##### 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, 2007ORo

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
  þ o
  Regulation S-K Form 10-K Form 10-K. o
  Rule 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, 2007
    TABLE OF CONTENTS
   
 PagePART IITEM 1.

BUSINESS


1ITEM 1A.

RISK FACTORS


6ITEM 1B.

UNRESOLVED STAFF COMMENTS


12ITEM 2.

PROPERTIES


12ITEM 3.

LEGAL PROCEEDINGS


13ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY
    HOLDERS


13PART IIITEM 5.

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


14ITEM 6.

SELECTED FINANCIAL DATA


16ITEM 7.

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


17ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
    MARKET RISK


30ITEM 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA


31ITEM 9.

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
    ACCOUNTING AND FINANCIAL DISCLOSURE


31ITEM 9A.

CONTROLS AND PROCEDURES


31ITEM 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


36EXHIBIT 10.4EXHIBIT 10.5EXHIBIT 10.6EXHIBIT 10.15EXHIBIT 21.1EXHIBIT 23.1EXHIBIT 23.2EXHIBIT 31.1EXHIBIT 31.2EXHIBIT 32.1EXHIBIT 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 2008.
  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
    business-to-business business-to-government
      Customers
    Research,
    Development and Engineering
    
    the PlumeRAE, in a Rapid Deployment Kit, and HazRAE, which
    provide first responders with powerful decision support
    capabilities when determining the best course of action for a
    population near an incident; 3




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
    the AreaRAE Gamma, which provides wireless delivery of remotely
    sensed gas vapors and gamma radiation, an industry
    first; and
    networking advances, which allow RAE sensors to be connected to
    industrial command and control systems via mesh networking with
    bridges to Ethernet.      Manufacturing
      Competition
      and/or
  Employees
   4




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##### Table of Contents



Executive
    Officers of the Registrant
    Name

Age

PositionRobert I. Chen


60


President, Chief Executive Officer and Chairman of the BoardRandall Gausman


58


Vice President and Chief Financial OfficerPeter C. Hsi


57


Chief Technology OfficerChristopher Hameister


53


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


45


Vice President China Business OperationsLi-chung Lee


60


Vice President EngineeringMing-Ching Tang


57


Vice President Manufacturing   Robert I. Chen
  Randall Gausman
  Dr. Peter C. Hsi
  Christopher Hameister
  Fei-Zhou Shen
 5




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##### Table of Contents



Dr. Li-chung Lee
  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.
  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 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.
   6




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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.
        The
    securities laws and regulations have and are likely to continue
    to have a significant effect on our costs.
   7




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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.
     8




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##### Table of Contents



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;
    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
 9




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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.
     10




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We may
    face intellectual property infringement claims that might be
    costly to resolve and affect our results of
    operations.
      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.
   11




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##### Table of Contents



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.
    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     12




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##### Table of Contents



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).
      ITEM 4.
    SUBMISSION
    OF MATTERS TO A VOTE OF SECURITY HOLDERS   13




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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,
  2007

2006High

Low

High

LowFirst Quarter

$
3.75


$
2.52


$
3.93


$
3.26Second Quarter

$
2.95


$
2.23


$
4.54


$
3.27Third Quarter

$
3.35


$
1.90


$
4.14


$
2.40Fourth Quarter

$
3.68


$
2.40


$
4.05


$
2.81      14




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##### Table of Contents



PERFORMANCE
    GRAPH
  3800-3899
    COMPARISON
    OF 5 YEAR CUMULATIVE TOTAL RETURN*
    
     12/02



12/03



12/04



12/05



12/06



12/07RAE Systems Inc.



100.00




809.52




1,738.10




835.71




761.90




642.86AMEX Composite



100.00




143.18




175.20




215.26




257.04




299.37AMEX stocks for SIC codes 3800 - 3899 Measuring
    Instruments



100.00




148.58




155.91




135.48




148.39




171.08  15




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##### Table of Contents



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

2006

2005

2004(1)(2)(3)

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

(8)

(9)(10)

2003(In thousands, except share and per share data)Operating Data:Net sales

$
90,836


$
67,721


$
60,293


$
45,540


$
31,361Gross profit

$
46,408


$
35,523


$
35,603


$
27,023


$
19,256Operating income (loss) from continuing operations

$
(4,171
)

$
(2,871
)

$
(1,588
)

$
3,514


$
3,759Income (loss) from continuing operations

$
(10,542
)

$
(1,369
)

$
(759
)

$
2,335


$
2,738Basic income (loss) per share from continuing operations

$
(0.18
)

$
(0.03
)

$
(0.01
)

$
0.04


$
0.06Diluted income (loss) per share from continuing operations

$
(0.18
)

$
(0.03
)

$
(0.01
)

