**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

**x**                                ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe fiscal year ended September 30, 2006**

**OR**

**o**                                   TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from                    to                    .**

**CommissionFile No. 0-31157**

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**INNOVATIVE SOLUTIONS ANDSUPPORT, INC.**

(Exact name of registrantas specified in its charter)

| **Pennsylvania**                                |   | **23-2507402**                     |
|-------------------------------------------------|--------|------------------------------------|
| (State or other  jurisdiction of incorporation) |   | (IRS Employer  Identification No.) |
| **720 Pennsylvania Drive, Exton, Pennsylvania** |   | **19341**                          |
| (Address of  principal executive offices)       |   | (Zip Code)                         |

 

**(610) 646-9800**

(Registrant’s telephonenumber, including area code)

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**Securities registered pursuant to Section 12(b) ofthe Act:**

| Title of each class:                    | ** ** | **Name of each exchange on which registered** |
|-----------------------------------------|------------|-----------------------------------------------|
| Common Stock par  value $.001 per share |       | NASDAQ National  Market                       |

 

**Securities registered pursuant to Section 12(g) ofthe Act: None**

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.  Yes o  No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act  Yes o  No x

Note: Checking the abovebox will not relieve any registrant required to file reports pursant to section13 or section 15(d) of the Exchange Act from their obligations under thosesections.

Indicate by check markwhether registrant (1) has filed all reports required to be filed bysection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x  No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment tothis Form 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
| Large accelerated filer o |   | Accelerated  filer x |   | Non-accelerated  filer o |
|--------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act).  Yes o  No x

The aggregate market valueof the Registrant’s common stock held by non-affiliates of the Registrant as ofMarch 31, 2006 (the last business day of the registrant’s most recentlycompleted second quarter) was approximately $99 million. Shares of common stockheld by each executive officer and director and by each person who owns 10% ormore of our outstanding common stock have been excluded since such persons maybe deemed affiliates. This determination of affiliate status is not necessarilya conclusive determination for other purposes.

As of December 1,2006, there were 16,818,886 outstanding shares of the Registrant’s Common Stock

**DocumentsIncorporated by Reference**

Portions of the Registrant’sProxy Statement for the 2007 Annual Meeting of Shareholders to be filed priorto February 8, 2007 are incorporated by reference into Part III ofthis Report. Such Proxy Statement, except for the parts therein which have beenspecifically incorporated by reference, shall not be deemed “filed” for thepurposes of this Report on Form 10-K.

 

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.2006 Annual Report on Form 10-KTable of Contents**

|                   | ** ** | ** **                                                                                  | ** ** | ** ** | **Page** | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------------|------------|------------|----------|------------|
| **Part I**   |       |                                                                                        |       |
| Item 1.           |       | Business                                                                                    |       | 3          |     |
| Item 1A.          |       | Risk Factors                                                                                |       | 12         |     |
| Item 1B.          |       | Unresolved Staff Comments                                                                   |       | 17         |     |
| Item 2.           |       | Properties                                                                                  |       | 17         |     |
| Item 3.           |       | Legal Proceedings                                                                           |       | 17         |     |
| Item 4.           |       | Submission of Matters to a  Vote of Security Holders                                        |       | 17         |     |
| **Part II**  |       |                                                                                        |       |
| Item 5.           |       | Market for the Registrant’s  Common Equity and Related Shareholder Matters             |       | 18         |     |
| Item 6.           |       | Selected Financial Data                                                                     |       | 19         |     |
| Item 7.           |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |       | 20-26      |     |
| Item 7A.          |       | Quantitative and Qualitative  Disclosures About Market Risk                                 |       | 26         |     |
| Item 8.           |       | Financial Statements and  Supplementary Data                                                |       | 27-45      |     |
| Item 9.           |       | Changes in and Disagreements  with Accountants on Accounting and Financial Disclosure       |       | 45         |     |
| Item 9A.     |       | Controls and Procedures                                                                     |       | 46         |     |
| **Part III** |       |                                                                                        |       |
| Item 10.          |       | Directors and Executive  Officers of the Registrant                                         |       | 49         |     |
| Item 11.          |       | Executive Compensation                                                                      |       | 49         |     |
| Item 12.          |       | Security Ownership of  Certain Beneficial Owners and Management                             |       | 49         |     |
| Item 13.          |       | Certain Relationships and  Related Transactions                                             |       | 49         |     |
| Item 14.          |       | Principal Accounting Fees  and Services                                                     |       | 49         |     |
| **Part IV**  |       |                                                                                        |       |
| Item  15.         |       | Exhibits,  Financial Statement Schedules and Reports on Form 8-K                       |       | 50         |     |
|                   |            |                                                                                             |            |            |          |            |  |

 

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**FORWARD LOOKINGSTATEMENTS**

*This reportcontains forward looking statements within the meaning of Section 21E ofthe Securities Exchange Act of 1934. We have based these forward lookingstatements largely on our current expectations and projections about futureevents and trends affecting our business. In this report, the words “believe,” “may,”“will,” “estimate,” “continue,” “anticipate,” “intend,” “forecast,” “expect,” “plan,”“should,” “is likely” and similar expressions, as they relate to our business orour management, are intended to identify forward looking statements, but theyare not exclusive means of identifying them.*

*The forward lookingstatements in this report are only predictions and actual events or results maydiffer materially. In evaluating such statements, a number of risks,uncertainties and other factors could cause our actual results, performance,financial condition, cash flows, prospects and opportunities to differmaterially from those expressed in, or implied by, the forward-lookingstatements. These risks, uncertainties and other factors include those setforth in Item 1A (Risk Factors) of this Annual Report on Form 10-K.*

*Except as expresslyrequired by the federal securities laws, we undertake no obligation to publiclyupdate or revise any forward looking statements, whether as a result of newinformation, future events or otherwise after the date of this report. Ourresults of operations in any past period should not be considered indicative ofthe results to be expected for future periods. Fluctuations in operatingresults may also result in fluctuations in the price of our common stock.*

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**PART I**

**Item 1.**                        Business

**Overview**

Innovative Solutions and Support, Inc. (the “Company,”“IS&S” or “We”) was founded in 1988. The Company designs, manufactures andsells Flat Panel Display Systems, Flight Information Computers and advancedmonitoring systems to the Department of Defense (DoD), government agencies,defense contractors, commercial air transport carriers, original equipmentmanufacturers (OEMs), and the corporate/general aviation markets. The Companyis increasingly positioning itself as a system integrator; this capabilityprovides the Company with the potential to generate more substantive ordersover a broader product base. The Company has demonstrated the ability toincorporate added functionality such as electronic flight bags, charting, mappingand synthetic vision systems into its Flat Panel Display Systems’ product line.Our strategy as both a manufacturer and integrator is to leverage the latesttechnologies developed for the personal computer and telecommunicationsindustries into advanced, cost-effective solutions for both the aviationindustry and DoD. We believe this approach, combined with our industryexperience, enables us to develop high-quality products and systems,substantially reduce product time to market and achieve cost advantages overthe products offered by our competitors.

Through fiscal year 2005, the Company has focusedefforts on developing and marketing air data systems that measure, calculateand display critical flight information, such as airspeed and altitude, andinstruments that measure engine and fuel data. As a result, a substantialportion of our revenues in prior fiscal years, including 2005, have been fromthe sale of air data systems. These systems bring aircraft into compliance withcertain government regulations, including Reduced Vertical Separation Minimum(RVSM) requirements that were phased in by regulatory authorities on allheavily traveled global flight routes.

For several years the Company has also been workingwith advances in technology that have the potential to provide pilotsincreasing amounts of information that will enhance both the safety andefficiency of flying. These advances have come together in the Company’sCOCKPIT/IPTM (Cockpit Information Portal) or Flat Panel Display System product linethat incorporates proprietary technology, low cost, reduced power consumptionand weight as well as diverse functionality. The Company’s Flat Panel DisplaySystem product line is suited to address what we believe to be market demandthat we believe will be driven by regulatory mandates, new technologies andaging equipment on airplanes that have been in service for up to fifty years.We believe that the transition to Flat Panel Display Systems as part ofairplane retrofit requirements is underway.

In fiscal 2004 the COCKPIT/IPTM product line wassignificantly advanced when the Federal Aviation Administration (FAA) awardedthe Company a Technical Standard Order (TSO) for the Company’s large Flat PanelDisplay. The TSO establishes the product as meeting the requirements that havebeen implemented by the FAA to ensure safe flight on a variety of aircrafttypes. The TSO awarded to the Company addresses the most stringent CommercialAir Transport Market requirements as provided in Title 14 of the Code of FederalRegulation, subpart 25, Commercial Air Transport.

In fiscal 2005 the Company received several key FlatPanel Display System awards. The Royal Netherlands Air Force selected our FlatPanel Display System for their KC-10 cockpit avionics update program. Inaddition, the Company teamed with ABX Air to upgrade B-767 cockpits withour Flat Panel Display Systems; several B-767’s were upgraded with ourPrimary Flight and Navigation Flat Panel Display System. The first B-767FPDS received FAA TSO Approval and STC Certification on 10/19/05. We alsocaptured C-130 Flat Panel Engine Instrument Display System awards fromLockheed Martin and Spar Aerospace for international customers. Further,Marshalls of Cambridge, a well respected European systems integrator, selectedthe Company for its common core avionics upgrade featuring our Flat Panel 

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Display System. TheCanadian Department of National Defense also selected our Flat Panel DisplaySystem to retrofit their fleet of C-130 airplanes as did Snow Aviation,an international engineering integrator.

In fiscal 2006 the Flat Panel Display System productline continued to expand in terms of both FAA certifications and additionalcustomer orders. The FAA awarded the Company two new Technical Standard Orders(TSO’s) and two new Supplemental Type Certificates (STC’s) for 15” and 10” FlatPanel Display System installations on Pilatus PC-12 airplanes. TheCompany also received orders from two Pilatus distributors for 15”installations. Further, Kalitta Air placed an order with the Company for FlatPanel Engine Instrument Display Systems (FP/EIDS) for B-747 retrofitapplications. FAA certification relating to this display application is inprocess. Also, Marshalls of Cambridge, who last year chose us as their commoncore avionics upgrade, placed their first order with us this year. Theirinitial award was for C-130 retrofits. Jet Partners order for B-737Flat Panel Display Systems was particularly significant because of thepotential associated with the 3,500 Classic B-737 airplanes in operation.

Fiscal 2006 also sawdemand for air data products, particularly from the DOD as evidenced by asignificant order for Digital Air data Computers. Our Air Data business isexpected to continue although at reduced levels from the peak demand experiencedin fiscal 2005.

**Our Industry**

A wide range of information, including airspeed andaltitude, is critical for the proper and safe operation of aircraft. Withadvances in technology, new types of information to assist pilots, such assatellite based weather and ground terrain maps, are becoming available fordisplay in cockpits. We believe that aircraft cockpits will increasingly becomeinformation centers, capable of delivering additional information that iseither mandated by regulation or demanded by pilots to assist in safe andefficient operation of aircraft.

There are three general types of flight data: Flightcritical aircraft control data, aircraft heading and altitude data andnavigation data. Flight critical aircraft control information such as air dataincludes aircraft speed, altitude and rates of ascent and descent. Aircraftheading and altitude information includes engine data such as fuel and oilquantity and other engine measurements, and navigation data includes radioposition, flight management, GPS and alternative source information, which isinformation not originating on the aircraft, including weather depiction maps,GPS navigation and surface terrain maps. Air data calculations are basedprimarily on air pressure measurements derived from sensors on the aircraft.Engine data are determined by measuring various indices such as temperature,volume, RPM and pressure within an aircraft’s engines and other mechanicalequipment. Alternative source information is typically derived from satellitesor equipment located on land and fed by satellite or radio signals to theaircraft. Pilots can then display this information in the cockpit for referenceand enhanced position awareness.

Traditionally, flight dataand other cockpit information were displayed on a series of separate analogdials. In the early 1980s, digital displays using cathode ray tubes began toreplace some of the individual analog displays. The industry has now begun todevelop color flat panel displays using active matrix liquid crystal displays(AMLCD) to replace traditional analog or digital displays. We expect that theability to display more information in a space-efficient and customizedplatform will become increasingly important if additional information, such asweather depiction maps, traffic information and surface terrain maps, becomemandated by regulation or demanded by pilots. Accordingly, we believe that flatpanel displays, which can integrate and display a “suite” of information, willincreasingly replace individual displays as the method for delivering andordering information displayed in cockpits.

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**Flat Panel Displays**

Air data and other flightinformation were traditionally displayed on analog instrumentation and, morerecently, individual small digital displays. Within the last several years,color flat panel displays were introduced in aircraft cockpits. Flat paneldisplays are LCD screens that can replicate the display of one or a suite ofanalog or digital displays on one screen. Like other instrumentation, flatpanel displays can be installed in new aircraft or used to replace existingdisplays in aircraft already in use. LCDs are also being used for securitymonitoring on-board aircraft and as tactical workstations on military aircraft.The flat panel product line also presents numerous advantages for presentationof engine performance data.

**Engine and FuelDisplays**

Equipment data, such asengine and fuel related data, were traditionally displayed on conventionalsolid-state displays. Engine and fuel displays provide information on engineactivity, including oil and hydraulic pressures and temperature. Thisinstrumentation includes individual and multiple displays clustered throughoutan aircraft’s cockpit. Engine and fuel displays tend to be replaced more frequentlythan other displays due to increased obsolescence problems and normalwear-and-tear. As the information displayed by this instrumentation is vitalfor safe and efficient flight, aircraft operators continue to purchaseindividual conventional engine and fuel displays to replace older ornon-functioning displays. Increasingly, operators are beginning to replacetheir individual instruments with integrated Flat Panel Display Systems.

**Strategy**

Our objective is tobecome a leading supplier and integrator of cockpit information. We believe ourindustry experience and reputation, our technology and products and ourbusiness strategy provide a basis to achieve this objective. Key elements ofour strategy include:

·       *Maintaining our leadership in the air data markets.  *Webelieve that we are one of the largest suppliers of air data products to theU.S. retrofit market. Significant demand remains in retrofitting aging aircraftwith newer, more advanced and more supportable air data systems.

·       *Establishing leadership in the flat panel displaymarket.  *We expect that over the next several years, manyaircraft will either be retrofitted or newly manufactured with flat paneldisplays. Given the versatility, visual appeal and lower cost of displaying aseries of instruments and other flight-relevant information on a single flatpanel, we believe that flat panel displays will increasingly replace individualanalog and digital instruments. We also believe our COCKPIT/IPTM has significantbenefits over the flat panel displays currently offered by our competitors,including its lower cost, larger size and enhanced viewing angles. Accordingly,we believe these advantages will allow us to generate significant revenues fromour COCKPIT/IPTM and gain significant market share.

·       *Continuing our engineering and product developmentsuccesses.  *We developed innovative products by combining ouravionics, engineering and design expertise with commercially availabletechnologies, components and products from non-aviation applications, includingthe personal computer and telecommunications industries. We believe ourprocesses allow us to bring products to market quickly and to control ourdevelopment costs. Our COCKPIT/IPTM is an example of our ability to engineer asuperior product through the selective application of non-avionic technology.

·       *Increasing our sales to the DoD, other government agencies, defensecontractors, commercial air transport and corporate/general aviation markets.*   Westrengthened efforts to diversify our sales to include all end user markets ofthe aviation industry, particularly legacy military aircraft programs and thecommercial air transport market. This includes national and regional carriersand other 

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fleet operators, thecorporate/general aviation market, primarily through aircraft modificationcenters, and the OEM market. We continue to build a sales and marketing forcededicated to expanding our sales efforts to these markets while at the sametime maintaining our position as a provider of avionics products for the DoD.

·       *Expanding our international presence.  *Weplan to increase our international sales by adding sales and marketingpersonnel and foreign offices. As large flat panel displays become moreprevalent throughout the world, we believe that European and otherinternational aircraft operators and aircraft modification centers willaccelerate their retrofitting activities, thereby increasing the demand forlarge flat panel displays.

·       *Growth through acquisitions or joint ventures.  *We maypursue strategic acquisitions or joint ventures as a means of growing ourbusiness with respect to both information management products and content. Wehave identified profiles of the types of companies we would like to acquire andare evaluating various potential forms of joint ventures. We may seek toacquire developers or suppliers of complementary products, technology orinformation, or we may acquire suppliers of similar products as a means ofincreasing our product offerings and market share.

**Our Products**

Our current line ofproducts includes:

*Flat Panel DisplaySystems*

We developed a Flat Panel Display System that canreplace conventional analog and digital displays currently used in a cockpitand can display additional information that is not now commonly displayed in thecockpit. Our Cockpit Information Portal COCKPIT/IPTM is capable of displayingnearly all types of air data, engine and fuel data, altitude, heading andnavigational data and alternative source information. As technology andinformation delivery systems further develop, additional information, such assurface terrain maps and data link messaging, will be displayed in the cockpit.We designed our COCKPIT/IPTM to be capable of displaying information generatedfrom a variety of sources, including our RVSM air data system, engine and fuelinstrumentation and third-party data and information products.

In 2004, the Federal Aviation Administration (FAA)awarded the Company a Technical Standard Order (TSO) for the flat panel displayor COCKPIT/IPTM. The TSO establishes that our flat panel display meets FAArequirements that have been put in place to ensure safe flight on a variety ofaircraft types. The TSO awarded to the Company addresses the most stringentCommercial Air Transport Market requirements as provided in Title 14 of theCode of Federal Regulation, subpart 25, Commercial Air Transport.

The Royal Netherlands Air Force selected our FlatPanel System for their KC-10 cockpit avionics update program. The Companyalso teamed with ABX Air to upgrade B-767 cockpits with our Flat PanelDisplay Systems; the first B-767 was upgraded with our Primary Flight andNavigation Flat Panel Display System. We also received C-130 Flat PanelEngine Instrument Display System awards from Lockheed Martin and Spar Aerospacefor international customers. Further, Marshalls of Cambridge, a well respectedEuropean systems integrator, selected the Company for its common core avionicsupgrade featuring our Flat Panel Display System. The Canadian Department ofNational Defense also selected our Flat Panel Display System to retrofit theirfleet of C-130 airplanes, as did Snow Aviation, an internationalengineering integrator.

