##### Table of Contents



UNITED STATES SECURITIES AND
    EXCHANGE COMMISSION
 Washington, D.C.
    20549
      Form 10-K
  þ

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended
    December 31, 2006ORo

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period
    from          to   Commission file number:
    001-31783
       RAE Systems Inc.
 (Exact name of registrant as
    specified in its charter)
  Delaware

77-0280662(State or other jurisdiction
    of
    incorporation or organization)

(I.R.S. Employer 
    Identification No.)3775 North First Street
    San Jose, California(Address of principal
    executive offices)

95134(Zip Code)   408-952-8200
 (Registrants telephone number, including area code)
 Securities registered pursuant to Section 12(b) of the
    Act:
  Title of Each Class

Name of Each Exchange on Which RegisteredCommon Stock, $0.001 par
    value per share

The American Stock Exchange   Securities registered pursuant to Section 12(g) of the
    Act:
    None
       o þ
  o þ
  o þ
  Regulation S-K Form 10-K Form 10-K. o
  Rule 12b-2
  o þ o
  Rule 12b-2 o þ
    DOCUMENTS
    INCORPORATED BY REFERENCE
  Form 10-K.




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##### 



RAE
    SYSTEMS INC.
  INDEX
    TO
    ANNUAL REPORT ON
    FORM 10-K
    FOR YEAR ENDED DECEMBER 31, 2006
    TABLE OF CONTENTS
  PagePART I


3ITEM 1.


BUSINESS


3ITEM 1A.


RISK
    FACTORS


14ITEM 1B.


UNRESOLVED STAFF
    COMMENTS


21ITEM 2.


PROPERTIES


21ITEM 3.


LEGAL
    PROCEEDINGS


21ITEM 4.


SUBMISSION OF
    MATTERS TO A VOTE OF SECURITY HOLDERS


22PART II


23ITEM 5.


MARKET FOR
    REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND
    ISSUER PURCHASES OF EQUITY SECURITIES


23ITEM 6.


SELECTED FINANCIAL
    DATA


25ITEM 7.


MANAGEMENTS
    DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
    OPERATIONS


26ITEM 7A.


QUANTITATIVE AND
    QUALITATIVE DISCLOSURES ABOUT MARKET RISK


40ITEM 8.


FINANCIAL
    STATEMENTS AND SUPPLEMENTARY DATA


41ITEM 9.


CHANGES IN AND
    DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
    DISCLOSURE


41ITEM 9A.


CONTROLS AND
    PROCEDURES


41ITEM 9B.


OTHER
    INFORMATION


46PART III


46ITEM 10.


DIRECTORS,
    EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE


46ITEM 11.


EXECUTIVE
    COMPENSATION


46ITEM 12.


SECURITY OWNERSHIP
    OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
    STOCKHOLDER MATTERS


46ITEM 13.


CERTAIN
    RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
    INDEPENDENCE


46ITEM 14.


PRINCIPAL
    ACCOUNTING FEES AND SERVICES


46PART IV


47ITEM 15.


EXHIBITS, FINANCIAL
    STATEMENT SCHEDULES


47SIGNATURES


48EXHIBIT 10.13EXHIBIT 10.14EXHIBIT 21.1EXHIBIT 23.1EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 32.2   2




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PART I  In addition to historical information, this Annual Report on
    Form 10-K
    contains forward-looking statements. These statements typically
    are preceded or accompanied by words like believe,
    anticipate, expect, may,
    will, should, intend,
    plan, estimate, potential,
    or continue, and other words of similar meaning.
    These forward-looking statements are subject to certain risks
    and uncertainties that could cause actual results to differ
    materially from those reflected in these forward-looking
    statements. Readers are cautioned not to place undue reliance on
    those forward-looking statements, which reflect
    managements opinions only as of the date hereof. We
    undertake no obligation to revise or update or publicly release
    the results of any revisions or update to these forward-looking
    statements. Readers should carefully review the risk factors
    described herein and in other documents that we file from time
    to time with the Securities and Exchange Commission, including
    the Quarterly Reports on
    Form 10-Q
    that we file for the fiscal year 2007.
  ITEM 1.
    BUSINESS.  General
      clean-ups. part-per-billion
   3




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www.raesystems.com. Form 10-K, Form 10-Q, Form 8-K
  1-800-SEC-0330.
  Industry
    Background
    
    chemicals and manufacturing (process control);
    municipal and volunteer fire departments (arson investigations,
    hazardous fumes detection);
    petroleum (leaks, explosive vapors, records of worker exposure);
    transportation (airplane wing tank entry); and
    hazardous materials
    clean-up
    (environmental remediation).      
    protection through detection;
    portability for easy transport;
    rapid deployment for emergency response;
    fast and reliable detection of a broad array of chemicals; 4




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
    an open system architecture that allows networking among
    multiple detectors;
    wireless on-ramp to the Internet, allowing the data to be shared
    and acted upon;
    wireless networking for monitoring from remote
    locations; and
    information to make time and life critical decision.      Our
    Strengths
  We have a comprehensive product portfolio.
  We are a technological leader in the
    industry.
  We have an established customer base.
  We have modern, cost-efficient
    manufacturing.
 5




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We have strong research, development and engineering
    capabilities.
  Our
    Strategy
    Pursue the shifts in global industrial
    growth.
  Pursue the Homeland Security Market.
  Aggressively Pursue the Rapidly Expanding Network Detection
    Market.
  Develop New Products and Solutions.
  Leverage Our Cost-Efficient Infrastructure.
  Selectively Pursue Acquisitions, Joint Ventures and Licensing
    Agreements. state-of-the-art
  Technology
   6




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Sensor
    and Measurement Technology
    
    photoionization detectors for the measurement of volatile
    organic compounds, highly toxic chemical warfare agents and
    toxic industrial chemicals;
    catalytic bead pellistors for the detection and measurement of
    combustible gas;
    non-dispersive infrared sensors for the measurement of carbon
    dioxide and hydrocarbons; and
    electro-chemical sensors for the measurement oxygen and toxic
    gases such as carbon monoxide.  part-per-billion
  Integrated
    Wireless Technology
      Radiation
    Technology
     7




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Products
  Product

Description

ApplicationIntegrated SystemsAreaRAE

Wireless, multi-channel,
    integrated five-gas detection systems

 HazMat and emergency
    response
     Confined space entry
     Plant turnarounds
     Venue protection
     Oil platform protectionAreaRAEGamma

Wireless, combined multi-gas and
    radiation detector

 HazMat and emergency
    response
     Homeland defense
     Venue protectionRAEGuard PID

Permanently mounted photoionization

 Waste water treatment
    plantsRAEGuard EC

Detector (PID) equipped with
    digital display of the gas concentration, unit of measurement
    and functional keys for performing calibration

 Marine and off-shore
    oil wells
     Refineries
     Petrochemical plants
     Power plants
     Pulp and paper Solvent recovery
    systemsPhotoionization
    DetectionMiniRAE 2000

Versatile handheld volatile
    organic compound monitor with sensitivity range of 0 
    10,000
    parts-per-million

 Confined space
    entry
     Emergency response to hazardous spills
     Environmental remediation
     Soil remediation
     MilitaryUltraRAE

Combines vapor separation tubes
    and photoionization detection into compound-specific monitor for
    Benzene

 Crude oil production,
    pipelines
     Transportation of hazardous materials
     Refineries
     Plant turn-aroundsppbRAE Plus

Hand-held photoionization
    detection monitor to detect volatile organic compounds down to
    one
    part-per-billion

 Emergency response to
    hazardous spills
     Indoor air quality in new, sick and mixed usage
    buildings Personal monitoring Drug detectionEntryRAE

4-gas monitor plus photoionization
    (PID) detection

 Refineries
     Chemical processing
     Water & wastewater facilities
     Semiconductor manufacturingRadiation DetectionGammaRAE II

Rapid detector of gamma sources,
    includes cesium iodide (CsI) scintillator that provides low
    level detection in a compact unit

 Emergency response
     Customs and border patrols
     Law enforcement
     MilitaryGammaRAE II R

Combination Gamma Detector and
    Gamma Dosimeter

 Emergency response
     Customs and border patrols Law enforcement
     Military 8




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Product

Description

ApplicationNeutronRAE II

Rapid detector of gamma and
    neutron sources, includes both cesium iodide (CsI) and lithium
    iodide (LiI) scintillators that provide low level detection
    in a compact unit

 Emergency response
     Customs and border patrols
     Law enforcement
     MilitaryMulti-SensorMultiRAE IR

One-to-five
    gas surveyor with CO2 and photoionization detection

 Indoor air quality
     Beverage and brewery
     Food industryMultiRAE PLUS

Hand-held,
    1-to-5 gas
    monitor with lower explosive limit measurement capability, O2,
    two toxic sensors, and photoionization detector for toxic
    volatile organic compound detection

 Confined space
    entry
     Wing tank entry
     HazMatVRAE

Hand-held 5-gas confined space
    monitor and sniffer

 Refineries and
    petrochemical plants
     Confined space entry, hot work permits Utilities 
    Cable vaults, transformer stations Waste water treatment
    plantsQRAE / QRAE PLUS

Economical, robust 4-gas confined
    space monitor

 Confined space
    entry
     Refineries and petrochemicals plants Power plantsIAQRAE