$
0.04


$
0.06Weighted-average common shares:Basic outstanding shares


58,852,172



58,424,970



57,687,714



55,809,638



46,179,770Diluted outstanding shares


58,852,172



58,424,970



57,687,714



60,135,692



49,225,169Balance Sheet Data:Working capital

$
40,850


$
36,641


$
41,366


$
38,857


$
12,423Total assets

$
85,343


$
89,753


$
76,264


$
69,115


$
20,765Long-term liabilities

$
10,442


$
5,441


$
2,962


$
1,645


$
200Total shareholders equity

$
46,356


$
56,179


$
54,573


$
52,189


$
14,807       (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. 16




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##### Table of Contents



(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.(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 2008. 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
         17




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Critical
    Accounting Policies
      Revenue
    Recognition
  percentage-of-completion No. 00-10, Accounting for Shipping and Handling Fees and
    Costs
  Accounts
    Receivable, Trade Notes Receivable and Allowance for Doubtful
    Accounts
   18




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##### Table of Contents



Inventories
  first-in,
  Goodwill
  Goodwill and Other Intangible Assets Segment
    Reporting
    Long-lived
    Assets
    Stock-Based
    Compensation Expense
  Accounting for Stock-Based
    Compensation,
 19




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##### Table of Contents



Share-Based Payment
    Valuation and amortization method
  Expected Term
  Expected Volatility
  Expected Dividend
  Risk-Free Interest Rate
  Estimated Forfeitures trued-up
  Business
    Combinations
     20




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##### Table of Contents



Income
    Taxes
        Accounting for Uncertainty in Income Taxes
  RESULTS
    OF OPERATIONS
  Net
    Sales
  Percentage







Percentage2007

2006

Change

Change

2006

2005

Change

Change(In thousands)Net sales

$
90,836


$
67,721


$
23,115



34
%

$
67,721


$
60,293


$
7,428



12
%      21




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##### Table of Contents



Cost
    of Sales and Gross Profit
  Percentage







Percentage2007

2006

Change

Change

2006

2005

Change

Change(In thousands)Cost of sales

$
44,428


$
32,198


$
12,230



38
%

$
32,198


$
24,690


$
7,508



30
%Gross profit

$
46,408


$
35,523


$
10,885



31
%

$
35,523


$
35,603


$
(80
)


0
%Gross margin


51
%


52
%










52
%


59
%     year-over-year
  Sales
    and Marketing Expense
  Percentage







Percentage2007

2006

Change

Change

2006

2005

Change

Change(In thousands)Sales and marketing

$
25,434


$
18,987


$
6,447



34
%

$
18,987


$
16,835


$
2,152



13
%Percentage of net sales


28
%


28
%










28
%


28
%       Research
    and Development Expense
  Percentage







Percentage2007

2006

Change

Change

2006

2005

Change

Change(In thousands)Research and development

$
7,973


$
6,075


$
1,898



31
%

$
6,075


$
5,414


$
661



12
%Percentage of net sales


9
%


9
%










9
%


9
%    22




---



##### Table of Contents



General
    and Administrative Expense
  Percentage







Percentage2007

2006

Change

Change

2006

2005

Change

Change(In thousands)General and administrative

$
17,767


$
13,332


$
4,435



33
%

$
13,332


$
12,915


$
417



3
%Percentage of net sales


20
%


20
%










20
%


21
%       Gain/loss
    on Abandonment of Lease
  Percentage







Percentage2007

2006

Change

Change

2006

2005

Change

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

$
(595
)

$



$
(595
)


100
%

$



$
2,027


$
(2,027
)


(100
)%Percentage of net sales


(1
)%


0
%










0
%


3
%      23




---



##### Table of Contents



Other
    Income (Expense)
  Percentage











Percentage2007


2006


Change


Change


2006


2005


Change


Change(In thousands)Interest income

$
162


$
782


$
(620
)


(79
)%

$
782


$
641


$
141



22
%Interest expense


(705
)


(249
)


(456
)


183
%


(249
)


(180
)


(69
)


38
%Other, net


58



232



(174
)


(75
)%


232



25



207



828
%Total other income (expense)

$
(485
)

$
765


$
(1,250
)


(163
)%

$
765


$
486


$
279



57
%       Income
    Tax Benefit (Expense)
  Percentage







Percentage2007

2006

Change

Change

2006

2005

Change

Change(In thousands)Income tax expense (benefit)

$
5,883


$
(882
)

$
6,765



(767
)%

$
(882
)

$
(477
)

$
(405
)


85
%Effective tax rate


53
%


(38
)%










(38
)%


(37
)%     , Accounting for Income
    Taxes
 24




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##### Table of Contents



Minority
    Interest in Loss of Consolidated Subsidiaries
  Percentage







Percentage2007

2006

Change

Change

2006

2005

Change

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

$
(6
)

$
49


$
(55
)


(112
)%

$
49


$
62


$
(13
)


(21
)%       Loss
    From Discontinued Operations
     25




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##### Table of Contents



Accounting
    for the Impairment or Disposal of Long-Lived Assets
  Percentage2007


2006


Change


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

$
(4,939
)

$
(243
)

$
(4,696
)


