**UNITED
            STATES**
 **SECURITIES
            AND EXCHANGE COMMISSION**
 **WASHINGTON,
            D.C. 20549**
 
 **FORM
            20-F**
 
 o  REGISTRATION
            STATEMENT PURSUANT TO SECTION 12(b) OR (g)
 OF
            THE
            SECURITIES EXCHANGE ACT OF 1934; or
 
 x  ANNUAL
            REPORT PURSUANT TO SECTION 13 OR 15(d) OF
 THE
            SECURITIES EXCHANGE ACT OF 1934
 For
            the
            fiscal year ended August 31, 2006; or
 
 o  TRANSITION
            REPORT PURSUANT TO SECTION 13 OR 15(d) OF
 THE
            SECURITIES EXCHANGE ACT OF 1934
 For
            the
            transition period ________ to ________; or
 
 o  SHELL
            COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
 THE
            SECURITIES EXCHANGE ACT OF 1934
 Date
            of
            event requiring this shell company report
 
 **For
            the transition period from September 1, 2005 to August 31,
            2006**
 
 Commission
            File No. **0-30895**
 
 **EXFO
            ELECTRO-OPTICAL ENGINEERING INC. /**
 **EXFO
            INGÉNIERIE ÉLECTRO-OPTIQUE INC.**
 **(Exact
            name of registrant as specified in its charter)**
 
 **Canada**
 **(Jurisdiction
            of Incorporation or organization)**
 
 **400
            Godin Avenue**
 **Quebec,
            Quebec, G1M 2K2, Canada**
 **(418)
            683-0211**
 **(Address,
            including zip code and telephone number, including area code, of registrant’s
            principal executive offices)**
 
 Securities
            registered or to be registered pursuant to Section 12(b) of the
            Act:
 
 Title
                      of each class
                  Name
                      of each exchange on which registeredSubordinate
                      Voting Shares without par value
                  NASDAQSubordinate
                      Voting Shares without par value
                  TSX
 
 Securities
            registered or to be registered pursuant to Section 12(g) of the
            Act:
 
 None
 
 Securities
            for which there is a reporting obligation pursuant to Section 15(d) of
            the
            Act:
 
 None
  
  As
            of
            November 1, 2006, the registrant had 31,632,857 Subordinate Voting Shares
            outstanding.
 
 Indicate
            by check mark if the registrant is a well-known seasoned issuer, as defined
            in
            Rule 405 of the Securities Act.
 
 Yes o  No x
 
 If
            this
            report is an annual report or transition report, indicate by check mark
            if the
            registrant is not required to file reports pursuant to Section 13 or
            15 (d) of
            the Securities Exchange Act of 1934.
 
 Yes o  No x
 
 Indicate
            by check mark whether the registrant (1) has filed all reports required
            to be
            filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
            the
            preceding 12 months (or for such shorter period that the registrant was
            required
            to file such reports), and (2) has been subject to such filing requirements
            for
            the past 90 days.
 
 Yes x  No o
 
 Indicate
            by check mark whether the registrant is a large accelerated filer, an
            accelerated filer, or a non-accelerated filer. See definition of “accelerated
            filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
            one):
 
 Large
                      accelerated filero
                  Accelerated
                      filerx
                  Non-accelerated
                      filero
 
 Indicate
            by check mark which financial statement item the registrant has elected
            to
            follow:
 
 Item
            17 o  Item
            18 x
 
 If
            this
            is an annual report, indicate by check mark whether the registrant is
            a shell
            company (as defined in Rule 12b-2 of the Exchange Act).
 
 Yes o  No x










**Tableof
      Contents**






PART
        I.
 
 Item
        1.Identity
        of Directors, Senior Management and Advisors
 
 Item
        2.Offer
        Statistics and Expected Timetable
 
 Item
        3.Key
        Information
 A.Selected
        Financial Data
 B.Capitalization
        and Indebtedness
 C.Reasons
        for the Offer and Use of Proceeds
 D.Risk
        Factors
 
 Item
        4.Information
        on the Company
 A.History
        and Development of the Company
 B.Business
        Overview
 C.Organizational
        Structure
 D.Property,
        Plant and Equipment
 
 Item
        4A.Unresolved
        Staff Comments
 
 Item
        5.Operating
        and Financial Review and Prospects
 Item
        6.Directors,
        Senior Management and Employees
 A.Directors
        and Senior Management
 B.Compensation
 C.Board
        Practices
 D.Employees
 E.Share
        Ownership
 
 Item
        7.Major
        Shareholders and Related Party Transactions
 A.Major
        Shareholders
 B.Related
        Party Transactions
 
 Item
        8.Financial
        Information
 A.Consolidated
        Statements and Other Financial Information
 B.Significant
        changes
 
 Item
        9.Offer
        and
        Listing
 
 Item
        10.Additional
        Information
 A.Share
        Capital
 B.Memorandum
        and Articles of Association
 C.Material
        Contracts
 D.Exchange
        Controls
 E.Taxation
 F.Dividends
        and Paying Agents
 G.Statement
        by Experts
 H.Documents
        on Display
 I.Subsidiary
        Information
 
 Item
        11.Qualitative
        and Quantitative Disclosures about Market Risk
 
 Item
        12.Description
        of Securities Other than Equity Securities
  
  PART
        II.
 
 Item
        13.Defaults,
        Dividends Arrearages and Delinquencies
 
 Item
        14.Material
        Modifications to the Rights of Security Holders and Use of
        Proceeds
 
 Item
        15.Controls
        and Procedures
 
 Item
        16.[Reserved]
 Item
        16A.Audit
        Committee Financial Expert
 Item
        16B.Code
        of
        Ethics
 Item
        16C.Principal
        Accountant Fees and Services
 Item
        16D.Exemptions
        from the Listing Standards for Audit Committees
 Item
        16E.Purchases
        of Equity Securities by the Issuer and Affiliated Purchasers
 
 PART
        III.
 
 Item
        17.Financial
        Statements
 
 Item
        18.Financial
        Statements
 
 Item
        19.Exhibits
 
 Signatures




Table
          of Contents







**DISCLOSURE
      REGARDING FORWARD-LOOKING INFORMATION**





This
      annual report contains or incorporates by reference statements which constitute
      forward-looking statements within the meaning of the U.S. Private Securities
      Litigation Reform Act of 1995 and we intend that such forward-looking statements
      be subject to the safe harbors created thereby. Forward-looking statements
      are
      statements other than historical information or statements of current condition
      that refer to expectations, projections or other characterizations of future
      events and circumstances. They are not guarantees of future performance and
      involve risks and uncertainties. Actual results may differ materially from
      those
      in forward-looking statements due to various factors including those that are
      discussed under “Risk Factors” set forth in Item 3D of this annual report.
      Assumptions relating to forward-looking statements involve judgments and risks,
      all of which are difficult or impossible to predict and many of which are beyond
      our control. When used in this annual report, the words “believe”, “anticipate”,
“plan”, “expect”, “intend”, “estimate” or similar expressions are intended to
      identify forward-looking statements, although not all forward-looking statements
      contain such identifying words. We believe that the expectations reflected
      in
      the forward-looking statements are reasonable based on information currently
      available to us, but we cannot assure you that the expectations will prove
      to
      have been correct. Accordingly, you should not place undue reliance on these
      forward-looking statements. These statements speak only as of the date of this
      document. We undertake no obligation to revise or update any of them to reflect
      events or circumstances that occur after the date of this document.