Indoor air quality monitor with
    CO2, photoionization detection, relative humidity, temperature
    and toxic gas sensors

 Indoor air quality
     Beverage and brewery
     Food industrySingle-SensorBadgeRAE

Single gas H2S and CO disposable
    two year personal monitor

 Oil fields and
    refineries
     Utilities and power plants
     Chemical plantsToxiRAE Plus PID

Pocket-sized, single-gas PID
    monitor

 Oil fields and
    refineries Mining and metals Pulp and paper millsToxiRAE II

Full-featured gas monitor
    providing continuous, digital display of gas concentration,
    available with ten different sensors

 Refineries and chemical plants
 Oil production  Contractors
 Industrial safety Power plantsAutoRAE

A bench-top calibration and
    charging station that currently supports EntryRAE, MultiRAE
    Plus, ppbRAE, MiniRAE 2000 and QRAE Plus

 All existing and
    future users of these instrumentsTubesGas Detection Tubes

Single-use, single-sensor for the
    detection of specific chemicals

 Refineries
     Petrochemical plants
     Compressed gas distribution facilities 9




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Product

Description

ApplicationOtherHazRAE

Hazardous materials decision
    support facilities application for chemical, biological and WMD
    assessment that runs on handheld wireless devices

 Emergency first
    responders
     HazMat teams
     EMS and emergency roomsPlumeRAE

Plume measurement for chemical
    plants and first responders

 Law enforcement and
    forensics personnel Intelligence community   Sales,
    Marketing and Distribution
    business-to-business business-to-government
        Customers
   10




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Research,
    Development and Engineering
    
    the introduction of PlumeRAE, in a Rapid Deployment Kit, which
    provides first responders with powerful decision support
    capabilities when determining the best course of action for a
    population near an incident;
    the introduction of the AreaRAE Gamma, which provides wireless
    delivery of remotely sensed gas vapors and gamma radiation, an
    industry first; and
    networking advances, which allow RAE sensor to be connected to
    industrial command and control system via mesh networking of
    Ethernet.      Manufacturing
      
    material planning and production scheduling;
    procurement;
    incoming quality assurance;
    manufacturing process design;
    production, including precision machining, plastic injection,
    colorimetric tube production, electrochemical sensor
    manufacturing and printed circuit board assembly using surface
    mount technology;
    final assembly and test; and
    quality control and assurance.      
    material planning and production scheduling;
    procurement;
    sensor manufacturing;
    photoionization detection lamp manufacturing;
    prototyping for engineering; 11




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
    process design;
    final assembly and test;
    calibration; and
    final quality control and assurance.    
    material planning and production scheduling;
    procurement;
    sensor manufacturing;
    photoionization detection lamp manufacturing;
    prototyping for engineering;
    process design;
    final assembly and test;
    calibration; and
    final quality control and assurance.    Competition
      and/or
  Employees
   12




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Executive
    Officers of the Registrant
    Name

Age

PositionRobert I. Chen

59

President, Chief Executive Officer
    and Chairman of the BoardRandall Gausman

57

Vice President and Chief Financial
    OfficerPeter C. Hsi

56

Chief Technology Officer and Vice
    President of Emerging Technologies DevelopmentRudy Mui

46

Executive Vice President and
    Chief Operating OfficerChristopher Hameister

52

Vice President of Asia-Pacific,
    Europe, Middle East Business and OperationsFei-Zhou Shen

44

Vice President of China Business
    Worldwide ManufacturingGregory J. Vervais

59

Vice President and Chief Human
    Resources Officer   Robert I. Chen
  Randall Gausman
  Dr. Peter C. Hsi
  Rudy Mui
  Christopher Hameister
 13




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##### Table of Contents



Fei-Zhou Shen
  Gregory J. Vervais
  ITEM 1A.
    RISK
    FACTORS.  You should carefully consider the risks described below
    before making a decision regarding an investment in our common
    stock. If any of the following risks actually occur, our
    business could be harmed, the trading price of our common stock
    could decline and you may lose all or part of your investment.
    You should also refer to the other information contained in this
    report, including our financial statements and the related
    notes.
  Our
    future revenues are unpredictable, our operating results are
    likely to fluctuate from quarter-to-quarter, and if we fail to
    meet the expectations of securities analysts or investors, our
    stock price could decline significantly.
  period-to-period
  We may
    have difficulty sustaining profitability and may experience
    additional losses in the future. If we continue to report losses
    or are marginally profitable, the financial impact of future
    events may be magnified and may lead to a disproportionate
    impact on the trading price of our stock.
   14




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We may
    require additional capital in the future, which may not be
    available or may only be available on unfavorable
    terms.
    Form 8-K Form S-3 Form S-1
  The
    market for gas and radiation detection monitoring devices is
    highly competitive, and if we cannot compete effectively, our
    business may be harmed.
    
    devote greater resources to marketing and promotional campaigns;
    adopt more aggressive pricing policies; or
    devote more resources to technology and systems development.    We may
    not be successful in the development or introduction of new
    products and services in a timely and effective manner and,
    consequently, we may not be able to remain competitive and the
    results of operations may suffer.
     15




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Recently
    enacted changes in the securities laws and regulations have and
    are likely to continue to increase our costs.
    In the
    event we are unable to satisfy regulatory requirements relating
    to internal control over financial reporting or, if these
    controls are not effective, our business and financial results
    may suffer.
    Form 10-K, Accounting for Stock-Based Compensation time-to-time. Form 10-K,
    We are
    subject to risks and uncertainties of the government
    marketplace, including the risk that the government may not fund
    projects that our products are designed to address and that
    certain terms of our contracts with government agencies may
    subject us to adverse government actions or
    penalties.
     16




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We may
    not be successful in promoting and developing our brand, which
    could prevent us from remaining competitive.
    We may
    face risks from our substantial international operations and
    sales.
      
    difficulties with staffing and managing international operations;
    transportation and supply chain disruptions and increased
    transportation expense as a result of epidemics, terrorist
    activity, acts of war or hostility, generally higher oil prices,
    increased security and less developed infrastructure;
    economic slowdown
    and/or
    downturn in foreign markets;
    international currency fluctuations;
    political and economic uncertainty caused by epidemics,
    terrorism or acts of war or hostility;
    legislative and regulatory responses to terrorist activity such
    as increased restrictions on cross-border movement of products
    and technology;
    legislative, regulatory, police, or civil responses to epidemics
    or other outbreaks of infectious diseases such as quarantines,
    factory closures, or increased restrictions on transportation or
    travel;
    increased costs and complexities associated with complying with
    Section 404 of the Sarbanes-Oxley Act of 2002;
    general strikes or other disruptions in working conditions;
    labor shortages;
    political instability;
    changes in tariffs;
    generally longer periods to collect receivables; 17




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
    unexpected legislative or regulatory requirements;
    reduced protection for intellectual property rights in some
    countries;
    significant unexpected duties or taxes or other adverse tax
    consequences;
    difficulty in obtaining export licenses and other trade
    barriers; and
    ability to obtain credit and access to capital issues faced by
    our international customers.  and/or
  The
    loss of Normal Trade Relation status for China,
    changes in current tariff structures or adoption of other trade
    policies adverse to China could have an adverse effect on our
    business.
    The
    government of China may change or even reverse its policies of
    promoting private industry and foreign investment, in which case
    our assets and operations may be at risk.
    Any
    failure to adequately protect and enforce our intellectual
    property rights could harm our business.
   18




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We may
    face intellectual property infringement claims that might be
    costly to resolve and affect our results of
    operations.
    No. 05-CV-01887-JF).
  ten-day
   19




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Some
    of our products may be subject to product liability claims which
    could be costly to resolve and affect our results of
    operations.
    We
    sell a majority of our products through distributors, and if our
    distributors stop selling our products, our revenues would
    suffer.
  sixty-day
  Because
    we purchase a significant portion of our component parts from a
    limited number of third party suppliers, we are subject to the
    risk that we may be unable to acquire quality components in a
    timely manner, which could result in delays of product shipments
    and damage our business and operating results.
    Future
    acquisitions that we undertake could be difficult to integrate,
    disrupt our business, dilute stockholder value or harm our
    results of operations.
    Our
    ownership interest in Renex will cause us to incur losses that
    we would not otherwise incur.
   20




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Our
    business could suffer if we lose the services of any of our
    executive officers.
    Our
    officers, directors and principal stockholders beneficially own
    approximately 34% of our common stock and, accordingly, may
    exert substantial influence over the Company.
    ITEM 1B.
    UNRESOLVED
    STAFF COMMENTS.    ITEM 2.
    PROPERTIES.        ITEM 3.
    LEGAL
    PROCEEDINGS.  Polimaster
    Ltd. v. RAE Systems Inc., United States District Court for
    the Northern District of California, Case
    No. 05-CV-01887-JF
  No. 05-CV-01887-JF).
   21




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ten-day
    ITEM 4.
    SUBMISSION
    OF MATTERS TO A VOTE OF SECURITY HOLDERS.   22




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PART II  ITEM 5.
    MARKET
    FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER
    MATTERS. AND ISSUER PURCHASES OF EQUITY
    SECURITIES.  mark-ups,
  2006


2005High


Low


High


LowFirst Quarter

$
3.93


$
3.26


$
7.50


$
2.90Second Quarter

$
4.54


$
3.27


$
3.87


$
2.35Third Quarter

$
4.14


$
2.40


$
4.33


$
3.03Fourth Quarter

$
4.05


$
2.81


$
4.09


$
3.19      23




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PERFORMANCE
    GRAPH
  3800-3899
    COMPARISON
    OF 57 MONTH CUMULATIVE TOTAL RETURN*
    Among RAE Systems, Inc., The AMEX Composite Index
    And AMEX stocks for SIC codes 3800 - 3899 Measuring
    Instruments
  
   *
    
    $100 invested on 4/9/02 in stock or on 3/31/02 in
    index-including reinvestment of dividends.   4/02



12/02



12/03



12/04



12/05



12/06RAE Systems,
    Inc.