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On October 19, 2005 the FAA awarded the Company asecond TSO for our flat panel display or COCKPIT/IPTM. This TSO also establishesthat our flat panel display system meets FAA requirements that have been put inplace to ensure safe flight on a variety of aircraft types. This TSO alsoaddresses the most stringent Commercial Air Transport Market requirements asprovided in Title 14 of the Code of Federal Regulation, subpart 25, CommercialAir Transport. The STC states “It has been noted that this display systememploys an integrity monitoring system that assures integrity to acatastrophic/Level A design condition with the use of commercial graphicprocessors.”

In October 2005, the Company in a teamingarrangement with ABX Air received FAA Supplemental Type Certification (STC) ofits Flat Panel Display System for use on B-767 aircraft. ABX Air providedthe aircraft and turnkey services, including installation kits, labor, pilottraining and technical manual updates. The STC provides B-767 operatorswith a low cost, rapidly implemented retrofit of their cockpit avionics with amodern pilot and copilot suite of high resolution multi-color LCD flat paneldisplays. We believe that operators will also benefit from improved dispatchreliability, logistics savings, and adaptability to future requirements. Thereceipt of the STC positions the Company to pursue the more than 1,700 B-757and B-767 aircraft with similar needs for Flat Panel Display Systemupgrades. The STC also provides a foundation for incorporating the product intoother airplanes as well.

In fiscal 2006 the FlatPanel Display System product line continued to expand in terms of both FAAcertifications and additional customer orders. The FAA awarded the Company twonew Technical Standard Orders (TSO’s) and two new Supplemental TypeCertificates (STC’s) for 15” and 10” Flat Panel Display System installations onPilatus PC-12 airplanes. The Company also received orders from two Pilatusdistributors for 15” installations. Further, Kalitta Air placed an order withthe Company for Flat Panel Engine Instrument Display Systems (FP/EIDS) forB-747 retrofit applications. FAA certification relating to this displayapplication is in process. Also, Marshalls of Cambridge, who last year chose usas their common core avionics upgrade, placed their first order with us thisyear. Their initial award was for C-130 retrofits. Jet Partners order for B-737Flat Panel Display Systems was particularly significant because of thepotential associated with the 3,500 Classic B-737 airplanes in operation.

*Air Data Systemsand Components*

Our air data products calculate and display variousmeasures such as aircraft speed, altitude and rate of ascent and descent. Thefunctionality of our air data systems use advanced sensors to gather air pressuredata and use customized algorithms to interpret data, thus allowing the systemto more accurately calculate altitude. 

We sell individualcomponents as well as partial and complete air data systems. Our components andsystems include:

·                    digitalair data computers, which calculate various air data parameters such asaltitude, airspeed, vertical speed, angle of attack and other informationderived from the measure of air pressure;

·                    integratedair data computers and display units, which calculate and convey air datainformation;

·                    altitudedisplays, which convey aircraft altitude measurements;

·                    airspeeddisplays, which convey various types of airspeed measurements includingvertical airspeed and rates of ascent and descent; and

·                    altitudealerters, which allow the pilot to select a desired cruising altitude that theaircraft will reach and maintain, and also provide warnings to pilots when anunacceptable deviation occurs.

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*Engine and FuelDisplays*

We develop, manufacture and market engine and fueldisplays. Our solid-state multifunction displays convey information withrespect to fuel and oil levels and engine activity, such as oil and hydraulicpressure and temperature. This instrumentation includes individual and multipledisplays clustered throughout an aircraft’s cockpit. Our displays can be usedin conjunction with our own engine and fuel data equipment or that of othermanufacturers.

Engine and fuel displays are found in all aircraft andare vital to the safe and proper flight of the aircraft. In addition, theaccurate conveyance of engine and fuel information is critical for themonitoring of engine stress and the maintenance of engine parts. Engine andfuel displays tend to be replaced more frequently than other displays and haveremained largely unchanged since their introduction due to their low cost,standard design and universal use.

We believe that our engineand fuel displays are extremely reliable, and we have designed them to beprogrammable to adapt easily without major modification to most modernaircraft. Our products have been installed on C-130H, DC-9, DC-10,P3 and A-10 aircraft.

**Customers**

Our customers include, among others, the United StatesGovernment (including DOD), Garrett, Bombardier Aerospace (the manufacturer ofLearjet), Raytheon, Northwest Airlines, ABX Air, L-3, Spar Aerospace,Federal Express Corporation, The Boeing Company, Lockheed Martin Corporation,Rockwell Collins, Gulfstream Aerospace Corporation, Plain Avionics and StarAviation.

The Company recorded saleswith the DOD that amounted to 17% of total sales for the fiscal year 2006.

*Retrofit Market*

Historically, the majority of our sales have come fromthe retrofit market. Among other reasons, we have pursued the retrofit marketbecause of its continued rapid growth in response to the increasing need tosupport the world’s aging fleet of aircraft.

Updating anindividual aircraft’s existing electronics equipment has become increasinglycommon as new technology makes existing instrumentation outdated while anaircraft is still structurally and mechanically sound. Retrofitting an aircraftis generally a substantially less expensive alternative to purchasing a newaircraft. We expect our main customers in the retrofit market to be:

·                    theDoD and defense contractors;

·                    aircraftoperators; and

·                    aircraftmodification centers.

*Departmentof Defense and Defense Contractors.**  *We sell our products directly tothe DoD as well as to domestic and international defense contractors for enduse on military aircraft retrofit programs. DoD programs generally take one oftwo forms, a subcontract with a prime government contractor, such as Boeing orRockwell Collins, or a direct contract with the appropriate government agencysuch as the United States Air Force to satisfy its requirement for replacingCentral Air Data Computers on the fleet of A-10 aircraft. The government’sdesire for cost-effective retrofitting of aircraft has led it to purchasecommercial off-the-shelf equipment rather than requiring the development ofspecially designed products, which are usually more costly and take a longertime to develop. These contracts tend to be on arms length commercial terms,although some of the termination and other provisions of government contractsdescribed below are typically applicable to these contracts. Each governmentagency or general contractor 

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retains the right toterminate the contract at any time at its convenience. Upon such alteration ortermination, we would be entitled to an equitable adjustment to the contractprice so that we may receive the purchase price for already delivered items andreimbursement for allowable costs incurred.

*AircraftOperators.**  *Wealso sell our products to aircraft operators, including commercial airlines,cargo carriers and business and general aviation. Our products are used mostlyin the retrofitting of aircraft owned or operated by these customers, whichgenerally retrofit and maintain their aircraft themselves. Our commercial fleetcustomers include Northwest Airlines, Air Canada, Midcoast, MK Airlines, ABXAir, Federal Express, Kitty Hawk, ARC, Champion and Kelowna Flightcraft LTD. Wesell these customers a range of products from fuel quantity indicators to airdata systems.

*Aircraft ModificationCenters.**  *Basedon industry data, we believe that there are approximately 12,800 privateand corporate aircraft in service in North America. The primary retrofit marketfor private and corporate jets is through aircraft modification centers, whichrepair and retrofit private aircraft in a manner similar to the way automechanics service a person’s car. We have established relationships with anumber of aircraft modification centers throughout the United States. Thesemodification centers essentially act as distribution outlets for our products.We believe that our air data systems and related components are being promotedby aircraft modification centers to update older or outdated equipment. Ourlarge modification center customers include Bombardier Learjet, GarrettAviation, Star Aviation, Duncan Aviation, Plain Avionics and Raytheon AircraftServices.

**OEM Market**

We also market our products to original equipmentmanufacturers, particularly manufacturers of corporate and private jets as wellas to DoD contractors manufacturing military jets. Customers of our productsinclude Bombardier (the manufacturer of Learjet), Gulfstream, Boeing, Raytheon,Piaggio and Lockheed.

Most aircraftmanufacturers equip their current production aircraft with RVSM-compliant airdata systems. In addition, we expect that as flat panel displays becomeincreasingly popular, OEMs will begin manufacturing an increasing percentage oftheir aircraft with flat panel displays, either as standard or optionalequipment. Most new high-end business aviation aircraft have flat paneldisplays as standard equipment.

**Backlog**

As of September 30,2006 and 2005, our backlog was $28.0 million and $12.9 million, respectively.The year over year increase of $15.1 million or 117% was the result of growthin Flat Panel Display System and Air Data product lines. Flat Panel DisplaySystems backlog increased by 216% to $18.3 million The air data backlogincreased 37% to $9.7 million.

**Sales and Marketing**

We have generally focused our sales efforts on theDoD, prime DoD contractors, aircraft operators and OEMs, and more recently onaircraft modification centers. We continually evaluate our sales and marketingefforts with respect to the military, commercial and corporate aviation marketsand have made substantial use of third-party sales representatives who receivecompensation through commissions based on performance.

We believe our ability to provide prompt and effectiverepair and upgrade service is critical to our marketing efforts. As part of ourcustomer service program, we offer a 24-hour hotline that customers cancall for product repair or upgrade concerns. We employ field service engineersto service our equipment and, depending on the service required, we may eitherdispatch a service crew to make necessary repairs or 

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request that the customerreturn the product to us for repairs or upgrades at our facility. In the eventrepairs or upgrades are required to be made at our facility, we provide spareproducts for use by our customers during the repair time. Our in-houseturnaround repair times average 15 days and turnaround upgrade times average 30days. Before returning our products to customers, all repaired or upgradedproducts are retested for airworthiness.

In connection with ourcustomer service program, we typically provide customers with a two-yearwarranty on new products. We also offer customers extended warranties ofvarying terms for additional fees.

**GovernmentRegulation**

The manufacture and installation of our products inaircraft owned and operated in the United States is governed by FAAregulations. We maintain an FAA certified production facility. The mostsignificant of the product and installation regulations focus on TechnicalStandard Order (TSO) and Supplemental Type Certificate (STC) certifications.These certifications set forth the minimum general standards that a certaintype of equipment should meet. As required, we deliver our product inaccordance with FAA regulations.

Sales of our products to European or other non-U.S.owners of aircraft also typically require approval of the European AviationSafety Agency (EASA), the European counterpart of the FAA, or anotherappropriate governmental agency. EASA certification requirements for themanufacturing and installation of our products in European-owned aircraftmirror the FAA regulations. Much like the FAA certification process, the EASAhas established a process for granting European Certifications.

In addition toproduct-related regulations, we are also subject to U.S.Government procurementregulations with respect to sale of our products to government entities orgovernment contractors. These regulations dictate the manner in which productsmay be sold to the government and set forth other requirements that must be metin order to do business with or on behalf of government entities. For example,the government agency or general contractor may alter the price, quantity ordelivery schedule of our products. In addition, the government agency orgeneral contractor retains the right to terminate the contract at any time atits convenience. Upon such alteration or termination, we would be entitled toan equitable adjustment to the contract price so that we may receive thepurchase price for already delivered items and reimbursement for allowablecosts incurred.

**Manufacturing,Assembly and Materials Acquisition**

Our manufacturing activities consist primarily ofassembling and testing components and subassemblies and integrating them into afinished system. We believe that this method allows us to achieve relativelyflexible manufacturing capacity while minimizing expenses. We generallypurchase the components for our products from third-party vendors and assemblethem in a clean room environment to reduce impurities and improve theperformance of our products. Many of the components we purchase are standardproducts, although certain parts are made to our specifications.

When appropriate, we enterinto long-term supply agreements and use our relationships with long-termsuppliers to improve product quality and availability and to reduce deliverytimes and product costs. In addition, we are continually identifyingalternative suppliers for important component parts. Using component parts fromnew suppliers in our products generally requires FAA certification of theentire finished product if the newly sourced component varies significantlyfrom our original drawings and specifications. To date, we have not experiencedany significant delays in the delivery of our products caused by the inabilityto obtain either component parts or FAA approval of products incorporating newcomponent parts.

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**Quality Assurance**

Product quality is ofvital importance to our customers, and we have taken steps to enhance theoverall quality of our products. We are ISO 9001 and AS 9100 certified. ISO9001 and AS 9100 standards are an international consensus on effectivemanagement practices with the goal of ensuring that a company can consistentlydeliver its products and related services in a manner that meets or exceedscustomer quality requirements. These standards allow us to represent to ourcustomers that we maintain high quality industry standards in the education ofour employees and the design and manufacture of our products. In addition, ourproducts undergo extensive quality control testing prior to being delivered tocustomers. As part of our quality assurance procedures, we maintain detailedrecords of test results and our quality control processes.

**Our Competition**

The market for our products is highly competitive andcharacterized by several industry niches in which a number of manufacturersspecialize. Our competitors vary in size and resources, and substantially allof our competitors are much larger and have substantially greater resourcesthan us. With respect to air data systems and related products, our principalcompetitors include Kollsman Inc., Honeywell International Inc., RockwellCollins, Inc., Thales and Smiths PLC. With respect to flat panel displays,our principal competitors currently include Honeywell, Rockwell Collins, Inc.,L-3 Communications and Smiths. However, because the flat panel displayindustry is a new and evolving market, as the demand for flat panel displaysincreases we may face competition in this area from additional companies in thefuture.

We believe that theprincipal competitive factors in the markets we serve are cost, developmentcycle time, responsiveness to customer preferences, product quality, technologyand reliability. We believe that our significant and long-standing customerrelationships reflect our ability to compete favorably with respect to thesefactors.

**IntellectualProperty and Proprietary Rights**

We rely on patents to protect our proprietarytechnology. We currently hold 17 U.S. patents and have 5 U.S. patentapplications pending relating to our technology. In addition, we hold 11international patents and have 13 international patent applications pending.Certain of these patents and patent applications cover technology relating toair data measurement systems and calibration techniques while others covertechnology relating to flat panel display systems and other aspects of ourCOCKPIT/IPTM solution. While we believe that these patents have significantvalue in protecting our technology, we also believe that the innovative skill,technical expertise and the know-how of our personnel in applying thetechnology reflected in our patents would be difficult, costly and timeconsuming to reproduce.

While there are no pendinglawsuits against us regarding patent infringement or other intellectualproperty rights, we cannot be certain such infringement claims will not beasserted against us in the future.

**InnovativeSolutions and Support Website**

Our primary website is *http://www.innovative-ss.com*. We make available, free ofcharge, at our corporate website our annual report on Form 10-K,quarterly reports on Form 10-Q, current reports on Form 8-Kand amendments to those reports filed or furnished pursuant to Section 13(a) or15(d) of the Securities and Exchange Act of 1934, as amended, as soon asreasonably practicable after we electronically file such material with, orfurnish it to, the SEC.

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**Our Employees**

As of September 30, 2006, we had 138 employees,51 were in our manufacturing and assembly operations, 50 in research anddevelopment, 8 in quality and 29 in selling & general administrativepositions.

Our future success dependson our ability to attract, train and retain highly qualified personnel. We planto hire additional personnel, including, in particular, sales and marketingpersonnel, during the next twelve months. Competition for such qualifiedpersonnel is intense and we may not be able to attract, train and retain highlyqualified personnel in the future. Our employees are not represented by a laborunion.

**Other**

On June 13, 2005, the Company’s Board ofDirectors approved a three-for-two split of the Company’s common stock. Thestock split was in the form of a fifty percent (50%) stock dividend that waspaid on July 7, 2005 to shareholders of record on June 23, 2005. Theissued and outstanding common stock and all share and per share amounts (exceptpar value) have been retroactively restated in this report to give effect tothis three-for-two stock split.

**Executive Officers of theRegistrant**

Thefollowing is a list of our executive officers, their ages and their positions:

| **Name**                              | ** ** | ** ** | ** ** | **Age** | ** ** | **Position**                                       | ** ** |
|---------------------------------------|------------|------------|------------|---------|------------|----------------------------------------------------|------------|
| Geoffrey S. M. Hedrick |       |       | 64         |    |       | Chairman  of the Board and Chief Executive Officer |       |
| Roman G.  Ptakowski                   |       |       | 58         |    |       | President                                          |       |
| James J. Reilly                       |       |       | 66         |    |       | Chief Financial Officer                            |       |

 

*GeoffreyS. M. Hedrick*has been Chief Executive Officer sincehe founded IS&S in February 1988 and Chairman of the Board since 1997.Prior to founding IS&S, Mr. Hedrick served as President andChief Executive Officer of Smiths Industries North American AerospaceCompanies. He also founded Harowe Systems, Inc. in 1971, which wassubsequently acquired by Smiths Industries. Mr. Hedrick has over 35 yearsof experience in the avionics industry, and he holds a number of patents in theelectronics, optoelectric, electromagnetic, aerospace and contamination-controlfields.

*RomanG. Ptakowski*has been President since March 2003.Prior to that, Mr. Ptakowski served as a Group Vice President and GeneralManager and, before that, as a Vice President of Sales and Marketing at B/EAerospace, Inc. Previously, Mr. Ptakowski held a number of positionswith increasing responsibility within ASEA Brown Boveri Power T&D Company, Inc.There, he was General Manager of the Protective Relay Division before leavingto join B/E Aerospace, Inc. Mr. Ptakowski received a B.S. inElectrical Engineering from New York University and a MBA from Duke University.

*James J. Reilly*hasbeen Chief Financial Officer since February 2000. From 1996 to 1999, Mr. Reillywas employed by B/E Aerospace, Inc., Seating Products Group, as VicePresident and Chief Financial Officer. From 1989 to 1996, Mr. Reilly wasemployed by E-Systems, Inc. as Vice President and Principal AccountingOfficer. Mr. Reilly received a Bachelor of Science degree and a MBA fromThe University of Hartford.