All
        dollar amounts in this annual report are expressed in US dollars, except
        as
        otherwise noted.








**PART
      I.**




**Item
      1.**  **Identity
      of Directors, Senior Management and Advisors**





Not
      Applicable.





**Item
      2.**  **Offer
      Statistics and Expected Timetable**





Not
      Applicable.





**Item
      3.**  **Key
      Information**




**A.**
            **Selected Financial Data**




The
      consolidated statements of earnings data for the years ended August 31, 2002
      and
      2003 and the consolidated balance sheets data as at August 31, 2002, 2003 and
      2004 are derived from our audited consolidated financial statements not included
      in this annual report. The consolidated statements of earnings data for each
      of
      the three years ended August 31, 2004, 2005 and 2006 and the
      consolidated balance sheets data as at August 31, 2005 and 2006 are
      derived from our audited consolidated financial statements that are included
      elsewhere in this annual report.





Our
      consolidated financial statements are prepared in accordance with generally
      accepted accounting principles in Canada (“Canadian GAAP”) and significant
      differences in measurement and disclosure from generally accepted accounting
      principles in United States (“U.S. GAAP”) are set out in note 20 to our
      consolidated financial statements included elsewhere in this annual report.
      The
      historical results below are not necessarily indicative of the results to be
      expected for any future periods.





1
 Table
            of Contents







The
      selected financial data should be read in conjunction with our audited
      consolidated financial statements and the related notes included elsewhere
      in
      this annual report, and “Item 5. Operating and Financial Review and Prospects”
of this annual report.





**Years
                ended August 31,****2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002****(in
                thousands of US dollars, except share and per share
                data)****Consolidated
                Statements of Earnings Data:*****Amounts
                under Canadian GAAP***Sales
            
            $
            128,253
            
            $
            97,216
            
            $
            74,630
            
            $
            61,930
            
            $
            68,330Cost
                of sales(1)
            
            
            57,275
            
            
            44,059
            
            
            34,556
            
            
            36,197
            
            
            52,366Gross
                margin
            
            
            70,978
            
            
            53,157
            
            
            40,074
            
            
            25,733
            
            
            15,964Operating
                expensesSelling
                and administrative
            
            
            40,298
            
            
            31,782
            
            
            25,890
            
            
            26,991
            
            
            33,881Net
                research and development
            
            
            15,404
            
            
            12,190
            
            
            12,390
            
            
            15,879
            
            
            12,782Amortization
                of property, plant and equipment
            
            
            3,523
            
            
            4,256
            
            
            4,935
            
            
            5,210
            
            
            5,096Amortization
                of intangible assets
            
            
            4,394
            
            
            4,836
            
            
            5,080
            
            
            5,676
            
            
            12,451Impairment
                of long-lived assets and goodwill
            
            
            604
            
            
            −
            
            
            620
            
            
            7,427
            
            
            23,657Government
                grants
            
            
            (1,307
            )
            
            −
            
            
            −
            
            
            −
            
            
            −Restructuring
                and other charges
            
            
            −
            
            
            292
            
            
            1,729
            
            
            4,134
            
            
            2,880Total
                operating expenses
            
            
            62,916
            
            
            53,356
            
            
            50,644
            
            
            65,317
            
            
            90,747Earnings
                (loss) from operations
            
            
            8,062
            
            
            (199
            )
            
            (10,570
            )
            
            (39,584
            )
            
            (74,783
            )Interest
                and other income
            
            
            3,253
            
            
            2,524
            
            
            1,438
            
            
            1,245
            
            
            1,456Foreign
                exchange loss
            
            
            (595
            )
            
            (1,336
            )
            
            (278
            )
            
            (1,552
            )
            
            (458
            )Earnings
                (loss) before income taxes and amortization and write-down of
                goodwill
            
            
            10,720
            
            
            989
            
            
            (9,410
            )
            
            (39,891
            )
            
            (73,785
            )Income
                taxes
            
            
            2,585
            
            
            2,623
            
            
            (986
            )
            
            15,059
            
            
            (25,451
            )Earnings
                (loss) before amortization and write-down of goodwill
            
            
            8,135
            
            
            (1,634
            )
            
            (8,424
            )
            
            (54,950
            )
            
            (48,334
            )Amortization
                of goodwill
            
            
            −
            
            
            −
            
            
            −
            
            
            −
            
            
            38,021Write-down
                of goodwill
            
            
            −
            
            
            −
            
            
            −
            
            
            −
            
            
            222,169Net
                earnings (loss) for the year
            
            $
            8,135
            
            $
            (1,634
            )
            $
            (8,424
            )
            $
            (54,950
            )
            $
            (308,524
            )Basic
                and diluted net earnings (loss) per share
            
            $
            0.12
            
            $
            (0.02
            )
            $
            (0.13
            )
            $
            (0.87
            )
            $
            (5.09
            )Basic
                weighted average number of shares used in per share calculations
                (000’s)
            
            
            68,643
            
            
            68,526
            
            
            66,020
            
            
            62,852
            
            
            60,666**Other
                consolidated statements of earnings data:**Gross
                research and development
            
            $
            19,488
            
            $
            15,878
            
            $
            15,668
            
            $
            17,133
            
            $
            17,005Net
                research and development
            
            $
            15,404
            
            $
            12,190
            
            $
            12,390
            
            $
            15,879
            
            $
            12,782***Amounts
                under U.S. GAAP***Net
                earnings (loss) for the year
            
            $
            8,135
            
            $
            (2,920
            )
            $
            (9,571
            )
            $
            (48,201
            )
            $
            (382,893
            )Basic
                and diluted net earnings (loss) per share
            
            $
            0.12
            
            $
            (0.04
            )
            $
            (0.14
            )
            $
            (0.77
            )
            $
            (6.31
            )Basic
                weighted average number of shares used in per share calculations
                (000’s)
            
            
            68,643
            
            
            68,526
            
            
            66,020
            
            
            62,852
            
            
            60,666





**As
                at August 31,****2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002****(in
                thousands of US dollars)****Consolidated
                Balance Sheets Data:*****Amounts
                under Canadian GAAP***Cash
            
