upon Proprietary Technology; Risk of Third Party Claims of
Infringement  The Company's success and ability to compete are dependent in part
upon its proprietary 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 would have a material adverse
effect on the Company's business, operating results and financial condition.

Reliance on Suppliers  The Company purchases raw material and licenses
technology from a number of domestic and foreign sources. Several of the
Company's products introduced in 2003 and planned for introduction in 2004
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.

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 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 revenues and net income. 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 revenues will grow or be sustained in future
periods or that the Company will be profitable in any future period.

                           Applied Innovation Inc. 6
<PAGE>

Risk of Product Defects  Products as complex as those offered by the Company may
contain defects or failures when introduced or when new versions or enhancements
are released. The Company has in the past discovered defects in certain of its
products, including a power supply defect resulting in a recall in the first
quarter of 2003. 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; changes in operating expenses; mergers and acquisitions among
customers; personnel changes; demand for the Company's products; the number,
timing and significance of new product and product enhancement announcements by
the Company and its competitors; the ability of the Company to develop,
introduce and market new and enhanced versions of its products on a timely
basis; and the mix of direct and indirect sales and general economic factors. A
significant portion of the Company's revenues 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. In
particular, the Company would be materially adversely affected if it were to
lose the services of Gerard B. Moersdorf, Jr., Chairman, President and Chief
Executive Officer, who has provided significant leadership and direction to the
Company since its inception. The loss of other key management or technical
personnel could adversely affect the Company. The Company believes that its
future success will depend in large part upon its ability to attract and retain
highly skilled managerial, sales, professional services, customer support and
product development personnel. The Company has at times experienced and
continues to experience challenges in recruiting qualified personnel.
Competition for qualified personnel is intense, and there can be no assurance
that the Company will be successful in attracting and retaining such personnel.
Furthermore, competitors have in the past and may in the future attempt to
recruit the Company's employees. Failure to attract and retain key personnel
could have a material adverse effect on the Company's business, operating
results and financial condition.

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

                           Applied Innovation Inc. 7
<PAGE>

it more difficult for a third party to acquire, or of discouraging a third party
from attempting to acquire, control of the Company. The Company's By-Laws
provide for the Board of Directors to be divided into three classes of directors
serving staggered three-year terms. Such classification of the Board of
Directors expands the time required to change the composition of a majority of
directors and may tend to discourage a proxy contest or other takeover bid for
the Company. Additionally, the directors, executive officers and existing
principal stockholders of the Company and their affiliates beneficially own
approximately 41.8% of the Company's common stock as of January 31, 2004. Such
concentration of ownership may have the effect of delaying or preventing a
change in control of the Company.

Concentration of Stock Ownership  The present directors, executive officers and
principal stockholders of the Company and their affiliates beneficially own
approximately 41.8% of the Company's common stock as of January 31, 2004. In
particular, Gerard B. Moersdorf, Jr. beneficially owns approximately 39.4% of
the Company's common stock. In addition, Mr. Moersdorf, Jr. has the right, by
agreement, to vote all of his former spouse's shares. As a result, 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.

ITEM TWO  PROPERTIES
----------------------------------------------------

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

ITEM THREE  LEGAL PROCEEDINGS
----------------------------------------------------

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

ITEM FOUR  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
----------------------------------------------------

Not applicable.


                           Applied Innovation Inc. 8
<PAGE>

                                    PART TWO


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>
----------------------------------------------------
                           2003             2002
----------------------------------------------------
                       HIGH      LOW    HIGH     LOW
----------------------------------------------------
<S>                    <C>     <C>     <C>     <C>
Q1...................  $3.55   $2.36   $6.30   $4.35
Q2...................   3.73    2.60    5.02    3.56
Q3...................   6.50    3.35    4.40    2.11
Q4...................   7.35    5.86    3.74    2.20
----------------------------------------------------
</Table>

At February 27, 2004, the Company had 500 stockholders of record.

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

ITEM SIX  SELECTED FINANCIAL DATA
--------------------------------------------------------------------------------

The table below presents selected operating and balance sheet data for the years
ended and as of December 31, 2003, 2002, 2001, 2000 and 1999. The selected
financial data for those periods and as of those dates have been derived from
the Company's audited financial statements. This selected financial data should
be read in conjunction with "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Item 8. Financial Statements
and Supplementary Data."

SELECTED CONSOLIDATED FINANCIAL DATA

<Table>
<Caption>
------------------------------------------------------------------------------------------------------
Years Ended December 31,                 2003         2002         2001         2000          1999
------------------------------------------------------------------------------------------------------
<S>                                   <C>          <C>          <C>          <C>           <C>
OPERATING DATA:
  Sales............................. $33,968,086  $42,961,011  $73,019,150  $116,103,392  $ 49,523,619
  Cost of sales.....................  16,353,637   23,556,671   39,251,716    75,906,065    20,917,459
                                      ----------   ----------   ----------   -----------   -----------
    Gross profit....................  17,614,449   19,404,340   33,767,434    40,197,327    28,606,160
  Selling, general and
    administrative expenses.........  13,689,576   18,413,456   22,183,578    18,455,315    11,965,059
  Research and development
    expenses........................   5,575,652    7,084,646    9,648,898     8,176,622     7,479,496
  Restructuring charges.............     (32,237)   2,890,155      292,330            --            --
                                      ----------   ----------   ----------   -----------   -----------
    Total operating expenses........  19,232,991   28,388,257   32,124,806    26,631,937    19,444,555
                                      ----------   ----------   ----------   -----------   ----------
    (Loss) income from operations...  (1,618,542)  (8,983,917)   1,642,628    13,565,390     9,161,605
                                      ----------   ----------   ----------   -----------   -----------
  Interest and other income, net....     393,057      597,137    1,350,338     1,353,612       924,476
                                      ----------   ----------   ----------   -----------   ----------
    (Loss) income before income
      taxes.........................  (1,225,485)  (8,386,780)   2,992,966    14,919,002    10,086,081
  Income taxes......................    (690,000)  (3,532,000)     755,000     4,774,000     3,081,000
                                      ----------   ----------   ----------   -----------   -----------
    Net (loss) income............... $  (535,485) $(4,854,780) $ 2,237,966  $ 10,145,002  $  7,005,081
                                      ----------   ----------   ----------   -----------   -----------
  Basic (loss) earnings per share... $     (0.04) $     (0.32) $      0.14  $       0.65  $       0.45
                                      ----------   ----------   ----------   -----------   -----------
  Diluted (loss) earnings per
    share........................... $     (0.04) $     (0.32) $      0.14  $       0.63  $       0.45
                                      ----------   ----------   ----------   -----------   -----------
  Shares used in computing basic
    (loss) earnings per share.......  14,994,924   15,092,328   15,870,492    15,598,723    15,598,143
                                      ----------   ----------   ----------   -----------   -----------
  Shares used in computing diluted
    (loss) earnings per share.......  14,994,924   15,092,328   16,140,993    16,014,153    15,647,050
                                      ----------   ----------   ----------   -----------   -----------
BALANCE SHEET DATA:
  Cash and short-term and
    non-current investments......... $27,973,038  $23,964,017  $28,616,130  $ 26,274,009  $ 19,070,826
  Net working capital...............  20,957,201   25,127,859   31,803,653    35,204,228    22,851,872
  Total assets......................  49,882,879   50,384,908   60,847,804    80,668,451    44,594,329
  Stockholders' equity..............  43,476,636   43,299,366   50,903,912    49,991,620    37,087,664
------------------------------------------------------------------------------------------------------
</Table>

                           Applied Innovation Inc. 9
<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. (Applied Innovation, AI or the Company) is a network
management solutions company that simplifies and enhances the operation of
complex, distributed voice and data networks. Building on a deep knowledge of
network architecture, elements and management, AI delivers unique hardware,
software and service solutions that provide greater connectivity, visibility and
control of network elements and the systems that support them. 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. The Company targets three primary
markets in the U.S. and abroad: 1) telecommunications companies using wireline
networks; 2) telecommunications companies using wireless networks; and 3)
government networks. Its largest customers in those markets are the four RBOCs,
domestic wireless service providers and other large domestic and foreign phone
companies.