1933
%Income tax benefit


(785
)


(83
)


(702
)


846
%Loss from discontinued operations

$
(4,154
)

$
(160
)

$
(3,994
)


2496
%   Liquidity
    and Capital Resources
  year-over-year
           26




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##### Table of Contents



Year Ended December 31,2007


2006


2005(In thousands)Net cash provided by (used in):Operating activities

$
(9,979
)

$
1,051


$
1,368Investing activities


10,023



3,025



(9,562
)Financing activities


(2,684
)


230



108Effect of exchange rate changes on cash and cash equivalents


427



289



44Net decrease in cash and cash equivalents

$
(2,213
)

$
4,595


$
(8,042
)   Operating
    Activities
    
    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.    
    Non-cash charges to our net income were approximately
    $5.0 million. The non-cash adjustments to net income
    resulted primarily from depreciation and amortization of
    long-lived assets of $2.1 million, the reserve amounts to
    cover the anticipated payment to our landlord of the Sunnyvale,
    California, headquarters building of $2.0 million which was
    abandoned when we purchased our headquarters building in
    San Jose, California, compensation expense of fair value
    accounting for stock options of $2.2 million, other reserve
    and non-cash adjustments to our net income of approximately
    $0.6 million, partially offset by an adjustment to our
    deferred income taxes of $1.9 million.
    The positive effect of the non-cash adjustments described above,
    for the year 2005, was partially offset by an increased
    investment in working capital of $2.8 million, which was
    comprised primarily of increases in accounts receivable and
    inventory related to increased sales levels and the continued
    growth of the business in Asia. 27




---



##### Table of Contents



Investing
    Activities
           Financing
    activities
       28




---



##### Table of Contents



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)

$
2,561


$
191


$
1,715


$
655


$
Capital lease obligations(2)


136



78



58







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


13,229



1,906



3,052



2,645



5,626Construction in process


1,053



1,053











Open purchase orders(3)


7,090



7,090











Total

$
24,069


$
10,318


$
4,825


$
3,300


$
5,626     (1)
    
    For further discussion surrounding notes payable-related
    parties, refer to Note 12. Related Party
    Transactions to the Consolidated Financial Statements.(2)
    
    For further discussion surrounding purchase and lease
    obligations, refer to Note 9. 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
   29




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##### Table of Contents



Recent
    Accounting Pronouncements
  Fair Value Measurements
  The Fair Value Option for Financial Assets and
    Financial Liabilities-Including an Amendment of FASB statement
    No. 115 instrument-by-instrument
  Business Combinations
  Noncontrolling Interests in Consolidated Financial
    Statements-an amendment of ARB No. 51
  ITEM 7A.
    QUANTITATIVE
    AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK  Concentration
    of Credit Risk
    Interest
    Rate Risk
   30




---



##### Table of Contents



Foreign
    Currency Exchange Rate Risk
        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)
 31




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##### Table of Contents



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
      Remediation
    of Material Weakness Identified by Management as of
    December 31, 2006
    
    Implemented in China US GAAP accounting policies for
    depreciation, inventory reserves and balance sheet
    classification that are consistent with the Companys US
    accounting policy.
    Provided the Companys Chinese accounting staff with
    extended training on the proper implementation of US GAAP
    accounting policies for depreciation on property and equipment
    as well as inventory and balance sheet classification of assets
    and liabilities.
    Implemented specific accounting procedures and templates for
    calculating and reporting depreciation, reserves and balance
    sheet classifications. 32




---



##### Table of Contents




    The corporate controller and chief financial officer conducted
    extensive quarterly reviews of financial records of the
    Companys Chinese operations.    Form 10-K.
  Changes
    in Internal Control Over Financial Reporting
   33




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##### Table of Contents



Report of
    Independent Registered Public Accounting Firm
  
  in Internal Control  Integrated Framework
        Internal Control  Integrated Framework
  Share Based Payment Accounting for Uncertainty in Income Taxes an interpretation
    of FASB Statement No 109
     34




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##### 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 17, 2008/s/  Randall
    GausmanRandall
    Gausman

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

March 17, 2008/s/  Peter
    C. HsiPeter
    C. Hsi

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

March 17, 2008/s/  Lyle
    D. FeiselLyle
    D. Feisel

Director

March 17, 2008/s/  Neil
    W. FlanzraichNeil
    W. Flanzraich

Director

March 17, 2008/s/  Sigrun
    HjelmquistSigrun
    Hjelmquist

Director

March 17, 2008/s/  A.
    Marvin StraitA.
    Marvin Strait

Director

March 17, 2008/s/  James
    W. PowerJames
    W. Power

Director

March 17, 2008  36




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##### 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(9)23
.2

Consent of Deloitte & Touche 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. 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)
    
    Filed herewith. 38




---



##### 



RAE
    Systems Inc.
  Consolidated
    Financial Statements
 As of
    December 31, 2007 and 2006
   
