##### Table of Contents





UNITED STATES SECURITIES AND
    EXCHANGE COMMISSIONWashington, 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, 2008ORo

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

NYSE Alternext US   Securities registered pursuant to Section 12(g) of the
    Act:
 None
  o þ
  o þ
  þ o
  Regulation S-K Form 10-K Form 10-K. þ
  12b-2
  Large accelerated filer
    o

Accelerated filer
    þ

Non-accelerated
    filer o
    (Do not check if a smaller reporting company)

Smaller reporting
    company o   Rule 12b-2 o þ
    DOCUMENTS
    INCORPORATED BY REFERENCE
  Form 10-K.




---



##### 





RAE
    SYSTEMS INC.
    INDEX TO
    ANNUAL REPORT ON
    FORM 10-K
    FOR YEAR ENDED DECEMBER 31, 2008
    TABLE OF CONTENTS
   
 PagePART IITEM 1.


BUSINESS


1ITEM 1A.


RISK FACTORS


6ITEM 1B.


UNRESOLVED STAFF COMMENTS


14ITEM 2.


PROPERTIES


14ITEM 3.


LEGAL PROCEEDINGS


15ITEM 4.


SUBMISSION OF MATTERS TO A VOTE OF SECURITY
    HOLDERS


15PART IIITEM 5.


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


16ITEM 6.


SELECTED FINANCIAL DATA


18ITEM 7.


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


19ITEM 7A.


QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
    MARKET RISK


31ITEM 8.


FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


32ITEM 9.


CHANGES IN DISAGREEMENTS WITH ACCOUNTANTS ON
    ACCOUNTING AND FINANCIAL DISCLOSURE


32ITEM 9A.


CONTROLS AND PROCEDURES


32ITEM 9B.


OTHER INFORMATION


35PART IIIITEM 10.


DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
    GOVERNANCE


35ITEM 11.


EXECUTIVE COMPENSATION


35ITEM 12.


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


35ITEM 13.


CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
    AND DIRECTOR INDEPENDENCE


35ITEM 14.


PRINCIPAL ACCOUNTING FEES AND SERVICES


35PART IVITEM 15.


EXHIBITS, FINANCIAL STATEMENT SCHEDULES


35SIGNATURES


36EX-23.1EX-23.2EX-31.1EX-31.2EX-32.1EX-32.2




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##### Table of Contents



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 2009.
  ITEM 1.
    BUSINESS  Overview
  clean-ups.
        www.raesystems.com Form 10-K, Form 10-Q, Form 8-K
  1-800-SEC-0330. http://www.sec.gov.
 1




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##### Table of Contents



Industry
    Background
      Products
    Sensor
    and Measurement Products
    
    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;
    electro-chemical sensors for the measurement of oxygen and toxic
    gases such as carbon monoxide and hydrogen sulfide;
    solid polymer electrode sensors for the measurement of
    oxygen; and
    solid-state scintillation detectors for both neutron and gamma
    radiation.  part-per-billion
  Integrated
    Wireless Products
   2




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Radiation
    Products
    Sales,
    Marketing and Distribution
          Customers
   3




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Research,
    Development and Engineering
    
    the RAELink 3 a wireless modem with integrated GPS and Bluetooth
    radio technology that provides a data bridge for our products
    and complementary products such as chemical warfare agents and
    particle counters
    AutoRAE Lite a fast calibration and bump test station for
    personal and portable toxic gas monitors
    Solar power stations for placing AreaRAE monitors in remote
    locations
    Solid polymer sensors for oxygen that comply with EU, China and
    California reduction of hazardous substances (RoHS) acts.
    MeshGuard wireless, mesh radio based, explosive and toxic gas
    detection for oil and gas exploration, both on-shore and
    off-shore that give users a significant time a monitoring
    advantage over older fixed systems.  parts-per-billion
  Manufacturing
      Competition
     4




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##### Table of Contents



and/or
    Employees
    Executive
    Officers of the Registrant
    Name

Age

PositionRobert I. Chen


61


President, Chief Executive Officer and Chairman of the BoardRandall Gausman


59


Vice President and Chief Financial OfficerPeter C. Hsi


58


Chief Technology OfficerChristopher Hameister


54


Vice President Asia-Pacific, Europe and Middle East Business
    OperationsMichael Ownby


54


Vice President of Finance and Chief Compliance Office for China
    OperationsFei-Zhou Shen


46


Vice President China Business OperationsRyan Watson


36


Vice President Americas Sales and MarketingMing-Ching Tang


58


Vice President ManufacturingHong T. Sun


46


Vice President of Engineering and Business Development   Robert I. Chen
  Randall Gausman
 5




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##### Table of Contents



Dr. Peter C. Hsi
  Christopher Hameister
  Michael Ownby
  Fei-Zhou Shen
  Ryan Watson
  Dr. Hong T. Sun
  Dr. Ming-Ching Tang
  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.
 6




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We
    have discovered potential violations of the Foreign Corrupt
    Practices Act, the resolution of which could have a material
    adverse impact on our financial condition and results of
    operations.
    Economic
    conditions could materially adversely affect our
    business.
  and/or and/or
  Political
    events, war, terrorism, natural disasters, and other
    circumstances could materially adversely affect
    us.
    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.
   7




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We may
    have difficulty achieving and 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.
    We may
    require additional capital in the future, which may not be
    available or may only be available on unfavorable
    terms.
    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.
   8




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The
    securities laws and regulations have and are likely to continue
    to have a significant effect on 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, 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.
   9




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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, 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; 10




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
    general strikes or other disruptions in working conditions;
    labor shortages;
    political instability;
    changes in tariffs;
    generally longer periods to collect receivables;
    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.
   11




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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.
      We may
    face intellectual property infringement claims that might be
    costly to resolve and affect our results of
    operations.
     12




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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.
    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 shareholder value or harm our
    results of operations.
    Our
    ownership interest in Renex will cause us to incur losses that
    we would not otherwise incur.
   13




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Our
    business could suffer if we lose the services of any of our
    executive officers.
    Our
    officers and directors beneficially own approximately 33% of our
    common stock and, accordingly, may exert substantial influence
    over the Company.
    ITEM 1B.
    UNRESOLVED
    STAFF COMMENTS    ITEM 2.
    PROPERTIES               14




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ITEM 3.
    LEGAL
    PROCEEDINGS  Regulatory
    Compliance
    Polimaster
    Ltd., et al. v. RAE Systems Inc., United States District
    Court for the Northern District of California, Case
    No. 05-CV-01887-JF,
    United States Court of Appeals for the Ninth Circuit,
    No. 08-15708.
  No. 05-CV-01887-JF).
        ITEM 4.
    SUBMISSION
    OF MATTERS TO A VOTE OF SECURITY HOLDERS   15




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##### Table of Contents



PART II  ITEM 5.
    MARKET
    FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS
    AND ISSUER PURCHASES OF EQUITY SECURITIES  mark-ups,
  2008


2007High


Low


High


LowFirst Quarter

$
2.81


$
1.07


$
3.75


$
2.52Second Quarter

$
1.92


$
1.30


$
2.95


$
2.23Third Quarter

$
2.18


$
1.03


$
3.35


$
1.90Fourth Quarter

$
1.72


$
0.38


$
3.68


$
2.40      16




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##### Table of Contents



PERFORMANCE
    GRAPH
  3800-3899
    COMPARISON
    OF 5 YEAR CUMULATIVE TOTAL RETURN* Among
    RAE Systems Inc., the AMEX Composite Index, the Amex Stock
    Market (U.S. Companies),
    and a Peer Group of AMEX stocks for SIC codes 3800 
    3899 Measuring Instruments
    (photo, med & optical goods)
  Comparison
    of 5 Year Cumulative Total Return
 Assumes Initial Investment of $100
 December 2008
  
  *
    
    $ 100 invested on 12/31/03 in stock or index-including
    reinvestment of dividends.   2003


2004


2005


2006


2007


2008RAE Systems, Inc.



