<PAGE>

                                    FORM 10-K
                     U.S. Securities and Exchange Commission
                             Washington, D.C. 20549
                                   (Mark One)

|X|   ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                                  ACT OF 1934

                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

                                       OR

|_|   TRANSITION REPORT UNDER 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.
                (Name of registrant as specified in its charter)

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

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

                   Registrant's telephone number: 614-798-2000

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

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

Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, and (2) has been subject to the filing requirements for
at least the past 90 days. YES |X| NO |_|

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

Aggregate market value of voting stock held by non-affiliates of the registrant,
8,428,420 shares, based on the $5.06 closing sale price on March 8, 2002, was
$42,647,805.

Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date: 15,177,299 shares of Common
Stock were outstanding at March 8, 2002.

                       DOCUMENTS INCORPORATED BY REFERENCE

Part III - Proxy Statement for the Annual Meeting of Stockholders to be held
April 25, 2002, in part, as indicated.
<PAGE>
      This Annual Report on Form 10-K contains forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934, as amended,
and Section 26A of the Securities Act of 1933, as amended. The words
"anticipate," "believe," "expect," "estimate," and "project" and similar words
and expressions identify forward-looking statements which speak only as of the
date hereof. Investors are cautioned that such statements involve risks and
uncertainties that could cause actual results to differ materially from
historical or anticipated results due to many factors, including, but not
limited to, the factors discussed in "Business - Business Risks." The Company
undertakes no obligation to publicly update or revise any forward-looking
statements.

                                     PART I

ITEM 1. BUSINESS.

GENERAL

      Applied Innovation Inc. ("Applied Innovation", "AI", or the "Company")
provides products and services to mediate, monitor and manage large-scale,
complex telecommunications and wireless networks and to speed the delivery of
broadband services. The Company is a leader in the design, manufacture and
deployment of hardware, software and services to improve the management of
communications networks. Solutions from Applied Innovation allow
telecommunications, cable and Internet service providers to reduce operating
costs and optimize capital equipment purchases through protocol mediation,
network element management and broadband service delivery.

      The Company was founded in Columbus, Ohio in 1983 by Gerard Moersdorf, Jr.
The Company has a wholly owned subsidiary, Applied Innovation International
Inc., an Ohio corporation.

      The Company's corporate headquarters occupy a 115,000 square foot facility
in suburban Columbus, Ohio and are located at 5800 Innovation Drive, Dublin,
Ohio 43016, 800.247.9482. Applied Innovation's shares are traded on the NASDAQ
National Market under the symbol AINN.

THE COMPANY'S MARKETS

      Applied Innovation's customer list confirms its strong position in the
domestic telecommunications market. The customer base is comprised of Regional
Bell Operating Companies (RBOCs), long distance carriers, wireless and cable
companies and competitive local exchange carriers. With equipment installed in
over 20,000 locations, it has established its client relationships based on an
enduring belief that customers need technology partners - not vendors. The
Company also serves the international market, with equipment marketed to and
installed in Africa, Asia, Australia, Europe, and North and South America.

      The Company created a family of products and services, enabling its
customers to manage and grow their telecommunications networks. These products
and services include data communications networking equipment, broadband
aggregation equipment, and a variety of services offerings. Bridging


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the gap between new and existing equipment, AI's products and services improve
operating efficiency and service quality, and speed the deployment of new
services.

      The Company's data communications network (DCN) equipment simplifies
deployment, reduces costs, and improves network management by providing
interoperability between virtually any network element and any operational
support system. This extends the life of existing equipment and reduces the need
for comprehensive upgrades of the network as new services and equipment are
deployed. The service provider's DCN provides the infrastructure for the
comprehensive management of the telephone and broadband data services from the
network operations center (NOC). From the NOC, all traditional operations,
administration, maintenance and provisioning (OAM&P) functions are performed.

      Broadband services are delivered through Applied Innovation's
LuxConnect(TM) product line. LuxConnect was created to help customers meet the
demand for high-speed broadband for metro edge and campus fiber networks. It
affords them the power to rapidly accelerate deployment of Gigabit Ethernet to
remote sites, while lowering maintenance and administration costs.

      Applied Innovation serves the needs of wireless service providers through
its AIbadger product line. Improving service quality and reliability, AIbadger
provides remote site security and reduces overall maintenance costs.

      Applied Innovation's Services Division provides customers with the
telecommunications network expertise that has been central to the Company's own
success. Whether a customer is trying to grow an existing network or plan an
initial deployment, AI's network planning, design, installation, systems
integration, and project management services can leverage existing resources and
add specific expertise to drive down costs and speed implementation.

PRODUCTS

                               HARDWARE SOLUTIONS

AISWITCH(TM)

AIswitch improves productivity and reduces costs at central offices (COs) and
operations centers by ensuring connectivity, reliability, and availability from
support systems to network elements. Its wide variety of line cards, built upon
the latest technology, bridges the hardware and software gaps between old and
new equipment. This allows virtually any vintage of network equipment to be
integrated with the customer's support systems. Industry-standard,
open-architecture building blocks ensure easy connection of computers, network
elements, and other intelligent equipment with one or more network destinations.

Designed to meet carrier-grade requirements, AIswitch is fully Network Element
Building Standards (NEBS) Level 3 certified. By transforming a complex,
multi-vendor environment into an easily-managed, seamless network, AIswitch
increases the efficiency of OAM&P systems.



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AISCOUT(TM)

Based upon the technology of AIswitch, AIscout is a self-contained, economical,
mediation and concentration device providing versatile functionality, hardware
connectivity, and extensive management capability. It is ideal for protocol
mediation, port concentration, and for transporting OAM&P data between network
elements and operational support systems. Integrating optical Ethernet
technology within the AIscout allows OAM&P traffic to use the same fiber as
payload traffic -- eliminating the need for routers, CSU/DSUs, and recurring
costs for dedicated circuits.

AIBADGER(TM)

AIbadger provides a flexible, low-cost solution for mobile communications site
monitoring and network management. It provides remote IP networking
functionality and has various wide area network (WAN) connectivity options,
including an optional T1 drop and insert module. Bringing connectivity and alarm
visibility to remote network sites, AIbadger is designed to meet a broad range
of operating and security requirements.

AIFLEX(TM)

AIflex enables the use of existing fiber facilities to monitor and manage small
remote central offices, controlled environmental vaults, huts, and shelters.
Connecting directly to existing fiber without interfering with payload, AIflex
transmits management data between remote sites and the central office without
the additional cost and delays associated with extra lines or routers.

AISPY(TM)

AIspy is a comprehensive system for managing small telecommunications sites. It
provides monitoring capabilities for the entire facility through a multitude of
alarms and sensors and has the capability to control and record access into the
monitored site through either keypad or cellular phone input.

LUXCONNECT(TM)

LuxConnect is a Gigabit Ethernet multiplexer that aggregates up to eight
channels of Gigabit Ethernet into a single, protected 10-Gbps optical signal.
This improves fiber utilization and extends the reach for common Gigabit
Ethernet optical interfaces. More economical than SONET-based solutions,
LuxConnect provides significant performance advantages as well. As a native
Ethernet transmission platform, it flattens data transport architectures,
improves network administration and maintenance, and enhances total network
scalability.

INTEGRATED SYSTEMS

The Company offers turn-key systems integration for its customers. The Company
provides the necessary equipment detail engineering, equipment order and
material tracking, equipment installation, component configuration and
verification testing to "rack" and "stack" site specific configurations of
network or system components, from single racks to complete sites. These
"integrated systems" include third-party equipment combined with the Company's
network management products, pre-configured and tested at the Company's
facilities. They arrive at their destination ready to be powered-up, connected
to the network and brought on-line.

The revenue generated from integrated systems is included in Products and
Integration Sales in the Company's consolidated financial statements, and is
described as Integration Sales in the Company's product-line revenue analysis in
Management's Discussion and Analysis of Financial Condition and Results of
Operations.


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                     NETWORK MANAGEMENT SOFTWARE SOLUTIONS

The Company offers several network management software (NMS) solutions to help
telecommunications service providers manage their data communications networks.
The Company generates software license fees from the sale of these NMS
solutions. Such license fees are included in Products and Integration Sales in
the Company's consolidated financial statements and are included in Products
Sales in the Company's product-line revenue analysis in Management's Discussion
and Analysis of Financial Condition and Results of Operations.

APPLIEDVIEW(TM)

AppliedView is an element management system which allows the people and systems
in a NOC to monitor Applied Innovation equipment in remote locations. It
provides centralized, continuous surveillance and provisioning of the AI network
by giving technicians in the operations center the same view as if they were
standing in front of the AI device. A point-and-click graphical user interface
reduces the cost and time required for upgrades and remote site maintenance.

NEWEB(TM)

NEweb is a client/server application which provides secure remote access to
network elements. It controls which users have access to network elements and
which commands they can execute -- it can even log all connections in a central
repository. NEweb is non-vendor specific, so it can work with any of the network
elements in an environment. The client/server architecture makes NEweb extremely
scalable, supporting hundreds of users and thousands of network elements.

AIWATCH(TM)

AIwatch provides a complete picture of the "health" of a network through event
management, reports, and fault notification. It can be scaled to monitor any
size network, ranging from small, local operations consisting of a few elements
to large, international deployments with tens of thousands of managed devices.
AIwatch can be used to consolidate element management systems from different
vendors into one network management platform or to augment existing top-level
management platforms.

                               SERVICE SOLUTIONS

SERVICES

Applied Innovation's services organization offers a suite of service offerings
tailored to reduce deployment time and increase operational effectiveness.
Staffed with knowledgeable professionals who understand the technology and how
to apply it to meet specific business needs, the Company provides solutions
ranging from customized software packages to large-scale system design. These
include professional services, network security solutions, operational support
system services, network services, installation services, deployment services,
turn-key solutions and extended maintenance agreements. These services, alone or
in combination, provide the customer with increased resource flexibility and
added value to their network.


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The Company generates services revenue from customers under contracts and/or
purchase orders that define the scope of work for a given project. The Company
generally recognizes services revenue at project completion. Revenue from
service work is classified as Services Sales in the Company's consolidated
financial statements and is described as Services Sales in the Company's
product-line revenue analysis in Management's Discussion and Analysis of
Financial Condition and Results of Operations.

MANUFACTURING AND OPERATIONS

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

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

MARKETING, BUSINESS DEVELOPMENT, SALES AND SERVICES

      The Company's products and services are sold primarily through its own
sales force, except for independent sales agents in Australia, Greece, Mexico,
South Korea, South Africa, United Kingdom and Brazil. The Company is exploring
alternative distribution channels to allow sales of the Company's products to
markets that are not easily accessible nor cost effective for its own sales
force. In addition to the Dublin, Ohio headquarters, the Company maintains sales
offices in Atlanta, Chicago, Dallas, Denver, Pleasanton, CA and Mexico City.

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

      The technical complexity of the Company's products and the relative large
size of customers create a long sales cycle for the Company's products. The
technical nature of the products and CO environment also mandates a very
technical sales force. The Company's sales force receives incentive compensation
based on increased levels of sales.



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RESEARCH AND DEVELOPMENT

      The Company's research and development ("R&D") activity is coordinated
with product management and business development to create product development
teams which focus on customer requirements. Enhancements to AIswitch are focused
on increasing its capacity and adapting to the wide variety of existing and
emerging network element (NE) management interfaces. Investment is continuing to
leverage the AIswitch technology to create smaller, more highly integrated
products, such as AIscout and AIspy, which are appropriate for the smaller CO,
controlled environmental vault (CEV), or cabinet environments. Network
management/operations support system (OSS) products and services will continue
to play a key position in the Company's R&D spending as we expand our presence
into these emerging markets.

      Continued development is being made into enhancements for the AIbadger
product line as well as producing additional products for the wireless market to
enhance network management capabilities, improve service quality and speed the
introduction of new technologies. Enhancements to our existing product line and
development of new products are being investigated for networking solutions for
new markets such as enterprise, government and military. Additional investment
is being focused on the unique needs and requirements for international markets
to enable further penetration of targeted countries.