100.00




18.31




148.21




318.22




153.01




139.49AMEX Composite



100.00




91.97




132.86




163.99




202.49




240.92AMEX stocks for SIC codes 3800
    - 3899 Measuring Instruments



100.00




80.78




130.23




137.73




126.72




143.07  24




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ITEM 6.
    SELECTED
    FINANCIAL DATA.  SUMMARY
    FINANCIAL DATA
  Form 10-K.
  2006


2005


2004(1)(2)(3)(4)


(5)


(6)(7)


2003


2002Operating Data:Net sales

$
67,986,000


$
60,293,000


$
45,540,000


$
31,361,000


$
21,828,000Gross profit

$
35,735,000


$
35,603,000


$
27,023,000


$
19,256,000


$
13,071,000Operating (loss) income

$
(3,114,000
)

$
(1,588,000
)

$
3,514,000


$
3,759,000


$
(8,982,000
)Net (loss) income

$
(1,529,000
)

$
(759,000
)

$
2,335,000


$
2,738,000


$
(9,462,000
)Basic (loss) income per share

$
(0.03
)

$
(0.01
)

$
0.04


$
0.06


$
(0.24
)Diluted (loss) income per share

$
(0.03
)

$
(0.01
)

$
0.04


$
0.06


$
(0.24
)Weighted-average common shares:Basic outstanding shares


58,424,970



57,687,714



55,809,638



46,179,770



39,902,169Diluted outstanding shares


58,424,970



57,687,714



60,135,692



49,225,169



39,902,169Balance Sheet Data:Working capital

$
36,641,000


$
41,366,000


$
38,857,000


$
12,423,000


$
8,263,000Total assets

$
89,753,000


$
76,264,000


$
69,115,000


$
20,765,000


$
16,865,000Long-term liabilities

$
5,441,000


$
2,962,000


$
1,645,000


$
200,000


$
411,000Total shareholders equity

$
56,179,000


$
54,573,000


$
52,189,000


$
14,807,000


$
10,747,000     The following information summarizes events that affect
    comparability of the information reflected in selected financial
    data:(1)
    
    RAE Fushun joint venture was formed in December 2006. The fair
    value of assets acquired and liabilities assumed were included
    in the balance sheet as of December 31, 2006. There were no
    operating activities recorded in 2006.(2)
    
    The Company purchased an additional 32% ownership in RAE Beijing
    in July 2006. The Company has consolidated RAE Beijing since
    2004. With the purchase in July 2006, minority
    shareholders interest was reduced to 4%.(3)
    
    In July 2006, the Company purchased Aegison Corporation. The
    fair value of assets acquired and liabilities assumed were
    included in the balance sheet as of December 31, 2006.(4)
    
    As of December 31, 2006, the Company was in the process of
    acquiring Securay. The Company recorded $820,000 of acquisition
    in progress as of December 31, 2006.(5)
    
    During the second quarter of 2005, the Company abandoned its
    leased facility in Sunnyvale California and moved to a new
    headquarters and U.S. manufacturing facility. As a result,
    the Company took a before-tax charge of approximately
    $2.0 million for abandonment of its lease in the second
    quarter of 2005.(6)
    
    The Company purchased 64% of ownership in RAE Beijing in May
    2004. The fair value of assets acquired and liabilities assumed
    were included in the balance sheet at December 31, 2004.
    Seven months of operating activities were recorded in statement
    of operations in 2004.(7)
    
    In January 2004, the Company closed its public offering of
    8,050,000 shares of its common stock at $4.25 share,
    less the applicable underwriting discount. The net proceeds was
    approximately $31.8 million. 25




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Note 2 Mergers and Acquisition
  ITEM 7.
    MANAGEMENTS
    DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
    OPERATIONS.  The following Managements Discussion and Analysis of
    Financial Condition and Results of Operations contains
    forward-looking statements. In some cases, readers can identify
    forward-looking statements by terminology such as
    may, will, should,
    could, expects, plans,
    anticipates, believes,
    estimates, predicts,
    potential, or continue. These statements
    involve known and unknown risks, uncertainties and other factors
    that may cause our actual results, performance or achievements
    to be materially different from those stated herein. Factors
    that might cause or contribute to such differences include, but
    are not limited to, those discussed in Item 1A, Risk
    Factors as well as in Item 1, Business
    and Item 7, Managements Discussion and Analysis
    of Financial Condition and Results of Operations in this
    Annual Report on
    Form 10-K.
    You should carefully review these risks and also review the
    risks described in other documents we file from time to time
    with the Securities and Exchange Commission, including the
    Quarterly Reports on
    Form 10-Q
    that we will file in fiscal year 2007. You are cautioned not to
    place undue reliance on these forward-looking statements, and we
    expressly assume no obligations to update the forward-looking
    statements in this report that occur after the date hereof.
  Overview
         26




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Critical
    Accounting Policies
      Revenue
    Recognition
   27




---



##### Table of Contents



percentage-of-completion No. 00-10, Accounting for Shipping and Handling Fees and Costs.
  Accounts
    Receivable, Trade Notes Receivable and Allowance for
    Doubtful Accounts
      Inventories
  first-in,
  Investments
  held-to-maturity available-for-sale.
  Stock-Based
    Compensation Expense
     28




---



##### Table of Contents



Valuation and amortization method
  Expected Term
  Expected Volatility
  Expected Dividend
  Risk-Free Interest Rate
  Estimated Forfeitures
  Business
    Combinations
      Income
    Taxes
       29




---



##### Table of Contents



RESULTS
    OF OPERATIONS
  Comparison
    of Years Ended December 31, 2006 and 2005
  Total Net
    Sales
  Years Ended December 31,2006


2005


Change


% changeNet sales

$
67,986,000


$
60,293,000


$
7,693,000



13
%     Cost of
    Sales & Gross Profit
  Years Ended December 31,2006


2005


Change


% changeCost of sales

$
32,251,000


$
24,690,000


$
7,561,000



31
%Gross profit

$
35,735,000


$
35,603,000


$
132,000



0
%Gross profit as % of net sales


53
%


59
%   year-over-year
  Sales and
    Marketing Expense
  Years Ended December 31,2006

2005

Change

% changeSales and marketing

$
19,277,000


$
16,835,000


$
2,442,000



15
%As % of net sales


28
%


28
%    30




---



##### Table of Contents



Research
    and Development Expense
  Years Ended December 31,2006


2005


Change


% changeResearch and development

$
6,234,000


$
5,414,000


$
820,000



15
%As % of net sales


9
%


9
%     General
    and Administrative Expense
  Years Ended December 31,2006


2005


Change


% changeGeneral and administrative

$
13,338,000


$
12,915,000


$
423,000



3
%As % of net sales


20
%


21
%     Loss on
    Abandonment of Lease
  Years Ended December 31,2006


2005


Change


% changeLoss on abandonment of lease

$



$
2,027,000


$
(2,027,000
)


(100
)%As % of net sales


0
%


3
%     Other
    Income (Expense)
  Years Ended December 31,2006


2005


Change


% changeInterest income

$
782,000


$
641,000


$
141,000



22
%Interest expense


(249,000
)


(180,000
)


(69,000
)


38
%Other, net


232,000



25,000



207,000



828
%Equity in loss of unconsolidated
    affiliate


(194,000
)


(196,000
)


2,000



(1
)%Total

$
571,000


$
290,000


$
281,000



97
%As % of net sales


1
%


0
%    31




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##### Table of Contents



Income
    Taxes
  Years Ended December 31,2006


2005


Change


% changeIncome tax benefit

$
(965,000
)

$
(477,000
)

$
(488,000
)


102
%As % of loss before income taxes,
    minority interest and cumulative effect on change in accounting
    principle


(38
%)


(37
%)       Minority
    interest in income of consolidated subsidiaries
  Years Ended December 31,2006


2005


Change


% changeMinority interest in loss of
    consolidated subsidiaries

$
49,000


$
62,000


$
(13,000
)


(21
)%As % of net sales


0
%


0
%     Comparison
    of Years Ended December 31, 2005 and 2004
    Total Net
    Sales
  Years Ended December 31,2005


2004


Change


% changeNet sales

$
60,293,000


$
45,540,000


$
14,753,000



32
%    32




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##### Table of Contents



non-Americas non-Americas
  Cost of
    Sales & Gross Profit
  Years Ended December 31,2005