            $
            6,853
            
            $
            7,119
            
            $
            5,159
            
            $
            5,366
            
            $
            9,128Short-term
                investments
            
            
            104,437
            
            
            104,883
            
            
            83,969
            
            
            52,010
            
            
            40,553Working
                capital
            
            
            143,985
            
            
            135,288
            
            
            115,141
            
            
            76,659
            
            
            91,374Total
                assets
            
            
            219,159
            
            
            190,957
            
            
            172,791
            
            
            146,254
            
            
            177,926Long-term
                debt (excluding current portion)
            
            
            354
            
            
            198
            
            
            332
            
            
            453
            
            
            564Share
                capital
            
            
            148,921
            
            
            521,875
            
            
            521,733
            
            
            492,452
            
            
            489,611Shareholders’
                equity
            
            $
            196,234
            
            $
            173,400
            
            $
            157,327
            
            $
            129,826
            
            $
            165,406***Amounts
                under U.S. GAAP***Cash
            
            $
            6,853
            
            $
            7,119
            
            $
            5,159
            
            $
            5,366
            
            $
            9,128Short-term
                investments
            
            
            104,437
            
            
            104,883
            
            
            83,969
            
            
            52,010
            
            
            40,553Working
                capital
            
            
            149,436
            
            
            138,225
            
            
            117,116
            
            
            78,225
            
            
            91,305Total
                assets
            
            
            212,702
            
            
            182,852
            
            
            164,758
            
            
            138,020
            
            
            161,314Long-term
                debt (excluding current portion)
            
            
            354
            
            
            198
            
            
            332
            
            
            453
            
            
            564Share
                capital
            
            
            598,421
            
            
            597,664
            
            
            596,309
            
            
            565,291
            
            
            560,943Shareholders’
                equity
            
            $
            189,777
            
            $
            165,295
            
            $
            149,294
            
            $
            121,592
            
            $
            150,999


_________________________





(1)
            The
                cost of sales is exclusive of amortization, shown separately. Includes
                inventory write-offs of nil, nil, nil, $4,121,000 and $18,463,000
                for the
                years ended August 31, 2006, 2005, 2004, 2003 and 2002, respectively,
                and
                an unusual gain of $473,000 for the year ended August 31,
                2003.





2
 Table
          of Contents






**B.**  **Capitalization
      and Indebtedness**





Not
      Applicable.





**C.**  **Reasons
      for the Offer and Use of Proceeds**





Not
      Applicable.





**D.**  **Risk
      Factors** ****





**We
      must continue to overcome significant competition in our targeted industries
      in
      order to gain market share and achieve our growth
      strategy.**





The
      market for our primary business activity ─ namely designing, manufacturing,
      marketing and selling telecommunications test and measurement equipment ─ is
      rapidly evolving and is marked by intense competition and technical innovation.
      Likewise, the market for our selected life sciences and industrial solutions
      is
      very competitive. We anticipate the pace of change to remain high or even
      accelerate for our targeted industries in the future. We might see the emergence
      of new competitors or the consolidation of current competitors, as the markets
      for telecommunications test and measurement equipment as well as for life
      sciences and industrial solutions might evolve in response to technical
      innovations and economic conditions. Achieving our key performance indicator
      of
      20% sales growth in fiscal 2007 will largely depend on our ability to gain
      market share by increasing sales of current products at existing accounts,
      expanding into new accounts, introducing new products and product enhancements,
      and exploiting new market opportunities.





During
      the past couple of years, the telecommunications test and measurement industry
      has witnessed consolidation. Anritsu Corporation announced the acquisition
      of
      NetTest A/S in August 2005 and JDS Uniphase Corporation (JDSU) completed its
      acquisition of Acterna Corporation during the same month. Agilent Technologies
      Inc. divested itself of its semiconductor division to refocus its efforts on
      test and measurement. With the exception of JDSU (which also sells optical
      components), these competitors are global test and measurement vendors who
      complement their broad range of products with telecommunications test and
      measurement equipment. Similarly, Spirent plc, Tektronix, Inc. and Yokagawa
      are
      global test and measurement vendors who compete against us. Other competitors,
      such as Digital Lightwave Inc., Fluke Networks, an operating division within
      Danaher Corporation, IXIA, and Sunrise Telecom Inc., compete against us in
      niche
      markets. Some competitors in both groups may have greater financial, technical
      and/or marketing resources than us. Consequently, they may be able to devote
      greater resources to the development, marketing, manufacturing, selling and
      support of their products in order to capture market share.





Competitors
      also may be better positioned than us to capture market share or to acquire
      companies and new technologies that would potentially displace our products
      or
      render them obsolete. We cannot predict whether current or future competitors
      will develop or market products that offer higher performance, more features,
      or
      are more cost-effective than our current or future products. To remain
      competitive and achieve our growth strategy, we must increase our sales and
      develop cost-effective products and product enhancements that offer higher
      performance and more functionality, in current and new sectors, so that we
      can
      increase our market share. Our failure to do so may harm our business, results
      of operations and financial condition.








3
 Table
            of Contents







**Fluctuations
      in the exchange rates between the Canadian dollar, US dollar and other
      currencies may adversely affect our operating results.**





Most
      of
      our sales are denominated in currencies other than the Canadian dollar
      (principally US dollars and Euros). However, a large portion of our operating
      expenses and capital expenditures are denominated in Canadian dollars. As a
      result, even though we manage to some extent our exposure to currency risks
      with
      forward exchange contracts and certain operating expenses denominated in
      currencies other than the Canadian dollar, we are exposed to fluctuations in
      the
      exchange rates between the Canadian dollar on one hand and the US dollar
      and Euro on the other. As of October 31, 2006, the Canadian dollar increased
      approximately 5.1% versus the US dollar and decreased 1.3% versus the Euro,
      compared to October 31, 2005. Any increase in the value of the Canadian dollar
      relative to other currencies, especially the US dollar, could have a material
      adverse effect on our operating results and provide strategic advantages to
      our
      competitors.





**One
      of our customers has accounted for a high percentage of our sales in the past
      few years, and any adverse factor affecting this customer or our relationship
      with this customer could cause our sales to decrease.**





Although
      our customer base has been well diversified on a historical basis, a Tier-1
      carrier in the US accounted for 13.8% of our sales in fiscal 2006, 23.3% in
      2005
      and 13.8% in 2004. Even if this customer has a supply contract with us, it
      could
      change its purchasing practice, force us to renegotiate prices and is not
      obligated to purchase a specific amount of products from us or provide us with
      binding purchase forecasts for any period. In addition, our customers typically
      purchase our products under individual purchase orders and may cancel or defer
      purchases on short notice without significant penalties.





The
      loss
      of such a customer or the reduction, delay, or cancellation of orders from
      this
      customer or other significant customers could cause our sales and, therefore,
      net earnings to decline.