100.00




214.71




103.24




94.12




79.41




15.88AMEX Composite



100.00




125.53




158.38




189.84




228.22




132.38AMEX Stock Market (US Companies)



100.00




115.54




125.04




145.10




150.40




96.04Peer Group



100.00




102.77




80.72




80.49




62.78




33.90    17




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##### Table of Contents



ITEM 6.
    SELECTED
    FINANCIAL DATA  Form 10-K.
  2007


2006


2005


20042008


(1)(2)(3)


(4)(5)(6)(7)


(8)


(9)(10)(In thousands, except share and per share data)Operating Data:Net sales

$
95,383


$
90,836


$
67,721


$
60,293


$
45,540Gross profit

$
48,215


$
46,408


$
35,523


$
35,603


$
27,023Operating income (loss) from continuing operations

$
(6,089
)

$
(4,171
)

$
(2,871
)

$
(1,588
)

$
3,514Income (loss) from continuing operations

$
(7,163
)

$
(10,542
)

$
(1,369
)

$
(759
)

$
2,335Basic income (loss) per share from continuing operations

$
(0.12
)

$
(0.18
)

$
(0.03
)

$
(0.01
)

$
0.04Diluted income (loss) per share from continuing operations

$
(0.12
)

$
(0.18
)

$
(0.03
)

$
(0.01
)

$
0.04Weighted-average common shares:Basic outstanding shares


59,204,262



58,852,172



58,424,970



57,687,714



55,809,638Diluted outstanding shares


59,204,262



58,852,172



58,424,970



57,687,714



60,135,692Balance Sheet Data:Working capital

$
37,146


$
40,850


$
36,641


$
41,366


$
38,857Total assets

$
81,175


$
85,343


$
89,753


$
76,264


$
69,115Long-term liabilities

$
8,358


$
10,442


$
5,441


$
2,962


$
1,645Total shareholders equity

$
43,216


$
46,356


$
56,179


$
54,573


$
52,189       (1)
    
    In January 2007, the Company entered into an agreement to
    purchase the intellectual properties of Tianjin Securay
    Technology Ltd. Co. for approximately $1.5 million.
    Including transactions entered into during fiscal 2006, the
    total purchase price was $2.0 million in cash.(2)
    
    In August 2007, the Board of Directors approved the
    discontinuation of the Companys DVR business. Impairment
    expenses recognized in fiscal 2007 totaled $4.2 million.(3)
    
    In December 2007, the Company sold its headquarters building in
    San Jose, California for $12.7 million and leased back
    the facility for a period of 10 years. The Company
    recognized a gain on sale of $0.4 million in 2007 and
    recorded a deferred gain of $6.3 million. The deferred gain
    will be recognized in income straight-line over the life of the
    leaseback beginning in January 2008.(4)
    
    RAE Fushun joint venture was formed in December 2006. The fair
    value of assets acquired and liabilities assumed were included
    in the consolidated balance sheet as of December 31, 2006.
    There were no operating activities recorded in 2006.(5)
    
    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%.(6)
    
    In July 2006, the Company purchased Aegison Corporation. The
    fair value of assets acquired and liabilities assumed were
    included in the consolidated balance sheet as of
    December 31, 2006.(7)
    
    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. 18




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##### Table of Contents



(8)
    
    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.(9)
    
    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 consolidated balance sheet at
    December 31, 2004. Seven months of operating activities
    were recorded in the consolidated statement of operations in
    2004.(10)
    
    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 were
    approximately $31.8 million.  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 2009. 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
           19




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Critical
    Accounting Policies
      Revenue
    Recognition
  No. 00-10, Accounting for Shipping and Handling Fees and
    Costs
  Accounts
    Receivable, Trade Notes Receivable and Allowance for Doubtful
    Accounts
       20




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##### Table of Contents



Inventories
  first-in,
  Goodwill
  Goodwill and Other Intangible Assets
    Long-lived
    Assets
    Stock-Based
    Compensation Expense
  Share-Based Payment
    Valuation and amortization method
  Expected Term
  Expected Volatility
 21




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Expected Dividend
  Risk-Free Interest Rate
  Estimated Forfeitures trued-up
  Business
    Combinations
      Income
    Taxes
        RESULTS
    OF OPERATIONS
  Net
    Sales
  Percentage











Percentage2008


2007


Change


Change


2007


2006


Change


Change(In thousands)Net sales

$
95,383


$
90,836


$
4,547



5
%

$
90,836


$
67,721


$
23,115



34
%    22




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##### Table of Contents



Cost
    of Sales and Gross Profit
  Percentage











Percentage2008


2007


Change


Change


2007


2006


Change


Change(In thousands)Cost of sales

$
47,168


$
44,428


$
2,740



6
%

$
44,428


$
32,198


$
12,230



38
%Gross profit

$
48,215


$
46,408


$
1,807



4
%

$
46,408


$
35,523


$
10,885



31
%Gross margin


51
%


51
%










51
%


52
%       Sales
    and Marketing Expense
  Percentage







Percentage2008

2007

Change

Change

2007

2006

Change

Change(In thousands)Sales and marketing

$
21,427


$
25,434


$
(4,007
)


(16
)%

$
25,434


$
18,987


$
6,447



34
%Percentage of net sales


22
%


28
%










28
%


28
%      23




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##### Table of Contents



Research
    and Development Expense
  Percentage







Percentage2008

2007

Change

Change

2007

2006

Change

Change(In thousands)Research and development

$
6,665


$
7,973


$
(1,308
)


(16
)%

$
7,973


$
6,075


$
1,898



31
%Percentage of net sales


7
%


9
%










9
%


9
%       General
    and Administrative Expense
  Percentage







Percentage2008

2007

Change

Change

2007

2006

Change

Change(In thousands)General and administrative

$
22,864


$
17,767


$
5,097



29
%

$
17,767


$
13,332


$
4,435



33
%Percentage of net sales


24
%


20
%










20
%


20
%       Impairment
    of Goodwill
  Percentage







Percentage2008

2007

Change

Change

2007

2006

Change

Change(In thousands)Impairment of goodwill

$
3,348


$



$
3,348



100
%

$



$



$




0
%Percentage of net sales


4
%


0
%










0
%


0
%    24




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##### Table of Contents



Gain/loss
    on Abandonment of Lease
  Percentage







Percentage2008

2007

Change

Change

2007

2006

Change

Change(In thousands)(Gain) loss on abandonment of lease

$



$
(595
)