2004


Change


% changeCost of sales

$
24,690,000


$
18,517,000


$
6,173,000



33
%Gross profit

$
35,603,000


$
27,023,000


$
8,580,000



32
%Gross profit as % of net sales


59
%


59
%     Sales and
    Marketing Expense
  Years Ended December 31,2005


2004


Change


% changeSales and marketing

$
16,835,000


$
10,583,000


$
6,252,000



59
%As % of net sales


28
%


23
%     Research
    and Development Expense
  Years Ended December 31,2005


2004


Change


% changeResearch and development

$
5,414,000


$
4,383,000


$
1,031,000



24
%As % of net sales


9
%


10
%    33




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##### Table of Contents



General
    and Administrative Expense
  Years Ended December 31,2005


2004


Change


% changeGeneral and administrative

$
12,915,000


$
8,543,000


$
4,372,000



51
%As % of net sales


21
%


19
%     Loss on
    Abandonment of Lease
  Years Ended December 31,2005


2004


Change


% changeLoss on abandonment of lease

$
2,027,000


$



$
2,027,000



100
%As % of net sales


3
%


0
%     Other
    Income (Expense)
  Years Ended December 31,2005


2004


Change


% changeInterest income

$
641,000


$
333,000


$
308,000



92
%Interest expense


(180,000
)


(17,000
)


(163,000
)


959
%Other, net


25,000



194,000



(169,000
)


(87
)%Equity in loss of unconsolidated
    affiliate


(196,000
)


(353,000
)


157,000



(44
)%Total

$
290,000


$
157,000


$
133,000



85
%As % of net sales


0
%


0
%    34




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##### Table of Contents



Income
    Taxes
  Years Ended December 31,2005


2004


Change


% changeIncome tax benefit (expense)

$
(477,000
)

$
983,000


$
(1,460,000
)


(149
)%As % of (loss) income before
    income taxes, minority interest and cumulative effect on change
    in accounting principle


(37
%)


27
%     Minority
    interest in income of consolidated subsidiaries
  Years Ended December 31,2005


2004


Change


% changeMinority interest in loss (income)
    of consolidated subsidiaries

$
62,000


$
(353,000
)

$
415,000



(118
)%As % of net sales


0
%


(1
)%     Liquidity
    and Capital Resources
  year-over-year
     35




---



##### Table of Contents



Year Ended December 31,2006


2005


2004Net cash provided by (used in):Operating activities

$
1,051,000


$
1,368,000


$
3,207,000Investing activities


3,025,000



(9,562,000
)


(21,009,000
)Financing activities


230,000



108,000



31,816,000Effect of exchange rate changes on
    cash and cash equivalents


289,000



44,000



40,000Net increase (decrease) in cash
    and cash equivalents

$
4,595,000


$
(8,042,000
)

$
14,054,000   Operating
    Activities
                   36




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##### Table of Contents



Investing
    Activities
          Financing
    activities
        Commitments
    and Contingencies
  Operating
    leases
     37




---



##### Table of Contents



Purchase
    obligations
  lower-of-cost
    Guarantees
      Product
    Warranties
    Summary
    of Obligations
    Total


2007


2008


2009


2010


2011


ThereafterContractual obligations:Operating lease obligations

$
5,233,000


$
1,475,000


$
1,248,000


$
982,000


$
378,000


$
349,000


$
801,000Purchase obligations


4,764,000



4,290,000



244,000



230,000











Notes payable  related
    parties


4,779,000



859,000



257,000



1,756,000



967,000



940,000



Total

$
14,776,000


$
6,624,000


$
1,749,000


$
2,968,000


$
1,345,000


$
1,289,000


$
801,000  38




---



##### Table of Contents



Related
    Party Transactions
            Recent
    Accounting Pronouncements
     39




---



##### Table of Contents



ITEM 7A.
    QUANTITATIVE
    AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.    Concentration
    of Credit Risk
    Interest
    Rate Risk
  held-to-maturity available-for-sale.
  Foreign
    Currency Exchange Rate Risk
       40




---



##### Table of Contents



ITEM 8.
    FINANCIAL
    STATEMENTS AND SUPPLEMENTARY DATA.  page F-1
  ITEM 9.
    CHANGES
    IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
    FINANCIAL DISCLOSURE.    ITEM 9A.
    CONTROLS
    AND PROCEDURES.  Evaluation
    of Disclosure Controls and Procedures
    Form 10-K, Rules 13a-15(e) 15d-15(e) Managements Report on
    Internal Control over Financial Reporting.
  Managements
    Report on Internal Control over Financial Reporting
  Rules 13a-15(f) 15d-15(f)
      Internal Control 
    Integrated Framework
 41




---



##### Table of Contents



Remediation
    of Material Weakness Identified by Management as of
    December 31, 2006
    
    Implement in China US GAAP accounting policies for depreciation,
    inventory reserves and balance sheet classification that are
    consistent with the Companys US accounting policy.
    Provide the Companys Chinese accounting staff with
    extended training on the proper implementation of US GAAP
    accounting policies for depreciation on property and equipment,
    inventory and balance sheet classification of assets and
    liabilities.
    Implementation of specific accounting procedures and templates
    for calculating and reporting depreciation, reserves and balance
    sheet classifications.
    The corporate controller and chief financial officer shall
    conduct extensive quarterly reviews of financial records of the
    Companys Chinese operations.
    Assess the requirement to hire additional US GAAP trained
    accounting personnel in China. 42




---



##### Table of Contents



Remediation
    of Material Weaknesses Identified by Management as of
    December 31, 2005
  Form 10-K Form 10-K Form 10-Q Form 10-K
  Changes
    in Internal Control Over Financial Reporting
   43




---



##### Table of Contents



Report of
    Independent Registered Public Accounting Firm
  
  Internal Control 
    Integrated Framework
         44




---



##### Table of Contents



Internal Control  Integrated Framework Internal Control  Integrated Framework
       
    45




---



##### Table of Contents



ITEM 9B.
    OTHER
    INFORMATION.   PART III  ITEM 10.
    DIRECTORS,
    EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE      ITEM 11.
    EXECUTIVE
    COMPENSATION.    ITEM 12.
    SECURITY
    OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
    RELATED STOCKHOLDER MATTERS.    ITEM 13.
    CERTAIN
    RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
    INDEPENDENCE.    ITEM 14.
    PRINCIPAL
    ACCOUNTING FEES AND SERVICES.   46




---



##### Table of Contents



PART IV.  ITEM 15.
    EXHIBITS,
    FINANCIAL STATEMENT SCHEDULES.  Financial Statements
  Form 10-K.
  Financial Statement Schedules
    Exhibits
   47




---



##### Table of Contents



SIGNATURES      By:
    /s/  Robert
    I. Chen  Robert I. Chen
 President and Chief Executive Officer
  KNOW ALL PERSONS BY THESE PRESENTS attorneys-in-fact Form 10-K, attorneys-in-fact attorneys-in-fact
    Signature

Title

Date/s/  Robert
    I. ChenRobert
    I. Chen

President, Chief Executive Officer
    and Chairman of the Board (Principal Executive Officer)

March 16, 2007/s/  Randall
    GausmanRandall
    Gausman

Vice President and Chief Financial
    Officer (Principal Financial and Accounting Officer)

March 16, 2007/s/  Peter
    C. HsiPeter
    C. Hsi

Chief Technology Officer, Vice
    President of Emerging Technologies Development and Director

March 16, 2007/s/  Lyle
    D. FeiselLyle
    D. Feisel

Director

March 16, 2007/s/  Neil
    W.
    FlanzraichNeil
    W. Flanzraich

Director

March 16, 2007/s/  Sigrun
    HjelmquistSigrun
    Hjelmquist

Director

March 16, 2007/s/  A.
    Marvin
    StraitA.
    Marvin Strait

Director

March 16, 2007/s/  James
    W. PowerJames
    W. Power

Director

March 16, 2007  48




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##### Table of Contents



INDEX TO
    EXHIBITS
  ExhibitNumber

Description of Document3
.1

Certificate of Incorporation of
    Registrant(1)3
.2

Bylaws of Registrant(1)4
.1

Specimen certificate representing
    the common stock of Registrant(1)10
.0

Purchase and Sale Agreement dated
    November 1, 2004 by and between RAE Systems Inc. and
    CarrAmerica Realty Operating Partnership, L.P.(2)10
.1

Form of Indemnity Agreement
    between the Registrant and the Registrants directors and
    officers(1)10
.2

RAE Systems Inc. 2002 Stock Option
    Plan(1)10
.3

RAE Systems Inc. 1993 Stock Plan(1)10
.4

Form of Stock Option Agreement
    under the Registrants 2002 Stock option Plan(4)10
.5

Lease Agreement by and between
    Aetna Life Insurance Company and the Registrant dated
    June 1, 1999(1)10
.6

First Amendment to Lease by and
    between Moffett Office Park Investors LLC and the Registrant
    dated effective November 1, 2002 amending Lease Agreement
    between Aetna Life Insurance Company and the Registrant dated
    June 1, 1999(3)10
.7

Manufacturing Building Lease
    Agreement by and between Shanghai China Academic Science High
    Tech Industrial Park Development Co., Ltd. and RAE
    Systems(Asia), Ltd., incorporated in Hong Kong, dated
    September 15, 2001(1)10
.8