 Report of Independent Registered Public
    Accounting Firm


F-1Consolidated Financial StatementsConsolidated balance sheets


F-3Consolidated statements of operations


F-4Consolidated statements of shareholders
    equity


F-5Consolidated statements of cash flows


F-6Notes to consolidated financial statements


F-7-36




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##### Table of Contents



Report of
    Independent Registered Public Accounting Firm
  
  Share Based Payment
        Share Based Payment Accounting for
    Uncertainty in Income Taxes an interpretation of FASB Statement
    No. 109
  Internal Control  Integrated Framework
     F-1




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##### Table of Contents



Report of
    Independent Registered Public Accounting Firm               
   F-2




---



##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED
    BALANCE SHEETS
  December 31,


December 31,2007


2006(In thousands, except share and par value data)ASSETSCurrent assets:Cash and cash equivalents

$
15,906


$
18,119Short-term investments






3,248Trade notes receivable


2,793



1,977Accounts receivable, net of allowances of $2,060 and $843,
    respectively


22,749



16,966Accounts receivable from affiliate


21



154Inventories


17,542



15,382Prepaid expenses and other current assets


2,930



2,530Income taxes receivable


2,069



968Deferred tax assets, current






935Total current assets


64,010



60,279Property and equipment, net


12,258



15,120Acquisition in-progress






820Intangible assets, net


3,827



5,304Goodwill


3,143



3,760Investments in unconsolidated affiliates


425



420Deferred tax assets, non-current






3,402Other assets


1,680



648Total assets

$
85,343


$
89,753LIABILITIES, MINORITY INTEREST IN CONSOLIDATED ENTITIES AND
    STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

$
6,071


$
7,187Accounts payable to affiliate


411



360Payable to Fushun shareholder


609



3,926Bank lines of credit


2,618



Accrued liabilities


12,098



8,793Notes payable to related parties, current


191



822Income taxes payable


674



520Deferred revenue, current


488



2,030Total current liabilities


23,160



23,638Deferred revenue, non-current


514



736Deferred tax liabilities, non-current


277



438Deferred gain on sale of real estate


5,794



Other long-term liabilities


1,487



1,045Notes payable to related parties, non-current


2,370



3,222Total liabilities


33,602



29,079COMMITMENTS AND CONTINGENCIES (NOTE 9)MINORITY INTEREST IN CONSOLIDATED ENTITIES


5,385



4,495SHAREHOLDERS EQUITY:Common stock, $0.001 par value, 200,000,000 shares
    authorized; 59,171,980 and 59,274,596 shares issued and
    outstanding, respectively


59



59Additional paid-in capital


60,957



58,828Accumulated other comprehensive income


4,135



1,245Accumulated deficit


(18,795
)


(3,953
)Total stockholders equity


46,356



56,179Total liabilities, minority interest in consolidated entities
    and shareholders equity

$
85,343


$
89,753    F-3




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##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED
    STATEMENTS OF OPERATIONS
  Year Ended December 31,2007


2006


2005(In thousands, except per share data)Net sales

$
90,836


$
67,721


$
60,293Cost of sales


44,428



32,198



24,690Gross profit


46,408



35,523



35,603Operating expenses:Sales and marketing


25,434



18,987



16,835Research and development


7,973



6,075



5,414General and administrative


17,767



13,332



12,915(Gain) loss on abandonment of lease


(595
)






2,027Total operating expenses


50,579



38,394



37,191Operating loss from continuing operations


(4,171
)


(2,871
)


(1,588
)Other income (expense):Interest income


162



782



641Interest expense


(705
)


(249
)


(180
)Other, net


58



232



25Equity in gain (loss) of unconsolidated affiliates


3



(194
)


(196
)Loss from continuing operations before income taxes and minority
    interest


(4,653
)


(2,300
)


(1,298
)Income tax expense (benefit)


5,883



(882
)


(477
)Loss before minority interest


(10,536
)


(1,418
)


(821
)Minority interest in income (loss) of consolidated subsidiaries


(6
)


49



62Loss from continuing operations


(10,542
)


(1,369
)


(759
)Loss from discontinued operations, net of tax


(4,154
)


(160
)


Net loss

$
(14,696
)

$
(1,529
)

$
(759
)Net loss per share  basic and dilutedContinuing operations

$
(0.18
)

$
(0.03
)

$
(0.01
)Discontinued operations


(0.07
)






Net loss per share  basic and diluted

$
(0.25
)

$
(0.03
)

$
(0.01
)Weighted average common shares outstanding  Basic


58,852



58,425



57,688Stock options and warrants










Weighted average common shares outstanding  Diluted


58,852



58,425



57,688    F-4




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##### Table of Contents



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


OtherCommon Stock


Paid-in


Comprehensive


AccumulatedShares


Amount


Capital


Income


Deficit


Total(In thousands)December 31, 2004


57,315,175


$
57


$
53,660


$
137


$
(1,665
)

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


















(759
)