$
595



100
%

$
(595
)

$



$
(595
)


100
%Percentage of net sales


0
%


(1
)%










(1
)%


0
%     Other
    Income (Expense)
  Percentage











Percentage2008


2007


Change


Change


2007


2006


Change


Change(In thousands)Interest income

$
173


$
162


$
11



7
%

$
162


$
782


$
(620
)


(79
)%Interest expense


(397
)


(705
)


308



(44
)%


(705
)


(249
)


(456
)


183
%Other, net


(575
)


58



(633
)


(1091
)%


58



232



(174
)


(75
)%Total other income (expense)

$
(799
)

$
(485
)

$
(314
)


65
%

$
(485
)

$
765


$
(1,250
)


(163
)%       Income
    Tax Benefit (Expense)
  Percentage







Percentage2008

2007

Change

Change

2007

2006

Change

Change(In thousands)Income tax expense (benefit)

$
538


$
5,883


$
(5,345
)


(91
)%

$
5,883


$
(882
)

$
6,765



(767
)%Effective tax rate


8
%


53
%










53
%


(38
)%    25




---



##### Table of Contents



, Accounting for Income
    Taxes
    Minority
    Interest in Loss of Consolidated Subsidiaries
  Percentage











Percentage2008


2007


Change


Change


2007


2006


Change


Change(In thousands)Minority interest in (income) loss of consolidated subsidiaries

$
220


$
(6
)

$
226



(3767
)%

$
(6
)

$
49


$
(55
)


(112
)%       Loss
    From Discontinued Operations
     26




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##### Table of Contents



Accounting
    for the Impairment or Disposal of Long-Lived Assets
  Percentage











Percentage2008


2007


Change


Change


2007


2006


Change


Change(In thousands)Loss from discontinued operations before income taxes

$
11


$
(4,939
)

$
4,950



(100
)%

$
(4,939
)

$
(243
)

$
(4,696
)


1933
%Income tax benefit






(785
)


785



(100
)%


(785
)


(83
)


(702
)


846
%Loss from discontinued operations

$
11


$
(4,154
)

$
4,165



(100
)%

$
(4,154
)

$
(160
)

$
(3,994
)


2496
%   Liquidity
    and Capital Resources
             27




---



##### Table of Contents



Year Ended December 31,2008


2007


2006(In thousands)Net cash provided by (used in):Operating activities

$
3,178


$
(9,979
)

$
1,051Investing activities


(3,351
)


10,023



3,025Financing activities


(1,391
)


(2,684
)


230Effect of exchange rate changes on cash and cash equivalents


503



427



289Net decrease in cash and cash equivalents

$
(1,061
)

$
(2,213
)

$
4,595   Operating
    Activities:
    
    Non-cash charges included in our net loss of $7.2 million
    totaled $8.2 million. Our principal non-cash expenses were
    as follows: $3.3 million reduction in goodwill;
    $3.3 million depreciation and amortization;
    $1.6 million stock-based compensation; and
    $1.3 million provision for doubtful accounts. These
    non-cash expenses were partially offset by $0.6 million in
    gains on disposal of property and equipment; $0.6 million
    in deferred income tax benefits; and other net gains of
    $0.1 million.
    The net reduction in working capital of $2.2 million
    attributable to changes in operating assets and liabilities. The
    decrease in working capital resulted primarily from a
    $1.2 million decline in accounts receivable and a
    $1.1 million decline in trade notes receivable. Other
    operating accounts offset the change in receivables by
    $(0.1) million, net.    
    Cash was used mainly to support an increase of $9.5 million
    in working capital primarily consisting of an increase of
    $5.7 million in accounts receivable and $1.8 million
    in inventories primarily related to increased sales. The
    remaining $2.0 million was primarily comprised of changes
    in deferred revenue, deposits and other current operating
    accounts.
    The positive effect of the non-cash adjustments was due to
    depreciation and amortization of long lived assets of
    $3.7 million, deferred taxes of $4.1 million, stock
    based compensation expense of $1.9 million and provision
    for doubtful accounts of $1.9 million.    
    Non-cash charges to our net income were approximately
    $4.1 million. The non-cash adjustments to net income
    resulted primarily from depreciation and amortization of
    long-lived assets of $3.2 million, compensation expense of
    fair value accounting for stock options of $1.6 million,
    other reserve and non-cash adjustments to our net income of
    approximately $0.5 million, partially offset by an
    adjustment to our deferred income taxes of $1.2 million.
    The positive effect of the non-cash adjustments described above,
    for the year 2006, was partially offset by an increased
    investment in working capital of $1.5 million. The increase
    in working capital was primarily the result of increased sales
    in Asia, which has a longer average collection period for
    accounts receivable than sales in the United States, partially
    offset by higher payables related to the increased volume in
    December 2006. 28




---



##### Table of Contents



Investing
    Activities
        Financing
    activities
        Commitments
    and Contingencies
  Summary
    of Obligations
    Less than


1-3


3-5


AfterTotal


1 Year


Years


Years


5 Years(In thousands)Contractual ObligationsAmounts reflected in Consolidated Balance Sheets:Notes payable  related parties(1)

$
2,548


$
1,329


$
609


$
610


$
Capital lease obligations(2)


58



58











Other cash obligations not reflected in Consolidated Balance
    Sheets:Operating lease obligations(2)


12,142



1,988



2,827



2,585



4,742Construction in process














2,457



2,457Open purchase orders


4,942



4,942











Total

$
22,147


$
10,774


$
3,436


$
3,195


$
4,742  29




---



##### Table of Contents



(1)
    
    For further discussion surrounding notes payable-related
    parties, refer to Note 11. Related Party
    Transactions to the Consolidated Financial Statements.(2)
    
    For further discussion surrounding purchase and lease
    obligations, refer to Note 8. Commitments and
    Contingencies to the Consolidated Financial statements.(3)
    
    Represents estimated cancelable open purchase orders to purchase
    inventory and other goods and services in the normal course of
    business to meet operational requirements.  Guarantees
      Product
    Warranties
    Uncertain
    Tax Positions
    Recent
    Accounting Pronouncements
  Business Combinations
  Noncontrolling Interests in Consolidated Financial
    Statements-an amendment of ARB No. 51
  Disclosures about Derivative Instruments and Hedging
    Activities  an amendment to FASB Statement
    No. 133
 30




---



##### Table of Contents



Accounting for Derivative Instruments
    and Hedging Activities
  No. FAS No. 142-3, No. 142-3, Determination of Useful Life of Intangible
    Assets No. 142-3 Goodwill and Other Intangible
    Assets No. 142-3 No. 142-3 No. 142-3
  The Hierarchy of Generally Accepted Accounting
    Principles
  ITEM 7A.
    QUANTITATIVE
    AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK  Concentration
    of Credit Risk
    Interest
    Rate Risk
    Foreign
    Currency Exchange Rate Risk
     31