Lease Agreement by and between
    Shanghai Institute of Metallurgy Research, Chinese Academy of
    Sciences and WARAE Instrument(Shanghai) Incorporated,
    incorporated in Jiading, Shanghai, dated January 8, 1999(1)10
.9

Form of Share Transfer Agreement
    by and between RAE-KLH shareholders and RAE Systems Asia(Hong
    Kong) Ltd.(5)10
.10

Separation Agreement and General
    Release of Claims by and between Donald W. Morgan and the
    Registrant dated August 8, 2006(6)10
.11

RAE Systems Inc. Management
    Incentive Plan(7)10
.12

Employment Offer Letter by and
    between Randall Gausman and the Registrant dated
    October 17, 2006 (8)10
.13

Loan and Security Agreement dated
    as of March 14, 2007 between Silicon Valley Bank and the
    Registrant(9)10
.14

Joint Venture Agreement by and
    between Lioaning Coal Industry Group Co., Ltd. and RAE Systems
    (Asia), Ltd. dated December 10, 2006(9)21
.1

Subsidiaries of the Registrant(9)23
.1

Consent of BDO Seidman, LLP(9)24
.1

Power of Attorney(9) (included on
    signature page)31
.1

Certifications of Robert I. Chen,
    President and Chief Executive Officer of Registrant pursuant to
    Rule 13a-14
    adopted under the Securities Exchange Act of 1934, as amended,
    and Section 302 of the Sarbanes-Oxley Act of 2002(9)31
.2

Certifications of Randall Gausman,
    Vice President and Chief Financial Officer of Registrant
    pursuant to
    Rule 13a-14
    adopted under the Securities Exchange Act of 1934, as amended,
    and Section 302 of the Sarbanes-Oxley Act of 2002(9)32
.1

Certification pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002(9)32
.2

Certification pursuant to
    18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002(9)     (1)
    
    Previously filed as an exhibit to the Registrants
    quarterly report on
    Form 10-Q,
    for the quarter ended March 31, 2002 and incorporated
    herein by reference. 49




---



##### Table of Contents



(2)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on November 2, 2004 and incorporated herein by reference.(3)
    
    Previously filed on February 28, 2003 as an exhibit to the
    Registrants annual report on Form
    10-K, for
    the year ended December 31, 2002 and incorporated herein by
    reference.(4)
    
    Previously filed on March 31, 2006 as an exhibit to the
    Registrants annual report on
    Form 10-K,
    for the year ended December 31, 2005 and incorporated
    herein by reference.(5)
    
    Previously filed on August 8, 2006 as an exhibit to the
    Registrants quarterly report on Form
    10-Q, for
    the quarter ended June 30, 2006 and incorporated herein by
    reference.(6)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on August 8, 2006 and incorporated herein by reference.(7)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on August 16, 2006 and incorporated herein by reference.(8)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on October 18, 2006 and incorporated herein by reference.(9)
    
    Filed herewith. 50




---



##### Table of Contents



RAE
    Systems Inc.
    Consolidated
    Financial Statements
    As of December 31, 2006 and 2005
  Report of Independent
    Registered Public Accounting Firm


F-1Consolidated Financial
    StatementsConsolidated
    balance sheets


F-2Consolidated
    statements of operations


F-3Consolidated
    statements of shareholders equity


F-4Consolidated
    statements of cash flows


F-5Notes to
    consolidated financial statements


F-6  F-31




---



##### Table of Contents



Report of
    Independent Registered Public Accounting Firm
                
    F-1




---



##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED
    BALANCE SHEETS
  December 31,


December 31,2006


2005ASSETSCurrent Assets:Cash and cash equivalents

$
18,119,000


$
13,524,000Short-term investments


3,248,000



14,348,000Trade notes receivable


1,977,000



1,087,000Accounts receivable, net of
    allowance for doubtful accounts of $843,000 and $963,000 at
    December 31, 2006 and 2005, respectively


16,966,000



11,707,000Accounts receivable from affiliate


154,000



84,000Inventories, net


15,382,000



9,477,000Prepaid expenses and other current
    assets


3,498,000



2,773,000Deferred tax assets


935,000



2,869,000Total Current Assets


60,279,000



55,869,000Property and Equipment,net


15,120,000



14,911,000Long Term Investments






1,616,000Intangible Assets, net


5,304,000



1,782,000Goodwill


3,760,000



136,000Long Term Deferred Tax
    Assets


3,402,000



634,000Deposits and Other
    Assets


648,000



867,000Acquisition in
    Progress


820,000



Investment in Unconsolidated
    Affiliate


420,000



449,000Total Assets

$
89,753,000


$
76,264,000LIABILITIES, MINORITY INTEREST
    IN CONSOLIDATED ENTITIES AND SHAREHOLDERS EQUITYCurrent Liabilities:Accounts payable

$
7,187,000


$
3,979,000Accounts payable to affiliate


360,000



Payable to Fushun shareholder


3,926,000



Accrued liabilities


8,793,000



7,329,000Notes payable  related
    parties


822,000



759,000Income taxes payable


520,000



407,000Current portion of deferred revenue


2,030,000



2,029,000Total Current
    Liabilities


23,638,000



14,503,000Deferred Revenue,net of current portion


736,000



296,000Deferred Tax
    Liabilities


438,000



379,000Other Long Term
    Liabilities


1,045,000



1,466,000Long Term
    Notes Payable  Related Parties


3,222,000



821,000Total Liabilities


29,079,000



17,465,000Commitments and
    ContingenciesMinority Interest in
    Consolidated Entities


4,495,000



4,226,000Shareholders
    Equity:Common stock, $0.001 par
    value; 200,000,000 shares authorized; 59,274,596 and
    57,837,843 shares issued and outstanding at
    December 31, 2006 and 2005, respectively


59,000



58,000Additional paid-in capital


58,828,000



56,629,000Accumulated other comprehensive
    income


1,245,000



310,000Accumulated deficit


(3,953,000
)


(2,424,000
)Total Shareholders
    Equity


56,179,000



54,573,000Total Liabilities, Minority
    Interest in Consolidated Entities and Shareholders
    Equity

$
89,753,000


$
76,264,000    F-2




---



##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED
    STATEMENTS OF OPERATIONS
  Year Ended December 31,2006


2005


2004Net Sales

$
67,986,000


$
60,293,000


$
45,540,000Cost of Sales


32,251,000



24,690,000



18,517,000Gross Profit


35,735,000



35,603,000



27,023,000Operating Expenses:Sales and marketing


19,277,000



16,835,000



10,583,000Research and development


6,234,000



5,414,000



4,383,000General and administrative


13,338,000



12,915,000



8,543,000Loss on abandonment of lease






2,027,000



Total Operating
    Expenses


38,849,000



37,191,000



23,509,000Operating (Loss)
    Income


(3,114,000
)


(1,588,000
)


3,514,000Other Income
    (Expense):Interest income


782,000



641,000



333,000Interest expense


(249,000
)


(180,000
)


(17,000
)Other, net


232,000



25,000



194,000Equity in (loss) of unconsolidated
    affiliate


(194,000
)


(196,000
)


(353,000
)Total Other Income


571,000



290,000



157,000(Loss) Income Before Income
    Taxes and Minority Interest


(2,543,000
)


(1,298,000
)


3,671,000Income tax (benefit) expense


(965,000
)


(477,000
)


983,000(Loss) Income Before Minority
    Interest


(1,578,000
)


(821,000
)


2,688,000Minority interest in loss (income)
    of consolidated subsidiaries


49,000



62,000



(353,000
)Net (Loss) Income

$
(1,529,000
)

$
(759,000
)

$
2,335,000Basic (Loss) Income Per Common
    Share

$
(0.03
)

$
(0.01
)

$
0.04Diluted (Loss) Income Per
    Common Share

$
(0.03
)

$
(0.01
)

$
0.04Weighted average common shares
    outstanding  Basic


58,424,970



57,687,714



55,809,638Dilutive effect of employee stock
    plans










4,326,054Weighted average common shares
    outstanding  Diluted


58,424,970



57,687,714



60,135,692    F-3




---



##### Table of Contents



RAE
    SYSTEMS, INC.
  CONSOLIDATED
    STATEMENTS OF SHAREHOLDERS EQUITY
  AccumulatedAdditional


OtherCommon Stock


Paid-in


Comprehensive


AccumulatedShares


Amount


Capital


Income


Deficit


TotalBalances,December 31, 2003


46,824,626


$
47,000


$
18,753,000


$
7,000


$
(4,000,000
)

$
14,807,000Components of comprehensive income:Net income


















2,335,000



2,335,000Foreign currency translation
    adjustments














130,000







130,000Total comprehensive income






















2,465,000Issuance of common stock due to
    exercise of stock options


1,338,471



1,000



618,000











619,000Issuance of common stock due to net
    exercise of warrants


1,039,078



1,000



12,000











13,000Proceeds from the sale of common
    stock, net of offering costs of $370,000


8,050,000



8,000



31,782,000











31,790,000Compensation expense under fair
    value accounting of common stock options










1,404,000











1,404,000Issuance of common stock due to
    exercise of restricted stock


63,000







50,000











50,000Tax benefits from exercise of stock
    options










1,041,000











1,041,000Balances,December 31, 2004


57,315,175


$
57,000


$
53,660,000


$
137,000


$
(1,665,000
)