**Recent
      signs of market stability are not necessarily indicative of long-term growth.
      If
      market conditions significantly deteriorate or if we fail to implement adequate
      measures on a timely basis to align our cost structure to such conditions,
      it
      could have a material adverse effect on our business, results of operations
      and
      financial condition.**





Notwithstanding
      recent signs of market stability and generally increasing demand for our
      products, average selling prices may decline and revenue and profitability
      targets may be subject to uncertainty and variability. Any downturn in our
      markets or in general economic conditions,, or if we fail to adjust our cost
      structure accordingly, could harm our consolidated financial condition, results
      of operations and business.





**We
      have faced pricing pressure on our existing products and expect that this
      pressure will continue. If we do not control our manufacturing costs or
      introduce new products with higher margins, our gross margins may decrease
      and
      our operating results may be adversely affected.**





We
      continued implementing measures to protect our gross margin, which reached
      55.3%
      of sales in fiscal 2006 compared to 54.7% in fiscal 2005, despite the negative
      impact of the exchange rate between US and Canadian currencies. However,
      increased competitiveness in the telecommunications test and measurement
      industry will likely result in continuing downward pressure on average selling
      prices, which may in turn negatively affect our gross margins. Pricing pressure
      can result from a number of factors such as:





·
            Increased
                competition for business;


·
            Reduced
                demand;


·
            Limited
                number of potential customers;


·
            Competition
                from companies with lower production costs, including companies operating
                in lower cost environments;


·
            Introduction
                of new products by competitors;


·
            Greater
                economies of scale for higher-volume
                competitors;


·
            Large
                customers, who buy in high volumes, can exert substantial negotiating
                leverage over us;


·
            Resale
                of used equipment; and


·
            Equipment
                sales resulting from manufacturing and rental company
                bankruptcies.





4
 Table
          of Contents






In
      addition, gross margins may also be negatively affected by increased costs
      of
      raw materials as well as obsolescence and excess costs, product mix and
      under-absorption of fixed manufacturing costs.





As
      pricing pressure will likely continue to affect our existing products, we may
      have to increase the number of units sold to maintain our existing sales levels.
      If we are unable to increase our sales levels, lower our manufacturing costs,
      or
      introduce new products with higher margins, our gross margins may decline and
      our operating results may suffer.





**Our
      products may have unforeseen defects that could harm our reputation, impede
      market acceptance of our products and negatively impact our business, results
      of
      operations and financial condition.**





As
      a
      result of their complexity, our products may contain undetected software or
      hardware defects, inaccurate calibration or compatibility problems or regulatory
      compliance issues, particularly when they are first introduced or when new
      versions are released. There can be no assurance that, despite our testing,
      defects will not be found in new products after they have been fully deployed
      and operated under peak stress conditions or that customized products meet
      customer sign-off acceptance requirements. If we are unable to fix defects
      or
      other problems or meet custom requirements, we could experience, among other
      things:





·
            Costly
                repairs;


·
            Product
                returns or recalls;


·
            Damage
                to our brand reputation;


·
            Loss
                of customers, failure to attract new customers or achieve market
                acceptance;


·
            Diversion
                of development and engineering
                resources;


·
            Legal
                actions by our customers, including claims for consequential damages
                and
                loss of profits; and


·
            Legal
                actions by governmental entities, including actions to impose product
                recalls and/or forfeitures.





The
      occurrence of any one or more of the foregoing could seriously harm our
      business, results of operations and financial condition.





**We
      may not be able to make the necessary acquisitions needed for the development
      of
      our business or, if we do make such acquisitions, we cannot assure you that
      we
      will successfully integrate the businesses, products, technologies and
      personnel. In addition, such acquisitions could distract management’s attention
      from our day-to-day business and operations. Ultimately, the failure to make
      strategic acquisitions or the inability to carry out effective integrations
      could disrupt our overall business and harm our financial
      condition.**





We
      intend
      to carefully seek businesses that meet stringent criteria, products and
      technologies that are complementary to ours or that will expand our markets.
      There can be no assurance that we will ultimately make any such acquisition.
      Our
      competitors may be in a better position to acquire the same businesses, products
      and technologies that we wish to acquire. In addition, our fluctuating stock
      price or our cash position at the time of an acquisition may affect our ability
      to complete such an acquisition.





We
      have
      made strategic acquisitions in the past and we intend to continue making
      acquisitions of businesses, products and technologies as part of our overall
      growth strategy. In the event of any future acquisition, we could:





·
            Issue
                shares that would dilute individual shareholder percentage
                ownership;


·
            Incur
                debt;


·
            Assume
                liabilities and commitments;


·
            Incur
                significant expenses related to amortization of additional intangible
                assets;


·
            Incur
                significant impairment losses of goodwill and intangible assets related
                to
                such acquisitions; and


·
            Incur
                losses from operations.





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These
      acquisitions also involve numerous risks, including:





·
            Risk
                of not realizing the expected benefits or synergies of such
                acquisitions;


·
            Problems
                integrating the acquired operations, technologies, products and
                personnel;


·
            Risks
                associated with the transfer of acquired know-how and
                technology;


·
            Unanticipated
                costs or liabilities;


·
            Diversion
                of management’s attention from our core
                business;


·
            Adverse
                effects on existing business relationships with suppliers and
                customers;


·
            Risks
                associated with entering markets in which we have no or limited prior
                experience; and


·
            Potential
                loss of key employees, particularly those of acquired
                organizations.





**Our
      quarterly revenues and operating results are subject to significant fluctuations
      and you should not rely on them as an indication of our future
      performance.**





Our
      sales
      and operating results have fluctuated from quarter to quarter in the past and
      significant fluctuations may occur in the future. In addition, our sales and
      operating results generally depend on the volume and timing of the orders we
      receive from customers as well as our ability to fulfill received orders. Our
      operating expenses, which include selling and administrative, research and
      development, and amortization expenses, are relatively fixed in the short term.
      If we sell fewer products than anticipated, if there is a delay in the launch
      of
      new products, or if prices for our products decline, we may not be able to
      quickly reduce our operating expenses in response to lower sales. Factors that
      could affect the amount and timing of our sales, and cause quarterly
      fluctuations in our revenue and operating results include:





·
            Length
                of the product sales cycle for certain products, especially those
                that are
                higher priced and more complex;


·
            Timing
                of product launches and market acceptance of new products for us
                as well
                as our competitors;


·
            Our
                ability to sustain product volumes and high levels of quality across
                all
                product lines;


·
            Timing
                of shipments for large orders;


·
            Effect
                of seasonality on sales and bookings;
                and


·
            Losing
                key accounts and not successfully developing new
                ones.





