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United States


Securities and Exchange Commission


Washington, D.C. 20549


FORM 10-K


|                                            |  |                                                                                             
|------------------------------------------- |  | --------------------------------------------------------------------------------------------
|(Mark One)                                  |  |                                                                                             
|[X]                                         |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934    
|For the Fiscal Year Ended December 31, 2005
|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.




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




o þ


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S-K 10-K 10-K. o


12b-2). o o þ


12b-2 o þ






DOCUMENTS INCORPORATED BY REFERENCE












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This Annual Report on
Form 10-K contains
forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934, as
amended, and Section 27A of the Securities Act of 1933, as
amended. The words anticipate, believe,
expect, estimate, project
and similar words and expressions identify forward-looking
statements which speak only as of the date hereof. Investors are
cautioned that such statements involve risks and uncertainties
that could cause actual results to differ materially from
historical or anticipated results due to many factors,
including, but not limited to, the factors discussed in
Business  Business Risks. The Company
undertakes no obligation to publicly update or revise any
forward-looking statements.


Part One







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











The Companys Markets




















Applied Innovation Inc.




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Products





Hardware Solutions


AI tm AI AI


AI tm AI AI AI


AI tm AI


AI tm AI AI best-in AI


AI tm AI AI AI


AI tm AI AI AI


AI tm AI on-site AI


AI tm AI out-of


AI tm AI AI







Applied Innovation Inc.




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best-of


Financial Disclosures


Network Management Software Solutions




A V tm A V A V ® easy-to A V


AI tm AI


Financial Disclosures


Services Solutions






tm


Financial Disclosures







Applied Innovation Inc.




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Manufacturing and Operations











Marketing, Business Development and Sales









on-site




Significant Customers







Research and Development





AI AI AI AI





Applied Innovation Inc.




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AI


AI


AI




Services, Customer Service and Warranty











on-site 24-hour




Competition











Intellectual Property







Suppliers and Raw Materials










Applied Innovation Inc.




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Seasonality







Personnel














We desire to take advantage of the safe harbor
provisions of the Private Securities Litigation Reform Act of
1995. In addition to the other information in this report,
readers should carefully consider that the following important
factors, among others, in some cases have affected, and in the
future could affect, our actual results and could cause our
actual consolidated results of operations for the year ended
December 31, 2006, and beyond, to differ materially from
those expressed in any forward-looking statements made by us, or
on our behalf.


Because a small number of customers account for a high
percentage of our sales and there are only a small number of
potential customers in our industry, the loss of a key customer
could have a negative impact on our business, operating results
and financial condition.






period-to


A large portion of our revenues is derived from the sale,
service and support of our AIswitch family of products and a
decline in the demand for such product family could have a
material adverse affect on our business, financial condition and
results of operation.


AI





Applied Innovation Inc.




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Our ability to succeed in the future may depend upon our
ability to adapt to rapidly changing technologies and customer
requirements by our ability to enhance existing products and
develop and introduce new products.






The market for supplying equipment and services to
telecommunications service providers is highly competitive, and,
if we cannot compete effectively, our ability to grow our
business or even to maintain revenues and earnings at current
levels, will be impaired.




Our products are dependent in part upon our proprietary
technology.







Applied Innovation Inc.




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We rely on the availability of raw materials and licensed
technology on commercially reasonable terms for our products.




If we are unable to meet our additional capital needs in the
future, we may miss expansion opportunities or find ourselves
unable to respond to actions by our competitors, which could
impair our competitive position and hurt sales and earnings.




Our historical operating results may not necessarily be
indicative of our future growth.




Product problems may seriously harm our credibility and have
a significant impact on our revenues, earnings and growth
prospects.







Applied Innovation Inc.




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We may fail to meet market expectations because of
fluctuations in our quarterly operating results, which could
cause our stock price to decline. In addition, a small number of
customers account for a high percentage of our net sales; there
are only a small number of potential major customers in our
primary markets, and the loss of a key customer could have a
negative impact on our operating results and cause our stock
price to decline.


period-to


We rely on the expertise of certain key personnel.




There is a limited market for trading in our common stock and
our stock price has been volatile.







Applied Innovation Inc.




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We have certain anti-takeover provisions in our Certificate
of Incorporation and Bylaws that may make it difficult for a
third party to acquire us.




Ownership of our common stock is concentrated among a few
shareholders, who may be able to exert substantial influence
over our company.




We are subject to various regulations and may be a party to
litigation from time to time.



































Applied Innovation Inc.




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Part Two











|   |  |      |      |  |      |   |      |      |  |   |      |  |  |   |      | 
|-- |  | ---- | ---- |  | ---- | - | ---- | ---- |  | - | ---- |  |  | - | ---- | 
|   | 
|   |  | 2005 |      |  | 2004 |  
|   | 
|   |  | High |      |  | Low  |   |      | High |  |   | Low  | 
|   | 
|Q1 |  | $    | 4.02 |  |      | $ | 3.28 |      |  | $ | 8.00 |  |  | $ | 4.85 | 
|Q2 |  | $    | 4.96 |  |      | $ | 3.43 |      |  | $ | 5.62 |  |  | $ | 3.79 | 
|Q3 |  | $    | 5.37 |  |      | $ | 3.84 |      |  | $ | 4.31 |  |  | $ | 2.84 | 
|Q4 |  | $    | 3.91 |  |      | $ | 3.20 |      |  | $ | 4.25 |  |  | $ | 2.86 | 
|   |  |      |     








Applied Innovation Inc.




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|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |   |            |            |   |   |            |            | 
|------------------------ | -------------------------------------------------------- | --------------------------------- | - | ---------- | ---------- |  | - | ---------- | ---------- | - | ---- | ---------- | ---------- | ---- | - | ---------- | ---------- | - | - | ---------- | ---------- | 
|                         |                                                         
|Years Ended December 31, |                                                          | 2005                              |   |            | 2004       |  |   | 2003       |            |   | 2002 |            |            | 2001 |  
|                         |                                                         
|Operating Data:          |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |   |            |            |   |   |           
|                         | Sales                                                    |                                   | $ | 31,689,787 |            |  | $ | 31,396,937 |            |   | $    | 33,968,086 |            |      | $ | 42,961,011 |            |   | $ | 73,019,150 |           
|                         | Cost of sales                                            |                                   |   | 13,956,778 |            |  |   | 14,524,397 |            |   |      | 16,353,637 |            |      |   | 23,556,671 |            |   |   | 39,251,716 |           
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         |                                                          | Gross profit                      |   |            | 17,733,009 |  |   |            | 16,872,540 |   |      |            | 17,614,449 |      |   |            | 19,404,340 |   |   |            | 33,767,434 | 
|                         | Selling, general and administrative expenses             |                                   |   | 10,184,754 |            |  |   | 13,178,399 |            |   |      | 13,689,576 |            |      |   | 18,413,456 |            |   |   | 22,183,578 |           
|                         | Research and development expenses                        |                                   |   | 4,416,058  |            |  |   | 5,119,677  |            |   |      | 5,575,652  |            |      |   | 7,084,646  |            |   |   | 9,648,898  |           
|                         | Restructuring charges                                    |                                   |   | 873,083    |            |  |   | 605,804    |            |   |      | (32,237    | )          |      |   | 2,890,155  |            |   |   | 292,330    |           
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         |                                                          | Total operating expenses          |   |            | 15,473,895 |  |   |            | 18,903,880 |   |      |            | 19,232,991 |      |   |            | 28,388,257 |   |   |            | 32,124,806 | 
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         |                                                          | Income (loss) from operations     |   |            | 2,259,114  |  |   |            | (2,031,340 | ) |      |            | (1,618,542 | )    |   |            | (8,983,917 | ) |   |            | 1,642,628  | 
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         | Interest and other income, net                           |                                   |   | 821,866    |            |  |   | 451,756    |            |   |      | 393,057    |            |      |   | 597,137    |            |   |   | 1,350,338  |           
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         |                                                          | Income (loss) before income taxes |   |            | 3,080,980  |  |   |            | (1,579,584 | ) |      |            | (1,225,485 | )    |   |            | (8,386,780 | ) |   |            | 2,992,966  | 
|                         | Income tax (benefit) expense                             |                                   |   | 978,000    |            |  |   | (787,000   | )          |   |      | (690,000   | )          |      |   | (3,532,000 | )          |   |   | 755,000    |           
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         |                                                          | Net income (loss)                 |   | $          | 2,102,980  |  |   | $          | (792,584   | ) |      | $          | (535,485   | )    |   | $          | (4,854,780 | ) |   | $          | 2,237,966  | 
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         | Basic income (loss) per share                            |                                   | $ | 0.14       |            |  | $ | (0.05      | )          |   | $    | (0.04      | )          |      | $ | (0.32      | )          |   | $ | 0.14       |           
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         | Diluted income (loss) per share                          |                                   | $ | 0.14       |            |  | $ | (0.05      | )          |   | $    | (0.04      | )          |      | $ | (0.32      | )          |   | $ | 0.14       |           
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         | Shares used in computing basic income (loss) per share   |                                   |   | 15,189,895 |            |  |   | 15,077,118 |            |   |      | 14,994,924 |            |      |   | 15,092,328 |            |   |   | 15,870,492 |           
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|                         | Shares used in computing diluted income (loss) per share |                                   |   | 15,238,730 |            |  |   | 15,077,118 |            |   |      | 14,994,924 |            |      |   | 15,092,328 |            |   |   | 16,140,993 |           
|                         |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |  
|Balance Sheet Data:      |                                                          |                                   |   |            |            |  |   |            |            |   |      |            |            |      |   |            |            |   |   |           
|                         | Cash and short-term and non-current investments          |                                   | $ | 30,092,267 |            |  | $ | 25,697,634 |            |   | $    | 27,973,038 |            |      | $ | 23,964,017 |            |   | $ | 28,616,130 |           
|                         | Net working capital                                      |                                   |   | 24,037,792 |            |  |   | 20,777,822 |            |   |      | 20,957,201 |            |      |   | 25,127,859 |            |   |   | 31,803,653 |           
|                         | Total assets                                             |                                   |   | 50,507,466 |            |  |   | 47,397,922 |            |   |      | 49,882,879 |            |      |   | 50,384,908 |            |   |   | 60,847,804 |           
|                         | Stockholders equity                                     |                                   |   | 45,389,807 |            |  |   | 42,939,795 |            |   |      | 43,476,636 |            |      |   | 43,299,366 |            |   |   | 50,903,912 |           




Applied Innovation Inc.