The telecommunications industry has gone through several years of significant
turmoil. While there are signs the industry has begun to stabilize, the past
year was once again characterized by an overall reduction in capital spending,
headcount reductions and other cutbacks in operating costs. As a niche player in
the industry, AI's results have been negatively impacted by overall industry
conditions. Given the nature of the Company's products and services, customer
purchases of AI offerings are largely discretionary and therefore carry the risk
of being postponed or cancelled in times of uncertainty or underperformance.
However, the Company has taken a number of steps which have helped minimize the
negative industry impact and position the Company for future growth
opportunities expected once the industry recovers. Specifically, the Company
enacted a number of cost reduction measures over the last two years to better
align its operating expenses with expectations about the industry and customer
spending. In addition, the Company has responded with new product offerings and
ongoing development projects based on changing industry conditions and customer
needs. Also, the Company further diversified its customer base by entering the
wireless network management market through an acquisition in 2001 and the
Company experienced significant wireless growth in 2003. To further its goal of
customer and market diversification, the Company continues to look toward
international and government opportunities with great optimism and has aligned
resources to capitalize on those opportunities.

Looking ahead to 2004, the Company is encouraged by trends that are emerging in
each of its key markets. The following is an analysis of these trends, the
Company's positioning in each market and growth expectations for each in 2004.

Wireline  Capital spending announcements by domestic wireline carriers indicate
that overall 2004 capital spending may increase over 2003, the first such
increase in three years. The Company expects the wireline carriers to focus on
continued digital subscriber line (DSL) deployment,

                           Applied Innovation Inc. 10
<PAGE>

Voice over Internet Protocol (VoIP) initiatives and significantly increased
broadband availability with fiber to the premises (FTTP) plans. These new
spending initiatives are outside of Applied Innovation's core network management
focus. Therefore, the Company must ensure that its marketing, sales and
technology efforts will uncover network management applications for each of
these new carrier initiatives. The Company believes the new products it has
developed over the last year, such as AIextend(TM), AIconnect(TM) and
AIremote(TM), have the flexibility, adaptability and IP features that provide
value to the carriers.

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, the second quarter picks up significantly, 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 2004, the Company is
encouraged by the apparent recovery of the carriers. The Company is projecting
single digit sales growth in wireline sales for 2004, which would be the first
year of wireline sales growth after three years of decreasing sales.

Wireless  Wireless service providers are focused on differentiating their
service based on quality, national network availability and broadband data
applications. At the same time, the service providers' pricing power is limited
due to intense competition. In addition, the first steps towards industry
consolidation have been taken with Cingular Wireless' announced plans to acquire
AT&T Wireless. All of these trends indicate the wireless service providers will
find even more value in workforce automation, quality initiatives and
consolidating disparate networks. AI is well-positioned to capitalize on these
trends with its AIbadger(TM) and AIremote(TM) intelligent network management
devices. The Company's planned AIbadger(TM)-RFM product, which automates radio
frequency testing and diagnostics, is expected to be well accepted by the
market. Wireless sales grew nearly 400% in 2003, largely due to increased demand
from one large customer and the addition of a second wireless carrier. Looking
into 2004, the Company plans to broaden its sales penetration in existing
wireless accounts, add additional customers and find new applications such as
radio frequency testing. Double digit sales growth in wireless sales is expected
in 2004.

International  International sales in 2003 were below expectations, primarily
due to a dramatic slowdown in orders from the Company's largest international
customer in South Africa. However, business development efforts in Mexico and
Brazil over the last two years began to pay off at the end of 2003. AI expects
the customers in these two markets will continue to grow in 2004. 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 domestically for years through network mediation, network migration
and workforce automation. In 2004, solid sales growth is expected from
international business as demand from the Company's South African customer
increases 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.
This focus has led to deployments of new communication networks and upgrades to
existing infrastructure throughout the government, especially in the Department
of Defense (DoD), Department of Homeland Security (DHS) and other security
agencies. AI's networking expertise is well suited to this market, and the
Company is working to develop business relationships with large system
integrators and government customers. The Company expects that government sales
will also contribute to top line growth in 2004 and plans to continue investing
in the government market and leveraging the inroads made to date.

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 among its customers by diversifying the mix of products,
services and software. Likewise, the Company attempts to offset the seasonal
soft first quarter from domestic wireline customers with stronger demand from
international and wireless carriers. Looking into the first quarter of 2004, a
sequential decline in domestic wireline orders is likely, but may be offset by
growth in international and wireless sales. If international and wireless sales
do not materialize as expected, the Company could experience a sequential
decline in sales from the fourth quarter of 2003 to the first quarter of 2004.
Overall for 2004, however, sales are expected to increase over 2003 levels due
to the recent trends in each of the Company's key markets.

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

                           Applied Innovation Inc. 11
<PAGE>

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.............  $26,973,000   $13,790,000      51%
Services.............    6,995,000     3,824,000      55%
                       -----------   -----------
Total................  $33,968,000   $17,614,000      52%
                       ===========   ============
For the Year Ended December 31, 2002:
-------------------------------------

Products.............  $35,992,000   $16,775,000      47%
Services.............    6,969,000     2,629,000      38%
                       -----------   -----------
-------------------------------------
Total................  $42,961,000   $19,404,000      45%
                       ===========   ============
------------------------------------------------------------
</Table>

PRODUCTS SALES AND GROSS PROFIT

In 2003, product sales of $26,973,000 decreased by $9,019,000, or 25%, from the
prior year. As a percentage of total sales, product sales dropped from 84% in
2002 to 79% 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 51% 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 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. The Company
expects continued growth in its wireless and edge products sales in 2004, but
overall product gross profit margins are expected to be generally consistent
with 2003.

SERVICES SALES AND GROSS PROFIT

Services sales of $6,995,000 were 21% of total 2003 sales, versus services sales
of $6,969,000, 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 55% for the year ended December 31, 2003
compared to 38% 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. Services
gross profit margins in excess of 50% are unusually high and these margins are
expected to return closer to historical levels of 40%-50% in 2004.

                           Applied Innovation Inc. 12
<PAGE>

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. SG&A expenses in 2004 are
anticipated to be slightly higher than 2003 as a result of variable expenses,
such as bonuses, commissions and sales travel associated with anticipated
increases in sales volume.

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. In 2004, the Company
plans to continue to invest in product enhancements and new product development
to support changing industry and customer needs. R&D spending in 2004 is
expected to be comparable to 2003.

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. No additional workforce reductions or other cost
reduction actions are currently planned. However, the Company will continue to
monitor industry conditions and will take corrective action as industry
conditions change.

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.

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

                           Applied Innovation Inc. 13
<PAGE>

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.

----------------------------------------------------
COMPARISON OF 2002 TO 2001
TOTAL SALES AND GROSS PROFIT

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

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

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

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

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

<Table>
<Caption>
------------------------------------------------------------
                                                     Gross
                          Sales      Gross Profit   Profit %
------------------------------------------------------------
<S>                    <C>           <C>            <C>
For the Year Ended December 31, 2002:
-------------------------------------
Products.............  $35,992,000   $16,775,000      47%
Integration..........           --            --       --
Services.............    6,969,000     2,629,000      38%
                       -----------   -----------
Total................  $42,961,000   $19,404,000      45%
                       ===========   ===========
For the Year Ended December 31, 2001:
-------------------------------------
Products.............  $52,841,000   $28,190,000      53%
Integration..........    5,830,000       866,000      15%
Services.............   14,348,000     4,711,000      33%
                       -----------   -----------
Total................  $73,019,000   $33,767,000      46%
                       ===========   ===========
------------------------------------------------------------
</Table>

PRODUCTS SALES AND GROSS PROFIT

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

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

INTEGRATION SALES AND GROSS PROFIT

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

                           Applied Innovation Inc. 14
<PAGE>

SERVICES SALES AND GROSS PROFIT

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

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

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

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

RESEARCH AND DEVELOPMENT EXPENSES

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

RESTRUCTURING CHARGES

The Company recorded non-recurring charges to operating expenses of $2,890,000
during 2002 to account for total workforce reductions of approximately 150
employees, throughout all departments. The restructuring charges were incurred
as a result of two restructuring events in 2002. The first restructuring,
occurring in the first quarter of 2002, resulted in total charges of $408,000
relating primarily to severance and fringe benefits associated with the
termination of approximately 50 employees. The second restructuring occurred in
the third quarter of 2002 and resulted in total charges of $2,482,000. Those
charges related to severance and fringe benefit costs of terminating
approximately 100 employees, as well as charges related to excess equipment and
leased offices. The restructuring charges are shown as a separate line item on
the consolidated statements of operations. As of December 31, 2002, $583,000 of
such costs remained to be paid. In 2001, the Company recorded restructuring
charges of $292,000 related primarily to severance and fringe benefit costs
associated with the termination of approximately 40 employees, throughout all
departments.