      The Company spent $9,648,898, $8,176,622 and $7,479,496 on
Company-sponsored R&D during the fiscal years ended December 31, 2001, 2000, and
1999, respectively. R&D expenditures represented approximately 13.2%, 7.0% and
15.1% of annual sales in fiscal 2001, 2000, and 1999, respectively. The Company
expects to commit a substantial amount of resources and cash to its research and
development efforts during 2002. See "Business - Business Risks - New Products,
Research and Development, and Rapid Technological Change; Need to Manage Product
Transitions."

CUSTOMER SERVICE AND WARRANTY

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

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


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

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

      Warranty expense represented approximately 2.1%, 1.5% and 2.4% of annual
sales in 2001, 2000, and 1999, respectively. See "Business - Business Risks -
Risk of Product Defects."

COMPETITION

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

      Competition for the Company's DCN products arises primarily from suppliers
of telecommunications switching and transmission equipment, such as Cisco
Systems, Dantel, Mediatron Technology Corporation, DPS, ION Networks, Touch
Communications and IMCI Technologies. In some cases, newer products or
redesigned older products from these suppliers compete with the Company's
products. See "Business - Business Risks - Competition."

      Competition for the Company's LuxConnect product includes Nbase/Xyplex,
Hitachi, Riverstone, Lucent, Nortel and Cisco Systems.

      Competition for the Company's services division include Lucent Netcare,
Sprint North Supply and Marconi.

PERSONNEL

      As of March 8, 2002, the Company had 251 full-time and part-time
employees. The Company's employees are distributed among the following
departments: Sales and Marketing 59; Research and Development 62; Customer
Service 59; Manufacturing 37; and Operations 34. The Company anticipates that it
will continue to increase the number of its employees as it grows.



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BUSINESS RISKS

      The Company desires to take advantage of the "safe harbor" provisions of
the Private Securities Litigation Reform Act of 1995. In addition to the other
information in this report, readers should carefully consider that the following
important factors, among others, in some cases have affected, and in the future
could affect, the Company's actual results and could cause the Company's actual
consolidated results of operations for the year ended December 31, 2002, and
beyond, to differ materially from those expressed in any forward-looking
statements made by, or on behalf of, the Company.

      RISKS ASSOCIATED WITH CUSTOMER CONCENTRATION; DEPENDENCE ON
TELECOMMUNICATIONS INDUSTRY. A significant portion of the Company's revenues in
each fiscal quarter since inception has been derived from substantial orders
placed by large organizations, such as the RBOCs. As a result, the Company's
sales often have been concentrated among a relatively small number of customers.
In fiscal 2001, 2000, and 1999, sales from the Company's four, two and two
largest customers represented approximately 66%, 61%, and 42%, respectively, of
the Company's total sales. The Company expects that it will continue to be
dependent upon a limited number of customers for a significant portion of its
revenues in future periods. None of the Company's customers are contractually
obligated to license or purchase additional products or services from the
Company. As a result of this customer concentration, the Company's business,
operating results and financial condition could be materially adversely affected
by the failure of anticipated orders to materialize or by deferrals or
cancellations of orders. In addition, there can be no assurance that revenue
from customers that have accounted for significant sales in past periods,
individually or as a group, will continue, or if continued, will reach or exceed
historical levels in any future period. Furthermore, such customers are
concentrated in the telecommunications industry. Accordingly, the Company's
future success depends upon the capital spending patterns of such customers and
the continued demand by such customers for the Company's products and services.
Over the last 12 to 18 months, domestic telecommunications service providers
have significantly reduced spending on new equipment and services and many
competitive local exchange carriers (CLECs) have failed. Additionally, any
future mergers and acquisitions among our customers could impact future orders
from such customers. The Company's operating results may in the future be
subject to substantial period-to-period fluctuations as a consequence of such
customer concentration and factors affecting capital spending in the
telecommunications industry.

      PRODUCT CONCENTRATION. Revenue from the sale, service and support of the
Company's DCN family of products has accounted for a substantial portion of the
Company's sales since inception. The Company believes that revenue from the
sale, service and support of the DCN products will continue to account for a
significant portion of the Company's net sales in fiscal 2002. Therefore, the
Company's future operating results, particularly in the near term, are
significantly dependent upon the continued market acceptance of the DCN
products, improvements to the DCN product framework and new and enhanced
development tools and network operations support. There can be no assurance that
the Company's DCN products and software will continue to achieve market
acceptance or that the Company will be successful in developing, introducing or
marketing improvements to its products or new or enhanced development tools and
applications. The life cycles of products, including development tools and
applications, are difficult to estimate due in large part to the recent
emergence of many of the Company's markets, the effect of future product
enhancements and competition. A decline in the demand for DCN products as a
result of competition, technological change or other factors would have a


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

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

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

      COMPETITION. Most of the Company's current and potential competitors have
longer operating histories and significantly greater financial, technical,
sales, customer support, marketing and other resources, as well as greater name
recognition and a larger installed base of their products and technologies than
the Company. There can be no assurance that the Company's current or potential
competitors will not develop products comparable or superior to those developed
by the Company or adapt more quickly than the Company to new technologies,
evolving industry trends or changing customer requirements. There can be no
assurance that the Company will be able to compete successfully against current
and future competitors or that competitive pressures faced by the Company will
not have a material adverse effect on its business, operating results and
financial condition.

      DEPENDENCE UPON PROPRIETARY TECHNOLOGY; RISK OF THIRD PARTY CLAIMS OF
INFRINGEMENT. The Company's success and ability to compete is dependent in part
upon its proprietary software technology. The Company relies on a combination of
trade secret, copyright and trademark laws, nondisclosure and other contractual
agreements and technical measures to protect its proprietary rights. The Company
currently has no patents or patent applications pending. Despite the Company's
efforts to protect its proprietary rights, unauthorized parties may attempt to



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copy aspects of the Company's products or to obtain and use information that the
Company regards as proprietary. There can be no assurance that the steps taken
by the Company to protect its proprietary technology will prevent
misappropriation of such technology, and such protections may not preclude
competitors from developing products with functionality or features similar to
the Company's products. In addition, effective copyright and trade secret
protection may be unavailable or limited in certain foreign countries. While the
Company believes that its products and trademarks do not infringe upon the
proprietary rights of third parties, there can be no assurance that the Company
will not receive future communications from third parties asserting that the
Company's products infringe, or may infringe, the proprietary rights of third
parties. The Company expects that software product developers will be
increasingly subject to infringement claims as the number of products and
competitors in the Company's industry segment grows and the functionality of
products in different industry segments overlap. Any such claims, with or
without merit, could be time-consuming, result in costly litigation and
diversion of technical and management personnel, cause product shipment delays
or require the Company to develop non-infringing technology or enter into
royalty or licensing agreements. Such royalty or licensing agreements, if
required, may not be available on terms acceptable to the Company or at all.
In the event of a successful claim of product infringement against the Company
and failure or inability of the Company to develop non-infringing technology or
license the infringed or similar technology, the Company's business, operating
results and financial condition could be materially adversely affected.

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

      RELIANCE ON SUPPLIERS. The Company purchases raw material and licenses
technology from a number of domestic and foreign sources. The Company believes
that currently there are acceptable alternatives to the suppliers of raw
material and technology used in its products which could be substituted for over
time, with the exception of network routing products supplied by Cisco Systems,
Inc. The Company currently purchases network routing products and licenses
technology regarding the same from Cisco Systems, Inc. pursuant to a Technology
Agreement. The term of the Technology Agreement expires on December 31, 2002 and
automatically renews for one year periods, unless either party elects not to
renew. Additionally, the Technology Agreement may be terminated by either party
for any reason upon six months notice. The Company believes that some of its
customers place a high value on the incorporation of network routing products
and technology from Cisco Systems, Inc. into the Company's products. While the
Company believes that it could obtain similar quality network routing products
and technology from other vendors, the termination of the Technology Agreement
could materially adversely affect the acceptance of the Company's products,
which could have a material adverse effect on the Company's business, financial
condition and results of operations.


                                     - 11 -
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      FUTURE CAPITAL NEEDS; UNCERTAINTY OF ADDITIONAL FINANCING. The Company
currently anticipates that its existing cash, cash equivalents, investments,
cash to be generated from future operations, and funds which may be obtained
from future financing activities will provide sufficient capital to meet the
currently anticipated business needs of the Company. See "Management's
Discussion and Analysis of Financial Condition and the Results of Operations -
Liquidity and Capital Resources." The Company may need to raise additional funds
through public or private debt or equity financings in order to take advantage
of unanticipated opportunities, including more rapid expansion or acquisitions
of complementary businesses or technologies, or to develop new or enhanced
services and related products or otherwise respond to unanticipated competitive
pressures. If additional funds are raised through the issuance of equity
securities, the percentage ownership of the then current stockholders of the
Company may be reduced and such equity securities may have rights, preferences
or privileges senior to those of the holders of the Company's common stock.
There can be no assurance that additional financing will be available on terms
favorable to the Company, or at all. If adequate funds are not available or are
not available on acceptable terms, the Company may not be able to take advantage
of unanticipated opportunities, develop new or enhanced services and related
products or otherwise respond to unanticipated competitive pressures and the
Company's business, operating results and financial condition could be
materially adversely affected.

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

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

      POTENTIAL FLUCTUATIONS IN QUARTERLY RESULTS; SEASONALITY. The Company's
quarterly operating results have in the past and will in the future vary
significantly depending on factors such as the timing of significant orders and
shipments; capital spending patterns of the Company's customers; changes in
pricing policies by the Company or its competitors; the lengthy sales cycle of
the Company's products; increased competition; changes in operating expenses;
mergers and acquisitions among customers; personnel changes; demand for the
Company's products; the number, timing and significance of new product and
product enhancement announcements by the Company and its competitors; the
ability of the Company to develop, introduce and market new and enhanced
versions of its products on a timely basis; and the mix of direct and indirect
sales and general economic factors. A significant portion of the Company's
revenues have been, and will continue to be, derived from substantial orders
placed by large organizations, such as the RBOCs, and the timing of such orders
and their fulfillment has caused and will continue to cause material


                                     - 12 -
<PAGE>
fluctuations in the Company's operating results, particularly on a quarterly
basis. Due to the foregoing factors, quarterly net sales and operating results
have been and will continue to be difficult to forecast. Revenues are also
difficult to forecast because the Company's sales cycle, from initial evaluation
to product shipment, varies substantially from customer to customer. For these
and other reasons, the sales cycle associated with the purchase of the Company's
products is typically lengthy and subject to a number of significant risks,
including customers' budgetary constraints and internal acceptance reviews, over
which the Company has little or no control. The Company's expense levels are
based, in part, on its expectations as to future revenue levels. If revenue
levels are below expectations, operating results are likely to be materially
adversely affected. In particular, because only a small portion of the Company's
expenses varies with sales, net income (loss) may be disproportionately affected
by a reduction in sales. The Company's business has experienced and is expected
to continue to experience significant seasonality, in part due to an increase in
capital expenditures by customers in certain quarters. Based upon all of the
foregoing, the Company believes that quarterly sales and operating results are
likely to vary significantly in the future and that period-to-period comparisons
of its results of operations are not necessarily meaningful and should not be
relied upon as indications of future performance. Further, it is likely that in
some future quarter, the Company's sales or operating results will be below the
expectations of public market analysts and investors. In such event, the price
of the Company's common stock could be materially adversely affected.

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

      LIMITED MARKET; VOLATILITY OF STOCK PRICE. Although the Company is listed
on the Nasdaq National Market, there can be no assurance that an active or
liquid trading market in the Company's common stock will continue. The market
price of the shares of the Company's common stock is likely to be highly
volatile and may be significantly affected by factors such as actual or
anticipated fluctuations in the Company's operating results, announcements of
technological innovations, new products or new contracts by the Company or its
competitors, developments with respect to copyrights or proprietary rights,
general market conditions and other factors. In addition, the stock market has
from time to time experienced significant price and volume fluctuations that



                                     - 13 -
<PAGE>
have particularly affected the market prices for the common stocks of technology
companies. These types of broad market fluctuations may adversely affect the
market price of the Company's common stock. In the past, following periods of
volatility in the market price of a company's securities, securities class
action litigation has often been initiated against such company. Such litigation
could result in substantial costs and a diversion of management's attention and
resources, which could have a material adverse effect upon the Company's
business, operating results and financial condition.