---



##### 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
  Rules 13a-15(f) 15d-15(f)
    Internal Control 
    Integrated Framework
 32




---



##### Table of Contents



Changes
    in Internal Control Over Financial Reporting
  Rule 13a-15(f)
 33




---



##### Table of Contents



Report of
    Independent Registered Public Accounting Firm
     Internal Control 
    Integrated Framework
        Internal Control  Integrated Framework
     
 34




---



##### 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   PART IV  ITEM 15.
    EXHIBITS,
    FINANCIAL STATEMENT SCHEDULES  Financial Statements
  Form 10-K.
  Financial Statement Schedules
    Exhibits
   35




---



##### Table of Contents



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

Title

Date/s/  Robert
    I. ChenRobert
    I. Chen

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

March 13, 2009/s/  Randall
    GausmanRandall
    Gausman

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

March 13, 2009/s/  Peter
    C. HsiPeter
    C. Hsi

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

March 13, 2009/s/  Lyle
    D. FeiselLyle
    D. Feisel

Director

March 13, 2009/s/  Neil
    W. FlanzraichNeil
    W. Flanzraich

Director

March 13, 2009/s/  Sigrun
    HjelmquistSigrun
    Hjelmquist

Director

March 13, 2009/s/  A.
    Marvin StraitA.
    Marvin Strait

Director

March 13, 2009/s/  James
    W. PowerJames
    W. Power

Director

March 13, 2009  36




---



##### Table of Contents



INDEX TO
    EXHIBITS
  ExhibitNumber

Description of Document3
.1

Certificate of Incorporation of Registrant(1)3
.2

Amended and Restated Bylaws of Registrant(3)4
.1

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

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

RAE Systems Inc. 2007 Equity Incentive Plan(2)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 2007
    Equity Incentive Plan(9)10
.5

Lease Agreement by and between Inland American/Stephens (N
    First) Ventures, LLC and RAE Systems Inc., dated
    December 20, 2007(9)10
.6

Purchase and Sale Agreement by and between D.R.
    Stephens & Company, LLC and RAE Systems Inc., dated
    November 9, 2007(9)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.(4)10
.10

Separation Agreement and General Release of Claims by and
    between Donald W. Morgan and the Registrant dated August 8,
    2006(5)10
.11

RAE Systems Inc. Management Incentive Plan(6)10
.12

Employment Offer Letter by and between Randall Gausman and the
    Registrant dated October 17, 2006(7)10
.13

Loan and Security Agreement dated as of March 14, 2007
    between Silicon Valley Bank and the Registrant(8)10
.14

Joint Venture Agreement by and between Liaoning Coal Industry
    Group Co., Ltd. and RAE Systems (Asia), Ltd. dated
    December 10, 2006(8)10
.15

Separation Agreement and General Release of Claims by and
    between Rudy Mui and the Registrant dated March 4, 2008(9)21
.1

Subsidiaries of the Registrant(9)23
.1

Consent of BDO Seidman, LLP(10)23
.2

Consent of Deloitte & Touche LLP(10)24
.1

Power of Attorney(10) (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(10)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(10)32
.1

Certification pursuant to 18 U.S.C. Section 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002(10)32
.2

Certification pursuant to 18 U.S.C. Section 1350, as
    adopted pursuant to Section 906 of the Sarbanes-Oxley Act
    of 2002(10)     (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. 37




---



##### Table of Contents



(2)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on June 19, 2007 and incorporated herein by reference.(3)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on December 21, 2007 and incorporated herein by reference.(4)
    
    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.(5)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on August 8, 2006 and incorporated herein by reference.(6)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on August 16, 2006 and incorporated herein by reference.(7)
    
    Previously filed as an exhibit to the Registrants current
    report on
    Form 8-K
    on October 18, 2006 and incorporated herein by reference.(8)
    
    Previously filed as an exhibit to the Registrants annual
    report on
    Form 10-K
    for the year ended December 31, 2006 and incorporated
    herein by reference.(9)
    
    Previously filed as an exhibit to the Registrants annual
    report on
    Form 10-K
    for the year ended December 31, 2007 and incorporated
    herein by reference.(10)
    
    Filed herewith. 38




---



##### Table of Contents



RAE
    Systems Inc.
  Consolidated
    Financial Statements
 As of
    December 31, 2008 and 2007
  Consolidated Financial Statements


F-1Report of Independent Registered Public
    Accounting Firm


F-2Consolidated balance sheets


F-4Consolidated statements of operations


F-5Consolidated statements of shareholders
    equity and comprehensive loss


F-6Consolidated statements of cash flows


F-7Notes to consolidated financial statements


F-8  F-1




---



##### Table of Contents



Report of
    Independent Registered Public Accounting Firm  
               
   F-2




---



##### Table of Contents



Report of
    Independent Registered Public Accounting Firm
  
           
   F-3




---



##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED BALANCE SHEETS
  December 31,


December 31,2008


2007(In thousands, except shareand par value data)ASSETSCurrent assets:Cash and cash equivalents

$
14,845


$
15,906Trade notes receivable


1,870



2,793Accounts receivable, net of allowances of $3,472 and $2,060,
    respectively


20,961



22,749Accounts receivable from affiliate


100



21Inventories


17,604



17,542Prepaid expenses and other current assets


4,991



2,930Income taxes receivable


895



2,069Total current assets


61,266



64,010Property and equipment, net


14,976



12,258Intangible assets, net


3,342



3,827Goodwill






3,143Investments in unconsolidated affiliates


467



425Other assets


1,124



1,680Total assets

$
81,175


$
85,343LIABILITIES, MINORITY INTEREST IN CONSOLIDATED ENTITIES AND
    SHAREHOLDERS EQUITYCurrent liabilities:Accounts payable

$
6,387


$
6,071Accounts payable to affiliate


382



411Payable to Fushun shareholder


64



609Bank lines of credit


2,584



2,618Accrued liabilities


12,318



12,098Notes payable to related parties, current


1,329



191Income taxes payable


425



674Deferred revenue, current


631



488Total current liabilities


24,120



23,160Deferred revenue, non-current


685



514Deferred tax liabilities, non-current


83



277Deferred gain on sale of real estate


5,079



5,794Other long-term liabilities


1,292



1,487Notes payable to related parties, non-current


1,219



2,370Total liabilities


32,478



33,602COMMITMENTS AND CONTINGENCIES (NOTE 8)MINORITY INTEREST IN CONSOLIDATED ENTITIES


5,481



5,385SHAREHOLDERS EQUITY:Common stock, $0.001 par value, 200,000,000 shares
    authorized; 59,443,914 and 59,171,980 shares issued and
    outstanding, respectively


59



59Additional paid-in capital


62,549



60,957Accumulated other comprehensive income


6,555



4,135Accumulated deficit


(25,947
)


(18,795
)Total shareholders equity


43,216



46,356Total liabilities, minority interest in consolidated entities
    and shareholders equity