INTEREST AND OTHER INCOME, NET

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

INCOME TAXES

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

NET LOSS/INCOME AND LOSS/EARNINGS PER SHARE

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

                           Applied Innovation Inc. 15
<PAGE>

ASSETS

Total assets decreased from $60,848,000 at December 31, 2001 to $50,385,000 at
December 31, 2002, a decrease of $10,463,000. Total cash and investments
decreased $4,652,000 due primarily to funding of operations, which consumed cash
of $948,000, stock repurchases of $2,835,000 and purchases of machinery and
equipment of $961,000. Net accounts receivable decreased $2,657,000 as a result
of overall lower sales volume and increased collection efforts. Net inventory
decreased $3,912,000, relating primarily to inventory charges of over $2,000,000
which the Company recorded in 2002, the Company's efforts to reduce its working
capital investment, as well as overall lower sales volume. Net property, plant
and equipment decreased $1,030,000 as a result of current year purchases offset
by depreciation expense and asset disposals. Partially offsetting those
decreases was the increase in income taxes receivable of $2,176,000 due to tax
refunds resulting from the current year operating losses.

LIABILITIES AND STOCKHOLDERS' EQUITY

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

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

----------------------------------------------------
LIQUIDITY AND CAPITAL RESOURCES

Net working capital was $20,957,000 at December 31, 2003 compared to $25,128,000
at December 31, 2002. At December 31, 2003, the current ratio was 4.3:1 and the
Company's only debt outstanding was a $750,000 note payable issued in
conjunction with an asset acquisition in 2001. The note payable bears interest
at an annual rate of 8%, with interest payments due semi-annually and principal
due at maturity in August 2004.

The Company had $27,973,000 of cash and cash equivalents and short- and
long-term investments at December 31, 2003, an increase of $4,009,000 from the
December 31, 2002 balance of $23,964,000.

OPERATING ACTIVITIES

Despite the net loss of $535,000 in 2003, operating activities provided cash of
$3,760,000. Significant components of cash flows from operations included:
decreased income taxes receivable of $2,811,000; non-cash depreciation and
amortization expenses of $1,407,000; and decreased accounts receivable of
$1,591,000. The Company received a $3,600,000 federal income tax refund in 2003,
but is expecting a less significant federal tax refund in 2004, likely $500,000
to $1,000,000. The Company will likely have only $131,000 of amortization
expense in 2004 (compared to $210,000 in 2003) because the associated intangible
assets will become fully amortized in 2004. It is also likely that cash balances
in 2004 will be negatively impacted by increasing accounts receivable if sales
volumes increase as expected. Similarly, while inventory balances decreased by
$595,000 (net of non-cash charges) and thereby were another source of cash in
2003, inventory balances are near their lowest levels in a number of years. For
that reason and since higher inventory balances will be necessary to support
anticipated increased sales in 2004, it is likely that inventory balances will
increase in 2004 and require the use of cash. One additional source of cash in
2003 was deferred revenue which increased by $366,000.

Working capital changes in the opposite direction which required the use of cash
in 2003 included: increased other assets of $1,180,000, primarily as a result of
purchases of corporate owned life insurance on four executives totaling
$1,224,000; increased other current assets of $387,000 resulting from two
specific one-time occurrences of non-trade receivables which were collected
subsequent to year-end; decreased accrued restructuring costs of $539,000 as all
restructuring-related charges were paid off in 2003 except for the remaining
lease payments on vacated office space; and decreased accounts payable of
$765,000, due primarily to timing of invoice receipts and check payment cycles
near year end.

INVESTING ACTIVITIES

Investing activities in 2003 used $1,371,000 in cash, including $480,000 for
equipment purchases to support operations and $908,000 for investment securities
purchases (net of maturities and sales).

FINANCING ACTIVITIES

Financing activities provided $655,000 of cash in 2003, resulting from the
$383,000 repayment of a note receivable for common stock as well as proceeds of
$272,000 from the issuance of common stock for stock option exercises 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 2004. 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

                           Applied Innovation Inc. 16
<PAGE>

significant research and development efforts. However, there can be no assurance
that additional financing will be available on terms favorable to the Company or
at all.

----------------------------------------------------
APPLICATION OF CRITICAL ACCOUNTING POLICIES

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

Revenue Recognition  Revenue is generally recognized on product and integration
sales as products are delivered and ownership and risk of loss are transferred.
In certain limited situations, customers may request that products are built and
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 estimated likelihood that customers will return products. At
December 31, 2003 and 2002, the Company has no sales return allowances recorded.

Allowance for Doubtful Accounts  The Company sells to its customers on credit,
generally requiring payment within thirty days from delivery. Since the
Company's customer base is generally comprised of very large, well-funded
service providers, the Company's historical credit risk has been very low.
However, the Company does establish allowances against accounts receivable for
potentially uncollectible amounts. The Company estimates necessary allowances
based on its analysis of customers' outstanding receivables at the individual
invoice level, the customers' payment history and any other known factors
concerning their current financial condition and ability to pay. After the
Company has exhausted its collection efforts and determined that amounts are
uncollectible at the individual invoice level, such amounts are charged off
against the allowance. To the extent any customers unexpectedly become insolvent
or unable to pay amounts due, the allowance estimates may be incorrect. Over the
last twelve to twenty-four months, many telecommunications service providers,
including some that have historically been customers of the Company, have
experienced financial challenges. The Company did not have any significant
exposure to bankruptcies among 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.

                           Applied Innovation Inc. 17
<PAGE>

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

Warranty  The Company generally warrants its products for a minimum of one year
after sale. Based primarily on historical experience and any known warranty
issues with existing products, the Company estimates its expected future
warranty costs and accrues such costs at the time of sale. Warranty costs
generally consist of labor and materials to repair defective parts, replacement
parts, shipping costs to replace materials, and labor and travel costs
associated with customer site visits to repair products or correct prior service
work. The Company's overall warranty costs have been decreasing over the past
several years, primarily due to improved product quality and lower sales
volumes. 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. 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. Had the Company accounted for its stock options using the Black
Scholes option-pricing model, a fair value-based method, rather than an
intrinsic value-based method, the Company would have recognized additional
compensation expense, net of related tax effects, of approximately $1,320,000,
$1,736,000 and $2,617,000 for the years ended December 31, 2003, 2002 and 2001,
respectively.

Use of Estimates  In addition to the above critical accounting policies, the
Company utilizes certain estimates in preparing its consolidated financial
statements. Because these estimates are inherently subjective and affect the
reported amounts of assets and liabilities as well as contingent assets and
liabilities, different estimates would yield different results as reported in
the consolidated financial statements. Areas that involve utilization of
significant estimates include accounting for doubtful accounts, inventory
obsolescence, estimated useful lives of property, plant and equipment and
intangible assets, depreciation and amortization, sales returns, warranty costs,
income taxes and contingencies. 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 three years for office space under
various operating leases. Future minimum lease payments, net of estimated
sublease payments under these leases, are $96,000 in 2004, $54,000 in 2005 and
$23,000 in 2006.

The Company's note payable of $750,000 is due in August 2004.

The Company utilizes the manufacturing services of several contract
manufacturers to supply certain components and subassemblies used in the
Company's products. Based on production schedules and necessary lead times, the
Company may enter into purchase commitments for inventory from these contract
manufacturers. At December 31, 2003, the Company had purchase commitments for
inventory of $844,000. These purchase commitments are expected to be fulfilled
by April 2004.