$
52,189,000Components of comprehensive (loss):Net loss


















(759,000
)


(759,000
)Foreign currency translation
    adjustments














173,000







173,000Total comprehensive loss






















(586,000
)Issuance of common stock due to
    exercise of stock options


522,668



1,000



324,000











325,000Compensation expense under fair
    value accounting of common stock options










1,970,000











1,970,000Adjustment to carrying value of
    investment in unconsolidated entity










489,000











489,000Tax benefits from exercise of stock
    options










186,000











186,000Balances,December 31, 2005


57,837,843


$
58,000


$
56,629,000


$
310,000


$
(2,424,000
)

$
54,573,000Components of comprehensive (loss):Net loss


















(1,529,000
)


(1,529,000
)Foreign currency translation
    adjustments














936,000







936,000Unrealized loss on investment, net
    of tax














(1,000
)






(1,000
)Total comprehensive loss






















(594,000
)Issuance of common stock due to
    exercise of stock options


1,115,497



1,000



632,000











633,000Issuance of common stock due to net
    exercise of warrants


321,256



















Compensation expense under fair
    value accounting of common stock options










1,620,000











1,620,000Adjustment to carrying value of
    investment in unconsolidated entity










146,000











146,000Deficient tax benefit from exercise
    of stock options










(199,000
)










(199,000
)Balances, December 31,
    2006


59,274,596


$
59,000


$
58,828,000


$
1,245,000


$
(3,953,000
)

$
56,179,000    F-4




---



##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED
    STATEMENTS OF CASH FLOWS
  Year End December 31,2006


2005


2004Increase (Decrease) in Cash and
    Cash EquivalentsCash Flows From Operating
    Activities:Net (Loss) Income

$
(1,529,000
)

$
(759,000
)

$
2,335,000Adjustments to reconcile net (loss)
    income to net cash provided by operating activities:Depreciation and amortization


3,189,000



2,143,000



991,000Provision for doubtful accounts


(123,000
)


313,000



489,000Loss on disposal of fixed assets


245,000



41,000



Inventory reserve


589,000



439,000



428,000Compensation expense under fair
    value accounting of common stock options


1,620,000



1,970,000



1,404,000Common stock warrants granted for
    services






69,000



165,000Equity in loss of unconsolidated
    affiliate


194,000



196,000



353,000Minority interest in loss of
    consolidated subsidiary


(49,000
)


(62,000
)


353,000Tax benefits from exercise of stock
    options






186,000



1,041,000Deferred income taxes


(1,180,000
)


(1,925,000
)


(810,000
)Loss on abandonment of lease






2,027,000



Amortization of discount on notes
    payable


187,000







Changes in operating assets and
    liabilities:










Trade notes receivable


(838,000
)


(535,000
)


(535,000
)Accounts receivable


(2,729,000
)


(2,091,000
)


(2,784,000
)Accounts receivable from affiliate


(49,000
)


35,000



(119,000
)Inventories


(2,890,000
)


(2,026,000
)


(2,627,000
)Prepaid expenses and other current
    assets


565,000



(1,248,000
)


(832,000
)Deposit and other


231,000



301,000



5,000Accounts payable


2,973,000



494,000



1,019,000Accounts payable to affiliate


335,000







(594,000
)Accrued liabilities


1,200,000



1,250,000



3,008,000Income taxes payable


(823,000
)


(13,000
)


(580,000
)Deferred revenue


384,000



939,000



439,000Other long-term liabilities


(451,000
)


(376,000
)


58,000Net Cash Provided By Operating
    Activities


1,051,000



1,368,000



3,207,000Cash Flows From Investing
    Activities:Purchase of investments


(12,615,000
)


(16,642,000
)


(15,729,000
)Proceeds from maturities of
    investments


16,801,000



11,935,000



4,484,000Proceeds from sales prior to
    maturity of investments


8,513,000







Purchase of property and equipment


(2,235,000
)


(4,855,000
)


(9,273,000
)Payments for business acquisitions,
    net of cash acquired


(7,439,000
)






Proceeds from business acquisition










377,000Purchased of intangibles










(77,000
)Deposits and other










(791,000
)Net Cash Provided By (Used In)
    Investing Activities


3,025,000



(9,562,000
)


(21,009,000
)Cash Flows From Financing
    Activities:Notes payable  related
    parties


(402,000
)






(435,000
)Payment on capital lease obligation






(217,000
)


(122,000
)Proceeds from the exercise of stock
    options and warrants


632,000



325,000



682,000Proceeds from the sale of common
    stock










32,160,000Bank borrowing










(120,000
)Offering cost










(370,000
)Proceeds from minority shareholder
    investment










21,000Net Cash Provided By Financing
    Activities


230,000



108,000



31,816,000Effect of exchange rate changes
    on cash and cash equivalents


289,000



44,000



40,000Net Increase (Decrease) in Cash
    and Cash Equivalents


4,595,000



(8,042,000
)


14,054,000Cash and Cash
    Equivalents, beginning
    of period


13,524,000



21,566,000



7,512,000Cash and Cash
    Equivalents, end of
    period

$
18,119,000


$
13,524,000


$
21,566,000Supplemental Disclosure of Cash
    Flow Information:Cash Paid:Income taxes

$
1,084,000


$
1,833,000


$
726,000Interest

$
6,000


$
8,000


$
17,000Noncash Investing and Financing
    Activities:Exchange of warrants for common
    stock

$



$



$
1,532,000Capital leases entered into for
    equipment

$



$



$
217,000Notes payable issued in conjunction
    with RAE Beijing Acquisition

$
2,648,000


$



$
Acquisitions:Fair value of assets acquired

$
27,352,000


$
243,000


$
7,890,000Liabilities assumed

$
6,486,000


$
243,000


$
3,976,000    F-5




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL STATEMENTS
  Note 1.
    Summary
    of Significant Accounting Policies  (a)
    The
    Company    (b)
    Principles
    of Consolidation    (c)
    Use of
    Estimates    (d)
    Revenue
    Recognition  percentage-of-completion No. 00-10, Accounting for Shipping and Handling Fees and Costs.
  (e)
    Cash
    and Cash Equivalents   F-6




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   (f)
    Accounts
    Receivable, Trade Notes Receivable and Allowance for
    Doubtful Accounts      (g)
    Inventories  lower-of-cost, first-in,
  (h)
    Property
    and Equipment    Buildings

20 to 25 yearsEquipment

3 to 10 yearsFurniture and fixtures

3 to 7 yearsComputers and software

3 to 7 yearsAutomobiles

3 to 5 yearsBuilding improvements

Lesser of useful life or remaining
    lease term   (i)
    Warranty
    Repairs   F-7




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    (j)
    Research
    and Development    (k)
    Advertising
    Costs    (l)
    Income
    Taxes  , Accounting for Income Taxes
        (m)
    Goodwill
    and Other Intangible Assets   F-8




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   (n)
    Long 
    Lived Assets    (o)
    Fair
    Values of Financial Instruments    
    Cash and Cash Equivalents, Accounts Receivable, Trade Notes
    Receivables, Accounts Receivable from Affiliate, Accounts
    Payable, Accrued Expenses, Inventory Purchase Obligations:    
    Investments:  available-for-sale.
  
    Lines of Credits:  Note 15 Subsequent Events.
  
    Notes Payable  Related Parties:      (p)
    Translation
    of Foreign Currencies  non-U.S. subsidiaries non-U.S. subsidiaries.
 F-9




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   (q)
    Stock-Based
    Compensation Expense      No. FAS 123(R)-3 Transition Election Related to Accounting for Tax
    Effects of Stock-based Payment Awards
  Determining Fair Value Valuation and Amortization
    Method
  Expected Term
  Expected Volatility
  Expected Dividend
  Risk-Free Interest Rate
  Estimated Forfeitures
  Fair Value
  December 31

2006


2005


2004Expect term in years


6



5



5Volatility


75-79
%


103-109
%


103-116
%Expected dividend










Risk-free interest rate


5.00
%


4.00
%


3.25
%Weighted-average fair value

$
2.62


$
2.80


$
4.34  F-10




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    (r)
    Earnings
    Per Share    (s)
    Retained
    Earnings    (t)
    Recent
    Accounting Pronouncements      (u)
    Segment
    Reporting  Disclosures About Segments of an
    Enterprise and Related Information
  (v)
    Reclassifications   F-11




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   Note 2.
    Mergers
    and Acquisitions  RAE
    Coal Mine Safety Instruments (Fushun) Co., Ltd.
      AmountCash

$
2,151,000Notes payable


8,606,000Acquisition related cost


38,000Total

$
10,795,000     AmountCash

$
1,506,000Accounts receivable


1,375,000Inventories


2,173,000Receivables due from RAE(*)


6,024,000Property & equipment, net


366,000Intangible assets


2,099,000Total assets


13,543,000Payable to Liaoning Group


(2,748,000
)Purchase price

$
10,795,000     *
    
    Balance eliminated in consolidation. F-12




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Weighted AverageAmount


Useful Life (Years)Customer list

$
1,478,000



9Tradenames


366,000



10Patents and technology


255,000



7Total

$
2,099,000       Years Ended December 31,2006


2005(Unaudited)


(Unaudited)Net sales

$
76,141,000


$
64,293,000Net loss

$
(1,632,000
)

$
(215,000
)Net loss per share 
    basic

$
(0.03
)

$
(0.00
)Ner loss per share 
    diluted

$
(0.03
)

$
(0.00
)   RAE
    Beijing Acquisition
     July 2009 


$1,499,000 July 2010 


$967,000 July 2011 


$940,000Total


$3,406,000    F-13




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    AmountCash

$
4,808,000Long term notes payable (net of
    discount of 0.8 million)


2,648,000Acquisition related cost


49,000Total

$
7,505,000     AmountCurrent assets

$
5,760,000Property and equipment, net


1,292,000Intangible assets


1,197,000Goodwill


2,754,000Total Assets


11,003,000Current liabilities


(3,146,000
)Long-term liabilities


(352,000
)Total Liabilities


(3,498,000
)Purchase price

$
7,505,000     Weighted AverageCost


Useful Life (Years)Customer list

$
817,000



6Business name and trade name


216,000



7Patents and technology


164,000



7$
1,197,000     Other
    Acquisitions
   F-14




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   98-3
  AmountCurrent assets

$
97,000Property & equipment, net


36,000Intangible assets


909,000Goodwill


816,00020% interest in Tianjin Securay
    Technology Ltd. Co.