      ANTI-TAKEOVER PROVISIONS; CERTAIN PROVISIONS OF DELAWARE LAW; CERTIFICATE
OF INCORPORATION AND BY-LAWS. Certain provisions of Delaware law and the
Company's Certificate of Incorporation and By-Laws could have the effect of
making it more difficult for a third party to acquire, or of discouraging a
third party from attempting to acquire, control of the Company. The Company's
By-Laws provide for the Board of Directors to be divided into three classes of
directors serving staggered three-year terms. Such classification of the Board
of Directors expands the time required to change the composition of a majority
of directors and may tend to discourage a proxy contest or other takeover bid
for the Company. Additionally, the directors, executive officers and existing
principal stockholders of the Company and their affiliates beneficially own
approximately 52.3% of the outstanding shares of the Company's common stock.
Such concentration of ownership may have the effect of delaying or preventing a
change in control of the Company.

      CONCENTRATION OF STOCK OWNERSHIP. The present directors, executive
officers and principal stockholders of the Company and their affiliates
beneficially own approximately 52.3% of the outstanding shares of the Company's
common stock. In particular, Gerard B. Moersdorf, Jr. and his former spouse own
approximately 42.4% of the outstanding shares of common stock. As a result,
these stockholders are able to exercise significant influence over matters
requiring stockholder approval, including the election of directors and approval
of significant corporate transactions. Such concentration of ownership may have
the effect of delaying or preventing a change in control of the Company.

      REVENUE FLUCTUATIONS DUE TO RESELLER PASS-THROUGH. One-time systems
integration project opportunities may contribute to significant fluctuations in
top line revenues on a non-recurring basis. These contributions are generally at
lower margins than core product line sales, and may affect margin performance.
However, these projects do make significant contributions to overall net
profits, and do not affect long term profit growth for the Company.

ITEM 2. PROPERTIES.

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


                                     - 14 -
<PAGE>
ITEM 3. LEGAL PROCEEDINGS.

      Not applicable.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

      Not applicable.


                                     - 15 -
<PAGE>
                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

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

<TABLE>
<CAPTION>
                           2001                       2000
                           ----                       ----

                    High          Low           High        Low
<S>                <C>           <C>           <C>         <C>
      Q1           $15.50        $8.25         $14.56      $7.75

      Q2           $16.74        $7.65         $12.13      $7.00

      Q3           $10.45        $5.35         $27.06     $10.25

      Q4            $9.49        $5.10         $16.50      $7.50
              --------------------------------------------------
</TABLE>

      At March 8, 2002, the Company had 501 stockholders of record.

      The Company has not paid any cash dividends and presently anticipates that
all of its future earnings will be retained for development of its business. The
Company does not anticipate paying cash dividends on its common stock in the
foreseeable future. The payment of any future dividends would be at the
discretion of the Company's Board of Directors and would depend upon, among
other things, future earnings, operations, capital requirements, the general
financial condition of the Company and general business conditions. Although the
Company's ability to pay dividends is not currently restricted by any of its
financing agreements, the Company may be subject to such restrictions in the
future.



                                     - 16 -
<PAGE>
ITEM 6. SELECTED FINANCIAL DATA.

                             APPLIED INNOVATION INC.

                      SELECTED CONSOLIDATED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                             Years Ended December 31,
                                                        2001             2000            1999           1998           1997
                                                    ------------    -------------    ------------    -----------   ------------
<S>                                                 <C>             <C>              <C>             <C>           <C>
OPERATING DATA:
  Sales                                             $ 73,019,150    $ 116,103,392    $ 49,523,619    $53,627,516   $ 46,661,054
  Cost of sales                                       39,251,716       75,906,065      20,917,459     22,236,650     20,091,096
                                                    ------------    -------------    ------------    -----------   ------------
     Gross profit                                     33,767,434       40,197,327      28,606,160     31,390,866     26,569,958

  Selling, general and administrative expenses        22,183,578       18,455,315      11,965,059     14,428,447     15,091,470
  Research and development expenses                    9,648,898        8,176,622       7,479,496     11,979,875     12,897,072
  Restructuring charges                                  292,330               --              --      3,800,000             --
                                                    ------------    -------------    ------------    -----------   ------------

     Total operating expenses                         32,124,806       26,631,937      19,444,555     30,208,322     27,988,542
                                                    ------------    -------------    ------------    -----------   ------------

     Income (loss) from operations                     1,642,628       13,565,390       9,161,605      1,182,544     (1,418,584)
                                                    ------------    -------------    ------------    -----------   ------------

  Interest income, net                                 1,389,517        1,374,546         992,665        614,705        535,409
  Other income (expense), net                            (39,179)         (20,934)        (68,189)     1,050,403       (134,020)
                                                    ------------    -------------    ------------    -----------   ------------
     Total other income, net                           1,350,338        1,353,612         924,476      1,665,108        401,389
                                                    ------------    -------------    ------------    -----------   ------------

     Income (loss) before income taxes                 2,992,966       14,919,002      10,086,081      2,847,652     (1,017,195)
  Income taxes                                           755,000        4,774,000       3,081,000        538,000       (380,000)
                                                    ------------    -------------    ------------    -----------   ------------
     Net income (loss)                              $  2,237,966    $  10,145,002    $  7,005,081    $ 2,309,652   $   (637,195)
                                                    ============    =============    ============    ===========   ============


  Basic earnings (loss) per share                   $       0.14    $        0.65    $       0.45    $      0.15   $      (0.04)
                                                    ============    =============    ============    ===========   ============
  Diluted earnings (loss) per share                 $       0.14    $        0.63    $       0.45    $      0.14   $      (0.04)
                                                    ============    =============    ============    ===========   ============

  Shares used in computing basic earnings
     (loss) per share                                 15,870,492       15,598,723      15,598,143     15,804,608     15,786,332
                                                    ============    =============    ============    ===========   ============

  Shares used in computing diluted earnings
     (loss) per share                                 16,140,993       16,014,153      15,647,050     15,962,846     15,786,332
                                                    ============    =============    ============    ===========   ============

BALANCE SHEET DATA:
  Cash and short-term and non-current
     investments                                    $ 28,616,130    $  26,274,009    $ 19,070,826    $17,211,499   $  8,195,156
  Net working capital                                 31,803,653       35,204,228      22,851,872     22,173,337     16,654,943
  Total assets                                        60,847,804       80,668,451      44,594,329     39,769,673     37,707,548
  Stockholders' equity                                50,903,912       49,991,620      37,087,664     31,642,683     29,402,982
</TABLE>

See notes to consolidated financial statements.


                                     - 17 -
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS.

SAFE HARBOR STATEMENT

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

OVERVIEW

      Applied Innovation Inc. develops, manufactures, and markets network
mediation and bridging products and related services to the telecommunications
industry. AI's products and services support the operation, maintenance,
administration and provisioning of a variety of switching and transmission
devices used by wireline and wireless telecommunications providers to assist in
the management of their customer service networks. AI's primary emphasis is on
providing integrated hardware, software, service and turnkey network management
solutions. The Company's largest customers are the four RBOCs, other large
domestic and foreign phone companies, and certain CLECs.

      Through the AIswitch(TM), AIscout(TM), AIflex(TM), AIspy(TM), and
AIbadger(TM) products, and the related AppliedView(TM), NEweb(TM), and
AIwatch(TM) software, AI provides the data network needed to monitor and
maintain thousands of pieces of electronic equipment used to deliver
telecommunication services. The Company's Services Division combines a number of
customer-focused services, including network systems planning and design,



                                     - 18 -
<PAGE>
systems integration, testing, installation, systems deployment and training.
In 2000, the Company announced the formation of LuxPath Networks, a new division
focusing on broadband Ethernet aggregation and transport products which provide
high-capacity, carrier-quality fiber optic transmission solutions. In 2001, the
Company had its first sale and successful deployment of that division's flagship
product, LuxConnect(TM). Also in 2001, AI acquired certain assets of the remote
network management systems and information collection device business of Badger
Technology, Inc. ("Badger"). The acquisition enables the Company to target the
wireless telecommunications market with its wireless network management and
information collection products.

      During the last twelve to eighteen months, the telecommunications industry
has undergone a dramatic and severe slowdown. Telecommunications service
providers have repeatedly reduced planned capital spending, have laid-off
workers, and some have gone into bankruptcy proceedings and/or ceased
operations. The spending cutbacks have affected the Company through reduced
product orders, even by our largest and most financially secure RBOC customers,
and also started to negatively impact service sales in the second half of 2001.
We cannot predict when this trend will reverse. Given the uncertainty regarding
our customers' near-term spending plans and the effect on near-term sales, the
Company has reduced its staffing level through two actions. In June 2001, the
Company reduced headcount by approximately 40 personnel, or 15%, and again in
February 2002, by approximately 50 personnel, or 16%. The Company believes that
the cost savings associated with these staffing reductions, as well as other
cost-saving measures enacted, will more closely align the Company's operating
expenses with near-term sales prospects.

      We believe that in the long-term, large domestic service providers will
resume spending on network equipment and our product sales will increase.
Despite the negative impact on domestic product sales in the near-term, the
Company remains optimistic about domestic and international opportunities in the
wireless market in 2002. Further, as a result of our expanded international
sales efforts over the last year, including establishing sales distributors and
customer quotations and product trials, we expect international sales growth in
2002. We also expect growth in 2002 services sales, largely driven by network
design, installation and maintenance of operating support system software.

COMPARISON OF 2001 TO 2000

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

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


                                     - 19 -
<PAGE>
      The following table summarizes sales and gross profit for products,
integration and services:

<TABLE>
<CAPTION>
                           For the Year Ended December 31, 2001                        For the Year Ended December 31, 2000
                 -------------------------------------------------------    -------------------------------------------------------

                   Products    Integration     Services        Total         Products      Integration     Services       Total
                 -----------   -----------    -----------    -----------    -----------    -----------    ----------   ------------
<S>              <C>           <C>            <C>            <C>            <C>            <C>            <C>          <C>
Sales            $52,841,000    $5,830,000    $14,348,000    $73,019,000    $64,030,000    $45,644,000    $6,429,000   $116,103,000
Gross Profit      28,190,000       866,000      4,711,000     33,767,000     34,740,000      2,682,000     2,775,000     40,197,000
Gross Profit %       53%           15%            33%            46%            54%             6%           43%            35%
</TABLE>

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

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

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

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

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


                                     - 20 -
<PAGE>

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

      Because of the Company's concentration of sales to RBOCs, long distance
phone companies, and large CLECs, a small number of customers have historically
comprised a substantial portion of the Company's sales. Sales to four customers
comprised 66% of sales in 2001, with each contributing between 13% and 23% of
sales. Because of the direct correlation and relative importance of these
significant customers' capital spending patterns to the Company, deviations from
historical spending levels could significantly impact the Company's future
operating results.

      Selling, general and administrative ("SG&A") expenses increased to
$22,184,000 in 2001 from $18,455,000 in 2000. As a percentage of total sales,
this represents 30% in 2001 and 16% in 2000. The increase in SG&A spending was
primarily attributable to increased staffing, additional personnel and costs
associated with the Badger acquisition, increased international travel and
selling expenses and higher insurance costs. In addition, SG&A expenses as a
percentage of total sales increased due to the decrease in integration sales in
the current year as compared to the prior year. As a result of staffing
reductions in June 2001 and in February 2002, the Company anticipates that total
SG&A expenses for 2002 will be slightly lower than 2001, but with certain
specific increases anticipated as the Company further pursues opportunities in
the international and wireless markets.

      Research and development ("R&D") expenses were $9,649,000 in 2001 and
$8,177,000 in 2000. As a percentage of total sales, this represents 13% for 2001
and 7% for 2000. The increase in R&D expenses was primarily attributable to
increased staffing costs to support product development associated with
international and wireless opportunities. The decrease in integration sales in
2001 as compared to 2000 also contributed to the increase in R&D expenses as a
percentage of total sales. The Company expects 2002 R&D spending to decrease
compared to 2001. However, the Company continues to invest in the enhancement of
existing products and development of new products to meet constantly changing
customer and industry needs.