                           Applied Innovation Inc. 18
<PAGE>

The following summarizes the Company's contractual obligations and commercial
commitments at December 31, 2003:

<Table>
<Caption>
------------------------------------------------------------------------------------------------
                                                          Payments due by period
------------------------------------------------------------------------------------------------
                                                       Less than    1 to      3 to     More than
                                             Total      1 year     3 years   5 years    5 years
------------------------------------------------------------------------------------------------
<S>                                        <C>         <C>         <C>       <C>       <C>
Operating leases.........................  $  173,000  $   96,000  $ 77,000   $     --   $    --
Note payable.............................     750,000     750,000        --         --        --
Purchase commitments.....................     844,000     844,000        --         --        --
                                           ----------   ---------   -------    -------   -------
Total....................................  $1,767,000  $1,690,000  $ 77,000   $     --   $    --
------------------------------------------------------------------------------------------------
</Table>

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. Related to an acquisition in 2001, the Company has a $750,000 note
payable due in August 2004, bearing interest at a fixed rate of 8% annually.

ITEM EIGHT  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
--------------------------------------------------------------------------------

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

INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Applied Innovation Inc.:

We have audited the accompanying consolidated balance sheets of Applied
Innovation Inc. and subsidiaries as of December 31, 2003 and 2002, 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, 2003.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Applied Innovation
Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2003, in conformity with accounting principles generally
accepted in the United States of America.

/s/ KPMG LLP

Columbus, Ohio
January 23, 2004

                           Applied Innovation Inc. 19
<PAGE>

APPLIED INNOVATION INC.

--------------------------------------------------------------------------------
CONSOLIDATED BALANCE SHEETS
--------------------------------------------------------------------------------

<Table>
<Caption>
---------------------------------------------------------------------------------------
DECEMBER 31,                                                     2003         2002
---------------------------------------------------------------------------------------
<S>                                                           <C>          <C>
ASSETS
Current assets:
  Cash and cash equivalents................................. $ 12,030,638  $  8,986,292
  Short term investments....................................    5,582,325     8,028,510
  Accounts receivable, net of allowance of $140,000 in 2003
    and $430,000 in 2002....................................    3,449,052     5,040,405
  Inventory, net............................................    2,814,442     3,409,842
  Income taxes receivable...................................      268,287     3,079,534
  Other current assets......................................    1,255,700       868,818
  Deferred income taxes.....................................    1,963,000     2,050,000
                                                             ------------  ------------
      Total current assets..................................   27,363,444    31,463,401
  Property, plant and equipment, net........................    7,060,034     7,793,014
  Investments...............................................   10,360,075     6,949,215
  Intangible assets, net of accumulated amortization of
    $633,750 in 2003 and $423,750 in 2002...................      131,250       341,250
Goodwill....................................................    3,525,801     3,477,001
Deferred income taxes.......................................      127,000       226,000
Other assets................................................    1,315,275       135,027
                                                             ------------  ------------
                                                             $ 49,882,879  $ 50,384,908
                                                             ============  ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Accounts payable.......................................... $   790,037   $  1,554,872
  Accrued expenses:
    Warranty................................................     479,062        542,651
    Payroll and related expenses............................     787,819        647,149
    Restructuring...........................................      43,825        582,811
    Taxes, other than income taxes..........................     563,252        274,681
    Other accrued expenses..................................     723,249        830,822
  Deferred revenue..........................................   2,268,999      1,902,556
  Note payable..............................................     750,000             --
                                                             -----------    -----------
      Total current liabilities.............................   6,406,243      6,335,542
Note payable................................................          --        750,000
                                                             -----------    -----------
      Total liabilities.....................................   6,406,243      7,085,542
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 15,033,409 shares in 2003
    and 14,950,749 shares in 2002...........................     150,334        149,507
  Additional paid-in capital................................   6,140,540      5,845,740
  Note receivable for common stock..........................          --       (382,783)
  Retained earnings.........................................  37,145,452     37,680,937
  Accumulated other comprehensive gain, net.................      40,310          5,965
                                                             -----------    -----------
      Total stockholders' equity............................  43,476,636     43,299,366
                                                             -----------    -----------
                                                             $49,882,879   $ 50,384,908
                                                             ===========    ===========
---------------------------------------------------------------------------------------
</Table>

See accompanying notes to consolidated financial statements.

                           Applied Innovation Inc. 20
<PAGE>

APPLIED INNOVATION INC.

--------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF OPERATIONS
--------------------------------------------------------------------------------

<Table>
<Caption>
---------------------------------------------------------------------------------------------------
Years Ended December 31,                                     2003           2002          2001
---------------------------------------------------------------------------------------------------
<S>                                                       <C>            <C>            <C>
Sales:
  Products and integration..............................  $26,973,066    $35,992,455    $58,670,859
  Services..............................................    6,995,020      6,968,556     14,348,291
                                                          -----------    -----------    -----------
    Total sales.........................................   33,968,086     42,961,011     73,019,150
Cost of sales:
  Cost of sales -- products and integration.............   13,182,991     19,216,831     29,614,268
  Cost of sales -- services.............................    3,170,646      4,339,840      9,637,448
                                                          -----------    -----------    -----------
    Total cost of sales.................................   16,353,637     23,556,671     39,251,716
                                                          -----------    -----------    -----------
    Gross profit........................................   17,614,449     19,404,340     33,767,434
Operating expenses:
  Selling, general and administrative...................   13,689,576     18,413,456     22,183,578
  Research and development..............................    5,575,652      7,084,646      9,648,898
  Restructuring charges.................................      (32,237)     2,890,155        292,330
                                                          -----------    -----------    -----------
    Total operating expenses............................   19,232,991     28,388,257     32,124,806
                                                          -----------    -----------    -----------
    (Loss) income from operations.......................   (1,618,542)    (8,983,917)     1,642,628
Interest and other income, net..........................      393,057        597,137      1,350,338
                                                          -----------    -----------    -----------
    (Loss) income before income taxes...................   (1,225,485)    (8,386,780)     2,992,966
Income taxes............................................     (690,000)    (3,532,000)       755,000
                                                          -----------    -----------    -----------
    Net (loss) income...................................  $  (535,485)   $(4,854,780)   $ 2,237,966
                                                          ===========    ===========    ===========
(Loss) earnings per share:
    Basic (loss) earnings per share.....................  $     (0.04)   $     (0.32)   $      0.14
                                                          ===========    ===========    ===========
    Diluted (loss) earnings per share...................  $     (0.04)   $     (0.32)   $      0.14
                                                          ===========    ===========    ===========
Weighted-average shares outstanding for basic (loss)
  earnings per share....................................   14,994,924     15,092,328     15,870,492
                                                          ===========    ===========    ===========
Weighted-average shares outstanding for diluted (loss)
  earnings per share....................................   14,994,924     15,092,328     16,140,993
                                                          ===========    ===========    ===========
---------------------------------------------------------------------------------------------------
</Table>

See accompanying notes to consolidated financial statements.

                           Applied Innovation Inc. 21
<PAGE>

APPLIED INNOVATION INC.

--------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
--------------------------------------------------------------------------------

<Table>
<Caption>
---------------------------------------------------------------------------------------------------------------------
                               Common stock                        Note
                           ---------------------                receivable                 Accumulated
                             Number                Additional      for                        other
                            of shares               paid-in       common      Retained    comprehensive
                           outstanding   Amount     capital       stock       earnings      gain, net       Totals
---------------------------------------------------------------------------------------------------------------------
<S>                        <C>           <C>       <C>          <C>          <C>          <C>             <C>
Balance --
 December 31, 2000.......  15,808,479   $158,085  $10,081,936   $(600,000)  $40,297,751    $  53,848      $49,991,620
Comprehensive income:
 Net income..............          --         --           --          --     2,237,966           --        2,237,966
 Unrealized loss on
   investments, net......          --         --           --          --            --       (5,361)          (5,361)
                                                                                                         ------------
Total comprehensive
 income..................                                                                                   2,232,605
Stock options
 exercised...............      99,720        997      479,513          --            --           --          480,510
Sale of stock to
 officer.................      50,000        500      427,625          --            --           --          428,125
Common stock
 repurchased.............    (445,300)    (4,453)  (3,023,674)         --            --           --       (3,028,127)
Repayment of note
 receivable for common
 stock...................          --         --           --     105,129            --           --          105,129
Tax benefit associated
 with exercise of stock
 options.................          --         --      694,050          --            --           --          694,050
                           ----------    -------   ----------   ---------   -----------      -------     ------------
Balance --
 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 option
 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
                           ==========   ========  ===========   ==========  ============   =========     ============
</Table>


See accompanying notes to consolidated financial statements.