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Safe Harbor Statement







Overview
















Applied Innovation Inc.




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AI AI AI


AI AI AI AI AI AI















Applied Innovation Inc.




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Comparison of 2005 to 2004





Total Sales and Gross Profit










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

Products Sales and Gross Profit











Applied Innovation Inc.




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Services Sales and Gross Profit








Selling, General and Administrative Expenses




Research and Development Expenses




Restructuring Charges










Interest and Other Income, Net




Income Taxes




Net Income (Loss) and Income (Loss) Per Share




Assets







Applied Innovation Inc.




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Liabilities and Stockholders Equity






Comparison of 2004 to 2003





Total Sales and Gross Profit










|                                      |  |       |            |  |              |   |            |         |  |  |    |  
|------------------------------------- |  | ----- | ---------- |  | ------------ | - | ---------- | ------- |  |  | -- | -
|                                      | 
|                                      |  | Gross |           
|                                      |  | Sales |            |  | Gross Profit |   |            | Profit% | 
|                                      | 
|For the Year ended December 31, 2004:
|Products                              |  | $     | 25,876,000 |  |              | $ | 13,785,000 |         |  |  | 53 | %
|Services                              |  |       | 5,521,000  |  |              |   | 3,088,000  |         |  |  | 56 | %
|                                      |  |       |            |  |              |   |            |         | 
|Total                                 |  | $     | 31,397,000 |  |              | $ | 16,873,000 |         |  |  | 54 | %
|                                      |  |       |            |  |              |   |            |         | 
|                                     
|For the Year ended December 31, 2003:
|Products                              |  | $     | 27,076,000 |  |              | $ | 14,664,000 |         |  |  | 54 | %
|Services                              |  |       | 6,892,000  |  |              |   | 2,950,000  |         |  |  | 43 | %
|                                      |  |       |            |  |              |   |            |         | 
|Total                                 |  | $     | 33,968,000 |  |              | $ | 17,614,000 |         |  |  | 52 | %
|                                      |  |       |            |  |              |   |            |         | 
|                                     

Products Sales and Gross Profit








Services Sales and Gross Profit







Applied Innovation Inc.




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Selling, General and Administrative Expenses




Research and Development Expenses




Restructuring Charges






Interest and Other Income, Net




Income Taxes




Net Loss and Loss Per Share




Assets







Applied Innovation Inc.




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Liabilities and Stockholders Equity






Liquidity and Capital Resources









Operating Activities




Investing Activities




Financing Activities






Application of Critical Accounting Policies














Applied Innovation Inc.




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







first-in,









Applied Innovation Inc.




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Contractual Obligations and 
 Commercial Commitments












Applied Innovation Inc.




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|                     |  |                        |         |  |                  |   |         | 
|-------------------- |  | ---------------------- | ------- |  | ---------------- | - | ------- | 
|                     | 
|                     |  | Payments due by period |        
|                     |  |                        |        
|                     |  | Total                  |         |  | Less than 1 year |  
|                     | 
|Operating leases     |  | $                      | 16,000  |  |                  | $ | 16,000  | 
|Purchase obligations |  |                        | 476,000 |  |                  |   | 476,000 | 
|                     |  |                        |         |  |                  |  
|Total                |  | $                      | 492,000 |  |                  | $ | 492,000 | 
|                     |  |                        |         |  |                  |  

Impact of Recently Issued Accounting Standards
























Applied Innovation Inc.




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Report of Independent Registered Public Accounting Firm
























Applied Innovation Inc.




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|                                     |                                                                                                                                                    |                                |                            |            |           |            |            |            |         |            | 
|------------------------------------ | -------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------ | -------------------------- | ---------- | --------- | ---------- | ---------- | ---------- | ------- | ---------- | 
|                                     |                                                                                                                                                   
|December 31,                         |                                                                                                                                                    | 2005                           |                            |            | 2004      |           
|                                     |                                                                                                                                                   
|Assets                               |                                                                                                                                                    |                                |                            |            |           |            |            |           
|Current assets:                      |                                                                                                                                                    |                                |                            |            |           |            |            |           
|                                     | Cash and cash equivalents                                                                                                                          |                                | $                          | 9,874,406  |           |            | $          | 9,773,586  |        
|                                     | Short term investments                                                                                                                             |                                |                            | 10,477,682 |           |            |            | 6,921,644  |        
|                                     | Accounts receivable, net of allowance of $150,000 in 2005 and
    $115,000 in 2004                                                                 |                                |                            | 4,273,406  |           |            |            | 4,657,914  |        
|                                     | Inventory, net                                                                                                                                     |                                |                            | 2,997,403  |           |            |            | 2,392,379  |        
|                                     | Other current assets                                                                                                                               |                                |                            | 523,554    |           |            |            | 571,426    |        
|                                     | Deferred income taxes                                                                                                                              |                                |                            | 1,009,000  |           |            |            | 919,000    |        
|                                     |                                                                                                                                                    |                                |                            |            |           |           
|                                     |                                                                                                                                                    |                                | Total current assets       |            |           | 29,155,451 |            |            |         | 25,235,949 | 
|Property, plant and equipment, net   |                                                                                                                                                    |                                | 5,898,916                  |            |           |            | 6,540,850  |           
|Investments                          |                                                                                                                                                    |                                | 9,740,179                  |            |           |            | 9,002,404  |           
|Goodwill                             |                                                                                                                                                    |                                | 3,525,801                  |            |           |            | 3,525,801  |           
|Deferred income taxes                |                                                                                                                                                    |                                | 808,000                    |            |           |            | 1,758,000  |           
|Other assets                         |                                                                                                                                                    |                                | 1,379,119                  |            |           |            | 1,334,918  |           
|                                     |                                                                                                                                                    |                                |                            |            |           |           
|                                     |                                                                                                                                                    | $                              | 50,507,466                 |            |           | $          | 47,397,922 |           
|                                     |                                                                                                                                                    |                                |                            |            |           |           
|                                    
|Liabilities and Stockholders Equity |                                                                                                                                                    |                                |                            |            |           |            |            |           
|Current liabilities:                 |                                                                                                                                                    |                                |                            |            |           |            |            |           
|                                     | Accounts payable                                                                                                                                   |                                | $                          | 1,029,777  |           |            | $          | 853,440    |        
|                                     | Accrued expenses:                                                                                                                                  |                                |                            |            |           |            |            |            |        
|                                     |                                                                                                                                                    | Warranty                       |                            |            | 336,000   |            |            |            | 425,000 |           
|                                     |                                                                                                                                                    | Payroll and related expenses   |                            |            | 1,275,036 |            |            |            | 810,608 |           
|                                     |                                                                                                                                                    | Restructuring                  |                            |            | 27,695    |            |            |            | 139,020 |           
|                                     |                                                                                                                                                    | Income taxes payable           |                            |            | 321,965   |            |            |            | 360,917 |           
|                                     |                                                                                                                                                    | Taxes, other than income taxes |                            |            | 396,484   |            |            |            | 398,974 |           
|                                     |                                                                                                                                                    | Other accrued expenses         |                            |            | 628,658   |            |            |            | 568,917 |           
|Deferred revenue                     |                                                                                                                                                    |                                | 1,102,044                  |            |           |            | 901,251    |           
|                                     |                                                                                                                                                    |                                |                            |            |           |           
|                                     |                                                                                                                                                    |                                | Total current liabilities  |            |           | 5,117,659  |            |            |         | 4,458,127  | 
|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
    15,230,408 shares in 2005 and 15,107,367 shares in 2004 |                                |                            | 152,304    |           |            |            | 151,074    |        
|                                     | Additional paid-in capital                                                                                                                         |                                |                            | 6,839,219  |           |            |            | 6,424,655  |        
|                                     | Retained earnings                                                                                                                                  |                                |                            | 38,455,848 |           |            |            | 36,352,868 |        
|                                     | Accumulated other comprehensive (loss) gain, net                                                                                                   |                                |                            | (57,564    | )         |            |            | 11,198     |        
|                                     |                                                                                                                                                    |                                |                            |            |           |           
|                                     |                                                                                                                                                    |                                | Total stockholders equity |            |           | 45,389,807 |            |            |         | 42,939,795 | 
|                                     |                                                                                                                                                    |                                |                            |            |           |           
|                                     |                                                                                                                                                    | $                              | 50,507,466                 |            |           | $          | 47,397,922 |           
|                                     |                                                                                                                                                    |                                |                            |            |           |           






Applied Innovation Inc.