**Item 1A.**                RiskFactors.

*You should carefully consider the risks, uncertaintiesand other factors described below, in addition to the other information setforth in this report, because they could materially and adversely affect ourbusiness, operating results, financial condition, cash flows and prospects aswell as adversely affect the value of an investment in our common stock.*

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*Risks Related toOur Business*

**Our salesprincipally relate to air data and flat panel systems products, and we cannotbe certain that the market will continue to accept these or other products.**

During fiscal 2006 and 2005, we derived 62% and 94%,respectively, of our revenues from the sale of air data systems and relatedproducts. We expect that revenues from our air data products will continue todecline as the peak demand associated with the FAA’s RVSM mandate has beenaccommodated. Accordingly, our revenues will decrease if new products such asour Flat Panel Display Systems do not receive market acceptance or if ourexisting customers do not continue to incorporate our products in theirretrofitting or manufacturing of aircraft. In seeking new customers, it may bedifficult for our products to displace competing products. Accordingly, wecannot assure you that potential customers will accept our products or thatexisting customers will not abandon them.

A portion of our sales have been, and we expect willcontinue to be, to defense contractors or government agencies in connectionwith government aircraft retrofit or original manufacturing contracts. Sales togovernment contractors and government agencies accounted for approximately 29%and 20% respectively, of our revenues during fiscal 2006 and 2005. Our revenuesin this area could decline as a result of DoD spending cuts and generalbudgetary constraints.

In addition, our revenues are concentrated with alimited number of customers. We derived 47% of our revenues during fiscal year2006 from 5 customers, DoD, Department of National Defense Canada, ABX Air,Boeing and Star Aviation. We derived 47% of our revenues during fiscal year2005 from 5 customers, Bombardier, Star Aviation, Garrett, FedEx and the DoD.We expect a relatively small number of customers to account for a majority ofour revenues for the foreseeable future. As a result of our concentratedcustomer base, a loss of one or more of these customers could have a materialadverse effect on our revenues and results of operations.

**The growth of ourcustomer base could be limited by delays or difficulties in completing thedevelopment and introduction of our planned products or product enhancements.If we fail to enhance existing products or to develop and achieve marketacceptance for flat panel displays and other new products that meet customerrequirements, our business may not grow.**

Although a substantial majority of our revenues in thepast have come from sales of air data systems and related products, wecurrently spend a large portion of our research and development efforts indeveloping and marketing our flat panel display systems (CIP) and complementaryproducts. Our ability to grow and diversify our operations through theintroduction and sale of new products, such as flat panel display systems, isdependent upon our success in continuing product development and engineeringactivities as well as our sales and marketing efforts and our ability to obtainrequisite approvals to sell such products. Our sales growth will also depend inpart on the market acceptance of and demand for our CIP and future products. Wecannot be certain that we will be able to develop, introduce or market our CIPor other new products or product enhancements in a timely or cost-effectivemanner or that any new products will receive market acceptance or necessaryregulatory approval.

**We rely on thirdparty suppliers for components of our air data systems products, and anyinterruption in the supply of these components could hinder our ability todeliver our products.**

Our manufacturing process consists primarily ofassembling components purchased from our supply chain. These suppliers may notcontinue to be available to us. If we are unable to maintain relationships withkey third party suppliers, the development and distribution of our productscould be delayed until equivalent components can be obtained and integratedinto our products. In addition, substitution of certain components from othermanufacturers may require FAA or other approval, which could delay our abilityto ship products.

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Our government retrofit projects are generallypursuant to either a direct contract with a government agency or a subcontractwith the general contractor to a government agency. Each contract includesvarious federal regulations that impose certain requirements on us, includingthe ability of the government agency or general contractor to alter the price,quantity or delivery schedule of our products. In addition, the governmentagency or general contractor retains the right to terminate the contract at anytime at its convenience. Upon alteration or termination of these contracts, wewould be entitled to an equitable adjustment to the contract price so that wemay receive the purchase price for items we have delivered and reimbursementfor allowable costs we have incurred. Accordingly, because these contracts canbe terminated, we cannot assure you that our government retrofit backlog willresult in sales.

**We depend on keypersonnel to manage our business effectively, and if we are unable to retainour key employees, our ability to compete could be harmed.**

Our success depends on the efforts, abilities andexpertise of our senior management and other key personnel. With the exceptionof our President, we generally do not have employment agreements with ouremployees. There can be no assurance that we will be able to retain suchemployees, the loss of some of whom could hurt our ability to execute ourbusiness strategy. We intend to continue hiring key management and sales andmarketing personnel. Competition for such personnel is intense, and we may notbe able to attract or retain additional qualified personnel. We do not maintainkey man life insurance for our executive officers.

Our future success will depend in part on our abilityto implement and improve our operational, administrative and financial systemsand controls and to manage, train and expand our employee base. We cannotassure you that our current and planned personnel levels, systems, proceduresand controls will be adequate to support our future operations. If inadequate,we may not be able to exploit existing and potential market opportunities. Anydelays or difficulties we encounter could impair our ability to attract newcustomers or enhance our relationships with existing customers. Our revenue andoperating results may vary significantly from quarter to quarter, which maycause our stock price to decline.

**Our revenues and operating results may varysignificantly from quarter to quarter due to a number of factors, including:**

·       demandfor our products;

·       capitalexpenditure budgets of aircraft owners and operators and appropriation cyclesof the U.S. government;

·       changesin the use of our products, including air data systems and flat panel displays;

·       delaysin introducing or obtaining government approval for new products;

·       newproduct introductions by competitors;

·       changesin our pricing policies or the pricing policies of our competitors; and

·       costsrelated to possible acquisitions of technologies or businesses.

We plan to increase our operating expenses to expandour sales and marketing operations and fund greater levels of productdevelopment. As a result, a delay in generating revenues could causesignificant variations in our operating results from quarter to quarter.

**Our competitionincludes other manufacturers of air data systems and flight informationdisplays against whom we may not be able to compete successfully.**

The markets for our products are intensely competitiveand subject to rapid technological change. Our competitors include Kollsman, Inc.,Honeywell International Inc., Rockwell Collins Inc., Smiths Industries plc andL-3 Communications. Substantially all of our competitors havesignificantly greater financial, 

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technical and humanresources than we do. In addition, our competitors have much greater experiencein and resources for marketing their products. As a result, our competitors maybe able to respond more quickly to new or emerging technologies and customerpreferences or devote greater resources to the development, promotion and saleof their products than we can. Our competitors may also have greater namerecognition and more extensive customer bases that they can use to theirbenefit. This competition could result in price reductions, fewer customerorders, reduced gross margins and loss of market share.

**We may not be ableto identify or complete acquisitions or we may consummate an acquisition thatadversely affects our operating results.**

One of our strategies is to acquire businesses ortechnologies that will complement our existing operations. We have limitedexperience in acquiring businesses or technologies. There can be no assurancethat we will be able to acquire or profitably manage acquisitions orsuccessfully integrate them into our operations. Furthermore, certain risks areinherent in pursuing acquisitions, such as the diversion of management’s timeand attention and combining disparate company cultures and facilities.Acquisitions may have an adverse effect on our operating results, particularlyin quarters immediately following the consummation of such transactions, as weintegrate the operations of the acquired businesses into our operations. Onceintegrated, acquisitions may not perform as expected.

**Our success dependson our ability to protect our proprietary rights, and there is a risk ofinfringement. If we are unable to protect and enforce our intellectual propertyrights, we may be unable to compete effectively.**

Our success and ability to compete will depend in parton our ability to obtain and maintain patent or other protection for ourtechnology and products, both in the United States and abroad. In addition, wemust operate without infringing the proprietary rights of others.

We currently hold 17 U.S.patents and have 5 U.S. patent applications pending. In addition, we hold11 international patents and have 13 international patent applicationspending. We cannot be certain that patents will be issued on any of our presentor future applications. In addition, our existing patents or any future patentsmay not adequately protect our technology if they are not broad enough, aresuccessfully challenged or other entities are able to develop competing methodswithout violating our patents. If we are not successful in protecting ourintellectual property, competitors could begin to offer products thatincorporate our technology. Patent protection involves complex legal andfactual questions and, therefore, is highly uncertain, and litigation relatingto intellectual property is often very time consuming and expensive. If asuccessful claim of patent infringement were made against us or we are unableto develop non-infringing technology or license the infringed or similartechnology on a timely and cost-effective basis, we might not be able to makesome of our products.

*Risks Related toOur Industry*

**If we are unable torespond to rapid technological change, our products could become obsolete andour reputation could suffer.**

Future generationsof air data systems, engine and fuel displays and flat panel displays embodyingnew technologies or new industry standards could render our products obsolete.The market for aviation products is subject to rapid technological change, newproduct introductions, changes in customer preferences and evolving industrystandards. Our future success will depend on our ability to:

·       adaptto rapidly changing technologies;

·       adaptour products to evolving industry standards; and

·       developand introduce a variety of new products and product enhancements to address theincreasingly sophisticated needs of our customers.

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Our future success will also depend on our developinghigh quality, cost-effective products and enhancements to our products thatsatisfy the needs of our customers and on our introducing these newtechnologies to the marketplace in a timely manner. If we fail to modify orimprove our products in response to evolving industry standards, our productscould rapidly become obsolete.

Our products are currently subject to directregulation by the FAA, its European counterpart, the European Aviation SafetyAdministration (EASA), and other comparable organizations. Our products, asthey relate to aircraft applications, must be approved by the FAA, EASA orother comparable organizations before they can be used in an aircraft. To becertified, we must demonstrate that our products are accurate and able tomaintain certain levels of repeatability over time. Although the certificationrequirements of the FAA and the EASA are substantially similar, there is noformal reciprocity between the two systems. Accordingly, even though some ofour products are FAA-approved, we may need to obtain approval from theEASA or other appropriate organizations to have them certified for installationoutside the United States.

Significant delay in receiving certification for newlydeveloped products or enhancements to our products or losing certification forour existing products could result in lost sales or delays in sales.Furthermore, the adoption of additional regulations or product standards, aswell as changes to the existing product standards, could require us to changeour products and underlying technology. We cannot assure you that we willreceive regulatory approval on a timely basis or at all.

**Because ourproducts utilize sophisticated technology and are deployed in complex aircraftcockpit environments, problems with these products may arise that couldseriously harm our reputation for quality assurance and our business.**

Our products usecomplex system designs and components that may contain errors, omissions ordefects, particularly when we incorporate new technologies into our products orwe release new versions or enhancements of our products. Despite our qualityassurance process, errors, omissions or defects could occur in our currentproducts, in new products or in new versions or enhancements of existingproducts after commercial shipment has begun. We may be required to redesign orrecall those products or pay damages. Such an event could result in thefollowing:

·       delayor loss of revenues;

·       cancellationof customer contracts;

·       diversionof development resources;

·       damageto our reputation;

·       increasedservice and warranty costs; or

·       litigationcosts.

Although we currently carry product liabilityinsurance, this insurance may not be adequate to cover our losses in the eventof a product liability claim. Moreover, we may not be able to maintain suchinsurance in the future.

**We have limited experience in marketing and distributingour products internationally.**

We expect to derive an increasing amount of ourrevenues from sales outside the United States, particularly in Europe. Thereare certain risks inherent in doing business on an international basis, suchas:

·       differingregulatory requirements for products being installed in aircraft;

·       legaluncertainty regarding liability;

·       tariffs,trade barriers and other regulatory barriers;

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·       politicaland economic instability;

·       changesin diplomatic and trade relationships;

·       potentiallyadverse tax consequences;

·       theimpact of recessions in economies outside the United States; and

·       varianceand unexpected changes in local laws and regulations.

Currently, all of ourinternational sales are denominated in U.S. dollars. An increase in the valueof the dollar compared to other currencies could make our products lesscompetitive in foreign markets. In the future, we may be required to conductsales in local currencies, exposing us to changes in exchange rates that couldadversely affect our operating results.

**Item 1B.**               UnresolvedStaff Comments.

None

**Item 2.**                        Properties.

In fiscal 2001 wepurchased 7.5 acres of land in the Eagleview Corporate Park in Exton,Pennsylvania, a suburb of  Philadelphia.There we constructed a 44,800 square foot design, manufacturing and officefacility. Land development approval allows for expansion of up to 20,400additional square feet. This would provide for a 65,200 square foot facility.The construction was principally funded with a Chester County, Pennsylvania,  Industrial Revenue Bond. The building servesas security for the Industrial Revenue Bond.

**Item 3.**                        LegalProceedings.

In the ordinary course ofour business, we are at times subject to various legal proceedings. We do notbelieve that any current legal proceedings will have a material adverse effecton our results of operations or financial position.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

No matters were submitted to a vote of ourshareholders during the three months ended September 30, 2006.

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**Part II**

**Item 5.**                        Marketfor the Registrant’s Common Equity and Related Stockholder Matters.

Ourcommon stock has been traded on the Nasdaq National Market under the symbol “ISSC”since our initial public offering on August 4, 2000. The following tablelists the high and low per share sale prices for our common stock for theperiods indicated:

| ** **     | ** ** | **Fiscal 2006** | ** ** | **Fiscal 2005** | ** ** |
|----------------|------------|----------------------|------------|----------------------|------------|
| **Period**     | ** ** | ** **           | ** ** | **High**             | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $                    | 15.90      |                 | $          | 11.70 |   | $ | 23.65 |   | $ | 13.37 |   |
| Second Quarter |       | $                    | 15.66      |                 | $          | 12.50 |   | $ | 22.79 |   | $ | 17.71 |   |
| Third Quarter  |       | $                    | 17.17      |                 | $          | 11.12 |   | $ | 26.13 |   | $ | 19.07 |   |
| Fourth Quarter |       | $                    | 16.25      |                 | $          | 13.61 |   | $ | 23.50 |   | $ | 14.75 |   |
|                |            |                      |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

On December 1, 2006, there were 26 holders of recordof the shares of outstanding common stock.

We have not paid cash dividends on our common stock,and we do not expect to declare or pay cash dividends on our common stock inthe near future. We intend to retain any earnings to finance the growth of ourbusiness.

On December 28, 2005the Company’s Board of Directors approved a common stock repurchase program toacquire up to 2,000,000 shares of our outstanding common stock. Purchases ofthe stock were to be made from time to time, subject to market conditions andat prevailing market prices. The program expired on June 30, 2006. Duringfiscal year 2006 we purchased 1,272,510 shares of common stock under theprogram at a cost of $18.1 million, or an average market price of $14.21 pershare. We financed these purchases through our available cash.

**Equity CompensationPlan Information**

Thefollowing table gives information about our common stock that may be issuedupon the exercise of options and rights under all of our existing equitycompensation plans and arrangements as of September 30, 2006, includingthe 1998 Stock Option Plan.

| **Plan Category**                                      | ** ** | ** ** | ** ** | **Number of Securities to  be issued upon exercise  of outstanding options  and rights** | ** ** | **Weighted-average  exercise price of  outstanding options  and rights** | ** ** | **Number of Securities  remaining available for future  issuance under equity  compensation plans  (excluding securities reflected  in second column)** | ** ** |
|-------------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                        |       |       |       |                                                                                                                                  |       |                                                                                         |       |                                                                                                                                                                                                                |       |   |   |   |   |
| Equity  compensation plans approved by security holders     |       |       | 705,129    |                                                                                                                                  |       |                                                                                         | $          | 9.95                                                                                                                                                                                                                |       |   |   | 1,698,065 |   |   |
| Equity  compensation plans not approved by security holders |       |       | 0          |                                                                                                                                  |       |                                                                                         | $          | 0.00                                                                                                                                                                                                                |       |   |   | 0 |   |   |
|                                                        |       |       | 705,129    |                                                                                                                                  |       |                                                                                         | $          | 9.95                                                                                                                                                                                                                |       |   |   | 1,698,065 |   |   |

 

The 2003 Restricted Stock Plan for non-employeedirectors was approved by shareholders at the Company’s February 26, 2004Annual Meeting of Shareholders. The Plan called for an annual award ofrestricted stock having a fair market value of $25,000 as of the close ofbusiness on October 1 of the current fiscal year for all eligiblenon-employee directors. The stock is awarded in four installments quarterlyduring the fiscal year provided the director is still serving on the board onthe quarterly issue date. In fiscal year 2005 the annual award was increased to$40,000 effective the fourth quarter of the fiscal year.

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In the fiscal years ended September 30,2006, 2005 and 2004, awards to our non-employee directors under the Plan were15,396, 15,828 and 30,855 shares respectively.