Our
      sales
      and operating results could also be affected by the following factors, some
      of
      which we have little or no control over:





·
            Fluctuating
                demand for telecommunications test and measurement equipment as well
                as
                life sciences and industrial
                solutions;


·
            Changes
                in the capital spending and operating budgets of our customers, which
                may
                cause seasonal or other fluctuations in product mix, volume, timing
                and
                number of orders we receive from our
                customers;


·
            Order
                cancellations or rescheduled delivery
                dates;


·
            Pricing
                changes by our competitors or
                suppliers;


·
            Customer
                bankruptcies and difficulties in collecting accounts
                receivable;


·
            Restructuring
                and impairment charges; and


·
            General
                economic conditions.





In
      addition, we may in the future choose to reduce prices, increase spending,
      or
      modify our product portfolio in response to actions by competitors or as an
      effort to pursue new market opportunities. These actions may also adversely
      affect our business and operating results and may cause our quarterly results
      to
      be lower than the results of previous quarters. Due to these factors, you should
      not rely on quarter-to-quarter comparisons of our results of operations as
      an
      indication of our future performance.








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**If
      we are unable to adapt to current and future changes in technology or if we
      are
      unable to introduce new and enhanced products on a timely basis, our products
      may become obsolete, which could prevent us from achieving our growth strategy
      and adversely affect our operating results.**





The
      industries that we target are characterized by rapidly evolving technology
      and
      industry standards that result in frequent new product introductions. Any
      failure by us to anticipate or respond to new technological developments,
      customer requirements or evolving standards could have a material adverse effect
      on our business, results of operations and financial condition. The development
      of proprietary technology entails significant technical and business risks
      and
      requires substantial expenditures and lead-time. The success of our new product
      introductions will depend on several factors, including our ability
      to:





·
            Properly
                identify and anticipate customer
                needs;


·
            Innovate
                and develop new products;


·
            Gain
                timely market acceptance for new
                products;


·
            Manufacture
                and deliver our new products on time and in sufficient
                volume;


·
            Price
                our products competitively;


·
            Continue
                investing in our research and development programs;
                and


·
            Anticipate
                competitors’ announcements of new
                products.





Failure
      to do the above could be exploited by our competitors. If we lose market share
      as a result of lapses in our product development, our business would
      suffer.





**If
      we fail to adapt appropriately to the challenges associated with operating
      internationally, the expected growth of our business may be impeded and our
      operating results may be affected.**





For
      the
      fiscal year ended August 31, 2006, customers outside of the United States and
      Canada accounted for 46.8% of our sales. Our international sales will be limited
      if we cannot establish and maintain relationships with international
      distributors, set up additional foreign operations, expand international sales
      channel management, hire additional personnel, develop relationships with
      international service providers and operate adequate after-sales support
      internationally. Even if we are able to successfully continue our international
      operations, we may not be able to maintain or increase international market
      demand for our products. Our international operations are subject to a number
      of
      risks, including:





·
            Challenges
                in staffing and managing foreign operations due to the limited number
                of
                qualified candidates, employment laws and practices in foreign countries,
                any of which could increase the cost and reduce the efficiency of
                operating in foreign countries;


·
            Our
                ability to comply with import/export, environmental and other trade
                compliance regulations of the countries in which we do business,
                together
                with unexpected changes in such
                regulations;


·
            Adhering
                to laws, regulations and contractual obligations relating to customer
                contracts in various countries;


·
            Difficulties
                in establishing and enforcing our intellectual property
                rights;


·
            Maintaining
                a competitive list of distributors for indirect
                sales;


·
            Tariffs
                and other trade barriers;


·
            Economic
                instability in foreign markets;


·
            Wars,
                acts of terrorism and political
                unrest;


·
            Language
                and cultural barriers;


·
            Integration
                of foreign operations;


·
            Currency
                fluctuations;


·
            Potential
                foreign and domestic tax
                consequences;


·
            Technology
                standards that differ from those on which our products are based,
                which
                could require expensive redesign and retention of personnel familiar
                with
                those standards;


·
            Longer
                accounts receivable payment cycles and possible difficulties in collecting
                payments which may increase our operating costs and hurt our financial
                performance; and


·
            Certification
                requirements.





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Any
      of
      these factors could harm our international operations and negatively affect
      our
      business, results of operations and financial condition. The recurrence of
      weakness in these economies or of weakness in other foreign economies could
      have
      a significant negative effect on our future operating results.





**We
      may make misjudgments in our strategic planning that could have material adverse
      effects on our business, results of operations and financial
      condition.**





We
      devise
      an annual strategic business plan, which is prepared by management and approved
      by our Board of Directors. This strategic plan, reviewed by management on a
      regular basis, is mainly based on market research and analysis related to future
      market trends and demands. In our strategic plans, we have made and will
      continue to make judgments based on our analysis of future market trends and
      requirements. These decisions may involve substantial investments in the
      development of new product lines, diversification of our business on a
      geographic basis, as well as expansion into new market segments — either
      organically or through acquisitions. We may make misjudgments in our strategic
      planning that could have material adverse effects on our business, results
      of
      operations and financial condition.





**If
      customers fail to meet their financial commitments to us, it could have a
      material adverse effect on our business, results of operations and financial
      condition.**




Some
      of
      our customers may experience, cash flow problems. Consequently, we may have
      customers who delay payments or may not be able to meet their financial
      commitments to us. Furthermore, they may not order as many products from us
      as
      originally forecasted or they may cancel their orders outright. The failure
      of
      customers to order products would result in decreased revenues for us. We
      attempt to reduce the possibility of large outstanding bills remaining unpaid
      by
      carrying out credit checks on customers and by having a diversified customer
      base. However, there is no assurance that such measures will reduce our exposure
      to customer credit risks. If customers fail to meet their financial commitments
      to us, it could have a material adverse effect on our business, results of
      operations and financial condition.





**As
      our customers consolidate, they may reduce or halt purchases of our products,
      which would harm our sales and operating results.**





Consolidation
      in the telecommunications industry could reduce the number of customers to
      which
      our products are sold. Some of our customers have been subject to consolidation
      and could obtain products from a vendor other than us, or demand more favorable
      terms and conditions from us, which would harm our sales and operating results.
      In addition, some customers may merge with or acquire our competitors and
      discontinue their relationships with us.





**If
      we fail to predict our supply requirements accurately, we will have excess
      inventory or insufficient inventory, either of which could cause us to incur
      additional costs and/or experience manufacturing delays.**





We
      provide non-binding forecasts of our requirements to some of our suppliers
      up to
      six months prior to scheduled delivery of products to our customers. If we
      overestimate our forecasted requirements, we may have excess inventory, which
      could harm our relationships with our suppliers due to reduced future orders,
      increase our costs and require inventory write-offs. If we underestimate our
      requirements, we may have an inadequate inventory of parts, which could
      interrupt manufacturing of our products and result in shipment delays. In
      addition, lead times for materials and parts that we order may be long and
      depend on factors such as the procedures of, or supply terms with, a specific
      supplier and demand for each part at a given time.