                           Applied Innovation Inc. 22

<PAGE>

APPLIED INNOVATION INC.

<Table>
<Caption>
----------------------------------------------------------------------------------------------------------
CONSOLIDATED STATEMENTS OF CASH FLOWS
----------------------------------------------------------------------------------------------------------


----------------------------------------------------------------------------------------------------------
Years Ended December 31,                                   2003          2002          2001
----------------------------------------------------------------------------------------------------------
<S>                                                       <C>               <C>               <C>
Cash flows from operating activities:
  Net (loss) income...................................  $    (535,485)    $  (4,854,780)    $   2,237,966
  Adjustments to reconcile net (loss) income to net
    cash provided by (used in) operating activities:
    Depreciation......................................      1,196,697         1,715,261         1,721,061
    Amortization of intangible assets.................        210,000           210,000           213,750
    (Gain) loss on disposal of assets.................           (797)          241,914           (12,714)
    Deferred income tax expense (benefit).............        164,000           462,000           (33,000)
    Tax benefit of options exercised..................         23,017               340           694,050
    Effects of change in operating assets and
      liabilities, net of assets acquired and
      liabilities assumed in acquisition:
      Accounts receivable.............................      1,591,353         2,656,598        22,461,502
      Inventory.......................................        595,400         3,912,474         5,015,679
      Income taxes receivable.........................      2,811,247        (2,176,265)       (3,294,671)
      Other current assets............................       (386,882)         (238,225)          222,391
      Other assets....................................     (1,180,248)           34,660            71,354
      Accounts payable................................       (764,835)         (204,814)      (17,280,850)
      Accrued expenses................................       (329,707)       (1,119,820)       (1,398,102)
      Deferred revenue................................        366,443        (1,587,516)         (450,985)
                                                        -------------     -------------     -------------
    Net cash provided by (used in) operating
      activities......................................      3,760,203          (948,173)       10,167,431
Cash flows from investing activities:
  Purchases of property, plant and equipment..........       (479,712)         (961,400)       (1,825,076)
  Proceeds from sales of property, plant and
    equipment.........................................         16,792            34,566            34,459
  Payment for business acquisition....................             --                --        (4,044,969)
  Purchases of investments............................    (16,778,379)      (13,870,211)      (23,108,753)
  Proceeds from maturities of investments.............     15,669,233        10,983,967        15,598,693
  Proceeds from sales of investments..................        200,816           756,533         6,871,092
                                                        -------------     -------------     -------------
    Net cash used in investing activities.............     (1,371,250)       (3,056,545)       (6,474,554)
Cash flows from financing activities:
  Common stock repurchased............................             --        (2,834,891)       (3,028,127)
  Proceeds from payment on note receivable............        382,783           112,088           105,129
  Proceeds from issuance of common stock..............        272,610            15,219           908,635
                                                        -------------     -------------     -------------
Net cash provided by (used in) financing activities...        655,393        (2,707,584)       (2,014,363)
                                                        -------------     -------------     -------------
Increase (decrease) in cash and cash equivalents......      3,044,346        (6,712,302)        1,678,514
Cash and cash equivalents -- beginning of year........      8,986,292        15,698,594        14,020,080
                                                        -------------     -------------     -------------
Cash and cash equivalents -- end of year..............  $  12,030,638     $   8,986,292     $  15,698,594
                                                        =============     =============     =============
SUPPLEMENTAL CASH FLOW DISCLOSURE:
  Income taxes received (paid), net...................  $   3,688,265     $   1,818,737     $  (3,364,427)
                                                        =============     =============     =============
---------------------------------------------------------------------------------------------------------
</Table>

See accompanying notes to consolidated financial statements.

                           Applied Innovation Inc. 23
<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 three primary markets in the U.S. and
abroad: 1) telecommunications companies using wireline networks; 2)
telecommunications companies using wireless networks; and 3) government
networks. Synergies within the markets allow the Company to leverage its
knowledge and experience and deliver a common value proposition based on key
competitive differentiators -- namely, its extensive knowledge of network
infrastructure, its commitment to vendor neutrality, and its focus on customers.
At the same time, the Company delivers targeted value to each market by
understanding and meeting their unique demands.

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

PRINCIPLES OF CONSOLIDATION

The consolidated financial statements include the accounts of Applied Innovation
Inc. and its wholly owned subsidiaries. All significant 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, 2003 and 2002, cash equivalents of
$10,410,049 and $7,139,654, respectively, were invested in money markets,
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. Since the
Company does not intend to hold its investments in debt securities until
maturity and does not actively trade debt and marketable equity securities to
maximize trading gains, the Company classifies these 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. Any investment impairments deemed other than temporary by the Company
would be included in net income (loss) on the consolidated statements of
operations. No such impairment charges have been recorded in 2003, 2002 or 2001.

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

                           Applied Innovation Inc. 24
<PAGE>

NETWORK MANAGEMENT SYSTEM SALES  Revenue from the sale of network management
system projects may include a combination of the following multiple elements:
internally developed software 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.

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 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 provided using the straight-line
method over the estimated economic lives of the respective assets, generally up
to three years. Amortization expense for the years ended December 31, 2003, 2002
and 2001 was $210,000, $210,000 and $213,750, respectively. The assets will
become fully amortized in 2004, resulting in amortization expense of $131,250.

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 2003 and 2002, 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. In 2003, the Company
purchased corporate owned life insurance policies covering four of the Company's
executives. At December 31, 2003, other assets includes $1,241,361 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 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.

                           Applied Innovation Inc. 25
<PAGE>

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.

STOCK-BASED COMPENSATION PLANS

The Company accounts for 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 income (loss) and earnings
(loss) per share if the Company had applied the fair value recognition
provisions of SFAS No. 123, "Accounting for Stock-Based Compensation," to
stock-based employee compensation using the Black Scholes model:

<Table>
<Caption>
--------------------------------------------------------------------------------------------------------
                Years Ended December 31,                        2003          2002          2001
--------------------------------------------------------------------------------------------------------
<S>                                                       <C>             <C>             <C>
Net (loss) income, as reported...........................  $    (535,485)  $ (4,854,780)   $  2,237,966
Deduct: Total stock-based employee compensation expense
  determined under fair value based method for all
  awards, net of related tax effects.....................     (1,319,659)    (1,736,080)     (2,616,657)
                                                           -------------   ------------    -------------
Pro forma net loss.......................................  $  (1,855,144)  $ (6,590,860)   $   (378,691)
                                                           =============    ===========    =============
(Loss) earnings per share:
  Basic -- as reported...................................  $       (0.04)  $      (0.32)   $       0.14
  Basic -- pro forma.....................................          (0.12)         (0.44)          (0.02)
  Diluted -- as reported.................................  $       (0.04)  $      (0.32)   $       0.14
  Diluted -- pro forma...................................          (0.12)         (0.44)          (0.02)
--------------------------------------------------------------------------------------------------------
</Table>

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. 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.

                           Applied Innovation Inc. 26
<PAGE>

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, 2003 or 2002.