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|                                                                            |                                     |                                   |            |            |            |  |            |            |            |   |            |            |            |  
|--------------------------------------------------------------------------- | ----------------------------------- | --------------------------------- | ---------- | ---------- | ---------- |  | ---------- | ---------- | ---------- | - | ---------- | ---------- | ---------- | -
|                                                                            |                                    
|Years ended December 31,                                                    |                                     | 2005                              |            |            | 2004       |  |            | 2003       |           
|                                                                            |                                    
|Sales:                                                                      |                                     |                                   |            |            |            |  |            |            |            |   |            |           
|                                                                            | Products                            |                                   | $          | 25,834,456 |            |  | $          | 25,876,037 |            |   | $          | 27,076,251 |           
|                                                                            | Services                            |                                   |            | 5,855,331  |            |  |            | 5,520,900  |            |   |            | 6,891,835  |           
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|                                                                            |                                     | Total sales                       |            |            | 31,689,787 |  |            |            | 31,396,937 |   |            |            | 33,968,086 |  
|Cost of sales:                                                              |                                     |                                   |            |            |            |  |            |            |            |   |            |           
|                                                                            | Products                            |                                   |            | 12,030,064 |            |  |            | 12,091,272 |            |   |            | 12,411,771 |           
|                                                                            | Services                            |                                   |            | 1,926,714  |            |  |            | 2,433,125  |            |   |            | 3,941,866  |           
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|                                                                            |                                     | Total cost of sales               |            |            | 13,956,778 |  |            |            | 14,524,397 |   |            |            | 16,353,637 |  
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|                                                                            |                                     | Gross profit                      |            |            | 17,733,009 |  |            |            | 16,872,540 |   |            |            | 17,614,449 |  
|Operating expenses:                                                         |                                     |                                   |            |            |            |  |            |            |            |   |            |           
|                                                                            | Selling, general and administrative |                                   |            | 10,184,754 |            |  |            | 13,178,399 |            |   |            | 13,689,576 |           
|                                                                            | Research and development            |                                   |            | 4,416,058  |            |  |            | 5,119,677  |            |   |            | 5,575,652  |           
|                                                                            | Restructuring charges               |                                   |            | 873,083    |            |  |            | 605,804    |            |   |            | (32,237    | )         
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|                                                                            |                                     | Total operating expenses          |            |            | 15,473,895 |  |            |            | 18,903,880 |   |            |            | 19,232,991 |  
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|                                                                            |                                     | Income (loss) from operations     |            |            | 2,259,114  |  |            |            | (2,031,340 | ) |            |            | (1,618,542 | )
|Interest and other income, net                                              |                                     |                                   | 821,866    |            |            |  | 451,756    |            |            |   | 393,057    |           
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|                                                                            |                                     | Income (loss) before income taxes |            |            | 3,080,980  |  |            |            | (1,579,584 | ) |            |            | (1,225,485 | )
|Income tax expense (benefit)                                                |                                     |                                   | 978,000    |            |            |  | (787,000   | )          |            |   | (690,000   | )         
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|                                                                            |                                     | Net income (loss)                 |            | $          | 2,102,980  |  |            | $          | (792,584   | ) |            | $          | (535,485   | )
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|Income (loss) per share:                                                    |                                     |                                   |            |            |            |  |            |            |            |   |            |           
|                                                                            |                                     | Basic income (loss) per share     |            | $          | 0.14       |  |            | $          | (0.05      | ) |            | $          | (0.04      | )
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|                                                                            |                                     | Diluted income (loss) per share   |            | $          | 0.14       |  |            | $          | (0.05      | ) |            | $          | (0.04      | )
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|Weighted-average shares outstanding for basic income (loss) per
    share   |                                     |                                   | 15,189,895 |            |            |  | 15,077,118 |            |            |   | 14,994,924 |           
|                                                                            |                                     |                                   |            |            |            |  |            |            |           
|Weighted-average shares outstanding for diluted income (loss)
    per share |                                     |                                   | 15,238,730 |            |            |  | 15,077,118 |            |            |   | 14,994,924 |           
|                                                                            |                                     |                                   |            |            |            |  |            |            |           






Applied Innovation Inc.




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|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |   |   |         |         |   |   |            |           |  
|----------------------------------------------------- | ----------------------------------- | ------------ | ---------- | - | ------ | - | ----------- | ------- |  | -------------- | --------- | ----- | -------- | -------- | ------------- | ------------ | --- | - | ---------- | --------- | - | - | ------- | ------- | - | - | ---------- | --------- | -
|                                                      |                                    
|                                                      |                                     | Common stock |            |   |        |   | Accumulated |         |  |               
|                                                      |                                     |              |            |   |        |   | Note        |         |  |                |           | other |          |          |              
|                                                      |                                     | Number       |            |   |        |   | Additional  |         |  | receivable for |           |       |          |          | comprehensive |              |     |  
|                                                      |                                     | of shares    |            |   |        |   | paid-in     |         |  | common         |           |       | Retained |          |               | gain (loss), |     |   |           
|                                                      |                                     | outstanding  |            |   | Amount |   |             | capital |  |                | Stock     |       |          | earnings |               |              | net |   |            | Totals    |  
|                                                      |                                    
|BalanceDecember 31, 2002                             |                                     |              | 14,950,749 |   |        | $ | 149,507     |         |  | $              | 5,845,740 |       |          | $        | (382,783      | )            |     | $ | 37,680,937 |           |   | $ | 5,965   |         |   | $ | 43,299,366 |          
|Comprehensive loss:                                   |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |   |   |         |         |   |   |            |          
|                                                      | Net loss                            |              |            |  |        |   |             |        |  |                |           |      |          |          |               |             |     |   |            | (535,485  | ) |   |         |        |   |   |            | (535,485  | )
|                                                      | Unrealized gain on investments, net |              |            |  |        |   |             |        |  |                |           |      |          |          |               |             |     |   |            |          |   |   |         | 34,345  |   |   |            | 34,345    |  
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|Total comprehensive loss                              |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |   |   |         |         |   |   | (501,140   | )        
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|Stock options exercised                               |                                     |              | 37,900     |   |        |   | 379         |         |  |                | 151,459   |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 151,838    |          
|Stock issued for employee stock purchase plan         |                                     |              | 44,760     |   |        |   | 448         |         |  |                | 120,324   |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 120,772    |          
|Repayment of note receivable for common stock         |                                     |              |           |   |        |   |            |         |  |                |          |       |          |          | 382,783       |              |     |   |           |           |   |   |        |         |   |   | 382,783    |          
|Tax benefit associated with exercise of stock options |                                     |              |           |   |        |   |            |         |  |                | 23,017    |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 23,017     |          
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|BalanceDecember 31, 2003                             |                                     |              | 15,033,409 |   |        | $ | 150,334     |         |  | $              | 6,140,540 |       |          | $        |              |              |     | $ | 37,145,452 |           |   | $ | 40,310  |         |   | $ | 43,476,636 |          
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|Comprehensive loss:                                   |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |   |   |         |         |   |   |            |          
|                                                      | Net loss                            |              |            |  |        |   |             |        |  |                |           |      |          |          |               |             |     |   |            | (792,584  | ) |   |         |        |   |   |            | (792,584  | )
|                                                      | Unrealized loss on investments, net |              |            |  |        |   |             |        |  |                |           |      |          |          |               |             |     |   |            |          |   |   |         | (29,112 | ) |   |            | (29,112   | )
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|Total comprehensive loss                              |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |   |   |         |         |   |   | (821,696   | )        
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|Stock options exercised                               |                                     |              | 40,600     |   |        |   | 406         |         |  |                | 155,330   |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 155,736    |          
|Stock issued for employee stock purchase plan         |                                     |              | 28,714     |   |        |   | 287         |         |  |                | 94,702    |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 94,989     |          
|Stock issued to non-employees                         |                                     |              | 4,644      |   |        |   | 47          |         |  |                | 15,953    |       |          |          |               |              |     |   |            |           |   |   |         |         |   |   | 16,000     |          
|Tax benefit associated with exercise of stock options |                                     |              |           |   |        |   |            |         |  |                | 18,130    |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 18,130     |          
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|BalanceDecember 31, 2004                             |                                     |              | 15,107,367 |   |        | $ | 151,074     |         |  | $              | 6,424,655 |       |          | $        |              |              |     | $ | 36,352,868 |           |   | $ | 11,198  |         |   | $ | 42,939,795 |          
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|Comprehensive income:                                 |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |   |   |         |         |   |   |            |          
|                                                      | Net income                          |              |            |  |        |   |             |        |  |                |           |      |          |          |               |             |     |   |            | 2,102,980 |   |   |         |        |   |   |            | 2,102,980 |  
|                                                      | Unrealized loss on investments, net |              |            |  |        |   |             |        |  |                |           |      |          |          |               |             |     |   |            |          |   |   |         | (68,762 | ) |   |            | (68,762   | )
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|Total comprehensive income                            |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |   |   |         |         |   |   | 2,034,218  |          
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|Stock options exercised                               |                                     |              | 95,200     |   |        |   | 952         |         |  |                | 299,803   |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 300,755    |          
|Stock issued to non-employees                         |                                     |              | 2,286      |   |        |   | 23          |         |  |                | 7,977     |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 8,000      |          
|Stock issued for employee stock purchase plan         |                                     |              | 25,555     |   |        |   | 255         |         |  |                | 79,081    |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 79,336     |          
|Tax benefit associated with exercise of stock options |                                     |              |           |   |        |   |            |         |  |                | 27,703    |       |          |          |              |              |     |   |           |           |   |   |        |         |   |   | 27,703     |          
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  
|BalanceDecember 31, 2005                             |                                     |              | 15,230,408 |   |        | $ | 152,304     |         |  | $              | 6,839,219 |       |          | $        |              |              |     | $ | 38,455,848 |           |   | $ | (57,564 | )       |   | $ | 45,389,807 |          
|                                                      |                                     |              |            |   |        |   |             |         |  |                |           |       |          |          |               |              |     |   |            |           |  






Applied Innovation Inc.