353,000Total assets


2,211,000Current liabilities


(112,000
)Purchase price

$
2,099,000     Weighted AverageAmount


Useful Life (Years)Customer list

$
91,000



3Business name and trade name


108,000



2Trade secret


79,000



10Patents and technology


631,000



10Total

$
909,000     Acquisition
    in progress
  Note 15 Subsequent
    Events.
  Note 3.
    Investments  held-to-maturity available-for-sale
 F-15




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   available-for-sale
  Unrealized


FairCost


Losses


ValueCertificates of Deposit

$
1,050,000


$



$
1,050,000US Government Agencies


2,199,000



(1,000
)


2,198,000Total

$
3,249,000


$
(1,000
)

$
3,248,000   available-for-sale held-to-maturity
  Current


NoncurrentDecember 31,


December 31,2006


2005


2006


2005Certificates of Deposit

$
1,050,000


$
6,067,000


$



$
US Treasury Bonds & Notes






2,918,000







US Government Agencies


2,198,000



3,269,000







1,600,000Mortgage Backed Securities






2,094,000







Other














16,000$
3,248,000


$
14,348,000


$



$
1,616,000   other-than-temporary
    2006


2005Cost


Fair Value


Amortized CostYears to
    MaturityLess than one year

$
3,249,000


$
3,248,000


$
14,348,000One to five years










1,616,000$
3,249,000


$
3,248,000


$
15,964,000   Note 4.
    Inventories    December 31,2006


2005Raw materials

$
4,675,000


$
2,862,000Work-in-progress


1,858,000



2,286,000Finished goods


8,849,000



4,329,000$
15,382,000


$
9,477,000  F-16




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 5.
    Property
    and Equipment    December 31,2006


2005Building and building improvements

$
8,150,000


$
7,824,000Land


3,220,000



3,220,000Equipment


4,043,000



2,757,000Computer equipment


3,498,000



2,015,000Automobiles


1,126,000



851,000Furniture and fixtures


550,000



669,000Construction in progress


53,000



993,00020,640,000



18,329,000Less: accumulated depreciation


5,520,000



3,418,000$
15,120,000


$
14,911,000     Note 6.
    Goodwill
    and Intangible Assets      December 31, 2006


December 31, 2005Gross Carrying


Accumulated


Net Carrying


Gross Carrying


Accumulated


Net CarryingAmount


Amortization


Amount


Amount


Amortization


AmountCustomer list

$
3,059,000


$
675,000


$
2,384,000


$
644,000


$
321,000


$
323,000Patent and technology


1,966,000



381,000



1,585,000



915,000



207,000



708,000Trade name


1,661,000



401,000



1,260,000



971,000



220,000



751,000Trade secret


79,000



4,000



75,000











Total

$
6,765,000


$
1,461,000


$
5,304,000


$
2,530,000


$
748,000


$
1,782,000    F-17




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Expected FutureAmortization Expense2007

$
1,158,0002008


953,0002009


850,0002010


819,0002011


537,000Thereafter


987,000Total

$
5,304,000   Note 7.
    Accrued
    Liabilities    December 31,

2006


2005Compensation and related benefits

$
2,233,000


$
2,120,000Accrued commissions


1,815,000



1,415,000Professional fees


1,066,000



1,269,000Warranty reserve


553,000



377,000Marketing & advertising


933,000



177,000Taxes other than income tax


500,000



616,000Abandonment of lease (see
    note 9)


478,000



482,000Accrued inventory receipts


242,000



Payable to Aegison shareholder


200,000



Other


773,000



873,000Total

$
8,793,000


$
7,329,000   Note 8.
    Income
    Taxes    Year Ended December 31,2006


2005


2004U.S.

$
(3,456,000
)

$
(752,000
)

$
2,503,000Foreign


913,000



(546,000
)


1,168,000Total

$
(2,543,000
)

$
(1,298,000
)

$
3,671,000  F-18




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2006


2005


2004Current:Federal

$
(609,000
)

$
775,000


$
1,190,000State


22,000



1,000



1,000Foreign


792,000



672,000



604,000205,000



1,448,000



1,795,000Deferred:Federal


(880,000
)


(1,134,000
)


(839,000
)State


(202,000
)


(472,000
)


58,000Foreign


(88,000
)


(319,000
)


(31,000
)(1,170,000
)


(1,925,000
)


(812,000
)Total income tax (benefit) expense

$
(965,000
)

$
(477,000
)

$
983,000     Year Ended December 31,2006


2005


2004Federal income tax (benefit)
    expense at statutory rate

$
(890,000
)

$
(441,000
)

$
1,115,000State income tax (benefit)
    expense, net of federal benefit


(126,000
)


(141,000
)


39,000Foreign tax (benefit) expense


(71,000
)


313,000



296,000Nondeductible expenses


238,000



241,000



248,000Other


(359,000
)


(73,000
)


(132,000
)Change in valuation allowance


243,000



(376,000
)


(583,000
)Total income tax (benefit) expense

$
(965,000
)

$
(477,000
)

$
983,000  F-19




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2006


2005Deferred tax assets:Fixed assets

$
(102,000
)

$
13,000Allowance for doubtful accounts


64,000



62,000Inventories


300,000



265,000Accrued vacation


240,000



198,000Other accruals


1,348,000



1,071,000Capitalized research and
    development


703,000



959,000Unrealized foreign losses


1,450,000



995,000Federal tax credits


287,000



Stock-based compensation


1,436,000



1,068,000State income taxes and credits


(269,000
)


(251,000
)Valuation allowance


(1,120,000
)


(877,000
)Total deferred tax assets


4,337,000



3,503,000Deferred tax
    liabilities:Intangibles


(438,000
)


(379,000
)Total deferred tax liabilities


(438,000
)


(379,000
)Net deferred tax
    assets

$
3,899,000


$
3,124,000       non-U.S. subsidiaries
   F-20




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        Note 9.
    Commitments
    and Contingencies  (a)  Legal
    Proceedings
  Polimaster
    Ltd. v. RAE Systems Inc., United States District Court for the
    Northern District of California, Case
    No. 05-CV-01887-JF
  No. 05-CV-01887-JF).
  ten-day
    (b)  Operating
    leases
   F-21




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      (c)  Purchase
    obligations
  lower-of-cost
    (d)
    Guarantees     F-22




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  (e)
    Product
    Warranties    Summary
    of Obligations
    Total


2007


2008


2009


2010


2011


ThereafterContractual obligations:Operating lease obligations

$
5,233,000


$
1,475,000


$
1,248,000


$
982,000


$
378,000


$
349,000


$
801,000Purchase obligations


4,764,000



4,290,000



244,000



230,000











Notes payable  related
    parties (Note 14)


4,779,000



859,000



257,000



1,756,000



967,000



940,000



Total

$
14,776,000


$
6,624,000


$
1,749,000


$
2,968,000


$
1,345,000


$
1,289,000


$
801,000   Note 10.
    Employee
    Benefit Plans    Note 11.
    Concentrations      Year Ended December 31,

2006


2005


2004Net Sales to
    Customers:Americas(1)

$
33,068,000


$
33,902,000


$
29,901,000Asia


26,024,000



19,902,000



11,090,000Europe


8,894,000



6,489,000



4,549,000Total consolidated net sales to
    customers

$
67,986,000


$
60,293,000


$
45,540,000  F-23




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  December 31,

2006


2005


2004Property and equipment,
    net:Asia

$
8,105,000


$
7,134,000


$
5,433,000Americas


6,941,000



7,724,000



5,805,000Europe


74,000



53,000



49,000Total property and equipment, net

$
15,120,000


$
14,911,000


$
11,287,000     (1)
    
    Americas revenue included sales to customers in the United
    States, Canada and Latin American countries. Sales to Canada and
    Latin American countries represent less than 8% of total
    Americas sales.      Note 12.
    Shareholders
    Equity  Warrants
    WarrantsWarrants