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**We
      depend on a single supplier or a limited number of suppliers for some key
      components and materials in our products, which makes us susceptible to supply
      shortages or price fluctuations that could adversely affect our operating
      results.**





We
      depend
      on a limited number of suppliers for some of the parts used to manufacture
      our
      products for which alternative sources may not be readily available. In
      addition, all our orders are placed through individual purchase orders and,
      therefore, our suppliers may stop supplying parts to us at any time. The
      reliance on a single source or limited number of suppliers could result in
      increased costs, delivery problems and reduced control over product pricing
      and
      quality. Financial difficulties of suppliers could also affect our ability
      to
      obtain necessary parts in a timely manner. Any interruption or delay in the
      supply of any of these parts could significantly harm our ability to meet
      scheduled product deliveries to our customers and cause us to lose sales.
      Furthermore, the process of qualifying a new manufacturer for complex parts,
      designed to our specifications, such as our optical and mechanical parts, is
      lengthy and would consume a substantial amount of time of our technical
      personnel and management. If we were required to change a supplier in a short
      period of time, our business would be disrupted. In addition, we may be
      unsuccessful in identifying a new supplier capable of meeting and willing to
      meet our needs on terms that we would find acceptable. Consolidation involving
      suppliers could further reduce the number of alternatives available to us and
      increase the cost of parts, which would make our products less competitive
      and
      result in lower margins.





**Recently
      enacted regulatory changes caused us to incur increased
      costs.**





Recently
      enacted changes in the laws and regulations affecting public companies,
      including the provisions of the Sarbanes-Oxley Act of 2002, increased our
      expenses as we devoted resources to respond to these new requirements. In
      particular, we incurred additional general administrative expenses to become
      compliant with Section 404 of the Sarbanes-Oxley Act, which requires management
      to report on internal controls over financial reporting. Compliance with new
      rules could also result in continued diversion of management’s time and
      attention, which could prove to be disruptive to normal business operations.
      Furthermore, the impact of these changes could make it more difficult for us
      to
      attract and retain qualified persons to serve on our Board of Directors or
      as
      executive officers, which could harm our business.





**We
      require employees and management resources who are knowledgeable about the
      specialized nature of our business. If we are unable to attract and retain
      sufficient numbers of highly skilled technical, sales, marketing, senior
      management and other personnel, our operations and financial results will
      suffer.**





Due
      to
      the specialized nature of our business, we are highly dependent on the continued
      service of and on the ability to attract qualified engineering, sales,
      marketing, senior management and other personnel. If we are unable to attract
      and retain such qualified personnel, it could have a material adverse effect
      on
      our business, results of operations and financial condition.





We
      must
      also provide significant training for our employee base due to the highly
      specialized nature of telecommunications test and measurement as well as life
      sciences and industrial technologies. Our current personnel may be inadequate
      and we may fail to assimilate and train new employees. Highly skilled employees
      with the education and training that we require - especially employees with
      significant experience and expertise, international business development,
      product management, sales, engineering and operation - may be difficult to
      find.
      Once trained, our employees may also be hired by our competitors or leave the
      organization.








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**Our
      intellectual property and proprietary technology are important to the continued
      success of our business. Our failure to protect this proprietary technology
      may
      significantly impair our competitive position.**





Our
      success and ability to compete depend to a significant extent on our proprietary
      technology, since that is how we attempt to keep others from using the
      innovations that are central to our existing and future products. We currently
      hold 27 actively-maintained granted patents from the U.S. (including one
“design” patent), eight from Canada, two from Germany, two from the United
      Kingdom, two from France, and one from China. In addition, EXFO has
      15 US patent applications in
      process, 14 Canadian patents applications in process, two from China,
      one from Germany and three Patent Cooperation Treaty patent applications
      pending. We also rely on a combination of copyright and trademark laws, trade
      secrets, confidentiality procedures, contractual provisions and license
      agreements to protect our proprietary technology. We may have to engage in
      litigation in order to protect our patents and other intellectual property
      rights, or to determine the validity or scope of the proprietary rights of
      others. Such litigation can be time-consuming and expensive, regardless of
      whether we win or lose. Because it is critical to our success that we are able
      to prevent competitors from copying our innovations, we intend to continue
      to
      seek patent protection or maintain trade secrets for our
      technologies.





The
      process of seeking patent protection can be long and expensive and we cannot
      be
      certain that any currently pending or future applications will actually result
      in issued patents, or that, even if patents are issued, they will be of
      sufficient scope or strength to provide meaningful protection or any commercial
      advantage to us. We also rely on trade secret protection for our technology,
      in
      part through confidentiality agreements with our employees, consultants,
      distributors and third parties. However, these agreements may be breached or
      otherwise not effective and we may not have adequate remedies for any breach
      or
      shortfall of these agreements. In any case, others may come to know about our
      trade secrets through a variety of methods. In addition, the laws of some
      territories in which we sell our products may not protect our intellectual
      property rights to the same extent as do the laws of Canada and the United
      States.





Our
      intellectual property rights, particularly our existing or future patents,
      may
      be invalidated, circumvented, challenged or required to be licensed to others.
      Furthermore, others may develop technologies that are similar or superior to
      our
      technology, duplicate or reverse engineer our technology, or design around
      the
      patents owned or licensed by us. We cannot be sure that the steps that we take
      to protect our technology will prevent misappropriation or infringement. If
      we
      fail to protect our technology so that others may copy or use it, we will be
      less able to differentiate our products and our sales will decline.





**Others
      may claim that our products infringe upon their intellectual property rights,
      or
      they may infringe our intellectual property, and we may expend significant
      resources enforcing or defending our rights or suffer competitive
      injury.**





Litigation
      regarding intellectual property rights is common in the technology industry
      and,
      for this reason we expect that third-party infringement claims involving
      technologies may increase. If an infringement claim is filed against us, we
      may
      be prevented from using some of our technologies and may incur significant
      costs
      to resolve the claim. Conversely, we may be required to spend significant
      resources to monitor and police our intellectual property rights.





We
      could
      incur substantial costs in defending ourselves and our customers against
      infringement claims or in bringing infringement claims against others.
      Litigation could also adversely affect sales of the challenged product or
      technology and divert the efforts of our management and technical personnel.
      In
      the event of an infringement claim, we may be required to obtain one or more
      licenses from third parties. We cannot assure you that we, or our customers,
      could obtain necessary licenses from third parties at a reasonable cost or
      at
      all. If we fail to obtain a license where one is required, we could incur
      substantial liabilities and be forced to suspend the marketing of the challenged
      products.








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**Our
      insurance may not be sufficient to cover all potential liability. A successful
      claim exceeding our policy limits will reduce our cash position, increase our
      expenses and have a negative effect on our business, operating results and
      financial condition.**





Our
      products are designed to help network service providers, cable operators and
      manufacturers of optical networks and components ensure network reliability.
      We
      also leverage our core telecom technologies for life sciences and industrial
      applications. The failure of our products to perform to client expectations
      could give rise to product liability and warranty claims. We carry insurance
      for
      product liability and take accounting reserves for warranty claims that we
      consider adequate in view of industry practice.