      The Company recorded a non-recurring charge to operating expenses of
$292,000 in the second quarter of 2001 to account for an approximate 15%
reduction in workforce, or approximately 40 employees, throughout all
departments. This restructuring charge is separately stated on the consolidated
statements of earnings and reflects estimated severance and fringe benefit costs
associated with the termination of employees. The Company has paid out all such
costs as of December 31, 2001. As a further response to the continued industry
slowdown, the Company initiated an additional 16% reduction in workforce, or
approximately 50 employees, in the first quarter of 2002. Again across all
departments, the reduction in workforce resulted in restructuring charges of
approximately $650,000 in that quarter for estimated severance and other
personnel costs. The Company expects to pay out such costs through the remainder
of 2002. As a result of the restructuring and other enacted cost reductions,


                                     - 21 -
<PAGE>
the Company anticipates reducing its annual costs by approximately $4,500,000.
No additional workforce reductions or other cost reduction actions are currently
planned, however the Company will continue to monitor industry conditions and
will take corrective action as industry conditions change.

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

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

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

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

      Primarily due to the impact of the high volume of digital subscriber line
("DSL") systems integration work being performed late in the year ended December
31, 2000, several balance sheet accounts changed significantly between December
31, 2000 and December 31, 2001. The volume of such DSL systems integration work
declined significantly during the first quarter of 2001, and was non-existent
during the remainder of 2001. As a result, net inventory decreased from
$12,009,000 at December 31, 2000, to $7,322,000 at December 31, 2001, while
accounts payable decreased from $19,826,000 to $2,993,000. These decreases are
due to the high volume of DSL equipment inventory and associated trade payables
used to support a large systems integration project for one customer in the
second half of 2000. Net accounts receivable decreased from $29,991,000 at
December 31, 2000 to $7,697,000 at December 31, 2001, partially due to a
decrease of $11,118,000 for the same DSL systems integration customer. In
addition, accounts receivable at December 31, 2000 included significant amounts
related to software and annual maintenance agreements which were invoiced in
December 2000 and which did not exist at December 31, 2001 due primarily to
timing of the agreements and related invoices and payments. The December 31,
2001 consolidated balance sheet also includes goodwill of $3,423,000 and net
intangible assets of $551,000 as a result of the Badger acquisition in 2001.

COMPARISON OF 2000 TO 1999

      Sales for the year ended December 31, 2000 were $116,103,000, a 134%
increase from the prior year's sales of $49,524,000. Strong demand for the
Company's integration and services business, including integrated digital
subscriber line solutions, accounted for approximately $50,000,000 of the
increase. Additionally, higher demand for the Company's AIscout(TM),
AIswitch(TM), and AI130 products accounted for approximately $17,000,000 of the
increase. Because of the Company's concentration of sales to RBOCs, long
distance phone companies, and large CLECs, a small number of customers have


                                     - 22 -
<PAGE>
historically represented substantial portions of AI's sales. Two companies
accounted for 61% of net sales in 2000. These two customers contributed 47% and
14% of sales, respectively.

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

<TABLE>
<CAPTION>
                    For the Year Ended December 31, 2000                      For the Year Ended December 31, 1999
                -------------------------------------------                  ---------------------------------------

                  Products      Integration      Services         Total        Products    Integration     Services        Total
                ------------   ------------    ------------   ------------   ------------  -----------  ------------   ------------
<S>             <C>            <C>             <C>            <C>            <C>           <C>          <C>            <C>
Sales           $ 64,030,000   $ 45,644,000    $  6,429,000   $116,103,000   $ 46,967,000    $ --       $  2,557,000   $ 49,524,000
Gross Profit      34,740,000      2,682,000       2,775,000     40,197,000     27,709,000      --            897,000     28,606,000
Gross Profit %       54%             6%             43%            35%            59%          --            35%            58%
</TABLE>

      Product sales of $64,030,000 were 55% of total sales in 2000, versus
product sales of $46,967,000, or 95%, of total sales in 1999. This represented a
36% increase in product sales from the year 1999 to the year 2000. Product sales
include revenues from the sales of AIswitch(TM), AIscout(TM), and other
products, as well as software licensing revenues from NEweb(TM) and
AppliedView(TM).

      Integration revenues were $45,644,000 or 39% of total sales in 2000, and
were substantially all from one customer. There were no such sales in prior
years. Integration revenue consists of turnkey integrated systems and includes a
significant amount of third-party products integrated with the Company's
products.

      Services revenues of $6,429,000 were 6% of 2000 sales, versus services
revenues of $2,557,000, or 5% of 1999 sales. This represented a 151% increase in
services revenues from the prior year. Services revenues consist of project
management, installation and other services for our customers.

      Gross profit, as a percentage of total sales, was 35% in 2000, compared to
58% in 1999. Gross profit on product sales was 54% in 2000, compared with 59% in
1999. The decrease in gross profit as a percentage of product sales was
primarily attributable to a higher sales mix of products that have slightly
lower gross margins, such as the AIscout(TM), the AI130 and the AppliedView(TM)
systems' hardware support equipment. Gross profit on services sales was 43% in
2000, compared to 35% in 1999. Integration gross profit as a percentage of
integration sales was 6%. The percentage was significantly lower than the gross
profit percentage achieved on products and services due to the large amount of
third-party equipment costs.

      SG&A expenses increased to $18,455,000 (16% of sales) in 2000 from
$11,965,000 (24% of sales) in 1999. The increase in SG&A spending was primarily
attributable to new sales, sales engineering and senior management positions,
increased expenditures for the integration and services division, and higher
marketing expenditures.

      R&D expenses increased to $8,177,000 (7% of sales) in 2000 from $7,480,000
(15% of sales) in 1999. This was a result of additional staffing and
expenditures on new product initiatives, including LuxPath Networks' fiber optic
products.


                                     - 23 -
<PAGE>
      As a result of the above changes in sales and expenses, 2000 income from
operations increased to $13,565,000 from $9,162,000 in 1999. Income from
operations represented 12% of sales in 2000, compared to 19% of sales in 1999.

      Other income, which consists primarily of interest income on the Company's
investments, increased to $1,354,000 in 2000, versus $924,000 in 1999, due to a
higher average investment balance in 2000.

      Income before income taxes in 2000 was $14,919,000, compared to
$10,086,000 in 1999.

      The effective income tax rate was 32% in 2000 compared to 31% in 1999.

      Net income was $10,145,000, or $0.63 diluted earnings per share in 2000
versus net income of $7,005,000, or $0.45 diluted earnings per share in 1999.
The diluted weighted-average number of shares was 16,014,000 for 2000 compared
to 15,647,000 for 1999.

LIQUIDITY AND CAPITAL RESOURCES

      The Company had $28,616,000 of cash and cash equivalents and short- and
long-term investments at December 31, 2001 compared to $26,274,000 at December
31, 2000. During 2001, operating activities provided cash of $10,167,000. Cash
flow from operations resulted from net income, adjusted for non-cash items and
changes in operating assets and liabilities. Non-cash adjustments related
primarily to depreciation expense, provision for doubtful accounts and the tax
benefit associated with stock option exercises. Changes in operating assets and
liabilities resulted primarily from significant decreases in accounts receivable
and inventories, partially offset by decreases in accounts payable and accrued
expenses. Those balance sheet changes were attributable to the significant DSL
systems integration project that was in process at the end of 2000 and completed
in 2001. Investing activities in 2001 used $6,475,000 in cash, including
$1,825,000 for equipment purchases to support operations, $4,045,000 related to
the Badger acquisition and $639,000 for investment securities purchases (net of
maturities and sales). Additionally, financing activities used $2,014,000 of
cash in 2001, including $3,028,000 to repurchase common stock, partially offset
by $1,014,000 of proceeds from the issuance of common stock.

      Net working capital was $31,804,000 at December 31, 2001 compared to
$35,204,000 at December 31, 2000. At December 31, 2001, the current ratio was
4.5:1 and the Company's only debt outstanding was a $750,000 note payable issued
in conjunction with the Badger acquisition. The note payable bears interest at
an annual rate of 8%, with interest payments due semi-annually and principal due
at maturity in August 2004.

      On September 14, 2001, the Company's Board of Directors authorized a stock
repurchase program under which the Company may purchase up to 1,500,000 shares
of common stock over the next twelve months. As of December 31, 2001, 445,300
shares had been repurchased under this program at an average price of $6.80 per
share, for an aggregate price of $3,028,000.


                                     - 24 -
<PAGE>
      At the April 26, 2001 Annual Meeting of Stockholders, the Amended and
Restated Certificate of Incorporation was approved and adopted which increased
the number of authorized shares of the Company's common stock, $.01 par value,
from 30,000,000 to 55,000,000 shares and which authorized the issuance of
5,000,000 shares of preferred stock, $.01 par value. At December 31, 2001, the
Company had 15,512,899 shares of common stock issued and outstanding and no
shares of preferred stock issued and outstanding.

      The Company believes that its existing cash, cash equivalents, investments
and cash to be generated from future operations will provide sufficient capital
to meet the business needs of the Company through the end of 2002. However, if
the Company's working capital needs significantly increase due to circumstances
such as sustained weakness in the telecommunications industry resulting in
decreased demand for the Company's products and services and operating losses,
or alternatively, faster than expected growth resulting in increased accounts
receivable and inventory, significant stock repurchase activity, additional
acquisition activity, or significant research and development efforts, the
Company may seek to fund these requirements through a line of credit, other
debt, issuance of additional equity or sale of land.

CRITICAL ACCOUNTING POLICIES

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

Revenue Recognition

      Revenue is generally recognized on product and integration sales as
products are delivered and ownership and risk of loss are transferred. In
certain situations, customers may request that products are built and prepared
for shipment but held temporarily by the Company on the customer's behalf. In
those instances, revenue is recognized when all other terms and obligations of
the sale are met, including transfer of ownership and risk of loss.

      The Company also derives revenue from the sale of internally developed
software and related maintenance and support agreements. Basic revenue
recognition criteria related to software sales include the following four
elements: (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. Revenue associated with software maintenance and support
agreements is recognized straight-line over the term of the related agreement.

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


                                     - 25 -
<PAGE>
Sales Return Allowances

      Other than issues involving warranty claims, customers generally do not
have the right to return products. However, in certain limited circumstances as
defined in contracts, customers are permitted to return products. The Company
establishes a sales return allowance reflecting its estimate of such product
returns. The estimate is based on a number of factors, including the contract
provisions, the Company's understanding of each customer's forecasted usage of
previously purchased products and the estimated likelihood that customers will
return products.

Allowance for Doubtful Accounts

      The Company provides its customers with credit on purchases, generally
requiring payment within thirty days from delivery. Since the Company's customer
base is generally comprised of very large, well-funded service providers, the
Company's historical credit risk has been very low. However, the Company does
establish allowances against accounts receivable for potentially uncollectible
amounts. The Company estimates the necessary allowance based on an analysis of
customers' past payment practices and any known factors concerning their current
financial condition. To the extent any customers unexpectedly become insolvent
or unable to pay amounts due, the allowance estimates may be incorrect. Over the
last twelve months, many telecommunications service providers, including some
that have historically been customers of the Company, have experienced financial
challenges. The Company did not have any significant exposure to bankruptcies
among our customers. Further, the Company has not historically provided vendor
financing to its customers, and currently has no plans to do so.

Inventory

      The Company records inventory utilizing standard costs, which approximate
actual costs on a first-in, first-out basis. Additionally, the Company carries
inventory at the lower of cost or market. The Company periodically estimates its
necessary reserve for inventory obsolescence to ensure inventory balances are
properly stated. Such estimates are based on inventory quantities on hand, sales
forecasts for particular products, overall industry trends that may affect
individual product lines, as well as fluctuations in component prices from
suppliers. In 2001, the Company recorded $1,700,000 of inventory charges,
primarily related to weaker than expected demand for optical products. Continued
weak demand and falling component prices for optical transmission products could
impact the valuation of the Company's optical inventory. Likewise, decreases in
component part prices for the Company's general inventory could impact inventory
valuations.

Intangible Assets and Goodwill

      The Company has certain intangible assets resulting from business
acquisitions which are recorded at cost. These intangible assets are amortized
straight-line over their respective estimated economic lives, generally up to
three years, and reviewed for impairment under certain circumstances. Goodwill,
representing the excess of purchase price over the fair value of the net assets
acquired, is not subject to periodic amortization but is also periodically
reviewed for impairment.