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|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |            |            |            |             |            |            |  
|------------------------------------------------ | ------------------------------------------------------------------------------------------------------ | -------------------------------------------------------- | -------------------- | ----------- | ---------- | -------- | ---------- | ---------- | ---------- | ---------- | ---------- | ----------- | ---------- | ---------- | -
|                                                 |                                                                                                       
|Years ended December 31,                         |                                                                                                        | 2005                                                     |                      |             | 2004       |          |            | 2003       |           
|                                                 |                                                                                                       
|Cash flows from operating activities:            |                                                                                                        |                                                          |                      |             |            |          |            |            |            |            |            |            
|                                                 | Net income (loss)                                                                                      |                                                          | $                    | 2,102,980   |            |          | $          | (792,584   | )          |            | $          | (535,485    | )         
|                                                 | Adjustments to reconcile net income (loss) to net cash provided
    by (used in) operating activities: |                                                          |                      |             |            |          |            |            |            |            |            |             |           
|                                                 |                                                                                                        | Depreciation                                             |                      |             | 697,824    |          |            |            | 1,078,128  |            |            |             | 1,196,697  |           
|                                                 |                                                                                                        | Amortization of intangible assets                        |                      |             |           |          |            |            | 131,250    |            |            |             | 210,000    |           
|                                                 |                                                                                                        | Loss (gain) on disposal of property, plant and equipment |                      |             | 19,179     |          |            |            | 38,661     |            |            |             | (797       | )         
|                                                 |                                                                                                        | Deferred income tax                                      |                      |             | 860,000    |          |            |            | (569,000   | )          |            |             | 164,000    |           
|                                                 |                                                                                                        | Tax benefit of options exercised                         |                      |             | 27,703     |          |            |            | 18,130     |            |            |             | 23,017     |           
|                                                 |                                                                                                        | Stock issued to non-employees                            |                      |             | 8,000      |          |            |            | 16,000     |            |            |             |           |           
|                                                 |                                                                                                        | Effects of change in operating assets and liabilities:   |                      |             |            |          |            |            |            |            |            |             |            |           
|                                                 |                                                                                                        |                                                          | Accounts receivable  |             |            | 384,508  |            |            |            | (1,208,862 | )          |             |            | 1,591,353  |  
|                                                 |                                                                                                        |                                                          | Inventory            |             |            | (605,024 | )          |            |            | 422,063    |            |             |            | 595,400    |  
|                                                 |                                                                                                        |                                                          | Income taxes         |             |            | (38,952  | )          |            |            | 629,204    |            |             |            | 2,811,247  |  
|                                                 |                                                                                                        |                                                          | Other current assets |             |            | 47,872   |            |            |            | 684,274    |            |             |            | (386,882   | )
|                                                 |                                                                                                        |                                                          | Other assets         |             |            | (44,201  | )          |            |            | (19,643    | )          |             |            | (1,180,248 | )
|                                                 |                                                                                                        |                                                          | Accounts payable     |             |            | 176,337  |            |            |            | 63,403     |            |             |            | (764,835   | )
|                                                 |                                                                                                        |                                                          | Accrued expenses     |             |            | 321,354  |            |            |            | (254,688   | )          |             |            | (329,707   | )
|                                                 |                                                                                                        |                                                          | Deferred revenue     |             |            | 200,793  |            |            |            | (1,367,748 | )          |             |            | 366,443    |  
|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |           
|                                                 |                                                                                                        | Net cash provided by (used in) operating activities      |                      |             | 4,158,373  |          |            |            | (1,131,412 | )          |            |             | 3,760,203  |           
|Cash flows from investing activities:            |                                                                                                        |                                                          |                      |             |            |          |            |            |            |            |            |            
|                                                 | Purchases of property, plant and equipment                                                             |                                                          |                      | (96,687     | )          |          |            | (646,764   | )          |            |            | (479,712    | )         
|                                                 | Proceeds from sales of property, plant and equipment                                                   |                                                          |                      | 21,618      |            |          |            | 26,180     |            |            |            | 16,792      |           
|                                                 | Purchases of investments                                                                               |                                                          |                      | (13,507,167 | )          |          |            | (7,809,025 | )          |            |            | (16,778,379 | )         
|                                                 | Proceeds from maturities of investments                                                                |                                                          |                      | 8,335,279   |            |          |            | 6,971,705  |            |            |            | 15,669,233  |           
|                                                 | Proceeds from sales of investments                                                                     |                                                          |                      | 809,313     |            |          |            | 831,539    |            |            |            | 200,816     |           
|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |           
|                                                 |                                                                                                        | Net cash used in investing activities                    |                      |             | (4,437,644 | )        |            |            | (626,365   | )          |            |             | (1,371,250 | )         
|Cash flows from financing activities:            |                                                                                                        |                                                          |                      |             |            |          |            |            |            |            |            |            
|                                                 | Payment of note payable related to acquisition                                                         |                                                          |                      |            |            |          |            | (750,000   | )          |            |            |            |           
|                                                 | Proceeds from payment on note receivable                                                               |                                                          |                      |            |            |          |            |           |            |            |            | 382,783     |           
|                                                 | Proceeds from issuance of common stock                                                                 |                                                          |                      | 380,091     |            |          |            | 250,725    |            |            |            | 272,610     |           
|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |           
|                                                 |                                                                                                        | Net cash provided by (used in) financing activities      |                      |             | 380,091    |          |            |            | (499,275   | )          |            |             | 655,393    |           
|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |           
|Increase (decrease) in cash and cash equivalents |                                                                                                        |                                                          | 100,820              |             |            |          | (2,257,052 | )          |            |            | 3,044,346  |            
|Cash and cash equivalentsbeginning of year      |                                                                                                        |                                                          | 9,773,586            |             |            |          | 12,030,638 |            |            |            | 8,986,292  |            
|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |           
|Cash and cash equivalentsend of year            |                                                                                                        | $                                                        | 9,874,406            |             |            | $        | 9,773,586  |            |            | $          | 12,030,638 |            
|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |           
|SUPPLEMENTAL CASH FLOW DISCLOSURE:               |                                                                                                        |                                                          |                      |             |            |          |            |            |            |            |            |            
|                                                 | Income taxes received (paid), net                                                                      |                                                          | $                    | (86,249     | )          |          | $          | 865,335    |            |            | $          | 1,818,737   |           
|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |           
|                                                 | Interest paid                                                                                          |                                                          | $                    |            |            |          | $          | 197,163    |            |            | $          | 1,228       |           
|                                                 |                                                                                                        |                                                          |                      |             |            |          |            |            |           






Applied Innovation Inc.




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(1) Summary of Significant Accounting Policies







Description of Business Activity








Principles of Consolidation




Cash Equivalents




Investments






Allowance for Doubtful Accounts







Applied Innovation Inc.




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Revenue Recognition


Product Sales


Network Management System Sales




|  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 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
    generally recognized as the services are delivered or upon
    project completion.                                                                                                                                                                                                                                                                                                                                                         
| 
| | Revenue from maintenance and support agreements is recognized
    straight-line over the term of the related agreement.                                                                                                                                                                                                                                                                                                                                                                                       

Service Sales


Inventory


first-in,


Property, Plant and Equipment




|          |  |                  |     | 
|--------- |  | ---------------- | --- | 
|          | 
|          |  | Lives (in years) |    
|          | 
|Building  |  |                  | 40  | 
|Equipment |  |                  | 3-5 | 
|Furniture |  |                  | 7   | 
|         

Intangible Assets and Goodwill







Applied Innovation Inc.




---



##### 





---





--




---







Other Assets




Warranty




Income Taxes




Stock-Based Compensation Plans






|                                                                                                                                                    |                               |      |            |      |      |   |            |       |   |   |            |       |  
|--------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------- | ---- | ---------- | ---- | ---- | - | ---------- | ----- | - | - | ---------- | ----- | -
|                                                                                                                                                    |                              
|Years ended December 31,                                                                                                                            |                               | 2005 |            |      | 2004 |   |            | 2003  |  
|                                                                                                                                                    |                              
|Net income (loss), as reported                                                                                                                      |                               | $    | 2,102,980  |      |      | $ | (792,584   | )     |   | $ | (535,485   | )    
|Deduct: Total stock-based employee compensation expense
    determined under fair value-based method for all awards, net of
    related tax effects |                               |      | (1,229,995 | )    |      |   | (1,470,146 | )     |   |   | (1,319,659 | )    
|                                                                                                                                                    |                               |      |            |      |      |   |            |       |  
|Pro forma net income (loss)                                                                                                                         |                               | $    | 872,985    |      |      | $ | (2,262,730 | )     |   | $ | (1,855,144 | )    
|                                                                                                                                                    |                               |      |            |      |      |   |            |       |  
|Income (loss) per share:                                                                                                                            |                               |      |            |      |      |   |            |       |   |   |            |      
|                                                                                                                                                    | Basic and dilutedas reported |      | $          | 0.14 |      |   | $          | (0.05 | ) |   | $          | (0.04 | )
|                                                                                                                                                    | Basic and dilutedpro forma   |      |            | 0.06 |      |   |            | (0.15 | ) |   |            | (0.12 | )
|                                                                                                                                                   




Applied Innovation Inc.




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##### 





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--




---





Research and Development




General Credit Risk




Use of Estimates




Impairment of Long-Lived Assets






(2) Inventory







|                         |  |      |           |   |      |   |           |  
|------------------------ |  | ---- | --------- | - | ---- | - | --------- | -
|                         | 
|                         |  | 2005 |           |   | 2004 |  
|                         | 
|Raw materials            |  | $    | 2,237,102 |   |      | $ | 2,098,741 |  
|Work-in-process          |  |      | 136,882   |   |      |   | 1,461     |  
|Finished goods           |  |      | 910,419   |   |      |   | 455,177   |  
|                         |  |      |           |   |      |  
|                         |  |      | 3,284,403 |   |      |   | 2,555,379 |  
|Reserve for obsolescence |  |      | (287,000  | ) |      |   | (163,000  | )
|                         |  |      |           |   |      |  
|                         |  | $    | 2,997,403 |   |      | $ | 2,392,379 |  
|                         |  |      |           |   |      |  
|                        






Applied Innovation Inc.