Outstanding as ofOutstanding as of


Expired


Exercised


December 31,


ExpireExercise Price

December 31, 2005


2006


2006


2006


Date$0.74


















$1.07


450,000







(450,000
)






Jun-07$1.19


















$1.98


















$8.51


















$22.68


















450,000







(450,000
)   F-24




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  WarrantsWarrants








Outstanding as ofOutstanding as of


Expired


Exercised


December 31,


ExpireExercise Price

December 31, 2004


2005


2005


2005


Date$0.74


264,551



(264,551
)










Apr-05$1.07


450,000











450,000



Jun-07$1.19


10,000



(10,000
)










Apr-05$1.98


61,729



(61,729
)










Oct-05$8.51


388,008



(388,008
)










Jun-05$22.68


2,719,004



(2,719,004
)










Jan-053,893,292



(3,443,292
)






450,000   Non-Plan
    Restricted Stock
    Non-Plan
    Stock Options
      Options OutstandingDecember 31, 2006


December 31, 2005


December 31, 2004Weighted-





Weighted-





Weighted-Average





Average





AverageExercise





Exercise





ExerciseShares


Price


Shares


Price


Shares


PriceBeginning


337,000


$
1.02



337,000


$
1.02



400,000


$
0.99Granted





$







$







$
Exercised


(237,000
)

$
1.01






$




(63,000
)

$
0.80Cancelled





$







$







$
Ending


100,000


$
1.06



337,000


$
1.02



337,000


$
1.02Exercisable at year-end


100,000







293,249







193,249Aggregate intrinsic value of
    options exercised during 2006:





$
588,525Aggregate intrinsic value of
    options outstanding at December 31, 2006:





$
214,500  F-25




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Options Outstanding


Options ExercisableWeighted-Average


Weighted-





Weighted-Remaining


Average





AverageNumber


Contractual


Exercise


Number


ExerciseRange of Exercise Prices

Outstanding


Life (Years)


Prices


Exercisable


Prices$1.06


100,000



5.41


$
1.06



100,000


$
1.06100,000



5.41


$
1.06



100,000


$
1.06   Stock
    Option Plan
       F-26




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Options OutstandingDecember 31, 2006


December 31, 2005


December 31, 2004Weighted-





Weighted-





Weighted-Average





Average





AverageExercise





Exercise





ExerciseShares


Price


Shares


Price


Shares


PriceBeginning


2,701,554


$
2.92



3,105,494


$
2.57



4,046,683


$
1.18Granted


1,141,500


$
3.69



514,500


$
3.63



1,004,000


$
5.40Exercised


(342,497
)

$
1.15



(522,668
)

$
0.62



(1,338,471
)

$
0.46Cancelled


(361,742
)

$
4.42



(395,772
)

$
4.07



(606,718
)

$
2.63Ending


3,138,815


$
3.22


$
2,701,554


$
2.92



3,105,494


$
2.57Exercisable at year-end


1,573,479







1,602,044







1,285,604Weighted-average fair value of
    options granted during the period:





$
2.62






$
2.80






$
4.59Aggregate intrinsic value of
    options exercised during 2006:





$
840,383Aggregate intrinsic value of
    options outstanding at December 31, 2006:





$
2,051,448     Options Outstanding


Options ExercisableWeighted-Average


Weighted-





Weighted-Range of




Remaining


Average





AverageExercise

Number


Contractual


Exercise


Number


ExercisePrices

Outstanding


Life (Years)


Prices


Exercisable


Prices$0.01-0.50


235,870



4.63


$
0.08



235,870


$
0.08$0.51-1.00


102,152



6.00


$
0.58



101,149


$
0.58$1.01-1.50


461,240



5.48


$
1.07



454,864


$
1.07$1.51-3.00


85,000



9.61


$
2.81






$
$3.01-3.50


565,991



7.50


$
3.20



349,872


$
3.22$3.51-4.00


1,084,500



9.43


$
3.76



18,083


$
3.62$4.01-5.00


217,500



7.37


$
4.80



148,644


$
4.84$5.01-6.00


224,375



7.26


$
5.27



173,125


$
5.27$6.01-7.00


62,187



7.87


$
6.43



41,872


$
6.43$7.01-8.00


100,000



7.98


$
7.81



50,000


$
7.813,138,815



7.66


$
3.22



1,573,479


$
3.10    F-27




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     Exercisable


Unexercisable


TotalWeighted





Weighted





WeightedAverage





Average





AverageNumber of


Exercise


Number of


Exercise


Number of


ExerciseShares


Price


Shares


Price


Shares


PriceStock Options with exercise prices
    less than or equal to $3.20


951,090


$
1.11



214,663


$
2.90



1,165,753


$
1.44Stock Options with exercise prices
    greater $3.20


622,389


$
4.81



1,350,673


$
4.02



1,973,062


$
4.271,573,479







1,565,336







3,138,815   Stock-Based
    Compensation Expense
          Note 13.
    Investments
    in Other Entities      December 31,2006


2005Current assets

$
988,000


$
1,053,000Noncurrent assets


285,000



328,000Total Assets


1,273,000



1,381,000Current liabilities


223,000



133,000Total Liabilities

$
223,000


$
133,000   F-28




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Year Ended December 31,2006


2005


2004Net sales

$
595,000


$
444,000


$
216,000Operating income (loss)

$
316,000


$
(600,000
)

$
(983,000
)Net loss

$
(217,000
)

$
(542,000
)

$
(981,000
)       Note 14.
    Related
    Party Transactions            Note 15.
    Subsequent
    Events   F-29




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 2 Mergers and Acquisitions
    Note 16.
    Quarterly
    Information (Unaudited)    First


Second


Third


FourthQuarter


Quarter


Quarter(1)


Quarter


2006Net sales

$
12,426,000


$
15,901,000


$
18,564,000


$
21,095,000


$
67,986,000Gross profit

$
6,710,000


$
8,462,000


$
9,967,000


$
10,596,000


$
35,735,000Operating (loss)
    income

$
(1,603,000
)

$
(444,000
)

$
659,000


$
(1,726,000
)

$
(3,114,000
)Net (loss) income

$
(1,033,000
)

$
(54,000
)

$
513,000


$
(955,000
)

$
(1,529,000
)Loss (income) per common
    share:Basic:

$
(0.02
)

$
(0.00
)

$
0.01


$
(0.02
)

$
(0.03
)Diluted:

$
(0.02
)

$
(0.00
)

$
0.01


$
(0.02
)

$
(0.03
)   First


Second


Third


FourthQuarter


Quarter(2)


Quarter


Quarter


2005Net sales

$
12,248,000


$
13,624,000


$
16,152,000


$
18,269,000


$
60,293,000Gross profit(3)

$
7,170,000


$
8,344,000


$
9,647,000


$
10,442,000


$
35,603,000Operating (loss)
    income

$
194,000


$
(2,847,000
)

$
842,000


$
223,000


$
(1,588,000
)Net (loss) income

$
94,000


$
(1,341,000
)

$
397,000


$
91,000


$
(759,000
)Loss (income) per common
    share:Basic:

$
0.00


$
(0.02
)

$
0.01


$
0.00


$
(0.01
)Diluted:

$
0.00


$
(0.02
)

$
0.01


$
0.00


$
(0.01
)     (1)
    
    The Company purchased an additional 32% ownership in RAE Beijing
    in July 2006. The Company has consolidated RAE Beijing since
    2004. With the purchase in July 2006, minority
    shareholders interest was reduced to 4%.(2)
    
    During the second quarter of 2005, the Company abandoned its
    leased facility in Sunnyvale California and moved to a new
    headquarters and U.S. manufacturing facility. As a result,
    the Company took a before-tax charge of approximately
    $2.0 million for abandonment of its lease in the second
    quarter of 2005. F-30




---



##### Table of Contents



RAE SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
   (3)
    
    Gross profit numbers in 2005 have been reclassified in order to
    comply with 2006 presentation. These reclassification
    adjustments do not have an impact on net income or loss for each
    quarter in 2005.  Note 17.
    Supplemental
    Disclosures    AdditionsBalance as of


Charged to





Balance as ofDescription

Beginning of Year


Expenses


Deductions


End of Year2006:Allowance for doubtful accounts

$
963,000


$



$
(120,000
)

$
843,0002005:Allowance for doubtful accounts

$
665,000


$
313,000


$
(15,000
)

$
963,0002004:Allowance for doubtful accounts

$
176,000


$
489,000


$



$
665,000   AdditionsBalance as of


Charged to





Balance as ofDescription

Beginning of Year


Expenses


Deductions


End of Year2006:Inventory reserve

$
1,015,000


$
592,000


$
(121,000
)

$
1,486,0002005:Inventory reserve

$
703,000


$
439,000


$
(127,000
)

$
1,015,0002004:Inventory reserve

$
275,000


$
428,000


$



$
703,000   AdditionsBalance as of


Charged to





Balance as ofDescription

Beginning of Year


Expenses


Deductions


End of Year2006:Warranty reserve

$
377,000


$
246,000


$
(70,000
)

$
553,0002005:Warranty reserve

$
490,000


$
218,000


$
(331,000
)

$
377,0002004:Warranty reserve

$
358,000


$
332,000


$
(200,000
)

$
490,000  F-31