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, 2003 and 2002 are summarized below:

<Table>
<Caption>
---------------------------------------------------------------------------------------------
                                                                     2003             2002
---------------------------------------------------------------------------------------------
<S>                                                           <C>              <C>
Raw materials...............................................   $  1,516,034     $   3,508,806
Work-in-process.............................................        134,874            15,004
Finished goods..............................................      1,597,534           993,191
                                                               ------------     -------------
                                                                  3,248,442         4,517,001
Reserve for obsolescence....................................       (434,000)       (1,107,159)
                                                               ------------     -------------
                                                               $  2,814,442     $   3,409,842
                                                               ------------     -------------
---------------------------------------------------------------------------------------------
</Table>

During 2003, the Company recorded inventory charges of $551,000 to cost of goods
sold, primarily related to certain potential excess and obsolete inventory.
During 2002, the Company recorded inventory charges of $2,152,000 to cost of
goods sold, primarily related to discontinuance of its optical transmission
product line and potential excess inventory and market price exposure associated
with certain other materials in inventory.

--------------------------------------------------------------------------------
(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 in securities:

<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
US 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>

                           Applied Innovation Inc. 27
<PAGE>

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

Gross realized gains included in income in 2003, 2002 and 2001 were $5,523,
$22,306 and $27,536, respectively, and gross realized losses included in income
in 2003, 2002 and 2001 were $4,545, $117,507 and $45,485, respectively. Realized
gains and losses are determined by specific identification.

Interest income, primarily from investments, was $467,738, $665,343 and
$1,418,385 in 2003, 2002 and 2001, respectively.

The Company's December 31, 2003 debt securities at fair market value mature as
follows: $5,582,325 in less than one year, $9,105,334 after one year but less
than five years and $695,000 in five or more years.

--------------------------------------------------------------------------------
(4) PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment at December 31, 2003 and 2002 are summarized
below:

<Table>
<Caption>
-----------------------------------------------------------------------------------------
                                                                  2003           2002
-----------------------------------------------------------------------------------------
<S>                                                         <C>             <C>
Land........................................................ $   1,639,303   $  1,639,303
Building....................................................     5,109,087      5,109,087
Equipment...................................................     8,381,748      8,015,609
Furniture...................................................     2,030,209      2,018,457
                                                             -------------   ------------
                                                                17,160,347     16,782,456
Accumulated depreciation....................................   (10,100,313)    (8,989,442)
                                                             -------------    -----------
                                                             $   7,060,034   $  7,793,014
                                                             =============   ============
-----------------------------------------------------------------------------------------
</Table>

--------------------------------------------------------------------------------
(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 to recall and replace
those units. During the year, the Company recorded adjustments 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. At December
31, 2003, the remaining reserve balance associated with the product recall was
$61,000.

The Company's warranty activity is summarized below:

<Table>
<Caption>
------------------------------------------------------------------------------------
Years Ended December 31,                                        2003         2002
------------------------------------------------------------------------------------
<S>                                                           <C>         <C>
Beginning balance........................................... $ 542,651   $   819,166
Warranty provision..........................................   918,616       974,119
Warranty costs incurred.....................................  (982,205)   (1,250,634)
                                                             ---------   -----------
Ending balance.............................................. $ 479,062   $   542,651
                                                             =========   ===========
------------------------------------------------------------------------------------
</Table>

                           Applied Innovation Inc. 28
<PAGE>

--------------------------------------------------------------------------------
(6) ACQUISITION

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

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

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

<Table>
<Caption>
------------------------------------------------------------------------
------------------------------------------------------------------------
<S>                                                         <C>
Accounts receivable......................................... $   167,806
Inventory...................................................     328,935
Property, plant and equipment...............................     128,427
Intangible assets...........................................     765,000
Goodwill....................................................   3,404,801
                                                             -----------
  Total assets acquired..................................... $ 4,794,969
                                                             ===========
------------------------------------------------------------------------
</Table>

The Company records contingent consideration as additional goodwill as the
contingencies are resolved. Of the contingent payment, cumulative totals of
$121,000 and $72,200 were recorded as additional goodwill at December 31, 2003
and 2002, respectively. Goodwill is expected to be fully deductible for tax
purposes.

--------------------------------------------------------------------------------
(7) MAJOR CUSTOMERS AND GEOGRAPHIC DATA

Revenues to major customers represented 74%, 75% and 66% of net sales for 2003,
2002 and 2001, respectively. The number of major customers previously referred
to were three, three and four for 2003, 2002 and 2001, respectively, with trade
accounts receivable balances of $1,925,468 and $3,566,498 at December 31, 2003
and 2002, respectively.

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

<Table>
<Caption>
-------------------------------------------------------------------------------------------------
               Years Ended December 31,                    2003          2002           2001
-------------------------------------------------------------------------------------------------
<S>                                                   <C>           <C>            <C>
United States......................................... $ 32,924,985  $  36,569,783  $  68,820,616
International.........................................    1,043,101      6,391,228      4,198,534
                                                       ------------  -------------  -------------
                                                       $ 33,968,086  $  42,961,011  $  73,019,150
                                                       ============  =============  =============
-------------------------------------------------------------------------------------------------
</Table>

                           Applied Innovation Inc. 29
<PAGE>

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

The calculations of earnings (loss) per share for the years ended December 31,
2003, 2002 and 2001, are based upon the weighted-average shares outstanding
during the periods and, when applicable, those stock options that are dilutive,
using the treasury stock method. Reconciliations of the numerators and
denominators of the basic and diluted earnings (loss) per share calculations
follow:

<Table>
<Caption>
-----------------------------------------------------------------------------------------------------
               Years Ended December 31,                      2003            2002            2001
-----------------------------------------------------------------------------------------------------
<S>                                                       <C>             <C>             <C>
Net (loss) income available to common stockholders....   $  (535,485)   $  (4,854,780)    $ 2,237,966
                                                         ===========    =============     ===========
Weighted average shares outstanding -- basic..........    14,994,924       15,092,328      15,870,492
Effect of dilutive securities -- stock options........            --               --         270,501
                                                         -----------    -------------      ----------
Weighted average shares outstanding -- diluted........    14,994,924       15,092,328      16,140,993
                                                         -----------    -------------     -----------
Basic (loss) earnings per share.......................   $     (0.04)   $       (0.32)    $      0.14
                                                         ===========    =============     ===========
Diluted (loss) earnings per share.....................   $     (0.04)   $       (0.32)    $      0.14
                                                         ===========    =============     ===========
-----------------------------------------------------------------------------------------------------
</Table>

Due to the Company's net loss for the years ended December 31, 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, 2003 and 2002
were 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, 2003, 2002
and 2001 which were excluded from the earnings per share calculations because
they were out-of-the-money were 1,263,720, 1,670,100 and 1,215,350,
respectively.

--------------------------------------------------------------------------------
(9) STOCK OPTION PLANS

The Company's 2001 Stock Incentive Plan ("the 2001 Plan") was adopted by the
Board of Directors on February 27, 2001, and approved by the stockholders of the
Company as of April 26, 2001, with 2,000,000 shares of common stock reserved for
issuance 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, 2003, there were 837,000 additional shares available for grant
under the 2001 Plan and 1,098,390 additional shares available for grant under
the 1996 Plan. The per share weighted-average fair value of stock options
granted during 2003, 2002 and 2001 was $2.35, $3.65 and $7.27, 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, 2003, 2002
and 2001, respectively: dividend yield of 0% for all years; expected volatility
of 90%, 90% and 93%; risk-free interest rate of 3.0%, 4.3% and 4.5%; and
expected life of 5.6, 5.6 and 5 years.

                           Applied Innovation Inc. 30
<PAGE>

A summary of stock option activity follows:

<Table>
<Caption>
------------------------------------------------------------------------------------------
                                                                              Weighted-
                                                              Number of        average
                                                                shares      exercise price
------------------------------------------------------------------------------------------
<S>                                                           <C>           <C>
Balance at December 31, 2000................................   1,776,980        $ 8.66
  Granted...................................................   1,082,000         10.99
  Exercised.................................................     (99,720)         4.82
  Canceled/expired..........................................    (392,430)        11.30
                                                              ----------
Balance at December 31, 2001................................   2,366,830        $10.55
  Granted...................................................     619,500          5.13
  Exercised.................................................      (4,000)         3.80
  Canceled/expired..........................................  (1,161,030)        12.17
                                                              ----------
Balance at December 31, 2002................................   1,821,300        $ 7.62
  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
                                                              ==========
------------------------------------------------------------------------------------------
</Table>

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

<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    369,250     9.00        $ 3.03          600     $ 2.95
   3.04 -  4.63    225,300      5.42          3.89      117,100       3.91
   4.69 -  5.89    382,520      7.55          5.18      149,320       5.15
   5.90 -  7.99    183,750      5.44          6.95      101,150       7.10
   8.11 -  9.88    259,850      6.52          8.35      163,450       8.34
  10.01 - 11.70    294,850      7.08         11.52      163,300      11.56
  12.13 - 17.38     82,750      6.69         13.74       46,100      13.71
                 ---------                             --------
                 1,798,270      7.10          6.65      741,020       7.87
                 ---------                             --------
----------------------------------------------------------------------------
</Table>

--------------------------------------------------------------------------------
(10) EMPLOYEE STOCK PURCHASE PLAN

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

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. On January 3, 2004 the
Company issued 14,766 shares of common stock at a price of $3.02 per share based
on employee payroll deductions for the six-month offering period ending December
31, 2003.