$
81,175


$
85,343    F-4




---



##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED STATEMENTS OF OPERATIONS
  Year Ended December 31,2008


2007


2006(In thousands, except per share data)Net sales

$
95,383


$
90,836


$
67,721Cost of sales


47,168



44,428



32,198Gross profit


48,215



46,408



35,523Operating expenses:Sales and marketing


21,427



25,434



18,987Research and development


6,665



7,973



6,075General and administrative


22,864



17,767



13,332Impairment of goodwill


3,348







Gain on abandonment of lease






(595
)


Total operating expenses


54,304



50,579



38,394Operating loss from continuing operations


(6,089
)


(4,171
)


(2,871
)Other income (expense):Interest income


173



162



782Interest expense


(397
)


(705
)


(249
)Other, net


(575
)


58



232Equity in gain (loss) of unconsolidated affiliates


43



3



(194
)Loss from continuing operations before income taxes and minority
    interest


(6,845
)


(4,653
)


(2,300
)Income tax expense (benefit)


538



5,883



(882
)Loss before minority interest


(7,383
)


(10,536
)


(1,418
)Minority interest in income (loss) of consolidated subsidiaries


220



(6
)


49Loss from continuing operations


(7,163
)


(10,542
)


(1,369
)Gain (loss) from discontinued operations, net of tax


11



(4,154
)


(160
)Net loss

$
(7,152
)

$
(14,696
)

$
(1,529
)Net loss per share  basic and dilutedContinuing operations

$
(0.12
)

$
(0.18
)

$
(0.03
)Discontinued operations






(0.07
)


Net loss per share  basic and diluted

$
(0.12
)

$
(0.25
)

$
(0.03
)Weighted average common shares outstanding  Basic


59,204



58,852



58,425Dilutive stock options and warrants










Weighted average common shares outstanding  Diluted


59,204



58,852



58,425    F-5




---



##### Table of Contents



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


OtherCommon Stock


Paid-in


Comprehensive


AccumulatedShares


Amount


Capital


Income


Deficit


Total(In thousands, except share data)December 31, 2005


57,837,843



58



56,629



310



(2,424
)


54,573Components of comprehensive loss:Net loss


















(1,529
)


(1,529
)Foreign currency translation adjustments














936







936Unrealized loss on investment, net of tax














(1
)






(1
)Total comprehensive loss






















(594
)Exercise of stock options


1,115,497



1



632











633Exercise of stock warrants


321,256



















Stock-based compensation expense










1,620











1,620Investment in unconsolidated entity










146











146Tax benefit from stock options










(199
)










(199
)December 31, 2006


59,274,596



59



58,828



1,245



(3,953
)


56,179Cumulative effect of adopting FIN 48  adjustment to
    accumulated deficit


















(146
)


(146
)Components of comprehensive loss:Net loss


















(14,696
)


(14,696
)Foreign currency translation adjustments














2,889







2,889Unrealized loss on investment, net of tax














1







1Total comprehensive loss






















(11,806
)Exercise of stock options


32,291







72











72Repurchase of restricted common stock


(134,907
)






(335
)










(335
)Stock-based compensation expense










2,553











2,553Investment in unconsolidated entity










(1
)










(1
)Tax benefit from stock options










(160
)










(160
)December 31, 2007


59,171,980



59



60,957



4,135



(18,795
)


46,356Components of comprehensive loss:Net loss


















(7,152
)


(7,152
)Foreign currency translation adjustments














2,420







2,420Total comprehensive loss






















(4,732
)Exercise of stock options


149,458







43











43Repurchase of restricted common stock


(27,524
)






(44
)










(44
)Stock issued for services


150,000







210











210Stock-based compensation expense










1,383











1,383December 31, 2008


59,443,914


$
59


$
62,549


$
6,555


$
(25,947
)

$
43,216    F-6




---



##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED STATEMENTS OF CASH FLOWS
  Year Ended December 31,2008


2007


2006(In thousands)CASH FLOWS FROM OPERATING ACTIVITIES:Net loss

$
(7,152
)

$
(14,696
)

$
(1,529
)Gain (loss) from discontinued operations


11



(4,154
)


(160
)Loss from continuing operations


(7,163
)


(10,542
)


(1,369
)Adjustments to reconcile net loss to net cash provided by (used
    in) operating activities:Depreciation and amortization


3,344



3,715



3,189Provision for doubtful accounts


1,275



1,948



(123
)(Gain) loss on disposal of property and equipment


(586
)


(285
)


245Stock-based compensation expense


1,593



1,871



1,620Equity in (gain) loss of unconsolidated affiliates


(43
)


(3
)


194Minority interest in (earnings) losses of consolidated entities


(220
)


6



(49
)Deferred income tax (benefit) expense


(608
)


4,117



(1,180
)Gain on abandonment of lease






(595
)


Amortization of discount on notes payable to related parties


52



79



187Impairment of intangible assets






609



Impairment of goodwill


3,348







Changes in operating assets and liabilities:Accounts receivable


1,174



(5,719
)


(2,729
)Accounts receivable from affiliate


(77
)


25



(49
)Trade notes receivable


1,056



(689
)


(838
)Inventories


661



(1,831
)


(2,301
)Prepaid expenses and other current assets


(1,929
)


(46
)


565Income taxes receivable


1,167







Other assets


557



(1,004
)


231Accounts payable


(1,036
)


(1,473
)


2,973Accounts payable to affiliate


(52
)


35



335Accrued liabilities


356



1,876



1,200Income taxes payable


(287
)


541



(823
)Deferred revenue


314



(977
)


384Other liabilities


275



(235
)


(451
)Net cash provided by (used in) operating activities of
    continuing operations


3,171



(8,577
)


1,211Net cash provided by (used in) operating activities of
    discontinued operations


7



(1,402
)


(160
)Net cash provided by (used in) operating activities


3,178



(9,979
)


1,051CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of investments










(12,615
)Proceeds from sales and maturities of investments






3,248



16,801Proceeds from sales prior to maturity of investments










8,513Business acquisitions, net of cash acquired






(1,618
)


(7,439
)Acquisition of property and equipment


(3,501
)


(4,014
)


(2,235
)Proceeds from sale of net assets


150



12,407



Net cash (used in) provided by investing activities


(3,351
)


10,023



3,025CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from the exercise of stock options and warrants


43



72



632Repurchases of common stock


(44
)


(335
)


Borrowings from bank lines of credit


4,961



12,156



Payments on bank lines of credit


(5,195
)


(9,600
)


Payments on payables to related parties


(1,156
)


(4,977
)


(402
)Net cash (used in) provided by financing activities


(1,391
)


(2,684
)


230Effect of exchange rate changes on cash and cash equivalents


503



427



289(Decrease) increase in cash and cash equivalents


(1,061
)


(2,213
)


4,595Cash and cash equivalents at beginning of period


15,906



18,119



13,524Cash and cash equivalents at end of period

$
14,845


$
15,906


$
18,119Supplemental disclosure of cash flow information:Cash paid for taxes, net