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##### 





---





--




---



(3) Investments and Financial Instruments









|                                   |  |           |            |  |            |   |         |            |  |   |          |   |  |   |            | 
|---------------------------------- |  | --------- | ---------- |  | ---------- | - | ------- | ---------- |  | - | -------- | - |  | - | ---------- | 
|                                   | 
|                                   |  | Gross     |            |  | Gross      |   |         |           
|                                   |  | Amortized |            |  | unrealized |   |         | unrealized |  |   | Fair     |  
|December 31, 2005                  |  | Cost      |            |  | gains      |   |         | losses     |  |   | value    |  
|                                   | 
|Certificates of deposit            |  | $         | 850,568    |  |            | $ |        |            |  | $ | (11,787  | ) |  | $ | 838,781    | 
|Corporate obligations              |  |           | 6,438,807  |  |            |   | 19      |            |  |   | (22,611  | ) |  |   | 6,416,215  | 
|Marketable equity securities       |  |           | 795,398    |  |            |   | 121,176 |            |  |   | (37,698  | ) |  |   | 878,875    | 
|U.S. government agency obligations |  |           | 12,226,651 |  |            |   | 3,181   |            |  |   | (145,843 | ) |  |   | 12,083,990 | 
|                                   |  |           |            |  |            |   |         |            |  |   |          |  
|Total                              |  | $         | 20,311,424 |  |            | $ | 124,376 |            |  | $ | (217,939 | ) |  | $ | 20,217,861 | 
|                                   |  |           |            |  |            |   |         |            |  |   |          |  
|Reported as:                       |  |           |            |  |            |   |         |            |  |   |          |   |  |   |            | 
|Short-term investments             |  |           |            |  |            |   |         |            |  |   |          |   |  | $ | 10,477,682 | 
|Investments                        |  |           |            |  |            |   |         |            |  |   |          |   |  |   | 9,740,179  | 
|                                   |  |           |            |  |            |   |         |            |  |   |          |  
|Total                              |  |           |            |  |            |   |         |            |  |   |          |   |  | $ | 20,217,861 | 
|                                   |  |           |            |  |            |   |         |            |  |   |          |  
|                                  

|                                   |  |           |            |  |            |   |         |            |  |   |          |   |  |   |            | 
|---------------------------------- |  | --------- | ---------- |  | ---------- | - | ------- | ---------- |  | - | -------- | - |  | - | ---------- | 
|                                   | 
|                                   |  | Gross     |            |  | Gross      |   |         |           
|                                   |  | Amortized |            |  | unrealized |   |         | unrealized |  |   | Fair     |  
|December 31, 2004                  |  | Cost      |            |  | gains      |   |         | losses     |  |   | value    |  
|                                   | 
|Certificates of deposit            |  | $         | 1,023,168  |  |            | $ | 80      |            |  | $ | (8,387   | ) |  | $ | 1,014,861  | 
|Corporate obligations              |  |           | 4,513,044  |  |            |   |        |            |  |   | (36,628  | ) |  |   | 4,476,416  | 
|Marketable equity securities       |  |           | 802,339    |  |            |   | 151,402 |            |  |   | (16,067  | ) |  |   | 937,674    | 
|Mutual funds                       |  |           | 93,594     |  |            |   | 1,180   |            |  |   | (7,888   | ) |  |   | 86,886     | 
|U.S. government agency obligations |  |           | 9,473,705  |  |            |   | 1,061   |            |  |   | (66,555  | ) |  |   | 9,408,211  | 
|                                   |  |           |            |  |            |   |         |            |  |   |          |  
|Total                              |  | $         | 15,905,850 |  |            | $ | 153,723 |            |  | $ | (135,525 | ) |  | $ | 15,924,048 | 
|                                   |  |           |            |  |            |   |         |            |  |   |          |  
|Reported as:                       |  |           |            |  |            |   |         |            |  |   |          |   |  |   |            | 
|Short-term investments             |  |           |            |  |            |   |         |            |  |   |          |   |  | $ | 6,921,644  | 
|Investments                        |  |           |            |  |            |   |         |            |  |   |          |   |  |   | 9,002,404  | 
|                                   |  |           |            |  |            |   |         |            |  |   |          |  
|Total                              |  |           |            |  |            |   |         |            |  |   |          |   |  | $ | 15,924,048 | 
|                                   |  |           |            |  |            |   |         |            |  |   |          |  
|                                  






Applied Innovation Inc.




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##### 





---





--




---





|                                   |  |                     |            |            |                   |   |         |            |            |   |           |  |  |            |        |  |        |   |            |  |  |   |         | 
|---------------------------------- |  | ------------------- | ---------- | ---------- | ----------------- | - | ------- | ---------- | ---------- | - | --------- |  |  | ---------- | ------ |  | ------ | - | ---------- |  |  | - | ------- | 
|                                   | 
|                                   |  | Less than 12 Months |            |            | 12 months or more |   |         | Total      |           
|                                   |  |                     |            |            |                   |   |         |            |           
|                                   |  |                     |            | Unrealized |                   |   |         |            | Unrealized |   |           |  |  | Unrealized |       
|                                   |  | Fair value          |            |            | losses            |   |         | Fair value |            |   | losses    |  |  | Fair value |        |  | losses |  
|                                   | 
|Certificates of deposit            |  | $                   | 315,911    |            |                   | $ | 4,181   |            |            | $ | 522,870   |  |  | $          | 7,606  |  |        | $ | 838,781    |  |  | $ | 11,787  | 
|Corporate obligations              |  |                     | 1,280,075  |            |                   |   | 15,338  |            |            |   | 1,194,884 |  |  |            | 7,273  |  |        |   | 2,474,960  |  |  |   | 22,611  | 
|Marketable equity securities       |  |                     | 175,650    |            |                   |   | 15,878  |            |            |   | 52,288    |  |  |            | 21,820 |  |        |   | 227,938    |  |  |   | 37,698  | 
|U.S. government agency obligations |  |                     | 10,717,535 |            |                   |   | 95,642  |            |            |   | 4,267,973 |  |  |            | 50,201 |  |        |   | 14,985,507 |  |  |   | 145,843 | 
|                                   |  |                     |            |            |                   |   |         |            |            |   |           |  |  |            |        |  |        |  
|Total                              |  | $                   | 12,489,171 |            |                   | $ | 131,039 |            |            | $ | 6,038,015 |  |  | $          | 86,900 |  |        | $ | 18,527,186 |  |  | $ | 217,939 | 
|                                   |  |                     |            |            |                   |   |         |            |            |   |           |  |  |            |        |  |        |  
|                                  







(4) Property, Plant and Equipment







|                         |  |      |             |   |      |   |            |  
|------------------------ |  | ---- | ----------- | - | ---- | - | ---------- | -
|                         | 
|                         |  | 2005 |             |   | 2004 |  
|                         | 
|Land                     |  | $    | 1,639,303   |   |      | $ | 1,639,303  |  
|Building                 |  |      | 5,086,561   |   |      |   | 5,086,561  |  
|Equipment                |  |      | 7,593,254   |   |      |   | 7,637,210  |  
|Furniture                |  |      | 1,985,766   |   |      |   | 2,022,578  |  
|                         |  |      |             |   |      |  
|                         |  |      | 16,304,884  |   |      |   | 16,385,652 |  
|Accumulated depreciation |  |      | (10,405,968 | ) |      |   | (9,844,802 | )
|                         |  |      |             |   |      |  
|                         |  | $    | 5,898,916   |   |      | $ | 6,540,850  |  
|                         |  |      |             |   |      |  
|                        

(5) Warranty










Applied Innovation Inc.




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##### 





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--




---











|                         |  |      |          |   |      |   |          |  
|------------------------ |  | ---- | -------- | - | ---- | - | -------- | -
|                         | 
|Years ended December 31, |  | 2005 |          |   | 2004 |  
|                         | 
|Beginning balance        |  | $    | 425,000  |   |      | $ | 479,062  |  
|Warranty provision       |  |      | 248,740  |   |      |   | 543,738  |  
|Warranty costs incurred  |  |      | (337,740 | ) |      |   | (597,800 | )
|                         |  |      |          |   |      |  
|Ending balance           |  | $    | 336,000  |   |      | $ | 425,000  |  
|                         |  |      |          |   |      |  
|                        

(6) Major Customers and Geographic Data









|                         |  |      |            |  |      |   |            |      |  |   |            | 
|------------------------ |  | ---- | ---------- |  | ---- | - | ---------- | ---- |  | - | ---------- | 
|                         | 
|Years ended December 31, |  | 2005 |            |  | 2004 |   |            | 2003 | 
|                         | 
|United States            |  | $    | 26,228,400 |  |      | $ | 29,322,593 |      |  | $ | 32,924,985 | 
|International            |  |      | 5,461,387  |  |      |   | 2,074,344  |      |  |   | 1,043,101  | 
|                         |  |      |            |  |      |   |            |      | 
|                         |  | $    | 31,689,787 |  |      | $ | 31,396,937 |      |  | $ | 33,968,086 | 
|                         |  |      |            |  |      |   |            |      | 
|                        

(7) Net Income (Loss) Per Share







|                                                   |  |      |            |  |      |   |            |      |  |   |            |  
|-------------------------------------------------- |  | ---- | ---------- |  | ---- | - | ---------- | ---- |  | - | ---------- | -
|                                                   | 
|Years ended December 31,                           |  | 2005 |            |  | 2004 |   |            | 2003 | 
|                                                   | 
|Net income (loss) available to common stockholders |  | $    | 2,102,980  |  |      | $ | (792,584   | )    |  | $ | (535,485   | )
|                                                   |  |      |            |  |      |   |            |      | 
|Weighted average shares outstanding basic         |  |      | 15,189,895 |  |      |   | 15,077,118 |      |  |   | 14,994,924 |  
|                                                   |  |      |            |  |      |   |            |      | 
|Weighted average shares outstanding diluted       |  |      | 15,238,730 |  |      |   | 15,077,118 |      |  |   | 14,994,924 |  
|                                                   |  |      |            |  |      |   |            |      | 
|Basic income (loss) per share                      |  | $    | 0.14       |  |      | $ | (0.05      | )    |  | $ | (0.04      | )
|                                                   |  |      |            |  |      |   |            |      | 
|Diluted income (loss) per share                    |  | $    | 0.14       |  |      | $ | (0.05      | )    |  | $ | (0.04      | )
|                                                   |  |      |            |  |      |   |            |      | 
|                                                  

in-the





Applied Innovation Inc.




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--




---



out-of out-of


(8) Stock Option Plans









out-of









Applied Innovation Inc.