**Item 6.**                        SelectedConsolidated Financial Data.

Thefollowing tables present portions of our consolidated financial statements. Youshould read the following selected consolidated financial data set forth belowtogether with “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and our consolidated financial statements and relatednotes to our financial statements appearing elsewhere herein. The selectedstatement of operations data for the years ended September 30, 2006, 2005and 2004 and the balance sheet data as of September 30, 2006 and 2005 arederived from our audited consolidated financial statements included elsewherein this Annual Report on Form 10-K. The selected statements of operationsdata for the years ended September 30, 2003 and 2002 and the balance sheetdata as of September 30, 2004, 2003 and 2002 are derived from our auditedconsolidated financial statements that are not included in this Annual Reporton Form 10-K.

|                                      | ** ** | **Fiscal year ended September 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Statement of Operations Data:**    | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                            |       | $                                                       | 16,721,967 |   | $ | 63,264,359 |   | $ | 46,099,777 |   | $ | 28,168,752 |   | $ | 28,345,620 |   |
| Cost of sales                        |       | 8,631,761                                               |       | 20,888,729 |   | 15,663,108 |   | 11,346,057 |   | 11,290,085 |   |
| Gross profit                         |       | 8,090,206                                               |       | 42,375,630 |   | 30,436,669 |   | 16,822,695 |   | 17,055,535 |   |
| Research and development             |       | 6,749,426                                               |       | 6,057,889 |   | 4,811,156 |   | 3,376,849 |   | 4,755,422 |   |
| Selling, general and administrative  |       | 9,863,758                                               |       | 8,898,622 |   | 7,567,959 |   | 5,890,362 |   | 5,732,886 |   |
| Total operating expenses             |       | 16,613,184                                              |       | 14,956,511 |   | 12,379,115 |   | 9,267,211 |   | 10,488,308 |   |
| Operating income (loss)              |       | (8,522,978                                              | )          | 27,419,119 |   | 18,057,554 |   | 7,555,484 |   | 6,567,227 |   |
| Interest (income) expense, net       |       | (3,091,986                                              | )          | (1,764,246 | ) | (404,727 | ) | (450,421 | ) | (722,850 | ) |
| Income (loss) before income taxes    |       | (5,430,992                                              | )          | 29,183,365 |   | 18,462,281 |   | 8,005,905 |   | 7,290,077 |   |
| Income tax (expense) benefit, net    |       | 2,548,600                                               |       | (10,598,563 | ) | (6,530,084 | ) | (2,464,715 | ) | (1,879,799 | ) |
| Net income (loss)                    |       | $                                                       | (2,882,392 | ) | $ | 18,584,802 |   | $ | 11,932,197 |   | $ | 5,541,190 |   | $ | 5,410,278 |   |
| Net income (loss)  per common share: |       |                                                    |       |   |   |   |   |   |   |   |   |
| Basic                                |       | $                                                       | (0.17      | ) | $ | 1.04 |   | $ | 0.69 |   | $ | 0.30 |   | $ | 0.28 |   |
| Diluted                              |       | $                                                       | (0.17      | ) | $ | 1.02 |   | $ | 0.67 |   | $ | 0.30 |   | $ | 0.28 |   |
| Weighted average  shares outstanding |       |                                                    |       |   |   |   |   |   |   |   |   |
| Basic                                |       | 17,388,524                                              |       | 17,873,780 |   | 17,400,380 |   | 18,391,626 |   | 19,246,341 |   |
| Diluted                              |       | 17,388,524                                              |       | 18,259,856 |   | 17,928,180 |   | 18,743,661 |   | 19,604,081 |   |

 

|                                                           | ** ** | **September 30,** | ** ** | ** **  | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|-------------|------------|
| ** **                                                | ** ** | **2006**               | ** ** | **2005**    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Balance Sheet Data:**                                   | ** ** | ** **             | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash equivalents                                 |       | $                      | 62,984,829 |        | $          | 83,172,582 |   | $ | 65,867,167 |   | $ | 48,789,744 |   | $ | 52,245,754 |   |
| Working capital                                           |       | 73,751,866             |       | 93,455,475  |       | 70,627,114 |   | 55,996,411 |   | 59,158,307 |   |
| Total Assets                                              |       | 87,232,880             |       | 107,034,878 |       | 87,468,627 |   | 69,876,625 |   | 72,616,685 |   |
| Debt and capital lease obligations, less current  portion |       | 4,239,587              |       | 4,248,113   |       | 4,255,681 |   | 4,235,000 |   | 4,235,000 |   |
| Total  shareholders’ equity                          |       | 78,201,353             |       | 97,866,098  |       | 75,454,987 |   | 61,058,290 |   | 64,726,210 |   |
|                                                           |            |                        |            |             |            |  |  |  |  |  |  |  |  |  |  |  |

 

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

The following discussionand analysis should be read in conjunction with “Selected ConsolidatedFinancial Data” and our financial statements and the related notes included inthis report.

**Overview**

Innovative Solutions and Support was founded in 1988.The Company designs, develops, manufactures and sells flight informationcomputers, large flat-panel displays and advanced monitoring systems thatmeasure and display critical flight information, including data relative toaircraft separation , airspeed, altitude as well as engine and fuel datameasurements.

Our sales are derived from the sale of our products tothe retrofit market and, to a lesser extent, original equipment manufacturers(OEMs). Our customers include the DoD and their commercial contractors,aircraft operators, aircraft modification centers and various OEMs. Althoughwe occasionally sell our products directly to the DoD, we primarily have soldour products to commercial customers for end use in DoD programs. Sales todefense contractors are on commercial terms, although some of the terminationand other provisions of government contracts are applicable to these contracts.

Our cost-of-sales is comprised of material componentspurchased through our supplier base and direct in-house assembly labor andoverhead costs. Many of the components we use in assembling our products arestandard, although certain parts are manufactured to meet our specifications. Theoverhead portion of cost of sales is primarily comprised of salaries andbenefits, building occupancy, supplies, and outside service costs related toour production, purchasing, material control and quality departments, andwarranty costs.

We intend to continue investing in the development ofnew products that complement our current product offerings and will expenseassociated research and development costs as they are incurred.

Our selling, general andadministrative expenses consist of sales, marketing, business development,professional services and salaries and benefits for executive andadministrative personnel as well as facility costs, recruiting, legal,accounting and other general corporate expenses.

**Results ofOperations**

**Fiscal Year Ended September 30,2006 Compared to Fiscal Year Ended September 30, 2005**

*Netsales.**  *Netsales decreased $46.5 million or 73% to $16.7 million for fiscal 2006 from$63.3 million for fiscal 2005. The decrease in net sales was primarily theresult of a fall off in Air Data deliveries coupled with a slow start up ofFlat Panel Display System deliveries. Significant Air Data product deliverieswere realized in fiscal 2005 in order for aircraft to meet the Federal AviationAdministration’s (FAA) Reduced Vertical Separation Minimum (RVSM) mandate thatbecame effective on January 20, 2005. As a result Air Data sales peaked infiscal 2005 and were sharply reduced in fiscal 2006. Flat Panel Display Systemsales amounted to $6.4 million in fiscal 2006 and exceeded the prior year by56%. The increase, however, was not sufficient enough to offset reduced AirData sales.

*Costof sales.*   Cost of sales decreased $12.3 millionor 59% to $8.6 million, or 51% of net sales, for fiscal 2006 from $20.9million, or 33% of net sales, for fiscal 2005. The decrease in the dollaramount was essentially due to lower sales in the period. The increase as apercent of net sales was primarily the result of fixed operating costs beingabsorbed over lower net sales in the fiscal year.

*Researchand development.**  *Researchand development expenses increased $0.7million, or 11% to $6.7 million, or 40%of net sales for fiscal 2006 from $6.1 million or 10% of net sales for fiscal2005. The dollar increase was principally due to increased salaries andassociated benefits, consultants and supplies. Expense on a percent to salesbasis increased due to lower sales in the fiscal year.

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*Selling,general and administrative expenses.**  *Selling, general and administrativeexpenses increased $1.0 million or 11% to $9.9 million, or 59% of net sales,for fiscal 2006 from $8.9 million, or 14% of net sales, for fiscal 2005. Theincrease in the dollar amount was principally the result of legal and otherfees relating to intellectual property matters and to recording, for the firsttime in accordance with FAS 123R, stock based compensation expense. Increasesin these two areas were partially offset by lower commissions and lower salaryrelated expenses. The increase as a percent of net sales was the result of bothincreased expenses and lower sales in the fiscal year.

*Interest(income) expense, net.**  *Netinterest income increased $1.3 million or 75% to $3.1 million for fiscal 2006from $1.8 million for fiscal 2005. Net interest income for fiscal 2006 washigher mainly because of higher interest rates in the period.

*Incometax.  *The income tax benefit for fiscal 2006 was$2.5 million. The income tax expense for fiscal 2005 was $10.6 million. Thedecrease in the amount of tax from a tax expense to a tax benefit was primarilydue to recording a loss before tax fiscal year 2006.

The effective tax rate for fiscal 2006 was a benefitof 46.9%. For fiscal 2005 the effective tax rate was 36.3%. For fiscal 2006 theeffective tax rate differs from the statutory rate due to the benefit for stateincome taxes and an adjustment to the tax payable accounts, partially offset bythe loss of benefit from the deduction for domestic production activities andthe exclusion for extraterritorial income due to the taxable loss for the year.For fiscal 2005 the effective tax rate differs from the statutory rate due tostate tax expense, partially offset by the utilization of research anddevelopment tax credits.

*Net income (loss).**  *As a result of the factorsdescribed above, our net loss for fiscal 2006 was $2.9 million a $21.5million decrease from net income of $18.6 million for fiscal 2005. On a fullydiluted basis, the loss per share of $0.17 for fiscal 2006 compares to an earningsper share of $1.02 for fiscal 2005.

**Fiscal Year Ended September 30,2005 Compared to Fiscal Year Ended September 30, 2004**

*Netsales.**  *Netsales increased $17.2 million or 37% to $63.3 million for fiscal 2005 from$46.1 million for fiscal 2004. The rise in net sales was primarily due toincreased demand for our Air Data Products. Flat Panel Display System salesincreased from $1.1 million in fiscal 2004 to $3.9 million in fiscal 2005, a250% increase. Approximately one-half of the increased Air Data demand wasattributable to military retrofit programs. The balance was principally inresponse to commercial aviation upgrading aircraft with air data systems thatcomply with the Federal Aviation Administration’s (FAA) Reduced VerticalSeparation Minimum (RVSM) mandate. Several general aviation customers,including Garrett, Gulfstream, Bombardier, Star Aviation and AeroMechcontributed to the year over year growth in net sales.

*Costof sales.*   Cost of sales increased $5.2 millionor 33% to $20.9 million, or 33% of net sales, for fiscal 2005 from $15.7million, or 34% of net sales, for fiscal 2004. The increase in the gross dollaramount was due to higher net sales in the period. The decline as a percentageof net sales was primarily the result of our fixed operating cost beingabsorbed over higher net sales in the current period.

*Researchand development.**  *Researchand development expenses increased $1.2 million, or 26% to $6.1 million, or 10%of net sales in fiscal 2005 from $4.8 million or 10% of net sales in fiscal2004. The gross dollar increase was principally due to increased salaries andassociated benefits. Expense on a percent to sales basis was essentiallyunchanged from year to year.

*Selling,general and administrative expenses.**  *Selling, general and administrativeexpenses increased $1.3 million or 18% to $8.9 million, or 14% of net sales,for fiscal 2005 from $7.6 million, or 16% of net sales, for fiscal 2004. Theincrease in the dollar amount was the result of higher wages, the cost ofcorporate governance initiatives and commissions due to higher net sales. Thedecrease as a percent of net sales was the result of higher net sales in thecurrent period.

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*Interest(income) expense, net.**  *Netinterest income increased $1.4 million or 336% to $1.8 million for fiscal 2005from $0.4 million in fiscal 2004. Net interest income for fiscal 2005 washigher because of higher interest rates in the period coupled with higher cashbalances.

*Incometax.**  *Incometax expense was $10.6 million in fiscal 2005 compared to $6.5 million in fiscal2004. The $4.1 million income tax increase was the result of a higher pre taxprofits for fiscal 2005. Tax rates in both years were essentially unchanged,ranging from 35.4% in fiscal 2004 to 36.3% in fiscal 2005.

*Net income.**  *As a result of the factorsdescribed above, net income increased $6.7 million or 56% to $18.6 million, or29% of net sales in fiscal 2005 from $11.9 million, or 26% of net sales infiscal 2004. On a fully diluted basis, earnings per share (EPS) increased $0.35or 52% to $1.02 during fiscal 2005 from $0.67 in fiscal 2004.

**Related-PartyTransactions:**

The Company incurred legal fees of $357,000, $137,000,and $115,898 with a law firm that is a shareholder of the Company for the yearsended September 30, 2006, 2005 and 2004, respectively. The fees paid andservices rendered were comparable with the fees paid and services renderedprior to the law firm’s investment in the Company.

For the years ended September 30,2006, 2005 and 2004, respectively, we incurred service fees of $25,000, $33,000and $124,932 with a commercial graphics firm controlled by an individual who ismarried to a significant shareholder and the daughter of the Company’s Chairmanand Chief Executive Officer.

**Liquidity andCapital Resources**

Our primary source of liquidity over the past threeyears has been cash flows from operations. We require cash principally tofinance inventory, payroll and accounts receivable.

Our cash flow used in operating activities was a $1.6million in fiscal 2006 as compared to a contribution of $16.0 million in fiscal2005. The $17.6 million difference was attributable to a swing in net income of$21.5 million from net loss in the current fiscal year of $2.9 million to $18.6million of net income in fiscal year 2005; also, inventory grew by $3.8million. Partially offsetting the decline in operating cash flow were reducedprepaid expenses, $3.3 million, accounts receivable, $2.6 million, and accruedexpenses, $0.9 million.

Our cash flow provided by operating activities was$16.0 million in fiscal 2005 as compared to $16.1 million in fiscal 2004.While the cash flows were essentially the same, there were several offsettingamounts, as follows: Net income was up $6.7 million, inventory improved $3.6million and tax benefits contributed $1.3 million. Offsetting the increase inyear over year cash flow were prepaid expenses ($3.4) million, accountspayable ($2.5) million and accounts receivable ($2.4) million.

Our cash used in investing activities was $0.7 millionin fiscal 2006 and consisted of spending for product certification, productionequipment and laboratory test equipment as compared to $0.5 million used infiscal 2005 for production equipment, laboratory test equipment, computerequipment and office furniture. Our cash used in investing activities, mainlyfor manufacturing and engineering equipment, was $0.8 million in fiscal 2004.

Our cash outflow from financing activities was $17.9million for fiscal 2006. The primary use of cash for financing activities wasattributable to the Company purchasing 1,272,510 shares of our stock at a totalcost of $18.1 million. In fiscal year 2005 our cash inflow from financingactivities was $1.8 million and was the result of stock option exercises. Infiscal year 2004 our cash inflow was due to the exercise of stock options, $1.1million, and the exercise of warrants, $0.7million.

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To accommodate our future growth, we purchased 7 and 1¤2acres of land in the Eagleview Corporate Park, Exton, Pennsylvania. There weconstructed a 44,800 square foot facility that is expandable to 65,200 squarefeet. Both the land and building cost approximate $6.5 million. Of this amount,$4.3 million was funded through an Industrial Development Bond (IDB) and theremainder from cash from operations.

The IBD requires the Company to maintain certainfinancial covenants including a ratio of liabilities to earnings beforeinterest, taxes and depreciation and amortization (EBDITDA), fixed charge ratioand a minimum tangible net worth. As of June 30, 2006, the Company was inviolation of these financial covenants. The defaults were subsequently waivedand an amendment to the agreement was entered into with the lender whereby theexisting covenants were suspended until the fiscal quarter ending on June 30, 2007.

Our future capital requirements depend on numerousfactors, including market acceptance of our products (in particular flat paneldisplay systems), the timing and rate of expansion of our business, acquisitions,joint ventures and other factors. We have experienced increases in ourexpenditures since our inception consistent with growth in our operations,personnel, and product line and we anticipate that our operations andexpenditures will continue to increase in the foreseeable future. We believethat our cash and cash equivalents, together with net proceeds from any newcredit facility we may enter into, will provide sufficient capital to fund ouroperations for at least the next twelve months. However, we may need to raiseadditional funds through public or private financing or other arrangements inorder to support more rapid expansion of our business than we currentlyanticipate. Further, we may develop and introduce new or enhanced products, respondto competitive pressures, invest in or acquire businesses or technologies orrespond to unanticipated requirements or developments.

Ourcontractual obligations of September 30, 2006 mature as follows:

| ** **                                                     | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------|------------|
| **Contractual Obligations**                               | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **After 5  Years** | ** ** |
| Interest on loan  from Chester County Industrial Dev. Auth.(1) |       | $                                         | 1,505,979  |   | $ | 167,331 |   | $ | 334,662 |   | $ | 334,662 |   | $ | 669,324 |   |
| Principal on  Chester County Industrial Loan                   |       | 4,335,000                                 |       | 100,000 |   |   |   |   |   | 4,235,000 |   |
| Operating Lease                                                |       | 55,020                                    |       | 22,008 |   | 33,012 |   |   |   |   |   |
| Capital Leases                                                 |       | 12,478                                    |       | 7,891 |   | 4,587 |   |   |   |   |   |
| Puchase  Obligations(2)                                        |       | 1,111,683                                 |       | 812,364 |   | 247,883 |   | 50,400 |   | 1,036 |   |
|                                                           |       | $                                         | 7,020,160  |   | $ | 1,109,594 |   | $ | 620,144 |   | $ | 385,062 |   | $ | 4,905,360 |   |
|                                                                |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          The interest on theIndustrial Development Bond assumes the current rate of 3.86%. The interestrate set by the remarketing agent is consistent with 30-day tax-exemptcommercial paper.

(2)          A“purchase obligation” is defined as an agreement to purchase goods or servicesthat is enforceable and legally binding on the company and that specifies allsignificant terms, including: fixed or minimum quantities to be purchased;fixed, minimum or variable price provisions; and the approximate timing of thetransaction. These amounts are primarily comprised of open purchase ordercommitments to vendors and subcontractors pertaining to fulfillment of ourcurrent order backlog.

**Off-Balance SheetArrangements**

The Company does not haveany off-balance sheet arrangements.

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**Inflation**

We do not believe thatinflation has had a material effect on our financial position or results ofoperations during the past three years. However, we cannot predict the futureeffects of inflation.

**Critical AccountingPolicies**

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities, disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amount of revenues andexpenses during the reporting period. The Company’s most critical accountingpolicies are revenue recognition, income taxes, allowance for doubtfulaccounts, inventory valuation, share-based compensation and warranty reserves.

The Company recognizes sales for products when thefollowing revenue recognition criteria are met: persuasive evidence of anarrangement exists, product delivery and acceptance has occurred, pricing isfixed or determinable and collection is reasonably assured. The Companyrecognizes sales upon shipment of products to customers.

Sales related to certain long-term contracts requiringdevelopment and delivery of products over several accounting periods areaccounted for under the American Institute of Certified Public Accountants(AICPA) Statement of Position (SOP) 81-1, *Accountingfor Performance of Construction-Type and Certain Production-Type Contracts.*Weconsider the nature of these contracts as well as the types of products andservices provided when determining the appropriate accounting treatment for aparticular contract. Certain long-term contracts are recorded on a percentageof completion basis using cost-to-cost methodology to measure progress towardscompletion.

The Company offers its customers extended warrantiesfor additional fees. These warranty sales are recorded as deferred revenue andrecognized as sales on a straight-line basis over the warranty period.