In
      addition, we may face other types of claims by third parties in relation to
      the
      conduct of our business; a successful claim against us for an amount exceeding
      our policy limits would force us to use our own resources to pay the claim,
      which could result in a reduction of our cash available for other uses, increase
      our expenses and have a negative effect on our business, results of operations
      and financial condition.





**We
      may become involved in costly and time-consuming litigation that may
      substantially increase our costs and harm our business.**





We
      may
      from time to time become involved in various lawsuits and legal proceedings.
      For
      example, we are a defendant in a putative securities class action filed in
      the
      United States District Court for the Southern District of New York involving
      approximately 300 other issuing companies. Litigation is subject to inherent
      uncertainties, and an adverse result in these or other matters that may arise
      from time to time could have a material adverse effect on our business, results
      of operations or financial condition. Any litigation to which we are subject
      could require significant involvement of our senior management and may divert
      management attention from our business and operations.





**If
      we suffer loss to our factories or facilities, our operations could be seriously
      harmed.**





Our
      factories and facilities are subject to catastrophic loss due to fire,
      vandalism, terrorism or other natural or man-made disasters. We do not have
      redundant multiple site capacity and if any of our facilities or factories
      were
      to experience a catastrophic loss, it would disrupt our operations, delay
      production, shipments and revenue and result in large expenses, thereby harming
      our results of operation.





**Unexpected
      declines in our research and development and other tax credits and grants may
      have an adverse effect on our business.**





Our
      historical operating results reflect substantial benefits from programs
      sponsored by federal and provincial governments for the support of research
      and
      development activities, as well as in relation to other activities. For example,
      research and development tax credits and grants represented 21.0% of our gross
      research and development expenses for the year ended August 31, 2006.





If
      unexpected changes in the laws or government policies terminate or adversely
      modify the Canadian and Quebec government programs, under which we receive
      the
      majority of our research and development and other tax credits and grants,
      or if
      we unexpectedly become unable to participate in or take advantage of these
      programs, then our net research and development and other expenses will
      materially increase or we may decrease our research and development activities.
      In addition, to the extent that we increase our research and development
      activities outside Canada or Quebec, which could result from, among other
      things, future acquisitions, the increased activities may not be eligible for
      these programs. If we were required to decrease our research and development
      activities, or were unable to benefit from other tax credits and grants, this
      could have a material adverse effect on our business, results of operations
      and
      financial condition.








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**Our
      current principal stockholder has effective control over our
      business.**





As
      of
      November 1, 2006, Germain Lamonde, our Chairman of the Board, President and
      Chief Executive Officer, held 92.3% of the voting rights in our stock. By virtue
      of such stock ownership, Mr. Lamonde has effective control over all matters
      submitted to our stockholders, including the election of our Directors, and
      exercises significant control over our policies and affairs. Such concentration
      of voting power could have the effect of delaying, deterring or preventing
      a
      change in control or other business combinations that might otherwise be
      beneficial to our stockholders.





**If
      we complete major acquisitions of complementary businesses, products or
      technologies, we may need additional capital, and may not be able to raise
      additional capital on favorable terms or at all, which could limit our ability
      to grow and could increase our costs.**





Our
      future liquidity and capital requirements are difficult to predict because
      they
      depend on numerous factors, including the success of our existing and new
      product offerings as well as competing technological and market developments.
      As
      a result, we may not be able to generate sufficient cash flows from our
      operations to meet additional working capital requirements, support additional
      capital expenditures or take advantage of acquisition opportunities.
      Accordingly, we may need to raise additional capital in the future.





Our
      ability to obtain additional financing will be subject to a number of factors,
      including market conditions and our operations performance. These factors may
      render the timing, amount, terms and conditions of additional financing
      unattractive for us. If we raise additional funds by selling equity securities,
      the relative ownership of our existing investors could be diluted or the new
      investors could obtain terms more favorable than previous investors. If we
      raise
      funds through debt financing, we could incur significant borrowing costs. If
      we
      are unable to raise additional funds when needed or at terms satisfactory to
      us,
      our ability to operate and grow our business could be impeded. As at August
      31,
      2006, we had $111.3 million in cash and short-term investments.





**Our
      business and operations would suffer in the event of a failure of our
      information technology infrastructure.**





We
      rely
      upon the capacity, efficiency and security of our information technology
      hardware and software infrastructures as well as our ability to expand and
      update these infrastructures in response to our evolving needs. Any failure
      to
      manage, expand or update our information technology infrastructures or any
      failure in the operation of this infrastructure could harm our
      business.





Our
      information systems are vulnerable to damages from computer viruses, natural
      disasters, unauthorized access and other similar disruptions. Any system
      failure, accident or security breach could result in disruptions to our
      operations. To the extent that any disruption or security breach results in
      a
      loss or damage to our data, or inappropriate disclosure of our confidential
      information, it could harm our business. In addition, these events may force
      us
      to devote more money and resources in order to protect ourselves against damages
      caused by these disruptions or security breaches in the future.




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**Item
      4.**  **Information
      on the Company**




**A.**  **History
      and Development of the Company** ****





Our
      legal
      name and commercial name is EXFO Electro-Optical Engineering Inc. /EXFO
      Ingénierie électro-optique inc. Our head office is located at 400 Godin Avenue,
      Quebec, Quebec, Canada, G1M 2K2 and our main telephone number is (418) 683-0211.
      Our e-mail address is info@exfo.com and our website is www.exfo.com.
      Information on our website is not incorporated by reference in this annual
      report. Our agent for service in the United States is CT Corporation
      System, 111 Eighth Avenue, New York, New York 10011. Our Transfer Agent and
      Registrar is CIBC Mellon Trust Company, 2001 University Street, Suite 1600,
      Montreal, Quebec, Canada, H3A 2A6. This annual report contains trademarks
      and registered trademarks of us and other companies.





We
      were
      incorporated on September 18, 1985 pursuant to the *Canada
      Business Corporations Act.* Since
      that date, we have amended our articles on various occasions mainly
      to modify our legal and corporate names and our share capital.





On
      December 20, 2000, we acquired all of the shares of EXFO Burleigh Products
      Group
      Inc. (formerly Burleigh Instruments, Inc.) (“EXFO Burleigh”), Burleigh
      Instruments GmBH and Burleigh Instruments (U.K.) Ltd. for an aggregate purchase
      price of US$189.3 million, comprised of 6,488,816 of our subordinate voting
      shares and US$42.5 million in cash pursuant to the terms of an Agreement of
      Merger and Plan of Reorganization among us, EXFO Sub, Inc. and the selling
      shareholders, dated November 4, 2000, as amended on December 20, 2000. In
      April  2002,
      the
      name of Burleigh Instruments, Inc. was changed to EXFO Burleigh Products Group
      Inc. On November 12, 2002, Burleigh Instruments (UK) Ltd. was dissolved. EXFO
      Burleigh is a U.S. company, which was manufacturing precision scientific
      instruments used in basic and applied research engineering and production test
      applications in a variety of fields.