Warranty

      The Company generally warrants its products for one year, with negotiated
warranties available up to five years. Based primarily on historical experience,
the Company estimates its expected future warranty costs and accrues such costs
at the time of sale. Warranty costs generally consist of labor and materials to


                                     - 26 -
<PAGE>
repair defective parts, replacement parts, shipping costs to replace materials,
and labor and travel costs associated with customer site visits to repair
products or correct prior service work. The Company's overall warranty costs
have been decreasing over the past several years, primarily due to improved
product quality. However, as the Company introduces new products using new
technology or if defects are found in widely distributed products, such costs
could increase in the future.

Income Taxes

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

Stock-Based Compensation

      Under various stock option plans, the Company has issued stock options to
employees and members of the Company's Board of Directors. The Company applies
the intrinsic value-based method of accounting for its fixed plan stock options
and therefore must record compensation expense for any options granted with an
exercise price less than the current market price at the date of grant. Because
the Company has not granted any options with exercise prices less than market
prices at the date of grant, the Company has not recorded any compensation
expense in its consolidated statements of earnings. Had the Company utilized a
fair value-based method of accounting for its stock options rather than an
intrinsic value-based method, the Company would have recognized additional
compensation expense, net of related tax effects, of approximately $2,734,000,
$1,297,000 and $486,000 for the years ended December 31, 2001, 2000 and 1999,
respectively.

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

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

      The Company is obligated over the next two years for office space and
office equipment under various operating leases. Future minimum lease payments
under these leases are $297,000 in 2002 and $37,000 in 2003.

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


                                     - 27 -
<PAGE>
IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

      In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement No. 141, "Business Combinations", and Statement No. 142, "Goodwill and
Other Intangible Assets". Statement 141 requires that the purchase method of
accounting be used for all business combinations initiated after June 30, 2001
as well as all purchase method business combinations completed after June 30,
2001. Statement 142 will require that goodwill and intangible assets with
indefinite useful lives no longer be amortized, but instead be tested for
impairment at least annually in accordance with the provisions of Statement 142.
Statement 142 will also require that intangible assets with estimable useful
lives be amortized over their respective estimated useful lives to their
estimated residual values, and reviewed for impairment in accordance with FASB
Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of".

      Because the Company had not consummated any business combinations prior to
its acquisition of Badger's remote network management systems and information
collection device business on August 15, 2001, these pronouncements have no
impact on any prior business combinations. In accordance with these
pronouncements, the Badger acquisition was accounted for under the purchase
method of accounting. Intangible assets resulting from the acquisition are being
amortized over their respective estimated useful lives and will be reviewed for
impairment, while goodwill is not being amortized but will instead be tested for
impairment, as prescribed by the pronouncements.

      In August 2001, the FASB issued Statement No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets", which supersedes both Statement
121 and the accounting and reporting provisions of Accounting Principles Board
Opinion No. 30, "Reporting the Results of Operations - Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions", which relates to the disposal of a segment
of a business. Statement 144 retains the fundamental provisions in Statement 121
for recognizing and measuring impairment losses on long-lived assets held for
use and long-lived assets to be disposed of by sale, while also resolving
significant implementation issues associated with Statement 121.

      The Company is required to adopt Statement 144 no later than the year
beginning after December 15, 2001, and plans to adopt its provisions for the
quarter ending March 31, 2002. Management does not expect the adoption of
Statement 144 for long-lived assets held for use to have a material impact on
the Company's financial statements because the impairment assessment under
Statement 144 is largely unchanged from Statement 121. The provisions of
Statement 144 for assets held for sale or other disposal generally are required
to be applied prospectively after the adoption date to newly initiated disposal
activities.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

      The Company does not have any material exposure to interest rate changes,
commodity price changes, foreign currency fluctuations, or similar market risks.
Furthermore, the Company has not entered into any derivative contracts. Related
to the Badger acquisition, the Company has a $750,000 note payable, bearing
interest at a fixed rate of 8% annually and due in August 2004.


                                     - 28 -
<PAGE>
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

      The Company's consolidated balance sheets as of December 31, 2001 and
2000, and the related consolidated statements of earnings, stockholders' equity,
and cash flows for the years ended December 31, 2001, 2000 and 1999, appear on
pages F-1 through F-17 hereof, and are incorporated herein by reference. The
Company's financial statement schedule and the Independent Auditors' Report on
the financial statement schedule are included in the response to Item 14 below.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE.

      None.


                                     - 29 -
<PAGE>
                                    PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

      The information required by this item is included under the caption
"ELECTION OF DIRECTORS" on pages 4 through 8 of the Company's Proxy Statement
relating to the Company's Annual Meeting of Stockholders to be held on April 25,
2002 (the "Proxy Statement"), and under the caption "SECTION 16(a) BENEFICIAL
OWNERSHIP REPORTING COMPLIANCE" on page 21 of the Proxy Statement and is
incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION.

      The information required by this item is included under the caption
"ELECTION OF DIRECTORS" on pages 9 through 14 of the Proxy Statement and is
incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

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

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

      The information required by this item is included under the caption
"ELECTION OF DIRECTORS - Related Party Transactions" on pages 12 through 13 of
the Proxy Statement and is incorporated herein by reference.

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

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

      Independent Auditors' Report

      Consolidated Balance Sheets as of December 31, 2001 and 2000.

      Consolidated Statements of Earnings for the years ended December 31, 2001,
      2000, and 1999.

      Consolidated Statements of Stockholders' Equity for the years ended
      December 31, 2001, 2000 and 1999.

      Consolidated Statements of Cash Flows for the years ended December 31,
      2001, 2000 and 1999.

      Notes to Consolidated Financial Statements.


                                     - 30 -
<PAGE>
(a)(2) The following documents are filed as part of this report:

       Independent Auditors' Report

       Schedule II (Valuation and Qualifying Accounts)

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

<TABLE>
<CAPTION>
EXHIBIT NO.                            DESCRIPTION
<S>             <C>
      3.1       Amended and Restated Certificate of Incorporation of the
                Company. (Reference is made to Appendix C to the Company's
                Definitive Proxy Statement for the 2001 Annual Meeting of
                Stockholders held on April 26, 2001, filed with the Securities
                and Exchange Commission on March 23, 2001, and incorporated
                herein by reference).

      3.2       By-laws of the Company, as amended. (Reference is made to
                Exhibit 3.2 to the Company's Registration Statement on Form
                10-SB, filed with the Securities and Exchange Commission on
                March 10, 1993, and incorporated herein by reference).

      10.1      Company's Amended and Restated 1986 Incentive Stock Option Plan,
                including form of Stock Option Agreement. (Reference is made to
                Exhibit 10.1 to the Company's Registration Statement on Form
                10-SB, filed with the Securities and Exchange Commission on
                March 10, 1993, and incorporated herein by reference).

      10.2      Company's 1986 Amended and Restated Non-Statutory Stock Option
                Plan, including form of Stock Option Agreement. (Reference is
                made to Exhibit 10.2 to the Company's Registration Statement on
                Form 10-SB, filed with the Securities and Exchange Commission on
                March 10, 1993, and incorporated herein by reference).

      10.3      Form of Confidentiality, Assignment and Non-Competition
                Agreement between he Company and employee officers. (Reference
                is made to Exhibit 10.3 to the Company's Registration Statement
                on Form 10-SB, filed with the Securities and Exchange Commission
                on March 10, 1993, and incorporated herein by reference).

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

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

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


                                     - 31 -
<PAGE>
<TABLE>
<S>             <C>

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

      10.8      Employment Agreement between the Company and Robert L. Smialek.
                (Reference is made to Exhibit 10.1 to the Company's Quarterly
                Statement on Form 10-Q, filed with the Securities and Exchange
                Commission on November 14, 2000, and incorporated herein by
                reference).

      10.9      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).

      10.10     Employment Agreement between the Company and Michael P. Keegan.
                (Reference is made to Exhibit 10.11 to the Company's Annual
                Report on Form 10-K, filed with the Securities and Exchange
                Commission on March 27, 2001, and incorporated herein by
                reference).

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

      10.12     Employment Agreement between the Company and Tom McCabe.
                (Reference is made to Exhibit 10.1 to the Company's Quarterly
                Statement on Form 10-Q, filed with the Securities and Exchange
                Commission on November 14, 2001, and incorporated herein by
                reference).

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

      10.14     Employment Agreement between the Company and Joe Govern.
                (Reference is made to Exhibit 10.3 to the Company's Quarterly
                Statement on Form 10-Q, filed with the Securities and Exchange
                Commission on November 14, 2001, and incorporated herein by
                reference).

      10.15     Employment Agreement between the Company and Kathy Brooks
                (formerly Kathy Barrick). (Reference is made to Exhibit 10.4 to
                the Company's Quarterly Statement on Form 10-Q, filed with the
                Securities and Exchange Commission on November 14, 2001, and
                incorporated herein by reference).
</TABLE>


                                     - 32 -
<PAGE>
<TABLE>
<S>             <C>
      10.16     Company's 2001 Stock Incentive Plan. (Reference is made to
                Appendix B to the Registrant'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).

      10.17*    Employment Agreement between the Company and William J.
                Mrukowski.

      23*       Consent of KPMG LLP.

      24*       Power of Attorney.
      ------------
      *         Filed herewith.
</TABLE>


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

(c)   Exhibits - The exhibits to this report follow page F-17.

(d)   Financial Statement Schedules - The financial statement schedule and the
      independent auditors' report thereon follows the signature page.



                                     - 33 -
<PAGE>
                                   SIGNATURES

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

                                     APPLIED INNOVATION INC.


Date: March 25, 2002                 By: /s/ Robert L. Smialek
                                         -------------------------------------
                                         Robert L. Smialek,
                                         President and Chief Executive Officer

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

<TABLE>
<CAPTION>
         SIGNATURE                                   TITLE                                   DATE
         ---------                                   -----                                   ----
<S>                                         <C>                                         <C>
* Gerard B. Moersdorf, Jr.                  Chairman of the Board                       March 25, 2002
---------------------------------           and Director
Gerard B. Moersdorf, Jr.

/s/ Robert L. Smialek                       President and                               March 25, 2002
---------------------------------           Chief Executive Officer
Robert L. Smialek                           and Director
                                            (Principal Executive Officer)

/s/ Michael P. Keegan                       Vice President,                             March 25, 2002
---------------------------------           Chief Financial Officer
Michael P. Keegan                           and Treasurer
                                            (Principal Financial and
                                            Principal Accounting Officer)

* Michael J. Endres                         Director                                    March 25, 2002
---------------------------------
Michael J. Endres

* Curtis A. Loveland                        Director                                    March 25, 2002
---------------------------------
Curtis A. Loveland

* Gerard B. Moersdorf, Sr.                  Director                                    March 25, 2002
---------------------------------
Gerard B. Moersdorf, Sr.

* Richard W. Oliver                         Director                                    March 25, 2002
---------------------------------
Richard W. Oliver
</TABLE>


                                     - 34 -
<PAGE>
<TABLE>
<S>                                         <C>                                         <C>
* Thomas W. Huseby                          Director                                    March 25, 2002
---------------------------------
Thomas W. Huseby

* Alexander B. Trevor                       Director                                    March 25, 2002
---------------------------------
Alexander B. Trevor

* William H. Largent                        Director                                    March 25, 2002
---------------------------------
William H. Largent

*By: /s/ Robert L. Smialek
     ----------------------------
     Robert L. Smialek
     (Attorney-in-Fact)
</TABLE>


                                     - 35 -
<PAGE>
                          INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Applied Innovation Inc.:

Under date of February 5, 2002, we reported on the consolidated balance sheets
of Applied Innovation Inc. and subsidiary as of December 31, 2001 and 2000, and
the related consolidated statements of earnings, stockholders' equity, and cash
flows for each of the years in the three-year period ended December 31, 2001,
which are included herein. In connection with our audits of the aforementioned
consolidated financial statements, we also audited the related financial
statement schedule of valuation and qualifying accounts. This financial
statement schedule is the responsibility of the Company's management. Our
responsibility is to express an opinion on this financial statement schedule
based on our audits.