The Company enters into certain sales arrangementsthat include multiple deliverables as defined in Emerging Issues Task Force(EITF) Issue No. 00-21, *Accounting for RevenueArrangements with Multiple Deliverables*. Effective July 1,2003, the Company identifies all goods and/or services that are to be deliveredseparately under a sales arrangement and allocates revenue to each deliverablebased on fair value that is established with the customer during contractnegotiations. In general, revenues are separated between product sales andnon-recurring engineering services. The allocated revenue for each deliverableis then recognized using appropriate revenue recognition methods. Effective fortransactions entered into after October 1, 2003, the Company accounts fortransactions with software and non-software components under EITF Issue 03-5,“Applicability of AICPA Statement of Position 97-2, Software RevenueRecognition, to Non-Software Deliverables in an Arrangement ContainingMore-Than-Incidental Software.”

Income taxes are recorded in accordance with SFAS No. 109,*Accounting for Income Taxes*. Provisionsfor federal and state income taxes are calculated on reported financialstatement pre-tax income based on current tax law. The Company recognizesdeferred tax assets and liabilities for temporary differences between thefinancial reporting basis and the tax basis of the Company’s assets andliabilities and expected benefits of utilizing net operating losscarryforwards. The impact on deferred taxes of changes in tax rates and laws,if any, applied to the years during which temporary differences are expected tobe settled, are reflected in the consolidated financial statements in theperiod of enactment.

We maintain an allowance for doubtful accounts forestimated losses resulting from the inability of our customers to make requiredpayments. These allowances are determined by analyzing historical data andtrends. If actual losses are greater than estimated amounts or if the financialcondition of our 

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customers were todeteriorate, resulting in an impairment of their ability to make payments,future results from operations could be adversely affected.

Inventories are written down for estimatedobsolescence equal to the difference between the cost of inventory and theestimated net realizable value based upon assumptions about future marketconditions. If actual future demand or market conditions are less favorablethan those projected by management, additional inventory write-downs may berequired.

We offer warranties on some products of variouslengths. At the time of shipment, we establish a reserve for the estimated costof warranties based on our best estimate of the amounts necessary to settlefuture and existing claims using historical data on products sold as of thebalance sheet date. The length of the warranty period, the product’s failurerates and the customer’s usage affects warranty cost. If the actual cost ofwarranties differs from our estimated amounts, future results of operationscould be adversely affected.

Effective October 1,2005 the Company adopted the provisions of SFAS 123R, using the modifiedprospective approach and now accounts for share-based compensation applying thefair value method for expensing stock options. Accordingly, the adoption ofSFAS 123R’s fair value method results in compensation costs under the Company’s1998 Stock Option Plan.

**New AccountingPronouncements**

In September 2006, the Financial AccountingStandards Board (FASB) issued Statement of Financial Accounting Standards(SFAS) No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles, and expandsdisclosures about fair value measurements. This statement does not require anynew fair value measurements; however, the application of this Statement maychange current practice for some entities. SFAS 157 is effective for fiscalyears beginning after November 15, 2007. The Company is currentlyevaluating the impact of this pronouncement.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin 108, *“Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”).* SAB 108 providesguidance on how prior year misstatements should be taken into considerationwhen quantifying misstatements in current year financial statements forpurposes of determining whether the current year’s financial statements arematerially misstated. SAB 108 is effective for the first fiscal year endingafter November 15, 2006. The Company is in the process of evaluating theimpact of the adoption of this interpretation and does not believe that theadoption of the SAB 108 will have a material impact on the Company’s financial positionor results of operations.

In July 2006, the FASB issued FASB Interpretation48, *“Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109”**(“FIN 48”)*.FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with FASB Statement No. 109,“Accounting for Income Taxes.” This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return. ThisInterpretation also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition. FIN 48 is effective for fiscal years beginning after December 15,2006. The Company is currently evaluating the impact of this pronouncement.

In May 2005, the FASB issued SFAS No. 154, *“Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20and FASB Statement No. 3.”*  SFAS No. 154 requires retrospectiveapplication to prior periods’ financial statements of changes in accountingprinciple, unless it is impracticable to determine either the period-specificeffects or the cumulative effect of the change. 

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SFAS No. 154also requires that retrospective application of a change in accountingprinciple be limited to the direct effects of the change. Indirect effects of achange in accounting principle, such as a change in nondiscretionaryprofit-sharing payments resulting from an accounting change, should berecognized in the period of the accounting change. SFAS No. 154 alsorequires that a change in depreciation, amortization, or depletion method forlong-lived, non-financial assets be accounted for as a change in accountingestimate effected by a change in accounting principle. SFAS No. 154 iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005. Early adoption is permitted foraccounting changes and corrections of errors made in fiscal years beginningafter the date this Statement is issued. The Company will adopt the provisionsof SFAS No. 154 as applicable beginning in fiscal 2007.

In December 2004, the FASB issued FASB StaffPosition (FSP) FAS 109-1, *“Application of FASBStatement No. 109, Accounting for Income Taxes, to the Tax Deduction onQualified Production Activities Provided by the American Jobs Creation Act of2004.”* This FSP provides guidance on the application of Statement109 to the provisions within the American Jobs Creation Act of 2005 (the Act),which provides tax relief to U.S. domestic manufacturers. The FSP states that amanufacturer’s deduction provided for under the Act should be accounted for asa special deduction in accordance with Statement 109 and not as a tax ratereduction. The FSP also reminds preparers that the special deduction should beconsidered by an enterprise in (a) measuring deferred taxes when theenterprise is subjected to graduated tax rates, and (b) assessing whethera valuation allowance is necessary as required by Statement 109. This statementwas effective immediately. The Company adopted this statement during fiscalyear 2005 and it did not have a material impact on the Company’s financialposition or results of operations.

In November 2004, theFASB issued SFAS 151, *“Inventory Costs.”*This Statement amends the guidance in ARB No. 43, Chapter 4 “InventoryPricing,” to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material (spoilage). Paragraph 5of ARB 43, Chapter 4 previously stated that “... under some circumstances,items such as idle facility expense, excessive spoilage, double freight, andrehandling costs may be so abnormal as to require treatment as current periodcharges....” This Statement requires that those items be recognized ascurrent-period charges regardless of whether they meet the criterion of “soabnormal.” In addition, this Statement requires that allocation of fixedproduction overheads to the costs of conversion be based on the normal capacityof the production facilities. This statement is effective for inventory costsincurred during fiscal years beginning after June 15, 2005. The Companyadopted this statement on October 1, 2005 and it did not have a materialimpact on the Company’s financial position or results of operations.

**Business Segments**

The Company operates in one principal business segmentwhich designs, manufactures and sells flight information computers, largeflat-panel displays and advanced monitoring systems to the DoD, governmentagencies, defense contractors, commercial air transport carriers andcorporate/general aviation markets. The Company currently derives virtually allof its revenues from the sale of this equipment. Almost all of the Company’ssales, operating results and identifiable assets are in the United States. Netsales, operating results, and identifiable assets outside of the U.S. are notsignificant.

In Fiscal Year 2006 netsales outside the United States amounted to $2.8 million. Of this amount,$1.5 million was with Canada’s Department of National Defense.

**Item 7A.**                Quantitativeand qualitative disclosures about market risk.

The Company’s operationsare exposed to market risks primarily as a result of changes in interest rates.The Company does not use derivative financial instruments for speculative ortrading purposes. The Company’s exposure to market risk for changes in interestrates relates to its cash equivalents and an 

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industrialrevenue bond. The Company’s cash equivalents consist of funds invested in moneymarket accounts, which bear interest at a variable rate, while the industrialrevenue bond carries an interest rate that is consistent with 30-daytax-exempt commercial paper. As the interest rates are variable, a change ininterest rates earned on the cash equivalents or paid on the industrial revenuebond, would impact interest income and expense along with cash flows, but wouldnot impact the fair market value of the related underlying instruments.

**Item 8.**                        Financialstatements and supplementary data.

The financial statements of Innovative Solutions andSupport, Inc. listed in the index appearing under Item 8 herein are filedas part of this Report.

 

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**InnovativeSolutions and Support, Inc.INDEX TO CONSOLIDATED FINANCIAL STATEMENTS**

|                                                          | ** ** | **Page** | ** ** |
|----------------------------------------------------------|------------|----------|------------|
| Report of Independent  Registered Public Accounting Firm |       | 29       |       |
| Consolidated Balance Sheets                              |       | 30       |       |
| Consolidated Statements of  Operations                   |       | 31       |       |
| Consolidated Statements of  Shareholders’ Equity    |       | 32       |       |
| Consolidated Statements of  Cash Flows                   |       | 33       |       |
| Notes to Consolidated Financial Statements               |       | 34-46    |       |

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Shareholders ofInnovative Solutions and Support, Inc.Exton, Pennsylvania

We have audited the accompanying consolidated balancesheets of Innovative Solutions and Support, Inc. and subsidiaries (the “Company”)as of September 30, 2006 and 2005, and the related consolidated statementsof operations, cash flows, and shareholders’ equity for each of the three yearsin the period ended September 30, 2006. These consolidated financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of the Companyas of September 30, 2006 and 2005, and the results of its operations andits cash flows for each of the three years in the period ended September 30,2006 in conformity with accounting principles generally accepted in the UnitedStates of America.

Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of the Company’sinternal control over financial reporting as of September 30, 2006, basedon the criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission and our report dated December 7, 2006 expressed anunqualified opinion on management’s assessment of the effectiveness of theCompany’s internal control over financial reporting and an unqualified opinionon the effectiveness of the Company’s internal control over financialreporting.
| /s/ DELOITTE & TOUCHE LLP |   |
|------------------------------------|--------|
| Philadelphia, Pennsylvania         |
| December 7,  2006             |

 

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**INNOVATIVESOLUTIONS AND SUPPORT, INC.CONSOLIDATED BALANCE SHEETS**

| ** **                                                                                                                                                                                                        | ** ** | **As of**                   | ** **  | **As of**                   | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                        | ** ** | **September 30, 2006** | ** **  | **September 30, 2005** | ** ** |
| ***ASSETS***                                                                                                                                                                                                      |       |                             |        |                             |       |   |   |   |   |
| Current Assets:                                                                                                                                                                                                   |       |                             |        |                             |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                         |       |                             | $           | 62,984,829                       |       |   |   | $ | 83,172,582 |   |   |
| Accounts receivable, less allowance for doubtful  accounts of $100,000 at September 30, 2006 and 2005                                                                                                        |       |                             | 3,333,131   |                             |       |   | 5,479,936 |   |   |
| Inventories                                                                                                                                                                                                       |       |                             | 6,466,156   |                             |       |   | 3,911,626 |   |   |
| Deferred income taxes                                                                                                                                                                                             |       |                             | 1,082,931   |                             |       |   | 956,070 |   |   |
| Prepaid expenses and other current assets                                                                                                                                                                         |       |                             | 4,065,696   |                             |       |   | 4,028,498 |   |   |
| Total current assets                                                                                                                                                                                              |       |                             | 77,932,743  |                             |       |   | 97,548,712 |   |   |
| Property and  Equipment:                                                                                                                                                                                          |       |                             |        |                             |       |   |   |   |   |
| Computers and test equipment                                                                                                                                                                                      |       |                             | 4,592,410   |                             |       |   | 4,278,748 |   |   |
| Corporate airplane                                                                                                                                                                                                |       |                             | 3,027,502   |                             |       |   | 2,998,161 |   |   |
| Furniture and office equipment                                                                                                                                                                                    |       |                             | 748,827     |                             |       |   | 734,038 |   |   |
| Manufacturing facility                                                                                                                                                                                            |       |                             | 5,426,761   |                             |       |   | 5,420,741 |   |   |
| Land                                                                                                                                                                                                              |       |                             | 1,021,245   |                             |       |   | 1,021,245 |   |   |
|                                                                                                                                                                                                              |       |                             | 14,816,745  |                             |       |   | 14,452,933 |   |   |
| Less—Accumulated depreciation and amortization                                                                                                                                                               |       |                             | (5,846,272  | )                                |       |   | (5,091,881 | ) |   |
| Net property and equipment                                                                                                                                                                                        |       |                             | 8,970,473   |                             |       |   | 9,361,052 |   |   |
| Deposits and other assets                                                                                                                                                                                         |       |                             | 329,664     |                             |       |   | 125,114 |   |   |
| Total assets                                                                                                                                                                                                      |       |                             | $           | 87,232,880                       |       |   |   | $ | 107,034,878 |   |   |
| ***LIABILITIES AND SHAREHOLDERS’  EQUITY***                                                                                                                                                                  |       |                             |        |                             |       |   |   |   |   |
| CURRENT  LIABILITIES:                                                                                                                                                                                             |       |                             |        |                             |       |   |   |   |   |
| Current portion of notes payable                                                                                                                                                                                  |       |                             | $           | 100,000                          |       |   |   | $ | 100,000 |   |   |
| Current portion of capitalized lease obligations                                                                                                                                                                  |       |                             | 7,891       |                             |       |   | 7,257 |   |   |
| Accounts payable                                                                                                                                                                                                  |       |                             | 358,818     |                             |       |   | 305,516 |   |   |
| Accrued expenses                                                                                                                                                                                                  |       |                             | 3,122,542   |                             |       |   | 3,503,814 |   |   |
| Deferred revenue                                                                                                                                                                                                  |       |                             | 591,626     |                             |       |   | 176,650 |   |   |
| Total current liabilities                                                                                                                                                                                         |       |                             | 4,180,877   |                             |       |   | 4,093,237 |   |   |
| Note payable                                                                                                                                                                                                      |       |                             | 4,235,000   |                             |       |   | 4,235,000 |   |   |
| Long-term portion of capitalized lease obligations                                                                                                                                                                |       |                             | 4,587       |                             |       |   | 13,113 |   |   |
| Deferred revenue                                                                                                                                                                                                  |       |                             | 120,991     |                             |       |   | 191,463 |   |   |
| Deferred income taxes                                                                                                                                                                                             |       |                             | 490,072     |                             |       |   | 635,967 |   |   |
| Commitments and contingencies                                                                                                                                                                                     |       |                             | —      |                             |       |   | — |   |   |
| Shareholders’  Equity:                                                                                                                                                                                       |       |                             |        |                             |       |   |   |   |   |
| Preferred stock, 10,000,000 shares authorized,  $.001par value, of which 200,000 shares are authorized as Class A  Convertible stock. No shares issued and outstanding at September 30,  2006 and 2005. |       |                             | —      |                             |       |   | — |   |   |
| Common stock, $.001 par value: 75,000,000 shares  authorized, 18,088,121 and 18,047,425 shares issued and outstanding at  September 30, 2006 and 2005                                                        |       |                             | 18,088      |                             |       |   | 18,047 |   |   |
| Additional paid-in capital                                                                                                                                                                                        |       |                             | 43,230,352  |                             |       |   | 41,926,318 |   |   |
| Retained earnings                                                                                                                                                                                                 |       |                             | 53,039,341  |                             |       |   | 55,921,733 |   |   |
| Treasury stock, at cost, 1,272,510 and 0 shares at  September 30, 2006 and 2005                                                                                                                              |       |                             | (18,086,428 | )                                |       |   | — |   |   |
| Total shareholders’ equity                                                                                                                                                                                   |       |                             | 78,201,353  |                             |       |   | 97,866,098 |   |   |
| Total liabilities  and shareholders’ equity                                                                                                                                                                  |       |                             | $           | 87,232,880                       |       |   |   | $ | 107,034,878 |   |   |

 

The accompanying notes are an integral part of these statements.

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

| ** **                            | ** ** | **For the Fiscal Year Ended September 30,** | ** ** |
|---------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                             |       | $                                                                         | 16,721,967 |   | $ | 63,264,359 |   | $ | 46,099,777 |   |
| Cost of sales                         |       | 8,631,761                                                                 |       | 20,888,729 |   | 15,663,108 |   |
| Gross profit                          |       | 8,090,206                                                                 |       | 42,375,630 |   | 30,436,669 |   |
| Operating expenses:                   |       |                                                                      |       |   |   |   |   |
| Research and development              |       | 6,749,426                                                                 |       | 6,057,889 |   | 4,811,156 |   |
| Selling, general and administrative   |       | 9,863,758                                                                 |       | 8,898,622 |   | 7,567,959 |   |
|                                  |       | 16,613,184                                                                |       | 14,956,511 |   | 12,379,115 |   |
| Operating income  (loss)              |       | (8,522,978                                                                | )          | 27,419,119 |   | 18,057,554 |   |
| Interest income                       |       | 3,280,179                                                                 |       | 1,939,397 |   | 532,745 |   |
| Interest expense                      |       | (188,193                                                                  | )          | (175,151 | ) | (128,018 | ) |
| Income (loss) before income taxes     |       | (5,430,992                                                                | )          | 29,183,365 |   | 18,462,281 |   |
| Income taxes  (benefit)               |       | (2,548,600                                                                | )          | 10,598,563 |   | 6,530,084 |   |
| Net income (loss)                     |       | $                                                                         | (2,882,392 | ) | $ | 18,584,802 |   | $ | 11,932,197 |   |
| Net Income (loss) per  common share:  |       |                                                                      |       |   |   |   |   |
| Basic                                 |       | $                                                                         | (0.17      | ) | $ | 1.04 |   | $ | 0.69 |   |
| Diluted                               |       | $                                                                         | (0.17      | ) | $ | 1.02 |   | $ | 0.67 |   |
| Weighted average  shares outstanding: |       |                                                                      |       |   |   |   |   |
| Basic                                 |       | 17,388,524                                                                |       | 17,873,780 |   | 17,400,380 |   |
| Diluted                               |       | 17,388,524                                                                |       | 18,259,856 |   | 17,928,180 |   |

 

The accompanying notes are an integral part of these statements.