(759
)Foreign currency translation adjustments














173







173Total comprehensive loss






















(586
)Exercise of stock options


522,668



1



324











325Stock based compensation expense










1,970











1,970Investment in unconsolidated entity










489











489Tax benefit from stock options










186











186December 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
)

$
46,356    F-5




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##### Table of Contents



RAE
    SYSTEMS INC.
  CONSOLIDATED
    STATEMENTS OF CASH FLOWS
  Year Ended December 31,2007


2006


2005(In thousands)CASH FLOWS FROM OPERATING ACTIVITIES:Net loss

$
(14,696
)

$
(1,529
)

$
(759
)Loss from discontinued operations


(4,154
)


(160
)


Loss from continuing operations


(10,542
)


(1,369
)


(759
)Adjustments to reconcile net loss to net cash used in operating
    activities:Depreciation and amortization


3,715



3,189



2,143Provision for doubtful accounts


1,948



(123
)


313(Gain) loss on disposal of property and equipment


(285
)


245



41Stock-based compensation expense


1,871



1,620



2,225Equity in (gain) loss of unconsolidated affiliates


(3
)


194



196Minority interest in losses of consolidated entities


6



(49
)


(62
)Deferred income tax expense (benefit)


4,117



(1,180
)


(1,925
)(Gain) loss on abandonment of lease


(595
)






2,027Amortization of discount on notes payable to related parties


79



187



Impairment of intangible assets


609







Changes in operating assets and liabilities:Accounts receivable


(5,719
)


(2,729
)


(2,091
)Accounts receivable from affiliate


25



(49
)


35Trade notes receivable


(689
)


(838
)


(535
)Inventories


(1,831
)


(2,301
)


(1,587
)Prepaid expenses and other current assets


(46
)


565



(1,248
)Other assets


(1,004
)


231



301Accounts payable


(1,473
)


2,973



494Accounts payable to affiliate


35



335



Accrued liabilities


1,876



1,200



1,250Income taxes payable


541



(823
)


(13
)Deferred revenue


(977
)


384



939Other liabilities


(235
)


(451
)


(376
)Net cash used in operating activities of continuing operations


(8,577
)


1,211



1,368Net cash used in operating activities of discontinued operations


(1,402
)


(160
)


Net cash provided by (used in) operating activities


(9,979
)


1,051



1,368CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of investments






(12,615
)


(16,642
)Proceeds from sales and maturities of investments


3,248



16,801



11,935Proceeds from sales prior to maturity of investments






8,513



Business acquisitions, net of cash acquired


(1,618
)


(7,439
)


Acquisition of property and equipment


(4,014
)


(2,235
)


(4,855
)Proceeds from sale of net assets


12,407







Net cash provided by (used in) investing activities


10,023



3,025



(9,562
)CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from the exercise of stock options and warrants


72



632



325Repurchases of common stock


(335
)






Borrowings from bank lines of credit


12,156







Payments on bank line of credit


(9,600
)






Payments on capital lease obligation










(217
)Payments on payables to related parties


(4,977
)


(402
)


Net cash provided by financing activities


(2,684
)


230



108Effect of exchange rate changes on cash and cash equivalents


427



289



44Decrease in cash and cash equivalents


(2,213
)


4,595



(8,042
)Cash and cash equivalents at beginning of period


18,119



13,524



21,566Cash and cash equivalents at end of period

$
15,906


$
18,119


$
13,524Supplemental disclosure of cash flow information:Cash paid for taxes, net

$
1,133


$
1,084


$
1,833Cash paid for interest


422



6



8Non-cash investing and financing activities:Notes payable issued in conjunction with RAE Beijing acquisition






2,648



Payable to Fushun Shareholder






3,926



Unpaid property and equipment


589







    F-6




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##### 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-7




---



##### 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-8




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Research
    and Development
    Advertising
    Costs
    Income
    Taxes
          Goodwill
    and Other Intangible Assets
     F-9




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Long 
    Lived Assets
    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:    
    Notes Payable  Related Parties:    Translation
    of Foreign Currencies
  non-U.S. subsidiaries non-U.S. subsidiaries.
  Stock-Based
    Compensation Expense
     F-10




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Transition Election Related
    to Accounting for Tax Effects of Stock-based Payment
    Awards
  Net
    Loss Per Share
    Retained
    Earnings
      Variable
    Interest Entities
    Segment
    Reporting
   F-11




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Recent
    Accounting Pronouncements
  Fair Value Measurements
  The Fair Value Option for Financial Assets and
    Financial Liabilities-Including an Amendment of FASB statement
    No. 115 instrument-by-instrument
  Business Combinations
  Noncontrolling Interests in Consolidated Financial
    Statements-an amendment of ARB No. 51
  Note 2.
    Mergers
    and Acquisitions  RAE
    Coal Mine Safety Instruments (Fushun) Co., Ltd.
     F-12