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


/s/ KPMG LLP

Columbus, Ohio
February 5, 2002






                                     - 36 -
<PAGE>
                             APPLIED INNOVATION INC.
                 SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
              FOR THE YEARS ENDED DECEMBER 31, 1999, 2000 AND 2001

<TABLE>
<CAPTION>
Column A                                         Column B             Column C                Column D        Column E
--------                                         --------             --------                --------        --------
                                                              /---------Additions--------/
                                                Balance at      Charged to     Charged to
                                               beginning of     costs and        other                       Balance at
Description                                       period         expense        accounts     Deductions    end of period
-----------                                       ------         -------        --------     ----------    -------------
<S>                                            <C>            <C>              <C>           <C>           <C>
YEAR ENDED DECEMBER 31, 1999:
     Allowance for doubtful accounts           $   256,117    $   162,103      $      --     $  100,673    $    317,547
     Allowance for obsolete inventory              160,000             --             --             --         160,000
     Warranty provision                          2,644,738      1,602,570             --      2,369,577       1,877,731

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

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


                                     - 37 -
<PAGE>
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

<TABLE>
<S>                                                                             <C>
Independent Auditors' Report ................................................   F-1

Consolidated Balance Sheets as of December 31, 2001 and 2000 ................   F-2

Consolidated Statements of Earnings for the fiscal years ended December 31,
       2001, 2000, and 1999 .................................................   F-3

Consolidated Statements of Stockholders' Equity for the fiscal years ended
       December 31, 2001, 2000, and 1999 ....................................   F-4

Consolidated Statements of Cash Flows for the fiscal years ended December 31,
       2001, 2000, and 1999 .................................................   F-5

Notes to Consolidated Financial Statements ..................................   F-6
</TABLE>
<PAGE>
                          INDEPENDENT AUDITORS' REPORT

The Board of Directors and Stockholders
Applied Innovation Inc.:

We have audited the accompanying consolidated balance sheets of Applied
Innovation Inc. and subsidiary as of December 31, 2001 and 2000, and the related
consolidated statements of earnings, stockholders' equity, and cash flows for
each of the years in the three-year period ended December 31, 2001. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Applied Innovation
Inc. and subsidiary as of December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2001, in conformity with accounting principles generally
accepted in the United States of America.


/s/ KPMG LLP

Columbus, Ohio
February 5, 2002


                                       F-1
<PAGE>
                             APPLIED INNOVATION INC.
                           Consolidated Balance Sheets

<TABLE>
<CAPTION>
                                                                                        December 31,
                                                                                        ------------
Assets                                                                             2001               2000
                                                                               ------------       ------------
<S>                                                                            <C>                <C>
Current assets:
   Cash and cash equivalents                                                   $ 15,698,594       $ 14,020,080
   Short term investments                                                         6,067,770          6,386,236
   Accounts receivable, net of allowance of $475,000 in 2001
     and $690,602 in 2000                                                         7,697,003         29,990,699
   Inventory, net                                                                 7,322,316         12,009,060
   Income taxes                                                                     903,269                 --
   Other current assets                                                             630,593            852,984
   Deferred income taxes                                                          2,678,000          2,642,000
                                                                               ------------       ------------
         Total current assets                                                    40,997,545         65,901,059

Property, plant and equipment, net                                                8,823,355          8,612,658
Investments                                                                       6,849,766          5,867,693
Intangible assets, net of accumulated amortization of $213,750 in 2001              551,250                 --
Goodwill                                                                          3,423,201                 --
Other assets                                                                        202,687            307,041
                                                                               ------------       ------------

                                                                               $ 60,847,804       $ 80,688,451
                                                                               ============       ============

Liabilities and Stockholders' Equity

Current liabilities:
   Accounts payable                                                            $  2,992,537       $ 19,825,749
   Accrued expenses:
     Warranty                                                                       819,166          1,334,786
     Income taxes                                                                        --          2,391,402
     Payroll and related expenses                                                 1,512,229          2,460,907
     Other accrued expenses                                                         379,888            742,930
   Deferred revenue                                                               3,490,072          3,941,057
                                                                               ------------       ------------
         Total current liabilities                                                9,193,892         30,696,831

Note payable                                                                        750,000                 --
                                                                               ------------       ------------
         Total liabilities                                                        9,943,892         30,696,831

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 15,512,899 shares in 2001 and 15,808,479 shares in 2000            155,129            158,085
   Additional paid-in capital                                                     8,659,450         10,081,936
   Note receivable for common stock                                                (494,871)          (600,000)
   Retained earnings                                                             42,535,717         40,297,751
   Accumulated other comprehensive gain, net                                         48,487             53,848
                                                                               ------------       ------------

         Total stockholders' equity                                              50,903,912         49,991,620
                                                                               ------------       ------------

                                                                               $ 60,847,804       $ 80,688,451
                                                                               ============       ============
</TABLE>

See accompanying notes to consolidated financial statements.


                                       F-2
<PAGE>
                             APPLIED INNOVATION INC.
                       Consolidated Statements of Earnings

<TABLE>
<CAPTION>
                                                                Years ended December 31,
                                                  ---------------------------------------------------
                                                      2001                2000               1999
                                                  ------------       -------------       ------------
<S>                                               <C>                <C>                 <C>
Sales:
  Products and integration                        $ 58,670,859       $ 109,673,655       $ 46,967,009
  Services                                          14,348,291           6,429,737          2,556,611
                                                  ------------       -------------       ------------
     Total sales                                    73,019,150         116,103,392         49,523,620

Cost of sales:
  Cost of sales - products and integration          29,614,268          72,252,187         19,258,208
  Cost of sales - services                           9,637,448           3,653,878          1,659,252
                                                  ------------       -------------       ------------
     Total cost of sales                            39,251,716          75,906,065         20,917,460
                                                  ------------       -------------       ------------

     Gross profit                                   33,767,434          40,197,327         28,606,160

Operating expenses:
  Selling, general and administrative               22,183,578          18,455,315         11,965,059
  Research and development                           9,648,898           8,176,622          7,479,496
  Restructuring charges                                292,330                  --                 --
                                                  ------------       -------------       ------------
     Total operating expenses                       32,124,806          26,631,937         19,444,555
                                                  ------------       -------------       ------------

     Income from operations                          1,642,628          13,565,390          9,161,605

Other income (expense):
  Interest income, net                               1,389,517           1,374,546            992,665
  Other expense, net                                   (39,179)            (20,934)           (68,189)
                                                  ------------       -------------       ------------
     Total other income, net                         1,350,338           1,353,612            924,476
                                                  ------------       -------------       ------------

     Income before income taxes                      2,992,966          14,919,002         10,086,081
Income taxes                                           755,000           4,774,000          3,081,000
                                                  ------------       -------------       ------------
     Net income                                   $  2,237,966       $  10,145,002       $  7,005,081
                                                  ============       =============       ============

Earnings per share:
     Basic earnings per share                     $       0.14       $        0.65       $       0.45
                                                  ============       =============       ============
     Diluted earnings per share                   $       0.14       $        0.63       $       0.45
                                                  ============       =============       ============

Weighted-average shares outstanding
  for basic earnings per share                      15,870,492          15,598,723         15,598,143
                                                  ============       =============       ============

Weighted-average shares outstanding
  for diluted earnings per share                    16,140,993          16,014,153         15,647,050
                                                  ============       =============       ============
</TABLE>

See accompanying notes to consolidated financial statements.


                                       F-3
<PAGE>
                             APPLIED INNOVATION INC.
                 Consolidated Statements of Stockholders' Equity

<TABLE>
<CAPTION>
                                     Common stock
                               ------------------------                      Note                      Accumulated
                                 Number                     Additional    receivable                  other compre-
                                of shares                    paid-in      for common     Retained     hensive gain
                               outstanding     Amount        capital         stock       earnings      (loss), net       Totals
                               -----------    ---------    ------------   ----------    -----------   -------------   ------------
<S>                            <C>            <C>          <C>            <C>           <C>           <C>             <C>
Balance - December 31, 1998     15,786,132    $ 157,861    $  8,337,154    $      --    $23,147,668     $     --      $ 31,642,683

Comprehensive income:
   Net income                           --           --              --           --      7,005,081           --         7,005,081
   Unrealized loss on
        investments, net                --           --              --           --             --      (20,280)          (20,280)
                                                                                                                      ------------
Total comprehensive income                                                                                               6,984,801
Common stock repurchased          (414,200)      (4,142)     (1,535,678)          --             --           --        (1,539,820)
                               -----------    ---------    ------------    ---------    -----------     --------      ------------
Balance - December 31, 1999     15,371,932      153,719       6,801,476           --     30,152,749      (20,280)       37,087,664

Comprehensive income:
   Net income                           --           --              --           --     10,145,002           --        10,145,002
   Unrealized gain on
     investments, net                   --           --              --           --             --       74,128            74,128
                                                                                                                      ------------
Total comprehensive income                                                                                              10,219,130
Stock options exercised            336,547        3,366       1,670,573           --             --           --         1,673,939
Sale of stock to officer           100,000        1,000       1,199,000     (600,000)            --           --           600,000
Tax benefit associated with
   exercise of stock options            --           --         410,887           --             --           --           410,887
                               -----------    ---------    ------------    ---------    -----------     --------      ------------
Balance - December 31, 2000     15,808,479      158,085      10,081,936     (600,000)    40,297,751       53,848        49,991,620

Comprehensive income:
   Net income                           --           --              --           --      2,237,966           --         2,237,966
   Unrealized loss on
        investments, net                --           --              --           --             --       (5,361)           (5,361)
                                                                                                                      ------------
Total comprehensive income                                                                                               2,232,605
Stock options exercised             99,720          997         479,513           --             --           --           480,510
Sale of stock to officer            50,000          500         427,625           --             --           --           428,125
Common stock repurchased          (445,300)      (4,453)     (3,023,674)          --             --           --        (3,028,127)
Repayment of note receivable
   for common stock                     --           --              --      105,129             --           --           105,129
Tax benefit associated with
   exercise of stock options            --           --         694,050           --             --           --           694,050
                               -----------    ---------    ------------    ---------    -----------     --------      ------------
Balance - December 31, 2001     15,512,899    $ 155,129    $  8,659,450    $(494,871)   $42,535,717     $ 48,487      $ 50,903,912
                               ===========    =========    ============    =========    ===========     ========      ============
</TABLE>

See accompanying notes to consolidated financial statements.


                                       F-4
<PAGE>
                             APPLIED INNOVATION INC.
                      Consolidated Statements of Cash Flows

<TABLE>
<CAPTION>
                                                                                   Years Ended December 31,
                                                                       --------------------------------------------------
                                                                           2001               2000               1999
                                                                       ------------       ------------       ------------
<S>                                                                    <C>                <C>                <C>
Cash flows from operating activities:
  Net income                                                           $  2,237,966       $ 10,145,002       $  7,005,081
  Adjustments to reconcile net income to net cash
  provided by operating activities:
    Depreciation                                                          1,721,061          1,633,729          1,883,381
    Amortization of intangible assets                                       213,750                 --                 --
    Provision for doubtful accounts                                         443,527            464,548            162,103
    (Gain) loss on disposal of assets                                       (12,714)            17,080             68,189
    Deferred income tax (benefit) expense                                   (33,000)        (1,442,000)            80,000
    Tax benefit of options exercised                                        694,050            410,887                 --
    Effects of change in operating assets and liabilities, net of
    assets acquired and liabilities assumed in acquisition:
      Accounts receivable                                                22,017,975        (19,465,222)        (3,453,878)
      Inventory                                                           5,015,679         (8,095,628)          (292,777)
      Income taxes                                                       (3,294,671)           986,392           (845,544)
      Other current assets                                                  222,391           (352,352)          (281,168)
      Other assets                                                           71,354            (30,694)           (26,781)
      Accounts payable                                                  (16,833,211)        17,601,289          1,172,538
      Accrued expenses                                                   (1,845,741)           995,110         (1,205,740)
      Deferred revenue                                                     (450,985)         3,607,375            322,421
                                                                       ------------       ------------       ------------
    Net cash provided by operating activities                            10,167,431          6,475,516          4,587,825

Cash flows from investing activities:
  Purchases of property, plant and equipment                             (1,825,076)        (1,626,559)        (1,193,200)
  Payment for business acquisition                                       (4,044,969)                --                 --
  Purchases of investments                                              (23,108,753)        (8,885,238)       (32,071,575)
  Maturities of investments                                              15,598,693          3,171,770         11,478,082
  Sales of investments                                                    6,871,092            675,624         13,431,255
  Proceeds from sales of property, plant and equipment                       34,459              6,160             24,802
                                                                       ------------       ------------       ------------
    Net cash used in investing activities                                (6,474,554)        (6,658,243)        (8,330,636)

Cash flows from financing activities:
  Common stock repurchased                                               (3,028,127)                --         (1,539,820)
  Proceeds from issuance of common stock                                  1,013,764          2,273,939                 --
                                                                       ------------       ------------       ------------
    Net cash (used in) provided by financing activities                  (2,014,363)         2,273,939         (1,539,820)
                                                                       ------------       ------------       ------------

Increase (decrease) in cash and cash equivalents                          1,678,514          2,091,212         (5,282,631)
Cash and cash equivalents - beginning of year                            14,020,080         11,928,868         17,211,499
                                                                       ------------       ------------       ------------

Cash and cash equivalents - end of year                                $ 15,698,594       $ 14,020,080       $ 11,928,868
                                                                       ============       ============       ============

SUPPLEMENTAL CASH FLOW DISCLOSURE:
  Income taxes paid                                                    $  3,364,427       $  4,818,722       $  3,846,544
                                                                       ============       ============       ============
</TABLE>

See accompanying notes to consolidated financial statements.