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY**

| ** **                                     | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Treasury  Stock** | ** ** | **Total**   | ** ** |
|------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|---------------------|------------|-------------|------------|
| **Balance,  September 30, 2003**          |       | $                 | 13,081     |                             | $          | 46,248,224             |       | $                   | 25,410,743 |        | $          | (10,613,757 | ) | $ | 61,058,291 |   |
| Exercise of options to purchase common stock   |       | 133               |       | 1,553,662                        |       | —                 |       | —              |       | 1,553,795   |       |
| Exercise of  warrants to purchase common stock |       | 281               |       | 614,317                          |       | —                 |       | —              |       | 614,598     |       |
| Issuance of stock  to directors                |       | 20                |       | 296,086                          |       | —                 |       | —              |       | 296,106     |       |
| Net income                                     |       | —            |       | —                           |       | 11,932,197             |       | —              |       | 11,932,197  |       |
| **Balance, September 30, 2004**           |       | 13,515            |       | 48,712,289                       |       | 37,342,940             |       | (10,613,757         | )          | 75,454,987  |       |
| Exercise of options to purchase common stock   |       | 201               |       | 3,562,132                        |       | —                 |       | —              |       | 3,562,333   |       |
| Effect of stock  split (3 -for-2)              |       | 6,009             |       | —                           |       | (6,009                 | )          |                |       |        |       |
| Issuance of stock  to directors                |       | 12                |       | 263,964                          |       |                   |       |                |       | 263,976     |       |
| Retirement of  treasury stock                  |       | (1,690            | )          | (10,612,067                      | )          |                   |       | 10,613,757          |       | —      |       |
| Net income                                     |       | —            |       | —                           |       | 18,584,802             |       | —              |       | 18,584,802  |       |
| **Balance, September 30, 2005**           |       | 18,047            |       | 41,926,318                       |       | 55,921,733             |       | —              |       | 97,866,098  |       |
| Exercise of options to purchase common stock   |       | 25                |       | 408,779                          |       |                   |       |                |       | 408,804     |       |
| Share-based  compensation                      |       |              |       | 655,351                          |       |                   |       |                |       | 655,351     |       |
| Issuance of stock  to directors                |       | 16                |       | 239,904                          |       |                   |       |                |       | 239,920     |       |
| Purchase of  treasury stock                    |       |              |       |                             |       |                   |       | (18,086,428         | )          | (18,086,428 | )          |
| Net loss                                       |       |              |       |                             |       | (2,882,392             | )          |                |       | (2,882,392  | )          |
| **Balance,  September 30, 2006**          |       | $                 | 18,088     |                             | $          | 43,230,352             |       | $                   | 53,039,341 |        | $          | (18,086,428 | ) | $ | 78,201,353 |   |

 

The accompanying notes are an integral part of these statements.

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS**

| ** **                                                                                        | ** ** | **For the Fiscal Year Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                                                        | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                         |       |                                                                      |       |   |   |   |   |
| Net income (loss)                                                                                 |       | $                                                                         | (2,882,392 | ) | $ | 18,584,802 |   | $ | 11,932,197 |   |
| Adjustments to reconcile net income to net cash provided  by (used in) operating activities: |       |                                                                      |       |   |   |   |   |
| Depreciation and  amortization                                                                    |       | 858,641                                                                   |       | 797,990 |   | 729,993 |   |
| Stock-based compensation  expense                                                                 |       | 655,351                                                                   |       | — |   | — |   |
| Compensation expense for  stock issued to directors                                               |       | 239,920                                                                   |       | 263,976 |   | 296,106 |   |
| Loss on disposal of  fixed assets                                                                 |       | 22,066                                                                    |       | 1,253 |   | 1,660 |   |
| Excess and obsolete  inventory expense                                                            |       | 38,861                                                                    |       | 32,697 |   | (118,298 | ) |
| Disposal of obsolete  inventory                                                                   |       | —                                                                    |       | 23,522 |   | 163,856 |   |
| Deferred income taxes                                                                             |       | (272,756                                                                  | )          | 252,151 |   | 83,680 |   |
| Tax benefit from  exercise of stock options                                                       |       | 219,509                                                                   |       | 1,716,659 |   | 381,469 |   |
| Excess tax benefits from  share-based payments arrangements                                       |       | (44,504                                                                   | )          | — |   | — |   |
| (Increase) decrease in:                                                                           |       |                                                                      |       |   |   |   |   |
| Accounts receivable                                                                               |       | 2,146,805                                                                 |       | (476,836 | ) | 1,952,107 |   |
| Inventories                                                                                       |       | (2,593,391                                                                | )          | 1,223,783 |   | (2,396,538 | ) |
| Prepaid expenses and  other current assets                                                        |       | (35,348                                                                   | )          | (3,363,222 | ) | (55,966 | ) |
| Increase (decrease) in:                                                                           |       |                                                                      |       |   |   |   |   |
| Accounts payable                                                                                  |       | 53,302                                                                    |       | (1,390,731 | ) | 1,117,941 |   |
| Accrued expenses                                                                                  |       | (381,272                                                                  | )          | (1,250,827 | ) | 1,647,350 |   |
| Deferred revenue                                                                                  |       | 344,504                                                                   |       | (419,844 | ) | 357,514 |   |
| Net cash provided by  (used in) operating activities                                              |       | (1,630,704                                                                | )          | 15,995,373 |   | 16,093,071 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                         |       |                                                                      |       |   |   |   |   |
| Purchases of property  and equipment                                                              |       | (456,528                                                                  | )          | (528,064 | ) | (791,393 | ) |
| Purchases of other  assets                                                                        |       | (240,000                                                                  | )          | — |   | — |   |
| Net cash used in  investing activities                                                            |       | (696,528                                                                  | )          | (528,064 | ) | (791,393 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                         |       |                                                                      |       |   |   |   |   |
| Proceeds from exercise  of stock options                                                          |       | 189,295                                                                   |       | 1,845,674 |   | 1,127,991 |   |
| Proceeds from exercise  of warrants                                                               |       | —                                                                    |       | — |   | 658,934 |   |
| Purchase of treasury  stock                                                                       |       | (18,086,428                                                               | )          | — |   | — |   |
| Repayment of capitalized  lease obligations                                                       |       | (7,892                                                                    | )          | (7,568 | ) | (11,180 | ) |
| Excess tax benefits from  share-based payments arrangements                                       |       | 44,504                                                                    |       | — |   | — |   |
| Net cash provided by  (used in) financing activities                                              |       | (17,860,521                                                               | )          | 1,838,106 |   | 1,775,745 |   |
| Net increase (decrease)  in cash and cash equivalents                                             |       | (20,187,753                                                               | )          | 17,305,415 |   | 17,077,423 |   |
| Cash and cash  equivalents, beginning of year                                                     |       | 83,172,582                                                                |       | 65,867,167 |   | 48,789,744 |   |
| Cash and cash  equivalents, end of year                                                           |       | $                                                                         | 62,984,829 |   | $ | 83,172,582 |   | $ | 65,867,167 |   |
| **SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION**                                              |       |                                                                      |       |   |   |   |   |
| Cash paid for interest                                                                            |       | $                                                                         | 147,332    |   | $ | 102,192 |   | $ | 53,711 |   |
| Cash paid for income  taxes                                                                       |       | $                                                                         | 457,672    |   | $ | 8,600,619 |   | $ | 5,991,777 |   |
| Cash received from income tax refund                                                              |       | $                                                                         | (3,278,844 | ) | — |   | — |   |

 

The accompanying notes are an integral part of these statements.

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**1.**                 Background:

Innovative Solutions and Support, Inc., (the “Company”),was incorporated in Pennsylvania on February 12, 1988. The Company’sprimary business is the design, manufacture and sale of flight informationcomputers, large flat panel displays and advanced monitoring systems to theDepartment of Defense (DoD), defense contractors, commercial air transport andcorporate/general aviation markets.

On June 13, 2005, theCompany’s Board of Directors approved a three-for-two split of the Company’scommon stock. The stock split was in the form of a fifty percent (50%) stockdividend that was paid on July 7, 2005 to shareholders of record on June 23,2005. The issued and outstanding common stock and all share and per shareamounts (except par value) have been retroactively restated in this report togive effect to this three-for-two stock split. A transfer from RetainedEarnings to Common Stock of $6,009 was required as a result of no change to parvalue.

**2.**                 Concentrations:

*Major Customers andProducts*

In fiscal 2006, 2005 and 2004 the Company derived 47%,47% and 46% of net sales from five customers, although not all the samecustomers in each year. The accounts receivable related to the Company’s topfive customers was $1.8 million, $.4 million and $1.0 million for fiscal 2006,2005 and 2004 respectively.

The Company recorded sales with the DOD that amountedto 17% of total sales for fiscal year 2006.

In addition, sales of airdata systems and components were 62%, 94% and 97% of total sales for the yearsended September 30, 2006, 2005 and 2004, respectively. Flat Panel saleswere 38%, 6% and 2% of net sales in the years ended September 30, 2006,2005 and 2004 respectively. Sales to government contractors and agenciesaccounted for approximately 51%, 20% and 7% respectively, of the Company’s netsales during fiscal 2006, 2005 and 2004.

*Major Suppliers*

The Company currently buysseveral of its components from sole source suppliers. Although there are alimited number of manufacturers of the particular components, managementbelieves that other suppliers could provide similar components on comparableterms.

*Concentration ofCredit Risk*

Financial instruments that potentially subject theCompany to concentration of credit risk consist principally of cash balances andaccounts receivable. The Company invests its excess cash where preservation ofprincipal is the major consideration. The Company’s customer base principallyconsists of companies within the aviation industry. The Company routinelyrequests advance payments and/or letters of credit from new customers.

The Company also maintainsa reserve for doubtful accounts in the amount of $100,000 and had accountsreceivable write-offs of $0, $2,500 and $0 in fiscal 2006, 2005, and 2004respectively.

**3.**                 SummaryOf Significant Accounting Policies:

*Principles ofConsolidation*

The consolidated financialstatements include the accounts of the Company and its subsidiaries. Allmaterial inter-company balances and transactions were eliminated.

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*Use of Estimates*

Preparation of consolidatedfinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect reported amounts of assets and liabilities, anddisclosure of contingent assets and liabilities, as of the date of thefinancial statements and the reported amounts of revenues and expenses duringthe reporting period. Actual results could differ materially from thoseestimates.

*Cash and CashEquivalents*

Highly liquid investmentspurchased with an original maturity of three months or less are classified ascash equivalents. Cash equivalents at September 30, 2006 and 2005 consistof funds invested in money market accounts with financial institutions.

*Inventories*

Inventoriesare stated at the lower of cost (first-in, first-out) or market and consist ofthe following:

| ** **      | ** ** | **September 30,** | ** ** |
|-----------------|------------|------------------------|------------|
| ** **      | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Raw materials   |       | $                      | 3,006,088  |   | $ | 1,696,050 |   |
| Work-in-process |       | 2,237,489              |       | 1,151,828 |   |
| Finished goods  |       | 1,222,579              |       | 1,063,748 |   |
|            |       | $                      | 6,466,156  |   | $ | 3,911,626 |   |

 

*Property andEquipment*

Property and equipment arestated at cost. Depreciation is provided using an accelerated method over theestimated useful lives of the assets (the lesser of three to seven years orover the lease term), except for the airplane and manufacturing facility, whichare depreciated over a straight-line method. Major additions and improvementsare capitalized, while maintenance and repairs that do not improve or extendthe life of assets are charged to expense as incurred. Depreciation expense was$825,041, $785,990 and $717,993 for the fiscal years ended 2006, 2005 and 2004.

*Long-Lived Assets*

The Company assesses theimpairment of long-lived assets in accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*.This statement requires that long-lived assets be reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Also, in general, long-lived assets to bedisposed of should be reported at the lower of the carrying amount or fairvalue less cost to sell. The Company considers historical performance andfuture estimated results in its evaluation of potential impairment and thencompares the carrying amount of the asset to the estimated future cash flowsexpected to result from the use of the asset. If the carrying amount of theasset exceeds the estimated expected undiscounted future cash flows, theCompany measures the amount of the impairment by comparing the carrying amountof the asset to its fair value. The estimation of fair value is generallymeasured by discounting expected future cash flows. No impairment charges wererecorded in fiscal 2006, 2005, and 2004, respectively.

*Revenue Recognition*

The Company recognizes sales of products when thefollowing revenue recognition criteria are met: persuasive evidence of anarrangement exists, product delivery and acceptance has occurred, pricing is 

35

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fixed or determinable, andcollection is reasonably assured. The Company essentially recognizes sales uponshipment of products to customers.

Sales related to certain long-term contracts requiringdevelopment and delivery of products over several accounting periods areaccounted for under the American Institute of Certified Public Accountants(AICPA) Statement of Position (SOP) 81-1, *Accounting for Performance of Construction-Type and CertainProduction-Type Contracts* and the amounts are not significant forfiscal years 2006, 2005 and 2004.

The Company offers its customers extended warrantiesfor additional fees. These warranty sales are recorded as deferred revenue andrecognized as sales on a straight-line basis over the warranty period.

The Company enters intocertain sales arrangements that include multiple deliverables as defined inEmerging Issues Task Force (EITF) Issue No. 00-21, *Accounting for Revenue Arrangements with MultipleDeliverables.*Effective July 1, 2003, the Company identifiesall goods and/or services that are to be delivered separately under a salesarrangement and allocates revenue to each deliverable based on fair value thatis established using vendor-specific objective evidence. In general, revenuesare separated between product sales and non-recurring engineering services. Theallocated revenue for each deliverable is then recognized using appropriaterevenue recognition methods.

*Warranty*

Estimated cost to repairor replace products under warranty is provided when sales of product arerecorded.

*Income Taxes*

Income taxes are recordedin accordance with SFAS No. 109, “Accounting for Income Taxes” (see Note7).

*Research andDevelopment*

Research and developmentcharges incurred for product enhancements and future product development arerecorded as expense as incurred.

*ComprehensiveIncome*

Pursuant to SFAS No. 130,“Reporting Comprehensive Income,” the Company would be required to classifyitems of other comprehensive income by their nature in a financial statementand display the accumulated balance of other comprehensive income separatelyfrom retained earnings and additional paid-in capital in the equity section ofa statement of financial position. Comprehensive income consists of net incomeand there were no items of other comprehensive income for any of the periodspresented.

*Fair Value of FinancialInstruments*

The estimated fair valueamounts presented in these consolidated financial statements were determined bythe Company using available market information and appropriate methodologies.The Company’s financial instruments consist primarily of cash and cashequivalents, accounts receivable, accounts payable, accrued liabilities anddebt instruments. The carrying values of these assets and liabilities areconsidered to be representative of the respective fair values based onpertinent information available to management as of September 30, 2006 and2005.

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*Stock-BasedCompensation*

On December 16, 2004, the FASB finalized SFAS No. 123(R) Share-BasedPayment (SFAS 123(R)). SFAS 123(R) amends SFAS 123 and supersedes APB 25.SFAS 123(R) requires that the cost of share-based payment transactions(including those with employees and non-employee directors) be recognized inthe financial statements. SFAS 123(R) applies to all share-based paymenttransactions in which an entity acquires goods or services by issuing (oroffering to issue) its shares, share options, or other equity instruments(except for those held by an Employee Stock Option Plan (ESOP)) or by incurringliabilities (1) in amounts based (even in part) on the price of the entity’sshares or other equity instruments, or (2) that require (or may require)settlement by the issuance of an entity’s shares or other equity instruments.This statement was effective as of the first annual reporting period beginningafter June 15, 2005, which is the Company’s fiscal year beginning October 1,2005.

Effective October 1, 2005 the Company adopted theprovisions of SFAS 123(R), using the modified prospective approach and nowaccounts for share-based compensation applying the fair value method forexpensing stock options. Accordingly, the adoption of SFAS 123R’s fair valuemethod resulted in compensation costs under the Company’s 1998 Stock OptionPlan. The compensation cost that was charged against income as a result ofadoption of SFAS 123(R) for the plan was $655,351 for the fiscal yearended September 30, 2006. The total income tax benefit recognized in thestatement of operations for share-based compensation arrangements was $307,360for the fiscal year ended September 30, 2006.

Share-based compensation costs prior to October 1,2005 were recognized using the intrinsic value method in accordance withAccounting Principles Board Opinion (“APB”) No. 25, “Accounting for StockIssued to Employees.” For disclosure purposes, pro forma net income and netincome per share data were provided in accordance with SFAS No. 123, “Accountingfor Stock-Based Compensation,” as if the fair value method had been applied.Under SFAS No. 123, compensation cost related to stock options granted toemployees is computed based on the fair value of the stock option at the dateof grant using the Black-Scholes option pricing model. Had the Companyrecognized compensation cost for its stock option plans consistent with theprovisions of SFAS 123, the Company’s pro forma net income for the periodsended September 30, 2005 and 2004 would have been as follows:

| ** **                         | ** ** | **September 30,** | ** ** |
|------------------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Net income as  reported            |       | $                      | 18,584,802 |   | $ | 11,932,197 |   |
| Deduct fair  market value expense: |       |                   |       |   |   |
| Employee stock options(1)          |       | (814,736               | )          | (745,329 | ) |
| Pro forma net  income (loss)       |       | $                      | 17,770,066 |   | $ | 11,186,868 |   |
| Basic earnings  per share          |       |                   |       |   |   |
| As reported                        |       | $                      | 1.04       |   | $ | 0.69 |   |
| Pro forma                          |       | $                      | 0.99       |   | $ | 0.64 |   |
| Diluted earnings  per share :      |       |                   |       |   |   |
| As reported                        |       | $                      | 1.02       |   | $ | 0.67 |   |
| Pro forma                          |       | $                      | 0.97       |   | $ | 0.63 |   |

----

(1)          Amounts representcompensation expense if it had been determined under the fair market value based method, net of relatedtax effect.

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*New AccountingPronouncements*

In September 2006, the Financial AccountingStandars Borad (FASB) issued Statement of Financial Accounting Standards (SFAS)No. 157, *Fair Value Measurements* (“SFAS157”). SFAS 157 defines fair value, establishes a framework for measuring fairvalue in generally accepted accounting principles, and expands disclosuresabout fair value measurements. This statement does not require any new fairvalue measurements; however, the application of this Statement may changecurrent practice for some entities. SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007. The Company is currently evaluating theimpact of this pronouncement.