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##### 





---





--




---





|                             |                  |           |           |          |          |   |      |      | 
|---------------------------- | ---------------- | --------- | --------- | -------- | -------- | - | ---- | ---- | 
|                             |                 
|                             |                  | Weighted- |          
|                             |                  | average   |          
|                             |                  | Number of |           |          | exercise |  
|                             |                  | shares    |           |          | price    |  
|                             |                 
|Balance at December 31, 2002 |                  |           | 1,821,300 |          |          | $ | 7.62 |     
|                             | Granted          |           |           | 457,500  |          |   |      | 3.31 | 
|                             | Exercised        |           |           | (37,900  | )        |   |      | 4.01 | 
|                             | Canceled/expired |           |           | (442,630 | )        |   |      | 7.41 | 
|                             |                  |           |           |          |          |  
|Balance at December 31, 2003 |                  |           | 1,798,270 |          |          | $ | 6.65 |     
|                             | Granted          |           |           | 462,000  |          |   |      | 5.92 | 
|                             | Exercised        |           |           | (40,600  | )        |   |      | 3.84 | 
|                             | Canceled/expired |           |           | (355,300 | )        |   |      | 6.63 | 
|                             |                  |           |           |          |          |  
|Balance at December 31, 2004 |                  |           | 1,864,370 |          |          | $ | 6.53 |     
|                             | Granted          |           |           | 134,000  |          |   |      | 3.71 | 
|                             | Exercised        |           |           | (95,200  | )        |   |      | 3.16 | 
|                             | Canceled/expired |           |           | (630,770 | )        |   |      | 6.76 | 
|                             |                  |           |           |          |          |  
|Balance at December 31, 2005 |                  |           | 1,272,400 |          |          | $ | 6.38 |     
|                             |                  |           |           |          |          |  
|                            



|                |         |                     |  |           |                     |  |           |          |  |  |           |           |  |          |       |  |  |  |         |  |  |   |       | 
|--------------- | ------- | ------------------- |  | --------- | ------------------- |  | --------- | -------- |  |  | --------- | --------- |  | -------- | ----- |  |  |  | ------- |  |  | - | ----- | 
|                |        
|                |         | Options outstanding |  |           | Options exercisable | 
|                |         |                     |  |           |                     | 
|                |         |                     |  | Weighted- |                     |  | Weighted- |          |  |  |           | Weighted- | 
|                |         |                     |  | average   |                     |  | average   |          |  |  |           | average   | 
|Range of        |         | Number of           |  |           | remaining           |  |           | exercise |  |  | Number of |           |  | exercise |      
|exercise prices |         | shares              |  |           | contractual life    |  |           | price    |  |  | shares    |           |  | price    |      
|                |        
|$               | 2.96 -  |                     |  | 2.98      |                     |  | 45,000    |          |  |  | 8.74      |           |  | $        | 2.97  |  |  |  | 9,000   |  |  | $ | 2.97  | 
|$               | 3.00 -  |                     |  | 3.03      |                     |  | 177,450   |          |  |  | 7.00      |           |  | $        | 3.03  |  |  |  | 88,500  |  |  | $ | 3.03  | 
|$               | 3.06 -  |                     |  | 3.64      |                     |  | 131,500   |          |  |  | 8.46      |           |  | $        | 3.45  |  |  |  | 49,400  |  |  | $ | 3.32  | 
|$               | 3.73 -  |                     |  | 5.00      |                     |  | 93,000    |          |  |  | 7.75      |           |  | $        | 4.39  |  |  |  | 30,400  |  |  | $ | 4.34  | 
|$               | 5.15 -  |                     |  | 5.15      |                     |  | 197,750   |          |  |  | 6.06      |           |  | $        | 5.15  |  |  |  | 181,750 |  |  | $ | 5.15  | 
|$               | 5.20 -  |                     |  | 6.13      |                     |  | 36,250    |          |  |  | 7.62      |           |  | $        | 5.86  |  |  |  | 36,250  |  |  | $ | 5.86  | 
|$               | 6.73 -  |                     |  | 6.73      |                     |  | 202,000   |          |  |  | 8.00      |           |  | $        | 6.73  |  |  |  | 166,000 |  |  | $ | 6.73  | 
|$               | 6.81 -  |                     |  | 8.31      |                     |  | 157,850   |          |  |  | 4.17      |           |  | $        | 8.13  |  |  |  | 157,850 |  |  | $ | 8.13  | 
|$               | 8.50 -  |                     |  | 11.19     |                     |  | 39,850    |          |  |  | 5.11      |           |  | $        | 9.82  |  |  |  | 39,850  |  |  | $ | 9.82  | 
|$               | 11.70 - |                     |  | 17.38     |                     |  | 191,750   |          |  |  | 5.19      |           |  | $        | 12.09 |  |  |  | 182,250 |  |  | $ | 12.09 | 
|                |         |                     |  |           |                     |  |           |          |  |  |           |           |  |          |       |  |  | 
|                |         |                     |  |           |                     |  | 1,272,400 |          |  |  | 6.61      |           |  | $        | 6.38  |  |  |  | 941,250 |  |  | $ | 7.16  | 
|                |         |                     |  |           |                     |  |           |          |  |  |           |           |  |          |       |  |  | 
|               

(9) Employee Stock Purchase Plan












Applied Innovation Inc.




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---





(10) Defined Contribution Plan







(11) Income Taxes







|                              |                 |         |          |          |          |   |          |          |   |   |          |          |  
|----------------------------- | --------------- | ------- | -------- | -------- | -------- | - | -------- | -------- | - | - | -------- | -------- | -
|                              |                
|                              |                 | Current |          |          | Deferred |   |          | Total    |  
|                              |                
|Year ended December 31, 2005: |                 |         |          |          |          |   |          |          |   |   |          |         
|                              | Federal         |         | $        | (21,000  | )        |   | $        | 817,000  |   |   | $        | 796,000  |  
|                              | State and local |         |          | 101,000  |          |   |          | 81,000   |   |   |          | 182,000  |  
|                              |                 |         |          |          |          |   |          |          |  
|                              |                 | $       | 80,000   |          |          | $ | 898,000  |          |   | $ | 978,000  |         
|                              |                 |         |          |          |          |   |          |          |  
|Year ended December 31, 2004: |                 |         |          |          |          |   |          |          |   |   |          |         
|                              | Federal         |         | $        | (310,000 | )        |   | $        | (575,000 | ) |   | $        | (885,000 | )
|                              | State and local |         |          | 74,000   |          |   |          | 24,000   |   |   |          | 98,000   |  
|                              |                 |         |          |          |          |   |          |          |  
|                              |                 | $       | (236,000 | )        |          | $ | (551,000 | )        |   | $ | (787,000 | )       
|                              |                 |         |          |          |          |   |          |          |  
|Year ended December 31, 2003: |                 |         |          |          |          |   |          |          |   |   |          |         
|                              | Federal         |         | $        | (930,000 | )        |   | $        | 171,000  |   |   | $        | (759,000 | )
|                              | State and local |         |          | 76,000   |          |   |          | (7,000   | ) |   |          | 69,000   |  
|                              |                 |         |          |          |          |   |          |          |  
|                              |                 | $       | (854,000 | )        |          | $ | 164,000  |          |   | $ | (690,000 | )       
|                              |                 |         |          |          |          |   |          |          |  
|                             



|                                                               |  |      |           |   |      |   |          |      |  |   |          |  
|-------------------------------------------------------------- |  | ---- | --------- | - | ---- | - | -------- | ---- |  | - | -------- | -
|                                                               | 
|                                                               |  | 2005 |           |   | 2004 |   |          | 2003 | 
|                                                               | 
|Computed tax at the expected federal statutory rate            |  | $    | 1,048,000 |   |      | $ | (537,000 | )    |  | $ | (417,000 | )
|State and local income taxes, net of federal income tax effect |  |      | 408,000   |   |      |   | (39,000  | )    |  |   | (40,000  | )
|Change in valuation allowance                                  |  |      | (260,000  | ) |      |   | 112,000  |      |  |   | 83,000   |  
|Meals and entertainment expenses                               |  |      | 33,000    |   |      |   | 40,000   |      |  |   | 42,000   |  
|Research and experimentation credit                            |  |      | (172,000  | ) |      |   | 37,000   |      |  |   | (24,000  | )
|Tax contingency reserve adjustment                             |  |      | (89,000   | ) |      |   | (379,000 | )    |  |   | (351,000 | )
|Extraterritorial income exclusion                              |  |      | (50,000   | ) |      |   |         |      |  |   |         |  
|Tax-exempt interest income                                     |  |      | (12,000   | ) |      |   | (20,000  | )    |  |   | (20,000  | )
|Other                                                          |  |      | 72,000    |   |      |   | (1,000   | )    |  |   | 37,000   |  
|                                                               |  |      |           |   |      |   |          |      | 
|                                                               |  | $    | 978,000   |   |      | $ | (787,000 | )    |  | $ | (690,000 | )
|                                                               |  |      |           |   |      |   |          |      | 
|                                                              






Applied Innovation Inc.




---



##### 





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--




---





|                          |                                                                                                          |                                |           |         |         |   |           |           |         | 
|------------------------- | -------------------------------------------------------------------------------------------------------- | ------------------------------ | --------- | ------- | ------- | - | --------- | --------- | ------- | 
|                          |                                                                                                         
|                          |                                                                                                          | 2005                           |           |         | 2004    |  
|                          |                                                                                                         
|Deferred tax assets:      |                                                                                                          |                                |           |         |         |   |           |          
|                          | Accounts receivable allowance                                                                            |                                | $         | 56,000  |         |   | $         | 44,000    |        
|                          | Inventory, principally due to obsolescence reserve and
    additional costs inventoried for tax purposes |                                |           | 215,000 |         |   |           | 140,000   |        
|                          | Warranty reserve                                                                                         |                                |           | 126,000 |         |   |           | 164,000   |        
|                          | Restructuring costs                                                                                      |                                |           | 0       |         |   |           | 21,000    |        
|                          | Other accrued expenses                                                                                   |                                |           | 99,000  |         |   |           | 121,000   |        
|                          | Deferred revenue                                                                                         |                                |           | 414,000 |         |   |           | 347,000   |        
|                          | Federal tax net operating loss carryforwards                                                             |                                |           | 335,000 |         |   |           | 1,362,000 |        
|                          | State tax net operating loss carryforwards                                                               |                                |           | 453,000 |         |   |           | 780,000   |        
|                          | Research and experimentation credit carryforwards                                                        |                                |           | 434,000 |         |   |           | 263,000   |        
|                          | Other                                                                                                    |                                |           | 155,000 |         |   |           | 88,000    |        
|                          |                                                                                                          |                                |           |         |         |  
|                          |                                                                                                          |                                | 2,287,000 |         |         |   | 3,330,000 |          
|Valuation allowance       |                                                                                                          |                                | (244,000  | )       |         |   | (504,000  | )        
|                          |                                                                                                          |                                |           |         |         |  
|Net deferred tax assets   |                                                                                                          | $                              | 2,043,000 |         |         | $ | 2,826,000 |          
|                          |                                                                                                          |                                |           |         |         |  
|Deferred tax liabilities: |                                                                                                          |                                |           |         |         |   |           |          
|                          |                                                                                                          | Unrealized gain on investments |           | $       | 0       |   |           | $         | 7,000   | 
|                          |                                                                                                          | Depreciation and amortization  |           |         | 180,000 |   |           |           | 115,000 | 
|                          |                                                                                                          | Deferred interest              |           |         | 46,000  |   |           |           | 27,000  | 
|                          |                                                                                                          |                                |           |         |         |  
|                          |                                                                                                          | $                              | 226,000   |         |         | $ | 149,000   |          
|                          |                                                                                                          |                                |           |         |         |  
|                         



(12) Lease Commitments














Applied Innovation Inc.