--------------------------------------------------------------------------------
(11) DEFINED CONTRIBUTION PLAN

The Company sponsors a defined contribution 401(k) and profit sharing plan that
covers all eligible employees. Since October 1, 1999, the Company matched 50% of
each participant's contribution, up to 6% of that participant's contribution.
The Company may also make profit sharing contributions at the discretion of the
Board of Directors. No such contributions were made in 2003, 2002 or 2001. For
2003, 2002 and 2001, the total expense related to the plan was $195,294,
$260,531 and $464,802, respectively.

                           Applied Innovation Inc. 31
<PAGE>

--------------------------------------------------------------------------------
(12) INCOME TAXES

Income tax expense (benefit) consists of:

<Table>
<Caption>
---------------------------------------------------------------------------------------------------
                                                             Current       Deferred       Total
---------------------------------------------------------------------------------------------------
<S>                                                      <C>            <C>          <C>
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)
                                                           ============   ==========   ============
Year ended December 31, 2001:
  Federal................................................  $    568,000   $  (29,000)  $    539,000
  State and local........................................       220,000       (4,000)       216,000
                                                           ------------   ----------   ------------
                                                           $    788,000   $  (33,000)  $    755,000
                                                           ============   ==========   ============
---------------------------------------------------------------------------------------------------
</Table>

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

<Table>
<Caption>
---------------------------------------------------------------------------------------------------
                                                                 2003         2002        2001
---------------------------------------------------------------------------------------------------
<S>                                                         <C>         <C>           <C>
Computed tax at the expected federal statutory rate........ $  (417,000) $ (2,852,000) $  1,018,000
State and local income taxes, net of federal income tax
  effect...................................................      43,000      (148,000)      141,000
Meals and entertainment expenses...........................      42,000        62,000        88,000
Research and experimentation credit........................     (24,000)     (467,000)     (365,000)
Tax contingency reserve adjustment.........................    (351,000)           --            --
Dividends from foreign sales corporation...................          --      (101,000)      (55,000)
                                                            -----------    ----------     ---------
Tax-exempt interest income.................................     (20,000)      (22,000)      (85,000)
Other......................................................      37,000        (4,000)       13,000
                                                            -----------    ----------     ---------
                                                            $  (690,000) $ (3,532,000) $    755,000
                                                            ===========    ==========     =========
---------------------------------------------------------------------------------------------------
</Table>

The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and deferred tax liabilities at December 31, 2003 and
2002 are presented below:

<Table>
<Caption>
-------------------------------------------------------------------------------------
                                                                  2003         2002
-------------------------------------------------------------------------------------
<S>                                                           <C>         <C>
Deferred tax assets:
  Accounts receivable allowance............................. $    54,000  $   166,000
  Inventory, principally due to obsolescence reserve and
    additional costs inventoried for tax purposes...........     350,000      609,000
  Warranty reserve..........................................     184,000      209,000
  Restructuring costs.......................................      17,000      224,000
  Other accrued expenses....................................     129,000      113,000
  Deferred revenue..........................................     874,000      732,000
  State tax net operating loss carryforwards................     201,000      171,000
  Research and experimentation credit carryforwards.........     299,000           --
  Other.....................................................      81,000       55,000
                                                             -----------  -----------
                                                             $ 2,189,000  $ 2,279,000
                                                             ===========  ===========
Deferred tax liabilities:
  Unrealized gain on investments............................ $    25,000  $     3,000
  Other.....................................................      74,000           --
                                                             -----------  -----------
                                                             $    99,000  $     3,000
                                                             ===========  ===========
-------------------------------------------------------------------------------------
</Table>

                           Applied Innovation Inc. 32
<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 utilization of loss carrybacks or the generation of future
taxable income during the periods in which those temporary differences become
deductible. Management considers the scheduled reversal of deferred tax
liabilities, projected future taxable income, and tax planning strategies in
making this assessment. Based upon the level of historical taxable income and
projections for future taxable income over the periods which the deferred tax
assets are deductible, management believes that it is more likely than not the
Company will realize the benefits of these deductible differences and,
therefore, no valuation allowance has been provided. State net operating loss
carryforwards expire from 2007 through 2023 while federal research and
experimentation credit carryforwards expire in 2022 and 2023.

--------------------------------------------------------------------------------
(13) LEASE COMMITMENTS

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

Future minimum lease payments and estimated sublease receipts under the
operating leases as of December 31, 2003 are:

<Table>
<Caption>
---------------------------------------------------------------------------------
                                                               Lease     Sublease
                                                              payments   receipts
---------------------------------------------------------------------------------
<S>                                                         <C>        <C>
Years ending December 31,
2004........................................................   155,290    (59,136)
2005........................................................    74,678    (20,984)
2006........................................................    23,154         --
                                                             ---------  ---------
Total minimum lease payments................................ $ 253,121  $ (80,120)
                                                             =========  =========
---------------------------------------------------------------------------------
</Table>

Total rent expense, net of related sublease rental income, in 2003, 2002 and
2001 was $91,463, $276,850 and $3,856, respectively. 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.

--------------------------------------------------------------------------------
(14) EQUITY

On September 14, 2001, the Company's Board of Directors authorized a
twelve-month stock repurchase program under which the Company was authorized to
purchase up to 1,500,000 shares of common stock. During the twelve months of the
repurchase program, the Company paid $5,863,018 to repurchase 1,011,450 shares.

As part of an employment agreement dated July 13, 2000 with its previous
President and Chief Executive Officer, the Company sold 100,000 unregistered
shares of its common stock at $12 per share, the closing market price on the
date of the agreement. In exchange for the stock, the Company received $600,000
of cash and a $600,000 five year note, bearing interest at 6.62%, payable in
five annual installments of principal and interest commencing July 13, 2001. It
is reflected in the stockholders' equity section of the accompanying
consolidated balance sheet for the year ended December 31, 2002. In 2003, the
remaining balance on the note was received in full.

                           Applied Innovation Inc. 33
<PAGE>

--------------------------------------------------------------------------------
(15) 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. As of December 31, 2003 and 2002, the remaining
restructuring accrual was $43,825 and $582,811, respectively. The accrued
restructuring costs remaining at December 31, 2003 represent lease payments (net
of estimated sublease receipts) extending to 2005.

<Table>
<Caption>
-------------------------------------------------------------------------------------------------------
                                Employee        Employee          Lease
                              separations,    separations,    commitments,     Equipment
                              February 2002   August 2002    net of sublease   disposals      Total
-------------------------------------------------------------------------------------------------------
<S>                           <C>             <C>            <C>            <C>         <C>
Restructuring charges in
  2002......................    $ 407,730      $ 2,105,375      $ 184,977     $  192,073   $  2,890,155
Cash deductions.............     (407,730)      (1,647,354)       (60,187)            --     (2,115,271)
Non-cash deductions.........           --               --             --       (192,073)      (192,073)
                                ---------      -----------      ---------     ----------   ------------
Accrual balance -- December
  31, 2002..................    $      --      $   458,021      $ 124,790     $       --   $    582,811
                                =========      ===========      =========     ==========   ============
CASH DEDUCTIONS.............           --         (425,784)       (80,965)            --       (506,749)
NON-CASH ADJUSTMENTS........           --          (32,237)            --             --        (32,237)
                                ---------      -----------      ---------     ----------   ------------
ACCRUAL BALANCE -- DECEMBER
  31, 2003..................    $      --      $        --      $  43,825     $       --   $     43,825
                                =========      ===========      =========     ==========   ============
-------------------------------------------------------------------------------------------------------
</Table>

--------------------------------------------------------------------------------
(16) 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.