In September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin 108, “*Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements*” (“SAB 108”).  SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thecurrent year’s financial statements are materially misstated. SAB 108 iseffective for the first fiscal year ending after November 15, 2006. TheCompany is in the process of evaluating the impact of the adoption of thisinterpretation and does not believe that the adoption of the SAB 108 will havea material impact on the Company’s financial position or results of operations.

In July 2006, the FASB issued FASB Interpretation48, *“Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109” (“FIN 48”)*. FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with FASB Statement No. 109,“Accounting for Income Taxes”. This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return. ThisInterpretation also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition. FIN 48 is effective for fiscal years beginning after December 15,2006. The Company is currently evaluating the impact of this pronouncement.

In May 2005, the FASB issued SFAS No. 154, “AccountingChanges and Error Corrections—a replacement of APB Opinion No. 20 and FASBStatement No. 3.”   SFAS No. 154requires retrospective application to prior periods’ financial statements ofchanges in accounting principle, unless it is impracticable to determine eitherthe period-specific effects or the cumulative effect of the change. SFAS No. 154also requires that retrospective application of a change in accounting principlebe limited to the direct effects of the change. Indirect effects of a change inaccounting principles, such as a change in nondiscretionary profit-sharingpayments resulting from an accounting change, should be recognized in theperiod of the accounting change. SFAS No. 154 also requires that a changein depreciation, amortization, or depletion method for long-lived,non-financial assets be accounted for as a change in accounting estimateeffected by a change in accounting principle. SFAS No. 154 is effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. Early adoption is permitted for accountingchanges and corrections of errors made in fiscal years beginning after the datethis Statement is issued. The Company will adopt the provisions of SFAS No. 154as applicable beginning in fiscal 2007.

In December 2004, the FASB issued FASB StaffPosition (FSP) FAS 109-1, “Application of FASB Statement No. 109,Accounting for Income Taxes, to the Tax Deduction on Qualified ProductionActivities Provided by the American Jobs Creation Act of 2004.”. This FSPprovides guidance on the application of Statement 109 to the provisions withinthe American Jobs Creation Act of 2005 (the Act), which provides tax relief toU.S. domestic manufacturers. The FSP states that a manufacturer’s deductionprovided for under the Act should be accounted for as a special deduction inaccordance with Statement 109 and not as a tax rate reduction. The FSP alsoreminds preparers that the special deduction should be considered by anenterprise in (a) measuring deferred taxes when the enterprise issubjected to graduated tax rates, and 

38

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(b) assessing whethera valuation allowance is necessary as required by Statement 109. This statementis effective immediately. The Company adopted this statement during fiscal year2005 and it did not have a material impact on the Company’s financial positionor results of operations.

In November 2004, theFASB issued SFAS 151, “Inventory Costs.” This Statement amends the guidance inARB No. 43, Chapter 4 “Inventory Pricing,” to clarify the accounting forabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage). Paragraph 5 of ARB 43, Chapter 4 previously stated that “...under some circumstances, items such as idle facility expense, excessivespoilage, double freight, and rehandling costs may be so abnormal as to requiretreatment as current period charges...”. This Statement requires that those itemsbe recognized as current-period charges regardless of whether they meet thecriterion of “so abnormal.” In addition, this Statement requires thatallocation of fixed production overheads to the costs of conversion be based onthe normal capacity of the production facilities. This statement is effectivefor inventory costs incurred during fiscal years beginning after June 15,2005. The Company adopted this statement on October 1, 2005 and it did nothave a material impact on the Company’s financial position or results of operations.

**4.**                 NetIncome Per Share:

Net income per share is calculated pursuant to SFAS No. 128,“Earnings per Share” (EPS). Basic EPS excludes potentially dilutive securitiesand is computed by dividing net income by the weighted-average number of Commonshares outstanding for the period. Diluted EPS is computed assuming theconversion or exercise of all dilutive securities such as preferred stock,options and warrants.

UnderSFAS No. 128, the Company’s granting of certain stock options, warrantsand convertible preferred stock resulted in potential dilution of basic EPS.The following table summarizes the differences between basic weighted-averageshares outstanding and diluted weighted-average shares outstanding used tocompute diluted EPS.

| ** **                                 | ** ** | **For the Fiscal Year Ended September 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Weighted average  number of shares-basic   |       | 17,388,524                                                                |       | 17,873,780 |   | 17,400,380 |   |
| Effect of  dilutive securities:            |       |                                                                      |       |   |   |   |   |
| Stock Options                              |       |                                                                      |       | 386,076 |   | 417,764 |   |
| Warrants                                   |       |                                                                      |       | 0 |   | 110,036 |   |
| Weighted average number  of shares-diluted |       | 17,388,524                                                                |       | 18,259,856 |   | 17,928,180 |   |

 

The number of incrementalshares from the assumed exercise of stock options and warrants is calculated byusing the treasury stock method. For the fiscal years ended September 30,2006, 2005 and 2004, there were 462,281, 50,500 and 12,587 options outstanding,respectively, that were excluded from the computation of diluted earnings pershare as the effect would be anti-dilutive.

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**5.**                 AccruedExpenses:

Accruedexpenses consist of the following:

|                                     | ** ** | **September 30,** | ** ** |
|-------------------------------------|------------|------------------------|------------|
| ** **                          | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Salary, benefits  and payroll taxes |       | $                      | 471,576    |   | $ | 881,602 |   |
| Warranty                            |       | 617,116                |       | 770,845 |   |
| Income taxes  payable               |       | 622,295                |       | 1,051,963 |   |
| Professional fees                   |       | 970,597                |       | 361,250 |   |
| Other                               |       | 440,958                |       | 438,154 |   |
|                                |       | $                      | 3,122,542  |   | $ | 3,503,814 |   |

 

**6.**                 Warranty:

TheCompany provides for the estimated cost of product warranties at the timerevenue is recognized. Warranty cost is recorded as cost of sales in thefinancial statements. While the Company engages in extensive product qualityprograms and processes, the Company’s warranty obligation is affected byproduct failure rates and the related material, labor and delivery costsincurred in correcting a product failure. Should actual product failure rates,material or labor costs differ from the Company’s estimates, revisions to theestimated warranty liability would be required.

Warrantycost and accrual information for the fiscal period ended September 30, 2006 ishighlighted below:

| Warranty accrual  at September 30, 2005                |   | $        | 770,845 |   |
|-------------------------------------------------------------|--------|----------|---------|--------|
| Accrued expense  for the year ended September 30, 2006 |   | 65,709   |    |
| Warranty costs  for the year ended September 30, 2006  |   | (219,438 | )       |
| Warranty accrual  at September 30, 2006                |   | $        | 617,116 |   |

 

Warrantycost and accrual information for the fiscal period ended September 30,2005 is highlighted below:

| Warranty accrual  at September 30, 2004                |   | $        | 757,476 |   |
|-------------------------------------------------------------|--------|----------|---------|--------|
| Accrued expense  for the year ended September 30, 2005 |   | 186,558  |    |
| Warranty costs  for the year ended September 30, 2005  |   | (173,189 | )       |
| Warranty accrual  at September 30, 2005                |   | $        | 770,845 |   |

 

**7.**                 IncomeTaxes:

The Company accounts for income taxes under SFAS No. 109,which generally provides that deferred tax assets and liabilities be recognizedfor temporary differences between the financial reporting basis and the taxbasis of the Company’s assets and liabilities and expected benefits ofutilizing net operating loss (NOL) carryforwards. The impact on deferred taxesof changes in tax rates and laws, if any, applied to the years during whichtemporary differences are expected to be settled are reflected in the financialstatements in the period of enactment.

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Componentsof income taxes are as follows: 

| ** **                    | ** ** | **For the Fiscal Year Ended September 30,** | ** ** |
|-------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                    | ** ** | **2006**                                                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current provision  (benefit): |       |                                                                      |       |   |   |   |   |
| Federal                       |       | $                                                                         | (1,943,991 | ) | $ | 9,592,641 |   | $ | 6,155,438 |   |
| State                         |       |                                                                      |       | 753,772 |   | 601,943 |   |
|                          |       | (1,943,991                                                                | )          | 10,346,413 |   | 6,757,381 |   |
| Deferred provision (benefit): |       |                                                                      |       |   |   |   |   |
| Federal                       |       | (158,789                                                                  | )          | 102,434 |   | (195,414 | ) |
| State                         |       | (445,820                                                                  | )          | 149,716 |   | (31,883 | ) |
|                          |       | (604,609                                                                  | )          | 252,150 |   | (227,297 | ) |
|                          |       | $                                                                         | (2,548,600 | ) | $ | 10,598,563 |   | $ | 6,530,084 |   |

 

Followingis a reconciliation of the statutory federal rate to the Company’s effectiveincome tax rate:

| ** **                                  | ** ** | **For the Fiscal Year Ended September 30,**        | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **      2006      ** | ** ** | **      2005      ** | ** ** | **      2004      ** | ** ** |
| Federal statutory  tax rate                 |       |                                                                             | 35.0       | % |   |   | 35.0 | % |   |   | 35.0 | % |   |
| State income  taxes, net of federal benefit |       |                                                                             | 5.3        | % |   |   | 1.9 | % |   |   | 2.2 | % |   |
| Research and  development tax credits       |       |                                                                             | 0.5        | % |   |   | -0.4 | % |   |   | -1.4 | % |   |
| Other                                       |       |                                                                             | 6.1        | % |   |   | -0.2 | % |   |   | -0.4 | % |   |
|                                        |       |                                                                             | 46.9       | % |   |   | 36.3 | % |   |   | 35.4 | % |   |

 

The deferredtax effect of temporary differences giving rise to the Company’s deferred taxassets and liabilities consists of the components below. 

| ** **                 | ** ** | **September 30,** | ** ** |
|----------------------------|------------|------------------------|------------|
| ** **                 | ** ** | **2006**               | ** ** | **2005** | ** ** |
| Deferred tax assets:       |       |                   |       |   |   |
| Deferred revenue           |       | $                      | 72,312     |   | $ | 102,372 |   |
| Reserves and accruals      |       | 714,052                |       | 949,295 |   |
| NOL carryforwards          |       | 296,567                |       | — |   |
| Stock options              |       | 238,597                |       |   |   |
|                       |       | 1,321,528              |       | 1,051,667 |   |
| Deferred tax  liabilities: |       |                   |       |   |   |
| Depreciation               |       | (728,669               | )          | (731,564 | ) |
|                       |       | (728,669               | )          | (731,564 | ) |
|                       |       | $                      | 592,859    |   | $ | 320,103 |   |

 

During the year ending September 30, 2006, theCompany generated a federal net operating loss (NOLs) of approximately $5.6million and a credit of approximately $25,000. The NOL and credit can becarried-back to previous tax years and the Company will receive a refund of itspreviously paid federal income tax in the approximate amount of $2.0 million.

In addition, the Companygenerated state NOL’s in the amount of approximztely $10.7 million. These stateNOL’s can only be carried-forward resulting in a deferred tax asset ofapproximately $456,000, before the federal effect. These NOL’s will expire in2026 if unused. In the opinion of management, the Company expects to be able toutilize these state NOL’s and as a result no valuation allowance has beenprovided.

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**8.**                 NotesPayable:

TheCompany entered into a $4,335,000 loan agreement dated August 1, 2000 withthe Chester County, Pennsylvania Industrial Development Authority. The purposeof the loan was to fund the construction of the Company’s new office andmanufacturing facility. The loan matures in 2015 and carries an interest rateset by the remarketing agent that is consistent with 30-day tax-exemptcommercial paper. The future maturities of this note payable are as follows asof September 30, 2006:

| 2007—       |   | $ | 100,000   |   |
|------------------|--------|---|-----------|--------|
| 2008—       |   | $ | 150,000   |   |
| 2009—       |   | $ | 200,000   |   |
| 2010—       |   | $ | 250,000   |   |
| 2011—       |   | $ | 250,000   |   |
| Thereafter— |   | $ | 3,385,000 |   |

 

The loan agreement requires the Company to maintaincertain financial covenants including a ratio of liabilities to earnings beforeinterest, taxes and depreciation and amortization (EBITDA), fixed charge ratioand a minimum tangible net worth. The Company was in compliance with thecovenants contained in  the loanagreement as of September 30, 2005.

The Company was in violation of the financial covenantscontained in the loan agreement as of June 30, 2006. The defaults weresubsequently waived and an amendment to the agreement was entered into with thelender whereby the existing covenants were suspended through the fiscal quarterending on June 30, 2007.

The interest cost relatedto this debt for fiscal years 2006 and 2005 was $147,000 and $100,000respectively. The interest rate on this debt was 3.86% at September 30,2006. The Company is also required to maintain a letter of credit in the amountof $5,000,000 covering the debt.

**9.**                 SavingsPlan:

The Company sponsors avoluntary defined contribution savings plan covering all employees. The Companydoes not contribute to the plan.

**10.**          Shareholders’Equity:

*Common Stock*

The Company issued 15,396,15,828 and 30,855 shares of Common stock to non-employee directors, with fairvalues of $239,920, $263,964 and $296,086 for the years ended September 30,2006, 2005 and 2004, respectively. The fair value of the Common Stock wascharged to selling, general and administrative expense in the accompanyingconsolidated statements of operations. The Company accrued $49,944 at September 30,2006 for director shares earned during the year but not issued until afteryear-end.

*Stock Options*

The Company’s 1998 Stock Option Plan (the “Plan”)provides for the granting of incentive and nonqualified stock options toemployees, officers, directors and independent contractors and consultants.Through September 30, 2006, no stock options were granted to independentcontractors or consultants under this plan.

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Incentive stock options granted under the Plan haveexercise prices that must be at least equal to the fair value of the commonstock on the date of grant. Nonqualified stock options granted under the Planhave exercise prices that may be less than, equal to or greater than the fairvalue of the common stock on the date of grant. The number of shares of commonstock the Company has reserved for awards under the Plan was increased, byshareholder vote at the March 31, 2005 Annual Meeting of Shareholders, from1,889,025 to 3,389,025 shares. As of September 30, 2006 there were1,613,419 shares remaining and available for grant.

Asummary of the Plan activity for the fiscal years ended September 30,2006, 2005 and 2004, is as follows: 

| ** **                                      | ** ** | ** **  | ** ** | **Range of** | ** ** | **Weighted** | ** ** | ** **    | ** ** |
|-------------------------------------------------|------------|-------------|------------|-------------------|------------|--------------|------------|---------------|------------|
| ** **                                      | ** ** | ** **  | ** ** | **Exercise**      | ** ** | **Average**  | ** ** | **Aggregate** | ** ** |
| ** **                                      | ** ** | ** **  | ** ** | **Weighted**      | ** ** | **Exercise** | ** ** | **Intrinsic** | ** ** |
| ** **                                      | ** ** | **Options** | ** ** | **Prices**        | ** ** | **Price**    | ** ** | **Value**     | ** ** |
| Outstanding at  September 30, 2003         |       | 899,318     |       | $                 | 1.46       | -            | $          | 9.90          |       |   | $ | 5.85 |   |   |   |   |
| Granted                                         |       | 190,500     |       | 5.41              | -          | 18.21        |       |          | 10.72      |   |   |   |   |
| Exercised                                       |       | (200,108    | )          | 1.83              | -          | 9.64         |       |          | 5.86       |   |   |   |   |
| Cancelled                                       |       | (49,023     | )          | 4.21              | -          | 10.13        |       |          | 8.61       |   |   |   |   |
| Outstanding at September 30, 2004          |       | 840,687     |       | $                 | 1.46       | -            | $          | 18.21         |       |   | $ | 6.79 |   |   |   |   |
| Granted                                         |       | 117,000     |       | 15.41             | -          | 22.35        |       |          | 19.13      |   |   |   |   |
| Exercised                                       |       | (291,734    | )          | 1.46              | -          | 12.22        |       |          | 6.46       |   |   |   |   |
| Cancelled                                       |       | (71,700     | )          | 4.00              | -          | 21.17        |       |          | 12.51      |   |   |   |   |
| Outstanding at September 30, 2005          |       | 594,253     |       | $                 | 1.46       | -            | $          | 22.35         |       |   | $ | 8.76 |   |   |   |   |
| Granted                                         |       | 204,000     |       | 12.97             | -          | 16.00        |       |          | 14.36      |   |   |   |   |
| Exercised                                       |       | (25,300     | )          | 4.00              | -          | 10.13        |       |          | 7.48       |   |   |   |   |
| Cancelled                                       |       | (71,099     | )          | 4.73              | -          | 22.35        |       |          | 13.70      |   |   |   |   |
| Outstanding at September 30, 2006          |       | 701,854     |       | $                 | 1.46       | -            | $          | 22.35         |       |   | $ | 9.93 |   |   | $ | 3,226,327 |   |
| Options  exercisable at September 30, 2006 |       | 374,454     |       | $                 | 1.46       | -            | $          | 22.35         |       |   | $ | 6.35 |   |   | $ | 3,063,811 |   |

 

The weighted-average fair value of the stock optionsgranted during the fiscal years ended September 30, 2006, 2005 and 2004were $14.36, $19.13 and $10.72 respectively. The total intrinsic value ofoptions exercised during the fiscal year ended September 30, 2006, 2005and 2004 were $187,000, $4.8 million and $1.5 million respectively.