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(13) Equity









(14) Restructuring Charges


















Applied Innovation Inc.




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|                                   |  |                 |         |   |              |   |          |              |  |   |                |   |  |       |          |   |  |   |          |  
|---------------------------------- |  | --------------- | ------- | - | ------------ | - | -------- | ------------ |  | - | -------------- | - |  | ----- | -------- | - |  | - | -------- | -
|                                   | 
|                                   |  | Lease           |         |   | Employee     |   |          | Employee     |  |   | Employee       |   |  |      
|                                   |  | commitments,    |         |   | separations, |   |          | separations, |  |   | separations,   |   |  |      
|                                   |  | net of sublease |         |   | May 2004     |   |          | October 2004 |  |   | Jan & Feb 2005 |   |  | Total |         
|                                   | 
|Accrual balance December 31, 2003 |  | $               | 43,825  |   |              | $ |         |              |  | $ |               |   |  | $     |         |   |  | $ | 43,825   |  
|Restructuring event                |  |                 |        |   |              |   | 227,689  |              |  |   | 388,151        |   |  |       |         |   |  |   | 615,840  |  
|Cash deductions                    |  |                 | (18,356 | ) |              |   | (217,653 | )            |  |   | (274,600       | ) |  |       |         |   |  |   | (510,609 | )
|Non-cash adjustments               |  |                 |        |   |              |   | (10,036  | )            |  |   |               |   |  |       |         |   |  |   | (10,036  | )
|                                   |  |                 |         |   |              |   |          |              |  |   |                |   |  |       |         
|Accrual balance December 31, 2004 |  | $               | 25,469  |   |              | $ |         |              |  | $ | 113,551        |   |  | $     |         |   |  | $ | 139,020  |  
|                                   |  |                 |         |   |              |   |          |              |  |   |                |   |  |       |         
|Restructuring event                |  |                 |        |   |              |   |         |              |  |   |               |   |  |       | 965,481  |   |  |   | 965,481  |  
|Cash deductions                    |  |                 | (13,378 | ) |              |   |         |              |  |   | (82,473        | ) |  |       | (888,558 | ) |  |   | (984,409 | )
|Non-cash adjustments               |  |                 | (12,091 | ) |              |   |         |              |  |   | (31,078        | ) |  |       | (49,228  | ) |  |   | (92,397  | )
|                                   |  |                 |         |   |              |   |          |              |  |   |                |   |  |       |         
|Accrual balance December 31, 2005 |  | $               |        |   |              | $ |         |              |  | $ |               |   |  | $     | 27,695   |   |  | $ | 27,695   |  
|                                   |  |                 |         |   |              |   |          |              |  |   |                |   |  |       |         
|                                  

(15) Contingencies










Applied Innovation Inc.




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(16) Quarterly Financial Information (unaudited)







|                                         |  |    |       |   |    |   |       |    |  |   |       |  |  |   |       | 
|---------------------------------------- |  | -- | ----- | - | -- | - | ----- | -- |  | - | ----- |  |  | - | ----- | 
|                                         | 
|2005                                     |  | Q1 |       |   | Q2 |   |       | Q3 |  |   | Q4    | 
|                                         | 
|Net sales                                |  | $  | 6,933 |   |    | $ | 8,021 |    |  | $ | 8,424 |  |  | $ | 8,312 | 
|Gross profit                             |  |    | 4,056 |   |    |   | 4,482 |    |  |   | 4,662 |  |  |   | 4,533 | 
|Income (loss) before income taxes        |  |    | (447  | ) |    |   | 1,175 |    |  |   | 1,145 |  |  |   | 1,208 | 
|Net income (loss)                        |  |    | (282  | ) |    |   | 741   |    |  |   | 826   |  |  |   | 818   | 
|Basic net income (loss) income per share |  |    | (0.02 | ) |    |   | 0.05  |    |  |   | 0.05  |  |  |   | 0.05  | 
|Diluted net income (loss) per share      |  |    | (0.02 | ) |    |   | 0.05  |    |  |   | 0.05  |  |  |   | 0.05  | 
|                                        

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














13a-15(e) 15d-15(e)


















Applied Innovation Inc.




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Part Three










Code of Ethics




8-K


































Applied Innovation Inc.




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Part Four







|              |                                           
|------------- | ------------------------------------------
|Item Fifteen: | Exhibits and Financial Statement Schedules





|  |                                                                                                         
|- | --------------------------------------------------------------------------------------------------------
| | Report of Independent Registered Public Accounting Firm                                                 
| | Consolidated Balance Sheets as of December 31, 2005 and 2004                                            
| | Consolidated Statements of Operations for the years ended
    December 31, 2005, 2004 and 2003          
| | Consolidated Statements of Stockholders Equity for the
    years ended December 31, 2005, 2004 and 2003
| | Consolidated Statements of Cash Flows for the years ended
    December 31, 2005, 2004 and 2003          
| | Notes to Consolidated Financial Statements                                                              





|  |                                                        
|- | -------------------------------------------------------
| | Report of Independent Registered Public Accounting Firm
| | Schedule II (Valuation and Qualifying Accounts)        






Applied Innovation Inc.




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|        |    |             |  |                                                                                                                                                                                                                                                                                                                                                   
|------- | -- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|No.     |    | Description
|        |    |            
|        | 3  | .1          |  | Amended and Restated Certificate of Incorporation of the
    Company. (Reference is made to Appendix C to the
    Companys Definitive Proxy Statement for the 2001 Annual
    Meeting of Stockholders held on April 26, 2001, filed with
    the Securities and Exchange Commission on March 23, 2001,
    and incorporated herein by reference).
|        | 3  | .2          |  | By-laws of the Company, as amended. (Reference is made to
    Exhibit 3.2 to the Companys Registration Statement on
    Form 10-SB, filed with the Securities and Exchange
    Commission on March 10, 1993, and incorporated herein by
    reference).                                                                                          
|        | 10 | .1          |  | Form of Indemnification Agreement between the Company and
    officers and directors. (Reference is made to Exhibit 10.8
    to the Companys Annual Report on Form 10-K, filed
    with the Securities and Exchange Commission on March 31,
    1994, and incorporated herein by reference).                                                     
|        | 10 | .2*         |  | Schedule of Indemnification Agreements.                                                                                                                                                                                                                                                                                                           
|        | 10 | .3          |  | Companys Amended and Restated 1996 Stock Option Plan.
    (Reference is made to Exhibit 10.11 to the Companys
    Annual Report on Form 10-K, filed with the Securities and
    Exchange Commission on March 30, 2000, and incorporated
    herein by reference).                                                                               
|        | 10 | .4          |  | Employment Agreement between the Company and Gerard B.
    Moersdorf, Jr. (Reference is made to Exhibit 10.10 to
    the Companys Annual Report on Form 10-K, filed with
    the Securities and Exchange Commission on March 27, 2001,
    and incorporated herein by reference).                                                                
|        | 10 | .5          |  | Employment Agreement between the Company and Michael P. Keegan.
    (Reference is made to Exhibit 10.1 to the Companys
    Quarterly Report on Form 10-Q, filed with the Securities
    and Exchange Commission on May 12, 2004, and incorporated
    herein by reference).                                                                      
|        | 10 | .6          |  | Employment Agreement between the Company and Eric W. Langille.
    (Reference is made to Exhibit 10.2 to the Companys
    Quarterly Report on Form 10-Q, filed with the Securities
    and Exchange Commission on November 14, 2001, and
    incorporated herein by reference).                                                                  
|        | 10 | .7          |  | Companys 2001 Stock Incentive Plan. (Reference is made to
    Appendix B to the Companys Definitive Proxy Statement
    for the 2001 Annual Meeting of Stockholders held on
    April 26, 2001, filed with the Securities and Exchange
    Commission on March 23, 2001, and incorporated herein by
    reference).                             
|        | 10 | .8          |  | Form of Option Agreement under the Companys 2001 Stock
    Incentive Plan (Reference is made to Exhibit 10.1 to the
    Companys Current Report on Form 8-K filed with the
    Securities and Exchange Commission on January 5, 2005, and
    incorporated herein by reference).                                                                
|        | 10 | .9          |  | Companys Employee Stock Purchase Plan. (Reference is made
    to Appendix A to the Companys Definitive Proxy
    Statement for the 2002 Annual Meeting of Stockholders held on
    April 25, 2002, filed with the Securities and Exchange
    Commission on March 22, 2002, and incorporated herein by
    reference).                          
|        | 10 | .10         |  | Employment Agreement between the Company and John F. Petro.
    (Reference is made to Exhibit 10.1 to the Companys
    Quarterly Report on Form 10-Q, filed with the Securities
    and Exchange Commission on August 14, 2002, and
    incorporated herein by reference).                                                                       
|        | 10 | .11         |  | Employment Agreement between the Company and Thomas R. Kuchler.
    (Reference is made to Exhibit 10.12 to the Companys
    Annual Report on Form 10-K, filed with the Securities and
    Exchange Commission on March 8, 2004, and incorporated
    herein by reference).                                                                       
|        | 10 | .12         |  | Employment Agreement between the Company and Andrew J. Dosch.
    (Reference is made to Exhibit 10.1 to the Companys
    Quarterly Report on Form 10-Q, filed with the Securities
    and Exchange Commission on May 12, 2004, and incorporated
    herein by reference).                                                                        
|        | 10 | .13         |  | Employment Agreement between the Company and Angela R. Pinette.
    (Reference is made to Exhibit 10.1 to the Companys
    Current Report on Form 8-K, filed with the Securities and
    Exchange Commission on October 4, 2004, and incorporated
    herein by reference).                                                                      
|        | 10 | .14         |  | Letter Agreement between the Company and Michael P. Keegan
    (Reference is made to Exhibit 10.14 of the Companys
    Annual Report on Form 10-K, filed with the Securities and
    Exchange Commission on March 7, 2005, and incorporated
    herein by reference).                                                                            




Applied Innovation Inc.