---



##### Table of Contents



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

$
2,151Payable to RAE Fushun


8,606Direct transaction costs


191Total purchase price

$
10,948   (in thousands)
  Cash

$
2,151Accounts receivable


2,247Inventory


3,152Receivable from RAE Systems(1)


8,606Property & equipment


399Intangible asset acquired:Customer list


2,929Total assets


19,484Payable to Liaoning Group


(3,926
)Minority interest


(4,610
)Total purchase price

$
10,948     (1)
    
    Balance eliminated in consolidation.     F-13




---



##### Table of Contents



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

2005(Unaudited)

(Unaudited)(In thousands, except per share amounts)Net sales

$
76,141


$
64,293Net loss

$
(1,632
)

$
(215
)Net loss per share  basic and diluted

$
(0.03
)

$
     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  F-14




---



##### Table of Contents



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


6Trade name


7Patents and technology


7    F-15




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Other
    Acquisitions
  98-3 (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       WeightedAverageUseful Life(Years)Technology


10Trade name


2Customer List


3Trade secret


10      F-16




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  98-3 (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       Note 3.
    Discontinued
    Operations     F-17




---



##### Table of Contents



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


2006(In thousands)Net sales

$
319


$
265Loss from discontinued operations before income taxes


(4,939
)


(243
)Income tax benefit


(785
)


(83
)Loss from discontinued operations

$
(4,154
)

$
(160
)     December 31,


December 31,2007


2006(In thousands)Total current assets

$
59


$
224Acquisition in-progress






820Intangible assets, net






831Goodwill






859Other assets






12Total assets

$
59


$
2,746Total current liabilities

$
63


$
219   Note 4.
    Investments      December 31,


December 31,2007


2006(In thousands)Certificates of deposit

$



$
1,050U.S. government agencies






2,198Total available-for-sale investments

$



$
3,248  F-18




---



##### Table of Contents



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


EstimatedCost


Losses


Fair Value(In thousands)Certificates of deposit

$
1,050


$



$
1,050U.S. government agencies


2,199



(1
)


2,198Total available-for-sale investments

$
3,249


$
(1
)

$
3,248     Note 5.
    Balance
    Sheet Details  Allowance for Doubtful Accounts:
    Year Ended December 31,2007


2006


2005(In thousands)Allowance for doubtful accounts at beginning of year

$
843


$
963


$
665Charges to expense


1,948







313Write-offs of uncollectible accounts, net of recoveries


(833
)


(120
)


(15
)Foreign currency translation effects


102







Allowance for doubtful accounts at end of year

$
2,060


$
843


$
963   Inventories:
    December 31,


December 31,2007


2006(In thousands)Raw materials

$
5,278


$
4,675Work-in-progress


2,759



1,858Finished goods


9,505



8,849Total inventories, net

$
17,542


$
15,382    F-19




---



##### Table of Contents



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


December 31,2007


2006(In thousands)Buildings and improvements

$
5,905


$
8,150Land






3,220Equipment


4,646



4,043Computer equipment


4,346



3,498Automobiles


1,180



1,126Furniture and fixtures


325



550Construction in progress


3,428



5319,830



20,640Less: Accumulated depreciation


(7,572
)


(5,520
)Total property, plant and equipment, net

$
12,258


$
15,120       Accrued Liabilities:
    December 31,


December 31,2007


2006(In thousands)Compensation and related benefits

$
4,377


$
2,233Accrued commissions


2,091



1,815Accrued professional fees


924



1,066Other


4,706



3,679$
12,098


$
8,793  F-20




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
  Note 6.
    Goodwill
    and Intangible Assets    (In thousands)Balance as of December 31, 2005

$
136Acquisitions:KLH


2,754Aegison


816Currency translation adjustment


54Balance as of December 31, 2006


3,760Acquisitions:Securay


646Purchase price adjustment  Aegison


(19
)Impairment charges due to discontinued operations (Aegison and
    Securay)


(1,443
)Currency translation adjustment


199Balance as of December 31, 2007

$
3,143         December 31, 2007


December 31, 2006Gross








GrossCarrying


Accumulated


Net Carrying


Carrying


Accumulated


Net CarryingAmount


Amortization


Amount


Amount


Amortization


Amount(In thousands)Customer list

$
4,714


$
(1,574
)

$
3,140


$
3,059


$
(675
)

$
2,384Patents and technology














1,966



(381
)


1,585Trade name


1,267



(580
)


687



1,661



(401
)


1,260Trade secret














79



(4
)


75$
5,981


$
(2,154
)

$
3,827


$
6,765


$
(1,461
)

$
5,304        F-21




---



##### Table of Contents



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

$
9542009


8062010


7862011


5422012


312Thereafter


427Total amortization

$
3,827   Note 7.
    Income
    Taxes    Year Ended December 31,2007


2006


2005(In thousands)United States

$
(5,973
)

$
(3,213
)

$
(752
)Foreign


1,320



913



(546
)Loss before income taxes and minority interest

$
(4,653
)

$
(2,300
)