--------------------------------------------------------------------------------
(17) QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

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

<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>

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

                           Applied Innovation Inc. 34
<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 THREE


ITEM TEN  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
--------------------------------------------------------------------------------

The information required by this item is included under the caption "ELECTION OF
DIRECTORS" on pages 4 through 10 of the Company's Proxy Statement relating to
the Company's Annual Meeting of Stockholders to be held on April 22, 2004 (the
Proxy Statement), and under the caption "SECTION 16(a) BENEFICIAL OWNERSHIP
REPORTING COMPLIANCE" on page 20 of the Proxy Statement and is incorporated
herein by reference.

CODE OF ETHICS

We have adopted a code of ethics that applies to our directors, officers and all
employees. The code of ethics is posted on our website at and can be accessed
from our home page by clicking on "Company" and then "Investors".

We intend to satisfy the disclosure requirement under Item 10 of Form 8-K
regarding any amendment to, or waiver of, any provision of this code of ethics
by posting such information on our 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" on pages 11 through 16 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" on pages 2 through 3, under the
caption "SECURITY OWNERSHIP OF MANAGEMENT" on pages 3 through 4, and under the
caption "EQUITY COMPENSATION PLAN INFORMATION" on pages 14 through 15 of the
Proxy Statement, and is incorporated herein by reference.

ITEM THIRTEEN  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
--------------------------------------------------------------------------------

The information required by this item is included under the caption "RELATED
PARTY TRANSACTIONS" on page 15 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" on page 19 of the Proxy Statement and is incorporated herein by
reference.

                           Applied Innovation Inc. 35
<PAGE>

                                   PART FOUR


ITEM FIFTEEN  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
--------------------------------------------------------------------------------

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

  - Independent Auditors' Report

  - Consolidated Balance Sheets as of December 31, 2003 and 2002

  - Consolidated Statements of Operations for the years ended December 31, 2003,
    2002 and 2001

  - Consolidated Statements of Stockholders' Equity for the years ended December
    31, 2003, 2002 and 2001

  - Consolidated Statements of Cash Flows for the years ended December 31, 2003,
    2002 and 2001

  - Notes to Consolidated Financial Statements

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

  - Independent Auditors' Report

  - Schedule II (Valuation and Qualifying Accounts)

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

<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
              March 10, 1993, and incorporated herein by reference).
  10.1        Technology Agreement, dated November 12, 1996, between the
              Company and Cisco Systems, Inc. (Reference is made to
              Exhibit 10.4 to the Company's Annual Report on Form 10-K,
              filed with the Securities and Exchange Commission on March
              31, 1998, and incorporated herein by reference).
  10.2        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).
  10.3*       Schedule of Indemnification Agreements.
  10.4        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).
  10.5        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).
  10.6        Employment Agreement between the Company and Michael P.
              Keegan. (Reference is made to Exhibit 10.11 to the Company's
              Annual Report on Form 10-K, filed with the Securities and
              Exchange Commission on March 27, 2001, and incorporated
              herein by reference).
  10.7        Employment Agreement between the Company and Matthew P.
              Bruening. (Reference is made to Exhibit 10.1 to the
              Company's Quarterly Statement on Form 10-Q, filed with the
              Securities and Exchange Commission on August 9, 2001, and
              incorporated herein by reference).
  10.8        Employment Agreement between the Company and Eric W.
              Langille. (Reference is made to Exhibit 10.2 to the
              Company's Quarterly Statement on Form 10-Q, filed with the
              Securities and Exchange Commission on November 14, 2001, and
              incorporated herein by reference).
  10.9        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).
  10.10       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).
</Table>

                           Applied Innovation Inc. 36
<PAGE>

<Table>
<Caption>
Exhibit No.                           Description
-----------                           -----------
<S>           <C>
  10.11       Employment Agreement between the Company and John F. Petro.
              (Reference is made to Exhibit 10.1 to the Company's
              Quarterly Statement on Form 10-Q, filed with the Securities
              and Exchange Commission on August 14, 2002, and incorporated
              herein by reference).
  10.12*      Employment Agreement between the Company and Thomas R.
              Kuchler.
  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) Reports on Form 8-K

On October 16, 2003, the Company filed a current report on Form 8-K (Items 7 and
12), dated October 16, 2003, regarding its consolidated financial results of
operations for its third quarter ended September 30, 2003.

(c) Financial Statement Schedule - The financial statement schedule and the
independent auditors' report thereon follow the signature page.

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

                           Applied Innovation Inc. 37
<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 8, 2004                      By:   /s/ GERARD B. MOERSDORF, JR.
                                           -------------------------------------
                                                 Gerard B. Moersdorf, Jr.
                                               Chairman, President and Chief
                                                      Executive Officer

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

<Table>
<Caption>
                  Signature                                       Title                         Date
                  ---------                                       -----                         ----
<S>     <C>                                     <C>                                         <C>

        /s/ GERARD B. MOERSDORF, JR.                    Gerard B. Moersdorf, Jr.            March 8, 2004
        -----------------------------------      Chairman, President & Chief Executive
                                                                 Officer
                                                      (Principal Executive Officer)


        /s/ MICHAEL P. KEEGAN                               Michael P. Keegan               March 8, 2004
        -----------------------------------           Executive Vice President and
                                                         Chief Operating Officer
                                                        (Principal Financial and
                                                      Principal Accounting Officer)


        *MICHAEL J. ENDRES                                  Michael J. Endres               March 8, 2004
        -----------------------------------                     Director


        *THOMAS W. HUSEBY                                   Thomas W. Huseby                March 8, 2004
        -----------------------------------                     Director


        *WILLIAM H. LARGENT                                William H. Largent               March 8, 2004
        -----------------------------------                     Director


        *CURTIS A. LOVELAND                                Curtis A. Loveland               March 8, 2004
        -----------------------------------                     Director


        *RICHARD W. OLIVER                                  Richard W. Oliver               March 8, 2004
        -----------------------------------                     Director


        *JOHN D. RIEDEL                                      John D. Riedel                 March 8, 2004
        -----------------------------------                     Director


        *ALEXANDER B. TREVOR                               Alexander B. Trevor              March 8, 2004
        -----------------------------------                     Director


 *By:   /s/ GERARD B. MOERSDORF, JR.                    Gerard B. Moersdorf, Jr.
        -----------------------------------                  (Attorney-in-Fact)
</Table>

                           Applied Innovation Inc. 38

<PAGE>

INDEPENDENT AUDITORS' REPORT
--------------------------------------------------------------------------------

The Board of Directors and Stockholders
Applied Innovation Inc.:

Under date of January 23, 2004, we reported on the consolidated balance sheets
of Applied Innovation Inc. and subsidiaries as of December 31, 2003 and 2002,
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,
2003, which are included herein. In connection with our audits of the
aforementioned consolidated financial statements, we also audited the related
financial statement schedule of valuation and qualifying accounts. This
financial statement schedule is the responsibility of the Company's management.
Our responsibility is to express an opinion on this financial statement schedule
based on our audits.

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

/s/ KPMG LLP

Columbus, Ohio
January 23, 2004

APPLIED INNOVATION INC.

--------------------------------------------------------------------------------
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001

<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, 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       918,616        --         982,205       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       974,119        --       1,250,634       542,651
YEAR ENDED DECEMBER 31, 2001:
  Allowance for doubtful
    accounts....................   $  690,602    $  443,527      $ --      $  659,129    $  475,000
  Allowance for obsolete
    inventory...................      190,000     1,700,000        --         119,714     1,770,286
  Warranty provision............    1,334,786     1,519,734        --       2,035,354       819,166
-----------------------------------------------------------------------------------------------------
</Table>

                           Applied Innovation Inc. 39