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option-pricing model that uses the weighted average assumptionsnoted in the following table. Expected volatilities are based on historicalvolatility of the Company’s Common Stock, and other factors. The Company useshistorical data to estimate option exercise and employee termination within thevaluation model. The expected term of options is derived from historicalexercise behavior and represents the period of time that options granted areexpected to be outstanding. The risk-free rate for periods within thecontractual life of the option is based on U.S. treasuries with constantmaturities in effect at the time of grant. 

| ** **                                | ** ** | **Fiscal Year Ended September 30,**  | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                | ** ** | **    2006    ** | ** ** | **    2005    ** | ** ** | **    2004    ** | ** ** |
| Expected dividend  rate                   |       |                                                     | —     |   |   |   | — |   |   |   | — |   |   |
| Expected  volatility                      |       |                                                     | 63.7       | % |   |   | 66.4 | % |   |   | 67.4 | % |   |
| Weighted average  risk-free interest rate |       |                                                     | 2.4        | % |   |   | 2.0 | % |   |   | 1.5 | % |   |
| Expected lives (years)                    |       |                                                     | 8.41       |   |   |   | 7.35 |   |   |   | 10 |   |   |

 

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Thefollowing table summarizes information concerning outstanding and exercisableoptions at September 30, 2006:

| **Options Outstanding**    | ** ** | **Options Exercisable** | ** ** |
|---------------------------------|------------|------------------------------|------------|
| ** **                      | ** ** | ** **                   | ** ** | **Outstanding  As of** | ** ** | **Weighted-  Average  Remaining** | ** ** | **Weighted-  Average** | ** ** | **As of** | ** ** | **Weighted-  Average** | ** ** |
| **Range of Exercise** | ** ** | **September 30,**       | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **September 30,** | ** ** | **Exercise** | ** ** |
| **Prices**                      | ** ** | **2006**                     | ** ** | **Life** | ** ** | **Price** | ** ** | **2006** | ** ** | **Price** | ** ** |
|                            | $          | 0.00                         | -          | 5.00 |   |   | 226,305 |   |   |   | 4.8 |   |   |   | $ | 4.00 |   |   |   | 223,605 |   |   |   | $ | 4.00 |   |   |
|                            | $          | 5.01                         | -          | 10.00 |   |   | 156,049 |   |   |   | 5.5 |   |   |   | $ | 7.67 |   |   |   | 111,049 |   |   |   | $ | 7.69 |   |   |
|                            | $          | 10.01                        | -          | 15.00 |   |   | 242,000 |   |   |   | 9.4 |   |   |   | $ | 14.21 |   |   |   | 23,400 |   |   |   | $ | 13.81 |   |   |
|                            | $          | 15.01                        | -          | 20.00 |   |   | 61,700 |   |   |   | 8.9 |   |   |   | $ | 17.59 |   |   |   | 13,000 |   |   |   | $ | 17.89 |   |   |
|                            | $          | 20.01                        | -          | 22.35 |   |   | 15,800 |   |   |   | 8.7 |   |   |   | $ | 21.77 |   |   |   | 3,400 |   |   |   | $ | 21.73 |   |   |
|                            |       |                         |       |   |   | 701,854 |   |   |   | 7.8 |   |   |   | $ | 9.93 |   |   |   | 374,454 |   |   |   | $ | 6.35 |   |   |
|                                 |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of September 30,2006, there was approximately $2.2 million of unrecognized compensation cost, net of forfeitures, related tonon-vested stock options, which is expected to be recognized over a period ofapproximately 5 years.

**11.**          Commitmentsand Contingencies:

*Capital Lease*

The Company leases certainequipment under capital leases with terms of five years and implicit interestrates of 4.3%. The capitalized cost of $39,119 and the related accumulatedamortization of $32,359 and $18,749 have been included in property andequipment at September 30, 2006 and 2005 respectively. The balance due onthese leases was $12,478 and $20,370 as of September 30, 2006 and 2005respectively. The payments for fiscal 2007 and 2008 are $7,891 and $4,587respectively. Amortization expenses is included in depreciation expense.

*Operating Leases*

Rent expense underoperating leases totaled $11,004, $19,994 and $20,010 for the years ended September 30,2006, 2005 and 2004, respectively. As of September 30, 2006, future minimumpayments related to all cancelable operating leases total $55,020.

*Product Liability*

The Company currently hasproduct liability insurance of $50,000,000, which management believes isadequate to cover potential liabilities that may arise.

*Legal Proceedings*

From time to time, theCompany is subject to various legal proceedings in the ordinary course ofbusiness. Management does not believe that any of the current legal proceedingswill have a material adverse effect on the Company’s operations or financialcondition.

**12.**          Related-PartyTransactions:

The Company incurred legal fees of $357,000, $137,000and $115,898 with a law firm which is a shareholder of the Company for theyears ended September 30, 2006, 2005 and 2004, respectively. The fees paidand services rendered were comparable with the fees paid and services renderedprior to the law firm’s investment in the Company.

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For the years ended September 30,2006, 2005 and 2004, respectively, the Company incurred service fees of$25,000, $33,000 and $124,932 with a commercial graphics firm controlled by anindividual who is married to a significant shareholder and the daughter of theCompany’s Chairman and Chief Executive Officer.

**13.**          QuarterlyFinancial Data (unaudited):

Thesummarized quarterly results of operations of the Company for the years ended September 30,2006 and September 30, 2005 are presented below: 

| ** **                         | ** ** | **Year Ended September 30, 2006** | ** ** |
|------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                         | ** ** | **First Quarter**                                | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
| Net sales                          |       |                                                  | $          | 5,405,387 |   |   |   | $ | 3,744,752 |   |   |   | $ | 2,991,022 |   |   |   | $ | 4,580,806 |   |   |
| Cost of sales                      |       |                                                  | 2,702,018  |   |   |   | 2,194,718 |   |   |   | 1,667,301 |   |   |   | 2,067,724 |   |   |
| Gross profit                       |       |                                                  | 2,703,369  |   |   |   | 1,550,034 |   |   |   | 1,323,721 |   |   |   | 2,513,082 |   |   |
| Operating income  (loss)           |       |                                                  | (728,468   | ) |   |   | (2,567,404 | ) |   |   | (2,915,218 | ) |   |   | (2,311,888 | ) |   |
| Net income (loss)                  |       |                                                  | 6,125      |   |   |   | (777,656 | ) |   |   | (1,161,614 | ) |   |   | (949,247 | ) |   |
| Net income (loss) per common share |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic                              |       |                                                  | $          | — |   |   |   | $ | (0.04 | ) |   |   | $ | (0.07 | ) |   |   | $ | (0.06 | ) |   |
| Diluted                            |       |                                                  | $          | — |   |   |   | $ | (0.04 | ) |   |   | $ | (0.07 | ) |   |   | $ | (0.06 | ) |   |

 

| ** **                          | ** ** | **Year Ended September 30, 2005** | ** ** |
|-------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                          | ** ** | **First Quarter**                                | ** ** | **Second Quarter** | ** ** | **Third Quarter** | ** ** | **Fourth Quarter** | ** ** |
| Net sales                           |       | $                                                     | 18,978,804 |   |   | $ | 19,001,021 |   |   | $ | 17,101,620 |   |   | $ | 8,182,914 |   |   |
| Cost of sales                       |       | 6,182,143                                             |       |   | 5,777,273 |   |   | 5,846,912 |   |   | 3,082,402 |   |   |
| Gross profit                        |       | 12,796,661                                            |       |   | 13,223,748 |   |   | 11,254,708 |   |   | 5,100,512 |   |   |
| Operating income  (loss)            |       | 9,496,663                                             |       |   | 9,371,352 |   |   | 7,263,946 |   |   | 1,287,157 |   |   |
| Net income (loss)                   |       | 6,192,803                                             |       |   | 6,273,839 |   |   | 4,898,713 |   |   | 1,219,446 |   |   |
| Net income (loss)  per common share |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Basic                               |       | $                                                     | 0.35       |   |   | $ | 0.35 |   |   | $ | 0.27 |   |   | $ | 0.07 |   |   |
| Diluted                             |       | $                                                     | 0.34       |   |   | $ | 0.34 |   |   | $ | 0.27 |   |   | $ | 0.07 |   |   |

 

Quarterly and total yearearnings per share are calculated independently based on the weighted averagenumber of shares outstanding during each period.

**14.**          BusinessSegments

The Company operates inone principal business segment which designs, manufactures and sells flightinformation computers, flat panel displays and advanced monitoring systems tothe DoD, government agencies, commercial air transport carriers andcorporate/general aviation markets. The Company currently derives virtually allof its revenues from the sale of this equipment. Almost all of the Company’ssales, operating results and identifiable assets are in the United States. Netsales, operating results and identifiable assets outside of the U.S. are notsignificant.

**Item 9.**                        Changesin and disagreements with accountants on accounting and financial disclosure.

None

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**Item 9A.**                Controlsand procedures

(a)           An evaluation wasperformed under the supervision and with the participation of the Company’smanagement, including its Chief Executive Officer, or CEO, and Chief FinancialOfficer, or CFO, of the effectiveness of the Company’s disclosure controls andprocedures, as such term is defined under Rule 13a-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended (the “Exchange Act”) asof September 30, 2006. Based on that evaluation, the Company’s management,including the CEO and CFO, concluded that the Company’s disclosure controls andprocedures are effective to provide reasonable assurance that informationrequired to be disclosed by the Company in reports that it files or submitsunder the Exchange Act, is recorded, processed, summarized and reported asspecified in Securities and Exchange Commission rules and forms.

(b)          Therewere no changes in the Company’s internal control over financial reportingidentified in connection with the evaluation of such controls that occurredduring the Company’s most recent fiscal quarter that has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

**Management’s Reporton Internal Control over financial reporting**

Management of Innovative Solutions & Support, Inc.and its subsidiaries (the Company) is responsible for establishing andmaintaining adequate internal control over financial reporting. The Company’sinternal control over financial reporting is a process designed under thesupervision of the Company’s principal executive officer and principalfinancial officer to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of the Company’s financial statementsfor external purposes in accordance with accounting principles generallyaccepted in the United States of America.

The Company’s internal control over financialreporting includes policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the Company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the Company arebeing made only in accordance with authorizations of management and directorsof the Company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of theCompany’s assets that could have a material effect on the financial statements.

Due to its inherent limitations, internal control overfinancial reporting may not prevent or detect misstatements and, even whendetermined to be effective, can only provide reasonable, not absolute,assurance with respect to financial statement preparation and presentation.Projections of any evaluation of effectiveness to future periods are subject torisk that controls may become inadequate as a result of changes in conditionsor deterioration in the degree of compliance.

As of September 30, 2006, management assessed theeffectiveness of the Company’s internal control over financial reporting basedon the criteria established in Internal Control—Integrated Framework issued bythe Committee of Sponsoring Organizations of the Treadway Commission (COSO).Based on this assessment, management has determined that the Company’s internalcontrol over financial reporting as of September 30, 2006 is effective.

Our management’s assessment of the effectiveness ofour internal control over financial reporting has been audited by Deloitte &Touche LLP, an independent registered public accounting firm, as stated intheir report which is included herein.

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

To the Board of Directors and Shareholders ofInnovative Solutions and Support, Inc.Exton, Pennsylvania

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Controls over FinancialReporting, that Innovative Solutions and Support, Inc. and subsidiaries(the “Company”) maintained effective internal control over financial reportingas of September 30, 2006, based on criteria established in *Internal Control—Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission. The Company’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles. A company’s internalcontrol over financial reporting includes those policies and procedures that (1) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis. Also, projectionsof any evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that theCompany maintained effective internal control over financial reporting as of September 30,2006, is fairly stated, in all material respects, based on the criteriaestablished in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission.Also in our opinion, the Company maintained, in all material respects,effective internal control over financial reporting as of September 30,2006, based on the criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission.

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Wehave also audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated financialstatements as of and for the year ended September 30, 2006 of the Companyand our report dated December 7, 2006, expressed an unqualified opinion onthose financial statements.
| /s/ DELOITTE & TOUCHE LLP |   |
|------------------------------------|--------|
| Philadelphia, Pennsylvania         |
| December 7, 2006              |

 

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**PART III**

**Item 10.**                 Directorsand executive officers of the registrant.

This information (otherthan the information relating to executive officers included in Part IItem 1.) will be included in our Proxy Statement relating to our Annual Meetingof Shareholders, which will be filed within 120 days after the close of ourfiscal year covered by this Report, and is hereby incorporated by reference tosuch Proxy Statement. We have adopted a written code of business conduct andethics, known as our code of conduct, which applies to all of our directors,officers, and employees, including our chief executive officer, ourpresident and our chief financial officer. Our code of conduct is available onour Internet website, *www.innovative-ss.com*.Our code of conduct may also be obtained by contacting investor relations at(610) 646-9800. Any amendments to our code of conduct or waivers from theprovisions of the code for our directors and our officers will be disclosed onour Internet website promptly following the date of such amendment or waiver.

**Item 11.**                 Executivecompensation.

This information will beincluded in our Proxy Statement relating to our Annual Meeting of Shareholders,which will be filed within 120 days after the close of our fiscal year coveredby this Report, and is hereby incorporated by reference to such ProxyStatement.

**Item 12.**                 Securityownership of certain beneficial owners and management.

This information will beincluded in our Proxy Statement relating to our Annual Meeting of Shareholders,which will be filed within 120 days after the close of our fiscal year coveredby this Report, and is hereby incorporated by reference to such ProxyStatement.

**Item 13.**                 Certainrelationships and related transactions.

This information will beincluded in our Proxy Statement relating to our Annual Meeting of Shareholders,which will be filed within 120 days after the close of our fiscal year coveredby this Report, and is hereby incorporated by reference to such ProxyStatement.

**Item 14.**                 Principalaccounting fees and services

This information will be included in our ProxyStatement relating to our Annual Meeting of Shareholders, which will be filedwithin 120 days after the close of our fiscal year covered by this Report, andis hereby incorporated by reference to such Proxy Statement.

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**PART IV**

**Item 15.**                 Exhibits,financial statement schedules.

(a)           The following documentsare filed as part of this report:

(1)   *Financial Statements*

See index to Financial Statements at Item 8 on page 28of this report.

(2)   *Financial Statement Schedules*

Schedules have beenomitted because they are not applicable or are not required or the informationrequired to be set forth therein is included in the financial statements ornotes thereto.

(3)   The following exhibits are filed as part of,or incorporated by reference into this report:

| Exhibit  Number | ** ** | ** **                                                                                                                       | ** ** | **Exhibit Title** |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|
| 3.1#            |       | Articles of  Incorporation of IS&S.                                                                                          |
| 3.2#            |       | Bylaws of  IS&S.                                                                                                             |
| 10.1*#          |       | IS&S 1988  Incentive Stock Option Plan.                                                                                      |
| 10.2*#          |       | IS&S 1998  Stock Option Plan.                                                                                                |
| 10.8@           |       | Bond Purchase Agreement.                                                                                                         |
| 10.9@           |       | Reimbursement,  Credit and Security Agreement.                                                                                   |
| 10.11@          |       | Trust Indenture.                                                                                                                 |
| 10.12*†    |       | Employment  Agreement by and between Roman G. Ptakowski and IS&S dated March 29, 2003.                             |
| 21              |       | Subsidiaries of  IS&S.                                                                                                       |
| 23.1            |       | Consent of  Deloitte and Touche LLP.                                                                                             |
| 31.1            |       | Certification of  Chief Executive Officer pursuant to Rule 13a-14(a)                                                        |
| 31.2            |       | Certification of  Chief Financial Officer Pursuant to Rule 13a-14(a)                                                        |
| 32.1            |       | Certification Pursuant  to U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

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*                    Constitutes amanagement contract or compensatory plan or arrangement required to be filed asan exhibit to this form.

#                 Incorporated byreference from the Registrant’s Registration Statement on Form S-1(File No. 333-96584) filed with the Commission on May 9, 2000,as amended.

@              Incorporated byreference from the Registrant’s Form 10-K filed with the Commissionfor fiscal year 2000.

†                    Incorporatedby reference from the registrant’s Form 10-Q filed with theCommission for the quarter ended March 31, 2003.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|        | INNOVATIVE  SOLUTIONS AND SUPPORT, INC. |
|--------|----------------------------------------------|
|   | By:                                          | /s/ GEOFFREY S. M. HEDRICK |
|   | ** **                                   | **Geoffrey  S. M. Hedrick** |
|   | *** ***                                 | ***Chairman  of the Board and*** |
|   | *** ***                                 | ***Chief  Executive Officer*** |
|   | Dated: December 7,  2006           |

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, this report has been signed by the following persons on behalf ofthe Registrant and in the capacities and on the dates indicated.
|                                                  | **Signature** | ** **                 | ** ** | ** **             | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|--------------------------------------------------|---------------|----------------------------|------------|------------------------|-----------|------------|------------|------------|----------|------------|
| /s/ GEOFFREY S. M. HEDRICK                  |          | Chairman of the Board  and |       | December 7,  2006 |
| **Geoffrey S. M. Hedrick**                       |          | Chief Executive Officer    |       |                   |
| **(Principal Executive Officer)**                |          |                       |       |                   |
| /s/ ROMAN  G. PTAKOWSKI                     |          | President                  |       | December 7, 2006  |
| **Roman G. Ptakowski**                           |          |                       |       |                   |
| **(President))**                                 |          |                       |       |                   |
| /s/ JAMES  J. REILLY                        |          | Chief Financial  Officer   |       | December 7, 2006  |
| **James J. Reilly**                              |          |                       |       |                   |
| **(Principal Financial and Accounting Officer)** |          |                       |       |                   |
| /s/ GLEN  R. BRESSNER                       |          | Director                   |       | December 7, 2006  |
| **Glen R. Bressner**                             |          |                       |       |                   |
| /s/ WINSTON  J. CHURCHILL                   |          | Director                   |       | December 7, 2006  |
| **Winston J. Churchill**                         |          |                       |       |                   |
| /s/ IVAN  M. MARKS                          |          | Director                   |       | December 7, 2006  |
| **Ivan M. Marks**                                |          |                       |       |                   |
| /s/ ROBERT  E. MITTELSTAEDT, JR.       |          | Director                   |       | December 7, 2006  |
| **Robert E. Mittelstaedt, Jr.**             |          |                       |       |                   |
| /s/ ROBERT  H. RAU                          |          | Director                   |       | December 7, 2006  |
| **Robert H. Rau**                                |          |                       |       |                   |
|                                             |          | Director                   |       | December 7, 2006  |
|                                             |          |                       |       |                   |

 

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