$
(1,298
)     Year Ended December 31,2007


2006


2005(In thousands)Current:Federal

$
819


$
(550
)

$
775State


53



22



1Foreign


1,012



801



6721,884



273



1,448Deferred:Federal


2,917



(878
)


(1,134
)State


862



(189
)


(472
)Foreign


220



(88
)


(319
)3,999



(1,155
)


(1,925
)Total income tax expense (benefit)

$
5,883


$
(882
)

$
(477
)  F-22




---



##### Table of Contents



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


2006


2005(In thousands)Federal income tax benefit at statutory rate

$
(1,582
)

$
(725
)

$
(441
)State income tax benefit, net of federal benefit


(486
)


(117
)


(141
)Foreign tax expense (benefit)


(53
)


(81
)


313Nondeductible expenses


132



157



241Other


561



(359
)


(73
)Change in valuation allowance


7,311



243



(376
)Total income tax expense (benefit)

$
5,883


$
(882
)

$
(477
)     December 31,


December 31,2007


2006(In thousands)Deferred tax assets:Fixed assets

$
28


$
(102
)Inventories


262



300Accruals and reserves


3,216



1,652Capitalized research and development


448



703Unrealized foreign losses


2,007



1,450Federal tax credits


302



287Stock-based compensation


2,118



1,436State income taxes and credits


50



(269
)Valuation allowance


(8,431
)


(1,120
)Total deferred tax assets






4,337Deferred tax liabilities:Intangibles


(277
)


(438
)Total deferred tax liabilities


(277
)


(438
)Net deferred tax liabilities:

$
(277
)

$
3,899     non-U.S. subsidiaries
 F-23




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
             F-24




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    December 31,2007(In thousands)Balance at January 1, 2007

$
778Additions:Positions taken related to prior years


306Positions taken during the current year


109Balance at December 31, 2007

$
1,193     non-U.S. income
    United States  Federal

2004 - presentUnited States  State

2004 - presentChina

2005 - presentHong Kong

2004 - presentDenmark

2006 - present   Note 8.
    Lines of
    Credit       F-25




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Note 9.
    Commitments
    and Contingencies  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).
          Leases
  Accounting for Leases
 F-26




---



##### Table of Contents



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

Capital


Operating2008

$
78


$
1,9062009


58



1,6042010






1,4482011






1,3672012






1,278Thereafter






5,626Total minimum lease payments


136


$
13,229Less: Amount representing interest


(11
)Present value of minimum lease payments

$
125     Purchase
    obligations
      Guarantees
   F-27




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
      Product
    Warranties
    2007


2006(In thousands)Balance at beginning of year

$
553


$
377Provision for warranty


1,304



246Utilization of reserve


(992
)


(70
)Foreign currency translation effects


19



Balance at end of year

$
884


$
553   Note 10.
    Employee
    Benefit Plan    Note 11.
    Stock-Based
    Compensation  Stock
    Option Plans
       F-28




---



##### Table of Contents



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

Weighted-Averageof Shares

Exercise PriceBalance as of December 31, 2004


3,105


$
2.57Granted (weighted average fair value $2.80)


515



3.63Exercised


(522
)


0.62Canceled


(396
)


4.07Balance as of December 31, 2005


2,702



2.92Granted (weighted average fair value $2.62)


1,141



3.69Exercised


(342
)


1.15Canceled


(362
)


4.42Balance as of December 31, 2006


3,139



3.22Granted (weighted average fair value $1.66)


855



2.73Exercised


(32
)


2.25Canceled


(239
)


4.18Balance as of December 31, 2007


3,723



3.05     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 - 1.00


329,480



3.94


$
0.22


$
817



329,480






$
0.22


$
8171.01 - 2.00


457,491



4.42



1.07



746



457,491







1.07



7462.01 - 3.00


880,000



8.56



2.73



91



24,998







2.81



3.01 - 4.00


1,518,364



7.22



3.60







835,130







3.49



4.01 - 5.00


204,374



4.88



4.79







192,185







4.83



5.01 - 6.00


220,000



6.26



5.27







208,750







5.27



6.01 - 7.00


54,895



5.69



6.44







48,748







6.44



7.01 - 8.00


58,333



0.46



7.81







58,333







7.81



3,722,937



6.59



3.05


$
1,654



2,155,115



5.33



2.94


$
1,563  F-29




---



##### 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, 2004


337


$
1.02Granted






Exercised






Canceled






Balance 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



1.06     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



4.41


$
1.06


$
164



100,000



4.41


$
1.06


$
164  F-30




---



##### Table of Contents



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

Grant-Datedof Shares

Fair ValueUnvested as of December 31, 2005






Granted


536



2.81Vested






Forfeited






Unvested as of December 31, 2006


536



Granted






Vested


(354
)