$
687


$
1,133


$
1,084Cash paid for interest


333



422



6Non-cash investing and financing activities:Notes payable issued in conjunction with RAE Beijing acquisition










2,648Payable recorded in conjunction with RAE Fushun acquisition










3,926Unpaid property and equipment


1,100



589



    F-7




---



##### Table of Contents



RAE
    SYSTEMS INC.
 NOTES TO
    CONSOLIDATED FINANCIAL STATEMENTS  Note 1.
    Summary
    of Significant Accounting Policies  The
    Company
    Principles
    of Consolidation
    Use of
    Estimates
    Revenue
    Recognition
    Cash
    and Cash Equivalents
    Allowance
    for Doubtful Accounts
   F-8




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Trade
    Notes Receivable
    Concentration
    of Credit Risk
    Inventories
  first-in,
  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   Warranty
    Repairs
   F-9




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Research
    and Development
    Advertising
    Costs
    Income
    Taxes
  Accounting for Income
    Taxes
      Goodwill
    and Other Intangible Assets
      Long-Lived
    Assets
  Accounting for the Impairment or Disposal of Long-Lived
    Assets
 F-10




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    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:    
    Notes Payable to Related Parties:    Translation
    of Foreign Currencies
  non-U.S. subsidiaries non-U.S. subsidiaries.
  Stock-Based
    Compensation Expense
  Share-Based Payment
  Transition Election Related
    to Accounting for Tax Effects of Stock-based Payment
    Awards
  Net
    Loss Per Share
   F-11




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Retained
    Earnings
      Variable
    Interest Entities
    Segment
    Reporting
  Disclosures about Segments of
    an Enterprise and Related Information
  Recent
    Accounting Pronouncements
  Business Combinations
  Noncontrolling Interests in Consolidated Financial
    Statements-an amendment of ARB No. 51
 F-12




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Disclosures about Derivative Instruments and Hedging
    Activities  an amendment to FASB Statement
    No. 133 Accounting for Derivative Instruments and Hedging
    Activities
  No. FAS No. 142-3, Determination of Useful Life of Intangible Assets No. 142-3). FSP 142-3 Goodwill and Other Intangible
    Assets FSP 142-3 No. 142-3 FSP 142-3
  The Hierarchy of Generally Accepted Accounting
    Principles
  Note 2.
    Mergers
    and Acquisitions  RAE
    Coal Mine Safety Instruments (Fushun) Co., Ltd.
    (in
    thousands)
  Cash

$
2,151Notes payable


8,606Direct transaction costs


191Total purchase price

$
10,948  F-13




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  (in thousands)
  Cash

$
2,151Accounts receivable


2,247Inventory


3,152Note receivable from RAE Systems(1)


8,606Property & equipment


399Intangible asset acquired:Customer list


3,364Total assets


19,919Payable to Liaoning Group


(3,926
)Deferred tax liability


(435
)Minority interest


(4,610
)Total purchase price

$
10,948     (1)
    
    Balance eliminated in consolidation.        Year EndedDecember 31,(In thousands, except per share amounts)

2006(Unaudited)Net sales

$
76,141Net loss

$
(1,632
)Net loss per share  basic and diluted

$
(0.03
)    F-14




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  RAE
    Beijing Acquisition
  (in thousands)
  July 2009

$
1,499July 2010


967July 2011


940$
3,406   Accounting for Certain Financial
    Instruments with Characteristics of Both Liabilities and
    Equity (in thousands)
  Cash

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


2,648Direct transaction costs


49$
7,505   (in thousands)
  Current assets

$
5,760Property & equipment


1,292Intangible assets acquired:Customer list


817Trade name


216Patents and technology


164Goodwill


2,754Total assets


11,003Current liabilities


(3,146
)Long-term liabilities


(352
)Total liabilities


(3,498
)Purchase price

$
7,505  F-15




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    WeightedAverageUseful Life(Years)Customer list


6Trade name


7Patents and technology


7     Other
    Acquisitions
  (in
    thousands)
  Net tangible assets acquired

$
436Intangible assets acquired:Technology


631Trade name


108Customer list


91Trade secret


79Goodwill


797Total purchase price

$
2,142   in thousands)
  Current assets

$
97Property & equipment


3620% interest in Tianjin Securay Technology Ltd.


415Current liabilities


(112
)Net tangible assets acquired

$
436    F-16




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
     WeightedAverageUsefulLife (Years)Technology


10Trade name


2Customer list


3Trade secret


10     (in thousands)
  Net tangible assets acquired

$
467Intangible assets acquired:Customer list


741Trade name


141Technology


32Goodwill


646Total purchase price

$
2,027   (in thousands)
  Inventory

$
180Property & equipment


287Net tangible assets acquired

$
467     WeightedAverageUseful Life(Years)Customer list


7Trade name


7Technology


5    F-17




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Note 3.
    Discontinued
    Operations          Year Ended December 31,2008


2007


2006(In thousands)Net sales

$
3


$
319


$
265Gain (loss) from discontinued operations before income taxes


11



(4,939
)


(243
)Income tax benefit






(785
)


(83
)Gain (loss) from discontinued operations

$
11


$
(4,154
)

$
(160
)    F-18




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 4.
    Balance
    Sheet Details  Allowance
    for Doubtful
    Accounts:
    Year Ended December 31,2008


2007


2006(In thousands)Allowance for doubtful accounts at beginning of year

$
2,060


$
843


$
963Charges to expense


1,345



1,948



Write-offs of uncollectible accounts, net of recoveries


(70
)


(833
)


(120
)Foreign currency translation effects


137



102



Allowance for doubtful accounts at end of year

$
3,472


$
2,060


$
843   Inventories:
    December 31,


December 31,2008


2007(In thousands)Raw materials

$
8,213


$
5,278Work-in-progress


2,910



2,759Finished goods


6,481



9,505Total inventories

$
17,604


$
17,542     Prepaid
    Expenses and Other Current
    Assets:
    December 31,


December 31,2008


2007(In thousands)Supplier advances and deposits

$
977


$
1,162Amounts receivable from employees


661



244Prepaid insurance


437



428Deferred tax assets, current


578



Other current assets


2,338



1,096Total prepaid expenses and other current assets

$
4,991


$
2,930  F-19




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Property
    and Equipment, net:
    December 31,


December 31,2008


2007(In thousands)Buildings and improvements

$
10,327


$
5,905Equipment


5,070



4,646Computer equipment


4,971



4,346Automobiles


1,590



1,180Furniture and fixtures


434



325Construction in progress


2,457



3,42824,849



19,830Less: Accumulated depreciation


(9,873
)


(7,572
)Total property and equipment, net

$
14,976


$
12,258         Accrued
    Liabilities:
    December 31,


December 31,2008


2007(In thousands)Compensation and related benefits

$
2,445


$
4,377Accrued commissions


2,010



2,091Customer deposits


1,792



445Accrued professional fees


755



924Other


5,316



4,261Total accrued liabilities

$
12,318


$
12,098  F-20




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 5.
    Goodwill
    and Intangible Assets    (In thousands)Balance as of December 31, 2006