                                       F-5
<PAGE>
                             APPLIED INNOVATION INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(1)   SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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

         DESCRIPTION OF BUSINESS ACTIVITY

         The Company is a leading provider of network solutions for
         telecommunications service providers. The Dublin, Ohio, based company
         designs and manufactures products for network management, protocol
         conversion, mediation and data communication between network elements
         and operations support systems. The Company's products enable
         operations systems to manage all the elements in multivendor,
         multiprotocol telecommunications networks. The majority of the
         Company's customers are RBOCs, long distance phone companies and
         competitive access providers.

         PRINCIPLES OF CONSOLIDATION

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

         CASH EQUIVALENTS

         Cash equivalents represent short-term investments with original
         maturities of three months or less. At December 31, 2001 and 2000, cash
         equivalents of $14,122,256 and $12,242,463, respectively, were invested
         in money markets, corporate notes, commercial paper and taxable and
         tax-exempt bonds.

         INVESTMENTS

         Since the Company does not intend to hold its investments in debt
         securities until maturity and does not actively trade the securities to
         maximize trading gains, the Company classifies these securities as
         "available-for-sale" and, accordingly, reports such securities at fair
         value plus accrued interest. The fair value of debt securities is
         determined from public quotations for such securities as of the
         reporting date. Any temporary excess (deficiency) of fair value over
         (under) the underlying cost of the investment, net of taxes, is
         excluded from current period earnings and is reported as unrealized
         gains (losses) as a separate component of stockholders' equity.

         REVENUE RECOGNITION

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

         Software License Sales: Revenue is derived from the sale of internally
         produced software as well as maintenance and support agreements from
         software sales. The Company licenses software and provides related
         services including training, maintenance, installation and consulting.


                                      F-6
<PAGE>
         License fee revenues are generally recognized when the software product
         is shipped and the portion of the fees related to services is
         recognized as the services are performed.

         Services: Field service projects are generally short-term in nature and
         are accepted by the customer and billed by the Company on a
         project-by-project basis. The Company recognizes field service revenue
         at the completion of the project. Revenues from maintenance agreements
         are billed periodically, deferred and recognized straight-line over the
         term of the agreements.

         INVENTORY

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

         PROPERTY, PLANT AND EQUIPMENT

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

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

         INTANGIBLE ASSETS AND GOODWILL

         Purchased intangible assets resulting from business acquisitions,
         primarily intellectual property and non-compete agreements, are carried
         at cost less accumulated amortization. Amortization is provided using
         the straight-line method over the estimated economic lives of the
         respective assets, generally up to three years.

         Goodwill represents the excess of purchase price over the fair value of
         the net assets acquired. Statement of Financial Accounting Standards
         ("SFAS") No. 142, "Goodwill and Other Intangible Assets," requires
         goodwill to be tested for impairment under certain circumstances, and
         written off when impaired, rather than being amortized as previous
         standards required.

         WARRANTY

         The Company warrants its products for a minimum of one year after sale
         and up to five years as negotiated under contract. Accordingly, the
         Company accrues the estimated costs of such warranties at the time of
         sale.

         INCOME TAXES

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



                                      F-7
<PAGE>
         STOCK OPTION PLANS

         The Company applies the intrinsic value-based method of accounting
         prescribed by Accounting Principles Board ("APB") Opinion No. 25,
         "Accounting for Stock Issued to Employees," and related
         interpretations, in accounting for its fixed plan stock options. As
         such, compensation expense would be recorded on the date of grant and
         amortized over the period of service only if the current market price
         of the underlying stock exceeded the exercise price. SFAS No. 123,
         "Accounting for Stock-Based Compensation," established accounting and
         disclosure requirements using a fair value-based method of accounting
         for stock-based employee compensation plans. As allowed by SFAS No.
         123, the Company elected to continue to apply the intrinsic value-based
         method of accounting and has adopted the disclosure requirements of
         SFAS No. 123.

         RESEARCH AND DEVELOPMENT

         Research and development costs are expensed when incurred.

         GENERAL CREDIT RISK

         The Company grants credit on open account to its customers,
         substantially all of whom are in the telecommunications industry. To
         date, the Company has not provided extended payment terms under any
         type of vendor financing agreements.

         USE OF ESTIMATES

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

         IMPAIRMENT OF LONG-LIVED ASSETS

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

(2)   INVENTORY

      Major classes of inventory at December 31, 2001 and 2000 are summarized
      below:

<TABLE>
<CAPTION>
                                             2001                2000
                                             ----                ----
<S>                                      <C>                 <C>
      Raw materials                      $  7,104,242        $  8,201,638
      Work-in-process                         181,552           2,431,166
      Finished goods                        1,806,808           1,566,256
                                         ------------        ------------
                                            9,092,602          12,199,060
      Reserve for obsolescence             (1,770,286)           (190,000)
                                         ------------        ------------
                                         $  7,322,316        $ 12,009,060
                                         ============        ============
</TABLE>



                                      F-8
<PAGE>
(3)   INVESTMENTS

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

      The following summarizes the Company's investments in securities:

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

<TABLE>
<CAPTION>
                                                                Gross         Gross
                                               Amortized      unrealized    unrealized         Fair
      December 31, 2000                           cost          gains         losses           value
                                              -----------      --------      --------       -----------
<S>                                           <C>             <C>           <C>             <C>
      U.S. government agency obligations      $ 5,506,171      $ 51,697      $(17,836)      $ 5,540,032
      U.S. government obligations                 202,401         5,437        (2,469)          205,369
      Corporate obligations                     6,466,168        48,220        (5,860)        6,508,528
                                              -----------      --------      --------       -----------
      Total                                   $12,174,740      $105,354      $(26,165)      $12,253,929
                                              ===========      ========      ========       ===========
      Reported as:
      Short-term investments                                                                $ 6,386,236
      Investments                                                                             5,867,693
                                                                                            -----------
      Total                                                                                 $12,253,929
                                                                                            ===========
</TABLE>

      Gross realized gains included in income in 2001, 2000 and 1999 were
      $27,536, $13,237 and $375, respectively, and gross realized losses
      included in income in 2001, 2000 and 1999 were $45,485, $9,179, and
      $1,174, respectively. Realized gains and losses are determined by
      specific identification.

      The Company's December 31, 2001 debt securities at fair market value
      mature as follows: $6,067,770 in less than one year, $6,431,585 after
      one year but less than five years, and $418,181 in five or more years.


                                      F-9
<PAGE>
(4)   PROPERTY, PLANT AND EQUIPMENT

      Property, plant and equipment at December 31, 2001 and 2000 are summarized
      below:

<TABLE>
<CAPTION>
                                         2001               2000
                                         ----               ----
<S>                                 <C>                <C>
      Land                          $  1,639,303       $  1,639,303
      Building                         5,091,607          5,042,590
      Equipment                        8,265,643          6,678,641
      Furniture                        2,031,075          1,995,763
                                    ------------       ------------
                                      17,027,628         15,356,297
      Accumulated depreciation        (8,204,273)        (6,743,639)
                                    ------------       ------------
                                    $  8,823,355       $  8,612,658
                                    ============       ============
</TABLE>

(5)   ACQUISITION

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

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

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

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

      The Company will record any contingent consideration as additional
      goodwill as the contingencies are resolved. As of December 31, 2001,
      $18,400 of the total $750,000 contingent payment has been recorded as
      additional goodwill. Goodwill is expected to be fully deductible for tax
      purposes.

      The following unaudited pro forma information summarizes results of
      operations for the years indicated as if the Badger acquisition had been
      completed as of the beginning of the years presented:


                                      F-10
<PAGE>
<TABLE>
<CAPTION>
                                                 Years ended December 31,
                                            -----------------------------------
                                                  2001                2000
                                                  ----                ----
<S>                                         <C>                 <C>
            Net sales                       $    74,170,871     $   118,871,447
            Net income                            1,666,490           9,860,978
            Basic earnings per share                   0.11                0.63
            Diluted earnings per share                 0.10                0.62
</TABLE>

(6)   MAJOR CUSTOMERS AND GEOGRAPHIC DATA

      Revenues to major customers represented 66%, 61% and 42% of net sales for
      2001, 2000 and 1999, respectively. The number of major customers
      previously referred to were four, two and two for 2001, 2000 and 1999,
      respectively, with trade accounts receivable balances of $4,567,446 and
      $19,399,813 at December 31, 2001 and 2000, respectively.

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

<TABLE>
<CAPTION>
                                    2001              2000             1999
                                    ----              ----             ----
<S>                            <C>               <C>               <C>
            United States        68,820,616      $114,883,136      $48,544,837
            International         4,198,534         1,220,256          978,783
                               ------------      ------------      -----------
                               $ 73,019,150      $116,103,392      $49,523,620
                               ============      ============      ===========
</TABLE>

(7)   EARNINGS PER SHARE

      The calculations of earnings per share for the years ended December 31,
      2001, 2000, and 1999, are based upon the weighted-average shares
      outstanding during the periods and, when applicable, those stock options
      that are dilutive, using the treasury stock method. Reconciliations of the
      numerators and denominators of the basic and diluted earnings per share
      calculations follow:

<TABLE>
<CAPTION>
                                                                     Year ended December 31, 2001
                                                             --------------------------------------------
                                                                Income           Shares        Per share
                                                             (numerator)     (denominator)       amount
                                                             -----------     -------------    -----------
<S>                                                          <C>             <C>              <C>
      Basic  earnings per share-
           Net income available to common stockholders       $ 2,237,966       15,870,492     $      0.14
                                                                                              ===========
      Effect of dilutive securities-
          Stock options                                               --          270,501
                                                             -----------      -----------
      Diluted earnings per share-
          Net income available to common stockholders
               including assumed conversions                 $ 2,237,966       16,140,993     $      0.14
                                                             ===========      ===========     ===========
</TABLE>

<TABLE>
<CAPTION>
                                                                     Year ended December 31, 2000
                                                             --------------------------------------------
                                                                Income           Shares        Per share
                                                             (numerator)     (denominator)       amount
                                                             -----------     -------------    -----------
<S>                                                          <C>             <C>              <C>
      Basic  earnings per share-
           Net income available to common stockholders       $10,145,002       15,598,723     $      0.65
                                                                                              ===========
      Effect of dilutive securities-
          Stock options                                               --          415,430
                                                             -----------      -----------
      Diluted earnings per share-
          Net income available to common stockholders
               including assumed conversions                 $10,145,002       16,014,153     $      0.63
                                                             ===========      ===========     ===========
</TABLE>


                                      F-11
<PAGE>
<TABLE>
<CAPTION>
                                                                     Year ended December 31, 1999
                                                             --------------------------------------------
                                                                Income           Shares        Per share
                                                             (numerator)     (denominator)       amount
                                                             -----------     -------------    -----------
<S>                                                          <C>             <C>              <C>
      Basic  earnings per share-
            Net income available to common stockholders      $ 7,005,081       15,598,143     $      0.45
                                                                                              ===========
      Effect of dilutive securities-
          Stock options                                               --           48,907
                                                             -----------      -----------
      Diluted earnings per share-
          Net income available to common stockholders
               Including assumed conversions                 $ 7,005,081       15,647,050     $      0.45
                                                             ===========      ===========     ===========
</TABLE>

      Stock options which are out-of-the-money and, therefore, are anti-dilutive
      under the treasury stock method have been excluded from the above earnings
      per share calculations. These options totaled 1,170,401, 417,750 and
      205,750 in 2001, 2000 and 1999 respectively.