2.81Forfeited






Unvested as of December 31, 2007


182



2.81   Warrant
    Stock-Based
    Compensation Expense
   F-31




---



##### Table of Contents



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


2006


2005(In thousands)Cost of sales

$
129


$
93


$
37Sales and marketing


222



161



240Research and development


325



213



111General and administrative


1,195



1,078



1,612Total

$
1,871


$
1,545


$
2,000     Year Ended December 31,2007


2006(In thousands)Sales and marketing

$
628


$
75Research and development


53



6Total

$
681


$
81   Valuation
    Assumptions
    Year Ended December 31,2007

2006

2005Expected volatility


65
%


75-79
%


103-109
%Expected dividend yield


0.0
%


0.0
%


0.0
%Risk-free interest rate


4.8
%


5.0
%


4.0
%Expected term in years


5.5



6.1



5.5Weighted-average fair value

$
1.66


$
2.62


$
2.80   Expected Volatility
  Expected Dividend
  Risk-Free Interest Rate
  Expected Term
 F-32




---



##### Table of Contents



RAE
    SYSTEMS INC.
  NOTES TO
    CONSOLIDATED FINANCIAL
    STATEMENTS  (Continued)
    Estimated Forfeitures trued-up
  Note 12.
    Related
    Party Transactions                 F-33




---



##### Table of Contents



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




December 31,


December 31,2007


2006


2005




2007


2006(In thousands)Sales:













Accounts receivable:Renex

$
228


$
91


$
48


Renex

$
21


$
154RAE Benelux


1,596



1,041



503


RAE Benelux


287



162RAE Spain


442



331



243


RAE Spain


202



150$
2,266


$
1,463


$
794




$
510


$
466Purchases:













Accounts payable:Liaoning Group

$
4,448


$



$



Liaoning Group

$
566


$
Renex


675



573



408


Renex


411



360RAE Benelux













RAE Benelux






RAE Spain













RAE Spain






$
5,123


$
573


$
408




$
977


$
360       Note 13.
    Geographic
    Information    Year Ended December 31,2007


%


2006


%


2005


%(In thousands)Net sales:Americas

$
37,011



41


$
32,803



49


$
33,902



56Asia


42,107



46



26,024



38



19,902



33Europe


11,718



13



8,894



13



6,489



11Total net sales

$
90,836



100


$
67,721



100


$
60,293



100   F-34




---



##### Table of Contents



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





December 31,2007


%


2006


%(In thousands)Property and equipment, netAmericas

$
784



6


$
6,941



46Asia


11,292



92



8,105



54Europe


182



2



74



Total property and equipment, net

$
12,258



100


$
15,120



100       Note 14.
    Quarterly
    Information (Unaudited)    First


Second


Third


FourthQuarter(3)


Quarter(3)


Quarter(3)


Quarter(3)


2007(In thousands, except per share data)Net 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 income (loss)


(2,319
)


(2,455
)


(2,416
)


(7,506
)


(14,696
)Basic net income (loss) per common share:(1)Continuing operations

$
(0.03
)

$
(0.04
)

$
0.01


$
(0.12
)

$
(0.18
)Discontinued operations

$



$
(0.01
)

$
(0.05
)

$
(0.01
)

$
(0.07
)Basic net income (loss) per common share

$
(0.03
)

$
(0.05
)

$
(0.04
)

$
(0.13
)

$
(0.25
)Diluted net income (loss) per common share:(1)Continuing operations

$
(0.03
)

$
(0.04
)

$
0.01


$
(0.12
)

$
(0.18
)Discontinued operations






(0.01
)


(0.05
)


(0.01
)


(0.07
)Diluted net income (loss) per common share

$
(0.03
)

$
(0.05
)

$
(0.04
)

$
(0.13
)

$
(0.25
)   F-35




---



##### Table of Contents



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


Second


Third


FourthQuarter


Quarter


Quarter(2)


Quarter


2006Net sales

$
12,426


$
15,901


$
18,489


$
20,905


$
67,721Gross profit


6,710



8,462



9,901



10,450



35,523Operating income (loss) from continuing operations


(1,603
)


(444
)


732



(1,556
)


(2,871
)Income (loss) from continuing operations


(1,033
)


(54
)


564



(846
)


(1,369
)Loss from discontinued operations, net of tax










(51
)


(109
)


(160
)Net income (loss)


(1,033
)


(54
)


513



(955
)


(1,529
)Basic net income (loss) per common share:(1) 
    Continuing operations

$
(0.02
)

$



$
0.01


$
(0.02
)

$
(0.03
)Discontinued operations


















Basic net income (loss) per common share

$
(0.02
)

$



$
0.01


$
(0.02
)

$
(0.03
)Diluted net income (loss) per common share:(1)Continuing operations

$
(0.02
)

$



$
0.01


$
(0.02
)

$
(0.03
)Discontinued operations


















Diluted net income (loss) per common share

$
(0.02
)

$



$
0.01


$
(0.02
)

$
(0.03
)     (1)
    
    Net income (loss) per share is computed independently for each
    of the quarters presented. Therefore, the sum of the quarterly
    net loss per share may not equal the annual net loss per share.(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 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-36