$
3,760Acquisitions:Securay


646Purchase price adjustment  Aegison


(19
)Impairment charges due to discontinued operations


(1,443
)Currency translation adjustment


199Balance as of December 31, 2007


3,143Currency translation adjustment


205Impairment charges


(3,348
)Balance as of December 31, 2008

$
   Goodwill
    and Other Intangibles
      Goodwill and Other
    Intangible Assets
   F-21




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    December 31, 2008


December 31, 2007Gross





Net


Gross





NetCarrying


Accumulated


Carrying


Carrying


Accumulated


CarryingAmount


Amortization


Amount


Amount


Amortization


Amount(In thousands)Customer list

$
5,438


$
(2,636
)

$
2,802


$
4,714


$
(1,574
)

$
3,140Trade name


1,352



(812
)


540



1,267



(580
)


687Total intangible assets, net

$
6,790


$
(3,448
)

$
3,342


$
5,981


$
(2,154
)

$
3,827         (in thousands)
  Years Ended December 31,2009

$
9212010


9022011


6362012


3712013


280Thereafter


232Total amortization

$
3,342   Note 6.
    Income
    Taxes    Year Ended December 31,2008


2007


2006(In thousands)United States

$
(4,934
)

$
(5,973
)

$
(3,213
)Foreign


(1,911
)


1,320



913Loss before income taxes and minority interest

$
(6,845
)

$
(4,653
)

$
(2,300
)  F-22




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2008


2007


2006(In thousands)Current:Federal

$
(91
)

$
819


$
(550
)State


18



53



22Foreign


1,832



1,012



8011,759



1,884



273Deferred:Federal






2,917



(878
)State


(48
)


862



(189
)Foreign


(1,173
)


220



(88
)(1,221
)


3,999



(1,155
)Total income tax expense (benefit)

$
538


$
5,883


$
(882
)     Year Ended December 31,2008


2007


2006(In thousands)Federal income tax benefit at statutory rate

$
(2,327
)

$
(1,582
)

$
(725
)State income tax benefit, net of federal benefit


18



(486
)


(117
)Foreign tax expense (benefit)


1,116



(53
)


(81
)Nondeductible expenses


90



132



157Subpart F


320







Other


363



561



(359
)Change in valuation allowance


958



7,311



243Total income tax expense (benefit)

$
538


$
5,883


$
(882
)  F-23




---



##### Table of Contents



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


December 31,2008


2007(In thousands)Deferred tax assets:Fixed assets

$
30


$
28Other temporary differences


547



472Other accruals


4,468



3,006Capitalized research and development


233



448Unrealized foreign losses & temporary differences


2,722



2,007Federal and state tax credits


423



352Stock-based compensation


2,034



2,118Valuation allowance


(9,389
)


(8,431
)Total deferred tax assets


1,068



Deferred tax liabilities:Intangibles


(574
)


(277
)Total deferred tax liabilities


(574
)


(277
)Net deferred tax assets (liabilities)

$
494


$
(277
)     non-U.S. subsidiaries
      2008-2009
 F-24




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
              Accounting for Uncertainty in Income
    Taxes
   F-25




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    (In thousands)Balance at January 1, 2007

$
778Positions taken related to prior years


306Positions taken during the current year


109Balance at January 1, 2008


1,193Positions taken related to prior years


Positions taken during the current year


(64
)Reduction to UTB due to settlement with tax authorities


(12
)Balance at December 31, 2008

$
1,117     non-U.S. income
    United States  Federal


2005 - presentUnited States  State


2004 - presentChina


2006 - presentHong Kong


2005 - presentDenmark


2007 - present   Note 7.
    Lines of
    Credit     F-26




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
            Note 8.
    Commitments
    and Contingencies  Legal
    Proceedings
  Regulatory
    Compliance
    Legal
    proceedings
  Polimaster Ltd.  et al. v. RAE Systems Inc.,
    United States District Court for the Northern District of
    California, Case
    No. 05-CV-01887-JF,
    United States Court of Appeals for the Ninth Circuit,
    No. 08-15708
  No. 05-CV-01887-JF).
   F-27




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
        Leases
  Accounting for Leases
  (in thousands)
  Years Ended December 31,

Capital


Operating2009

$
58


$
1,9882010






1,4682011






1,3592012






1,2742013






1,311Thereafter






4,742Total minimum lease payments


58


$
12,142Less: Amount representing interest


(2
)Present value of minimum lease payments

$
56    F-28




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Purchase
    obligations
      Guarantees
      Product
    Warranties
    Year Ended December 31,2008


2007(In thousands)Balance at beginning of year

$
884


$
553Provision for warranty


844



1,304Utilization of reserve


(1,041
)


(992
)Foreign currency translation effects


20



19Balance at end of year

$
707


$
884  F-29




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 9.
    Employee
    Benefit Plan    Note 10.
    Stock-Based
    Compensation  Stock
    Option Plans
         F-30




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  in
    thousands, except weighted-average amounts
  Options OutstandingNumber of


Weighted-AverageShares


Exercise PriceBalance as of December 31, 2005


2,702


$
2.92Granted


1,141



3.69Exercised


(342
)


1.15Canceled


(362
)


4.42Balance as of December 31, 2006


3,139



3.22Granted


855



2.73Exercised


(32
)


2.25Canceled


(239
)


4.18Balance as of December 31, 2007


3,723



3.05Granted


1,299



1.51Exercised


(149
)


0.29Canceled


(680
)


3.83Balance as of December 31, 2008


4,193



2.55     Options Outstanding


Options ExercisableWeighted











WeightedAverage











AverageRemaining


Weighted


Aggregate





Remaining


Weighted


AggregateNumber


Contractual


Average


Intrinsic


Number


Contractual


Average


IntrinsicRange of

of


Life


Exercise


Value


of


Life


Exercise


ValueExercise Prices

Shares


(in Years)


Price


(000)


Shares


(in Years)


Price


(000)$0.00  0.50


120,877



2.51


$
0.08


$
56



120,877






$
0.08


$
560.51  1.00


87,936



3.99



0.58







87,936







0.58



1.01  1.50


1,468,282



7.67



1.31







428,282







1.07



1.51  2.00


200,000



9.28



1.87



















2.01  2.50


284,167



8.64



2.28







80,729







2.29



2.51  3.00


445,000



8.25



2.88







190,308







2.87



3.01  4.00


1,189,324



7.14



3.66







813,799







3.62



4.01  5.00


152,500



5.38



4.81







148,854







4.835.01  6.00


220,000



5.26



5.28







220,000







5.286.01  7.00


25,000



5.87



6.43







24,791







6.43



4,193,086



7.28



2.55


$
56



2,115,576



5.76



2.95


$
56    F-31




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Non-Plan
    Stock Options
    in thousands, except per share amounts
  Options OutstandingNumber


Weighted-Averageof Shares


Exercise PriceBalance as of December 31, 2005


337


$
1.02Granted






Exercised


(237
)