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|        |    |             |  |                                                                                                                                                                                                                                                                                                                  
|------- | -- | ----------- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|No.     |    | Description
|        |    |            
|        | 10 | .15         |  | Letter Agreement between the Company and Gerard B.
    Moersdorf, Jr. (Reference is made to Exhibit 10.15 of
    the Companys Annual Report on Form 10-K, filed with
    the Securities and Exchange Commission on March 7, 2005,
    and incorporated herein by reference).                                    
|        | 10 | .16         |  | Material Terms of the Consulting Arrangement between the Company
    and Gerard B. Moersdorf, Jr. (Reference is made to
    Exhibit 10.1 to the Companys Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on February 11, 2005, and incorporated herein by reference).     
|        | 10 | .17         |  | Employment Agreement between the Company and William H. Largent
    (Reference is made to Exhibit 10.1 to the Companys
    Current Report on Form 8-K/A, filed with the Securities and
    Exchange Commission on February 11, 2005, and incorporated
    herein by reference).                                 
|        | 10 | .18         |  | Separation Agreement and Release of All Claims between the
    Company and Michael P. Keegan (Reference is made to
    Exhibit 10.1 to the Companys Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on March 11, 2005, and incorporated herein by reference).             
|        | 10 | .19         |  | Description of the Material Terms of the Companys 2005
    Management Bonus Program (Reference is made to Exhibit 10.1
    to the Companys Current Report on Form 8-K, filed
    with the Securities and Exchange Commission on July 20,
    2005, and incorporated herein by reference).                      
|        | 10 | .20         |  | Separation Agreement and Release of All Claims between the
    Company and Andrew J. Dosch (Reference is made to
    Exhibit 10.1 to the Companys Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on September 8, 2005, and incorporated herein by reference).            
|        | 10 | .21         |  | Separation Agreement and Release of All Claims between the
    Company and Thomas R. Kuchler (Reference is made to
    Exhibit 10.1 to the Companys Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on November 30, 2005, and incorporated herein by reference).          
|        | 10 | .22         |  | Employment Agreement between the Company and Julia Fratianne
    (Reference is made to Exhibit 10.1 to the Companys
    Current Report on Form 8-K, filed with the Securities and
    Exchange Commission on December 21, 2005, and incorporated
    herein by reference).                                      
|        | 10 | .23         |  | Form of Restricted Stock Award Agreement under the
    Companys 2001 Stock Incentive Plan (Reference is made to
    Exhibit 10.1 to the Companys Current Report on
    Form 8-K filed with the Securities and Exchange Commission
    on February 9, 2006, and incorporated herein by reference).              
|        | 10 | .24         |  | Employment Agreement between the Company and William L. Pollack
    (Reference is made to Exhibit 10.2 to the Companys
    Current Report on Form 8-K, filed with the Securities and
    Exchange Commission on February 9, 2006, and incorporated
    herein by reference).                                    
|        | 10 | .25         |  | Description of Base Salaries and the Material Terms of the
    Companys 2006 Management Bonus Program (Reference is made
    to Exhibit 10.1 to the Companys Current Report on
    Form 8-K, filed with the Securities and Exchange Commission
    on February 15, 2006, and incorporated herein by reference).
|        | 23 | *           |  | Consent of KPMG LLP.                                                                                                                                                                                                                                                                                             
|        | 24 | *           |  | Power of Attorney.                                                                                                                                                                                                                                                                                               
|        | 31 | .1*         |  | Rule 13a-14(a) Certification of Principal Executive Officer.                                                                                                                                                                                                                                                     
|        | 31 | .2*         |  | Rule 13a-14(a) Certification of Principal Financial Officer.                                                                                                                                                                                                                                                     
|        | 32 | .1**        |  | Section 1350 Certification of Principal Executive Officer.                                                                                                                                                                                                                                                       
|        | 32 | .2**        |  | Section 1350 Certification of Principal Financial Officer.                                                                                                                                                                                                                                                       






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



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



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



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




Applied Innovation Inc.




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| |                        
| | -----------------------
| | APPLIED INNOVATION INC.



| |     |                       
| | --- | ----------------------
| | By: | /s/ William H. Largent

| |                                     
| | ------------------------------------
| |                                     
| | William H. Largent                  
| | Chief Executive Officer and Director





|                                                                         |  |                                                                                                                                     |  |      
|------------------------------------------------------------------------ |  | ----------------------------------------------------------------------------------------------------------------------------------- |  | -----
|                                                                         |  | Signature                                                                                                                           |  | Title
|                                                                         |  |                                                                                                                                     |  |      
|/s/ William H. LargentWilliam H. Largent                                 |  | Chief Executive Officer and Director
    (Principal Executive Officer)
    March 20, 2006                                          
|                                                                        
|/s/ Julia A. FratianneJulia A. Fratianne                                 |  | Vice President, Chief Financial Officer and Treasurer
    (Principal Financial and Principal Accounting Officer)
    March 20, 2006
|                                                                        
|* /s/ Gerald B.
    Moersdorf, Jr.Gerard B. Moersdorf, Jr.               |  | Chairman of the Board
    March 20, 2006                                                                                           
|                                                                        
|* /s/ Thomas W. HusebyThomas W. Huseby                                   |  | Director
    March 20, 2006                                                                                                        
|                                                                        
|* /s/ Kenneth E. JonesKenneth E. Jones                                   |  | Director
    March 20, 2006                                                                                                        
|                                                                        
|* /s/ Curtis A.
    LovelandCurtis A. Loveland                           |  | Director
    March 20, 2006                                                                                                        
|                                                                        
|* /s/ Richard W. OliverRichard W. Oliver                                 |  | Director
    March 20, 2006                                                                                                        
|                                                                        
|* /s/ Alexander B.
    TrevorAlexander B. Trevor                         |  | Director
    March 20, 2006                                                                                                        
|                                                                        
|*By: /s/ William H.
    LargentWilliam H. Largent
    (Attorney-in-Fact) |  |                                                                                                                                    




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|                              |                                  |            |   |           |            |  |          |            |   |            |   |            |        |  |   |           |  |  |   |         | 
|----------------------------- | -------------------------------- | ---------- | - | --------- | ---------- |  | -------- | ---------- | - | ---------- | - | ---------- | ------ |  | - | --------- |  |  | - | ------- | 
|                              |                                 
|Column A                      |                                  | Column B   |   |           | Column C   |  | Column D |            |   | Column E   |  
|                              |                                  |            |   | Additions |            |  |          |           
|                              |                                  |            |   |           |            |  |          |           
|                              |                                  | Balance at |   |           | Charged to |  |          | Charged to |   |            |   | Balance at |       
|                              |                                  | beginning  |   |           | costs and  |  |          | other      |   |            |   | end of     |       
|Description                   |                                  | of period  |   |           | expense    |  |          | accounts   |   | Deductions |   |            | period | 
|                              |                                 
|YEAR ENDED DECEMBER 31, 2005: |                                  |            |   |           |            |  |          |            |   |            |   |            |        |  |   |           |  |  |   |        
|                              | Allowance for doubtful accounts  |            | $ | 115,000   |            |  | $        | 52,734     |   |            | $ |           |        |  | $ | 17,737    |  |  | $ | 150,000 | 
|                              | Allowance for obsolete inventory |            |   | 163,000   |            |  |          | 233,000    |   |            |   |           |        |  |   | 109,000   |  |  |   | 287,000 | 
|                              | Warranty provision               |            |   | 425,000   |            |  |          | 248,740    |   |            |   |           |        |  |   | 337,740   |  |  |   | 336,000 | 
|YEAR ENDED DECEMBER 31, 2004: |                                  |            |   |           |            |  |          |            |   |            |   |            |        |  |   |           |  |  |   |        
|                              | Allowance for doubtful accounts  |            | $ | 140,000   |            |  | $        | 18,170     |   |            | $ |           |        |  | $ | 43,170    |  |  | $ | 115,000 | 
|                              | Allowance for obsolete inventory |            |   | 434,000   |            |  |          | 146,000    |   |            |   |           |        |  |   | 417,000   |  |  |   | 163,000 | 
|                              | Warranty provision               |            |   | 479,062   |            |  |          | 543,738    |   |            |   |           |        |  |   | 597,800   |  |  |   | 425,000 | 
|YEAR ENDED DECEMBER 31, 2003: |                                  |            |   |           |            |  |          |            |   |            |   |            |        |  |   |           |  |  |   |        
|                              | Allowance for doubtful accounts  |            | $ | 430,000   |            |  | $        | (73,342    | ) |            | $ |           |        |  | $ | 216,658   |  |  | $ | 140,000 | 
|                              | Allowance for obsolete inventory |            |   | 1,107,159 |            |  |          | 551,000    |   |            |   |           |        |  |   | 1,224,159 |  |  |   | 434,000 | 
|                              | Warranty provision               |            |   | 542,651   |            |  |          | 793,923    |   |            |   |           |        |  |   | 857,512   |  |  |   | 479,062 | 




Applied Innovation Inc.