(8)   STOCK OPTION PLANS

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

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

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

      At December 31, 2001, there were 1,246,500 additional shares available for
      grant under the 2001 Plan and 198,230 additional shares available for
      grant under the 1996 Plan. The per share weighted-average fair value of
      stock options granted during 2001, 2000 and 1999 was $10.16, $6.41 and
      $2.36, respectively, on the date of grant using the Black Scholes
      option-pricing model with the following assumptions used for grants in the
      years ended December 31, 2001, 2000 and 1999, respectively: dividend yield
      of 0% for all years; expected volatility of 193%, 77% and 71%; risk-free
      interest rate of 4.5%, 6% and 6%; and expected life of 5, 4.2 and 4.5
      years.

      The Company applies APB Opinion No. 25 in accounting for its plans and no
      compensation cost has been recognized for its stock options in the
      financial statements. Had the Company determined compensation cost based
      on the fair value at the grant date for its stock options under SFAS No.
      123, the Company's net income (loss) and earnings (loss) per share, net of
      related income tax effects, would have been reduced to the pro forma
      amounts indicated below:


                                      F-12
<PAGE>
<TABLE>
<CAPTION>
                                                                         2001                2000                1999
                                                                         ----                ----                ----
<S>                                                <C>              <C>                 <C>                 <C>
      Net income (loss)                            As reported      $    2,237,966      $   10,145,002      $    7,005,081
                                                   Pro forma              (496,198)          8,848,465           6,519,016

      Basic earnings (loss) per share              As reported      $         0.14      $         0.65      $         0.45
                                                   Pro forma                 (0.03)               0.57                0.42

      Diluted earnings (loss) per share            As reported      $         0.14      $         0.63      $         0.45
                                                   Pro forma                 (0.03)               0.55                0.42
</TABLE>

      A summary of stock option activity follows:

<TABLE>
<CAPTION>
                                                                                   Number of             Weighted-average
                                                                                    shares                exercise price
                                                                                    ------                --------------
<S>                                                                               <C>                    <C>
      Balance at December 31, 1998                                                      944,650             $      5.43
          Granted                                                                       515,000                    3.68
          Exercised                                                                          --                      --
          Canceled/expired                                                             (354,350)                   4.78
                                                                                  -------------
      Balance at December 31, 1999                                                    1,105,300                    4.82
          Granted                                                                     1,117,450                   13.21
          Exercised                                                                    (336,547)                   4.97
          Canceled/expired                                                             (109,223)                   6.25
                                                                                  -------------
      Balance at December 31, 2000                                                    1,776,980                    8.66
          Granted                                                                     1,082,000                   10.99
          Exercised                                                                     (99,720)                   4.82
          Canceled/expired                                                             (392,430)                  11.30
                                                                                  -------------
      Balance at December 31, 2001                                                    2,366,830             $     10.55
                                                                                  =============
</TABLE>


                                      F-13
<PAGE>
      The following table summarizes information about options outstanding at
      December 31, 2001:

<TABLE>
<CAPTION>
                                            Options outstanding                            Options exercisable
                             ---------------------------------------------------       ----------------------------
                                                    Weighted-
                                                    average            Weighted-                        Weighted-
                                                    remaining           average                          average
      Range of exercise         Number of          contractual          exercise        Number of        exercise
            prices                shares              life               price           shares           price
            ------                ------              ----               -----           ------           -----
<S>                           <C>                  <C>                 <C>             <C>              <C>
      $   3.44 -  5.00             360,730               3.6           $    4.20          229,740       $   4.37
      $   5.25 -  8.31             687,000               7.4                7.65          225,390           7.44
      $   8.34 - 11.70             627,850               9.1               11.02            4,700          10.21
      $  12.00 - 16.88             479,250               8.6               13.07           87,950          12.97
      $  17.25 - 24.00             212,000               8.5               23.62           42,400          23.62
                              ------------                                             ----------
                                 2,366,830               7.6               10.55          590,180           8.26
                              ============                                             ==========
</TABLE>

(9)   DEFINED CONTRIBUTION PLAN

      The Company sponsors a defined contribution 401(k) and profit sharing plan
      that covers all eligible employees. Since October 1, 1999, the Company
      matched 50% of each participant's contribution, up to 6% of that
      participant's contribution. From April 1, 1998 to October 1, 1999, the
      Company matched 35%, and prior to April 1, 1998, the Company matched 25%.
      The Company may also make profit sharing contributions at the discretion
      of the Board of Directors. For 2001, 2000 and 1999, the profit sharing
      contribution was $0, $400,000 and $250,000, respectively, and the total
      expense related to the plan was $458,082, $762,745 and $475,373,
      respectively.

(10)  INCOME TAXES

      Income tax expense (benefit) consists of:

<TABLE>
<CAPTION>
                                           Current           Deferred           Total
                                           -------           --------           -----
<S>                                      <C>               <C>               <C>
      Year ended December 31, 2001:
          Federal                        $   568,000       $   (29,000)      $  539,000
          State and local                    220,000            (4,000)         216,000
                                         -----------       -----------       ----------
                                         $   788,000       $   (33,000)      $  755,000
                                         ===========       ===========       ==========
      Year ended December 31, 2000:
          Federal                        $ 5,440,000       $(1,273,000)      $4,167,000
          State and local                    776,000          (169,000)         607,000
                                         -----------       -----------       ----------
                                         $ 6,216,000       $(1,442,000)      $4,774,000
                                         ===========       ===========       ==========
      Year ended December 31, 1999:
          Federal                        $ 2,663,000       $    74,000       $2,737,000
          State and local                    338,000             6,000          344,000
                                         -----------       -----------       ----------
                                         $ 3,001,000       $    80,000       $3,081,000
                                         ===========       ===========       ==========
</TABLE>


                                      F-14
<PAGE>
      A reconciliation of income tax expense at the expected federal statutory
      rate (34%) to income tax expense at the Company's effective rates for
      continuing operations is as follows:

<TABLE>
<CAPTION>
                                                                       2001              2000              1999
                                                                       ----              ----              ----
<S>                                                                <C>               <C>               <C>
      Computed tax at the expected federal statutory rate          $ 1,018,000       $ 5,072,000       $ 3,429,000
      State and local income taxes, net of federal income tax
         effect                                                        141,000           350,000           223,000
      Change in state rate applied to deferred tax assets                   --           (51,000)               --
      Meals and entertainment expenses                                  88,000           110,000            37,000
      Research and experimentation credit                             (420,000)         (661,000)         (585,000)
      Tax-exempt interest income                                       (85,000)          (68,000)          (33,000)
      Other                                                             13,000            22,000            10,000
                                                                   -----------       -----------       -----------
                                                                   $   755,000       $ 4,774,000       $ 3,081,000
                                                                   ===========       ===========       ===========
</TABLE>

      The tax effects of temporary differences that give rise to significant
      portions of the deferred tax assets and deferred tax liabilities at
      December 31, 2001 and 2000 are presented below:

<TABLE>
<CAPTION>
                                                                                         2001              2000
                                                                                         ----              ----
<S>                                                                                   <C>               <C>
      Deferred tax assets:
          Warranty reserve                                                            $  315,000        $  502,000
          Accounts receivable allowance                                                  183,000           266,000
          Inventory, principally due to obsolescence reserve and additional costs
              inventoried for tax purposes                                               864,000           255,000
          Deferred revenue                                                             1,343,000         1,517,000
          Other                                                                           44,000           168,000
                                                                                      ----------        ----------
                                                                                      $2,749,000        $2,708,000
                                                                                      ==========        ==========
      Deferred tax liabilities:
          Unrealized loss on investments and amortization of
              intangible assets                                                       $   38,000        $       --
                                                                                      ==========        ==========
</TABLE>

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

(11)  LEASE COMMITMENTS

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


                                      F-15
<PAGE>
      2002. Additionally, the Company is obligated under various operating
      leases for office equipment, with expiration dates varying over the next
      two years.

      Future minimum lease payments and related sublease receipts under the
      operating leases as of December 31, 2001 are:

<TABLE>
<CAPTION>
                                                     Lease          Sublease
      Year ending December 31:                      payments        receipts
                                                    --------        --------
<S>                                                 <C>             <C>
             2002                                   $296,929        $(6,696)
             2003                                     37,091             --
                                                    --------        -------
      Total minimum lease payments                  $334,020        $(6,696)
                                                    ========        =======
</TABLE>

      Total rent expense, net of related sublease rental income, in 2001, 2000
      and 1999 was $3,856, $156,746 and $92,222, respectively. Costs associated
      with the Company's North Carolina lease were accrued in 1998 as a
      component of a one-time non-recurring charge. Accordingly, such costs have
      been excluded from rent expense.

(12)  EQUITY

      On September 14, 2001, the Company's Board of Directors authorized a stock
      repurchase program under which the Company may purchase up to 1,500,000
      shares of common stock over the next twelve months. As of December 31,
      2001, 445,300 shares have been repurchased under this program at an
      average price of $6.80 per share.

      At the Annual Meeting of Stockholders held on April 26, 2001, the Amended
      and Restated Certificate of Incorporation was approved and adopted which
      increased the number of authorized shares of the Company's common stock,
      $.01 par value, from 30,000,000 to 55,000,000 shares and which authorized
      the issuance of 5,000,000 shares of preferred stock, $.01 par value.

      On July 13, 2000, the Company appointed Robert L. Smialek as President and
      Chief Executive Officer. As part of his Employment Agreement
      ("Agreement"), the Company sold 100,000 unregistered shares of its common
      stock at $12 per share, the closing market price on the date of the
      Agreement. Mr. Smialek paid for the stock with $600,000 of cash, and a
      $600,000 five year note, bearing interest at 6.62%, payable in five equal
      annual installments of principal and interest commencing July 13, 2001.
      The note receivable is reflected in the stockholders' equity section of
      the accompanying consolidated balance sheets.


                                      F-16
<PAGE>
(13)  RESTRUCTURING CHARGE

      On June 18, 2001, the Company announced a reduction in workforce of
      approximately 15 percent, or approximately 40 employees, throughout all
      departments. The Company recorded a workforce reduction charge of
      approximately $292,000 relating primarily to severance and fringe benefits
      which is separately stated on the consolidated statements of earnings. As
      of December 31, 2001, the Company had paid out all such costs.

(14)  SUBSEQUENT EVENT

      On February 5, 2002, the Company announced a reduction in workforce of
      approximately 16 percent, or approximately 50 employees, throughout all
      departments. As a result, the Company expects to record a workforce
      reduction charge of approximately $650,000 in the first quarter of 2002,
      relating primarily to severance and other fringe benefits. The Company
      expects to pay out such costs through the remainder of 2002.

(15)  QUARTERLY FINANCIAL INFORMATION (UNAUDITED)

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

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

<TABLE>
<CAPTION>
      2000                                                 Q1             Q2            Q3             Q4
                                                      -----------    ------------   -----------   -----------
<S>                                                   <C>            <C>            <C>           <C>
      Net sales                                       $    14,363    $     18,284   $    31,160   $    52,296
      Gross profit                                          7,536           9,578        11,047        12,064
      Income before income taxes                            2,283           3,364         4,117         5,154
      Net income                                            1,552           2,288         2,799         3,506
      Basic net income per share                             0.10            0.15          0.18          0.22
      Diluted net income per share                           0.10            0.15          0.17          0.22
</TABLE>


                                      F-17