1.01Canceled






Balance as of December 31, 2006


100



1.06Granted






Exercised






Canceled






Balance as of December 31, 2007


100



1.06Granted






Exercised






Canceled






Balance as of December 31, 2008


100



1.06     Options Outstanding

Options ExercisableWeighted







WeightedAverage







AverageRemaining

Weighted

Aggregate



Remaining

Weighted

AggregateNumber

Contractual

Average

Intrinsic

Number

Contractual

Average

IntrinsicRange of

of

Life

Exercise

Value

of

Life

Exercise

ValueExercise Prices

Shares

(in Years)

Price

(000)

Shares

(in Years)

Price

(000)$1.06


100,000



3.41


$
1.06


$




100,000



3.41


$
1.06


$
   Non-Plan
    Restricted Stock
   F-32




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      in thousands, except per share amounts
  Restricted Stock AwardsWeighted-AverageNumber


Grant-Datedof Shares


Fair ValueBalance as of December 31, 2005





$
Granted


536



2.81Vested






Forfeited






Balance as of December 31, 2006


536



2.81Granted






Vested


(354
)


2.81Forfeited






Balance as of December 31, 2007


182



2.81Granted






Vested


(73
)


2.81Forfeited






Balance as of December 31, 2008


109



2.81   Stock-Based
    Compensation Expense
    Year Ended December 31,2008


2007


2006(In thousands)Cost of sales

$
11


$
23


$
54Sales and marketing


49



109



90Research and development


307



325



213General and administrative


1,226



1,414



1,188Total

$
1,593


$
1,871


$
1,545  F-33




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Year Ended December 31,2007


2006(In thousands)Sales and marketing

$
628


$
75Research and development


53



6Total

$
681


$
81     Valuation
    Assumptions
    Year Ended December 31,2008

2007

2006Expected volatility

60-65%

65%

75-79%Expected dividend yield

0.0%

0.0%

0.0%Risk-free interest rate

2.7-3.6%

4.8%

5.0%Expected term in years

5.5-6.0

5.5

6.1Weighted-average grant date fair value

$0.89

$1.66

$2.62   Expected Volatility
  Expected Dividend
  Risk-Free Interest Rate
  Expected Term
  Estimated Forfeitures trued-up
  Note 11.
    Related
    Party Transactions   F-34




---



##### Table of Contents



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




December 31,


December 31,(In thousand)

2008


2007


2006




2008


2007Sales:













Accounts receivable:Renex

$
282


$
228


$
91


Renex

$
100


$
21RAE Benelux


2,287



1,596



1,041


RAE Benelux


411



287RAE Spain


604



442



331


RAE Spain


192



202$
3,173


$
2,266


$
1,463




$
703


$
510Purchases:













Accounts payable:Liaoning Group

$
20


$
4,448


$



Liaoning Group

$
72


$
566Renex


677



675



573


Renex


382



411RAE Benelux













RAE Benelux






RAE Spain













RAE Spain






$
697


$
5,123


$
573




$
454


$
977    F-35




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Note 12.
    Fair
    Value Measurements    Cash and cash equivalents and bank line of
    credit:
  Notes payable to related parties:
  Fair Value
    Measurements
  Level 1:
  Level 2:
  Level 3:
    December 31, 2008

December 31, 2007Carrying



CarryingCategory

Amounts

Fair Value

Amounts

Fair Value(In thousands)Bank lines of credit


Level 1



2,584



2,584



2,618



2,618Notes payable to related parties


Level 2



2,548



2,548



2,561



2,561   Note 13.
    Geographic
    Information    Year Ended December 31,2008


%


2007


%


2006


%(In thousands)Net sales:Americas

$
38,467



40


$
37,011



41


$
32,803



49Asia


41,422



44



42,107



46



26,024



38Europe


15,494



16



11,718



13



8,894



13Total net sales

$
95,383



100


$
90,836



100


$
67,721



100   F-36




---



##### Table of Contents



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





December 31,2008


%


2007


%(In thousands)Property and equipment, netAmericas

$
533



4


$
784



6Asia


14,228



95



11,292



92Europe


215



1



182



2Total property and equipment, net

$
14,976



100


$
12,258



100       Note 14.
    Quarterly
    Information (Unaudited)    First


Second


Third


FourthQuarter


Quarter


Quarter


Quarter


2008(In thousands, except per share data)Net sales

$
17,869


$
24,647


$
28,845


$
24,022


$
95,383Gross profit


8,855



13,091



15,775



10,494



48,215Operating income (loss) from continuing operations


(2,557
)


498



1,379



(5,409
)


(6,089
)Income (loss) from continuing operations


(2,346
)


(472
)


558



(4,903
)


(7,163
)Income (loss) from discontinued operations, net of tax


10



5



(4
)






11Net income (loss)


(2,336
)


(467
)


554



(4,903
)


(7,152
)Basic net income (loss) per common share:Continuing operations

$
(0.04
)

$
(0.01
)

$
0.01


$
(0.08
)

$
(0.12
)Discontinued operations

$



$



$



$



$
Basic net income (loss) per common share

$
(0.04
)

$
(0.01
)

$
0.01


$
(0.08
)

$
(0.12
)Diluted net income (loss) per common share:Continuing operations

$
(0.04
)

$
(0.01
)

$
0.01


$
(0.08
)

$
(0.12
)Discontinued operations


















Diluted net income (loss) per common share

$
(0.04
)

$
(0.01
)

$
0.01


$
(0.08
)

$
(0.12
)   F-37




---



##### Table of Contents



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


Second


Third


FourthQuarter(1)


Quarter(1)


Quarter(1)


Quarter(1)


2007Net sales

$
17,934


$
20,056


$
25,333


$
27,513


$
90,836Gross profit


9,134



9,987



13,322



13,965



46,408Operating income (loss) from continuing operations


(2,206
)


(1,966
)


1,156



(1,155
)


(4,171
)Income (loss) from continuing operations


(2,066
)


(2,223
)


875



(7,128
)


(10,542
)Loss from discontinued operations, net of tax


(253
)


(232
)


(3,291
)


(378
)


(4,154
)Net loss


(2,319
)


(2,455
)


(2,416
)


(7,506
)


(14,696
)Basic net income (loss) per common share:Continuing operations

$
(0.03
)

$
(0.04
)

$
0.01


$
(0.12
)

$
(0.18
)Discontinued operations

$



$
(0.01
)

$
(0.05
)

$
(0.01
)

$
(0.07
)Basic net loss per common share

$
(0.03
)

$
(0.05
)

$
(0.04
)

$
(0.13
)

$
(0.25
)Diluted net income (loss) per common share:Continuing operations

$
(0.03
)

$
(0.04
)

$
0.01


$
(0.12
)

$
(0.18
)Discontinued operations






(0.01
)


(0.05
)


(0.01
)


(0.07
)Diluted net loss per common share

$
(0.03
)

$
(0.05
)

$
(0.04
)

$
(0.13
)

$
(0.25
)     (1)
    
    In August 2007, the Board of Directors approved the
    discontinuation of the Companys DVR business. Impairment
    expenses recognized in fiscal 2007 totaled
    $4.2 million. Prior quarters results were
    adjusted to reflect discontinued operations. F-38