On
      March
      15, 2001, we acquired all of the shares of EXFO Photonic Solutions Inc.
      (formerly EFOS Inc.) (“EXFO Photonic”), a privately held company in Toronto,
      Canada, for a total consideration of US$110.1 million, of which US$25.1 million
      was paid in cash. We also issued 3,700,000 of our subordinate voting shares
      in connection with the acquisition. In September 2001, the name EFOS Inc. was
      changed to EXFO Photonic Solutions Inc.





EXFO
      Photonic, operating since 1984, is a supplier of precision light-based adhesive
      spot curing products as well as curing process control for the global optical
      component manufacturing market and other non-telecom markets. Its products
      deliver precise doses of the appropriate spectral light into photo-sensitive
      and
      heat-cured adhesives to significantly reduce bonding time and increase
      repeatability in optical component and other manufacturing activities. EXFO
      Photonic light-based curing technologies are supported by an extensive
      understanding of bonding and material sciences and by a broad intellectual
      property portfolio, including, as of November 1 2005, 15 patents
      and 12 patents pending.





Also
      on
      March 16, 2001, our wholly owned subsidiary, Burleigh Automation Inc. (“Burleigh
      Automation”), acquired substantially all the assets of Vanguard Technical
      Solutions, Inc., a wholly owned subsidiary of DT Industries, Inc. for a purchase
      price of US$600,000 paid in cash. Vanguard, an automation equipment manufacturer
      in Tucson, Arizona, specialized in the design and manufacturing of
      ultra-precision assembly equipment for sensitive process and critical assembly
      challenges on the production floor. This acquisition, which complemented our
      acquisition of Burleigh, was planned to fit with our overall strategy at that
      time of providing customers with a comprehensive solution for the assembly,
      alignment and testing of optical components and subsystems. Since September
      2001, Burleigh Automation has ceased operations and we have transferred all
      material intellectual property assets and most of the physical assets of
      Burleigh Automation to EXFO Burleigh.





In
      November 2001, we acquired all of the shares of Avantas Networks Corporation
      and
      simultaneously changed the name of that company to EXFO Protocol Inc. (“EXFO
      Protocol”). We paid a total consideration of US$69.4 million (or US$95.0 million
      for the equity minus US$25.6 million of cash in the hands of the acquired
      company) to acquire EXFO Protocol. Consideration paid consisted of 4,374,573
      of
      our subordinate voting shares and US$9.8 million in cash, net of cash acquired.
      EXFO Protocol, a company based in Montreal, Canada operating since 1998 is
      a
      supplier of fiber-optic testing and optical network performance management
      equipment that supports a wide range of protocols and data transmission
      rates.





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During
      fiscal 2001, we were forced to align our cost structure to market conditions.
      On
      June 27, 2001, we announced the reduction of non-customer-related expenses,
      postponement of plans to build a new facility in the Quebec Metro High-Tech
      Park, termination of non-cure operations of Nortech, a subsidiary that
      specialized in manufacturing fiber-optic temperature sensors and reduction
      of
      our work force by 15%.





During
      fiscal 2002, we were forced to **** re-align
      our cost structure to market conditions. First, on December 5, 2001, we
      announced the lowering of our operating expenses, a freeze in employee salaries,
      and the reduction of our workforce by 10%. Then, on May 15, 2002, we
      announced a further 20% reduction of our global workforce in an effort to lower
      our cost structure. In May 2002, we performed an assessment of the carrying
      value of goodwill and intangible assets recorded in conjunction with the three
      acquisitions made during the previous eighteen (18) months. Considering the
      ongoing unfavorable market conditions, we recorded a charge of
      US$222.2 million to write down a significant portion of goodwill and a
      charge of US$23.7 million to write down a significant portion of acquired core
      technology. Also, overall for fiscal 2002, we wrote off US$18.5 million in
      excess and obsolete inventories.





In
      August
      2002, EXFO Burleigh received confirmation of the extension of its contract
      with
      the U.S. Air Force Research Laboratory into phase 2 of a project for the
      development by EXFO Burleigh of new high-precision actuator system. The contract
      for phase 2 provided for an additional funding of US$1.7 million and extended
      through the first quarter of 2005.





In
      October 2002, our newly created, wholly owned subsidiary, EXFO Gnubi Products
      Group Inc. (“EXFO Gnubi”), acquired substantially all the assets of *gnubi
      communications L.P.,* including its technology, expertise, customer base, inventories and capital
      assets. Consideration paid consisted of US$1.9 million in cash and
      1,479,290 of our subordinate voting shares. Furthermore, an additional cash
      amount of US$241,000, based on sales volumes, was paid in fiscal 2004 in
      accordance with earn out provisions. With the acquisition of these assets,
      EXFO
      Gnubi, based in Dallas, Texas, continues the operations of *gnubi
      communications, L.P.,* as a
      supplier of multi-channel telecom and datacom testing solutions serving optical
      transport equipment manufacturers and research and development laboratories.
      At
      the time of the asset acquisition, 30 employees of gnubi communications
      transferred to EXFO Gnubi.





During
      fiscal 2003, we were required to implement further restructuring measures as
      a
      result of depressed spending levels in the telecommunications industry and
      geo-political and economic uncertainty. We reduced our workforce by 30%,
      rationalized our business activities and consolidated certain manufacturing
      operations. These measures incurred charges of US$4.1 million. The
      rationalization and consolidation initiatives involved the reorganization of
      our
      business into two new reportable market segments: Telecom Division and Photonics
      and Life Sciences Division and the exiting of the optical component
      manufacturing automation business. Our Telecom Division consists of the former
      Portable and Monitoring and telecom related Industrial and Scientific product
      lines. Our Photonics and Life Sciences Division includes previous non-telecom
      Industrial and Scientific product lines. Each division has been structured
      with
      its own sales, marketing, manufacturing, research and development and management
      teams.





In
      May
      2003, we performed our annual impairment test on goodwill recorded in
      conjunction with the acquisitions of EXFO Burleigh, EXFO Photonic and EXFO
      Protocol and also reviewed the carrying value of intangible assets related
      to
      these acquisitions. As a result of this assessment, we concluded that the
      carrying value of goodwill related to EXFO Burleigh and the carrying value
      of
      intangible assets related to EXFO Burleigh and EXFO Photonic was impaired and
      we
      recorded a charge of US$4.5 million to write down goodwill and a pre-tax charge
      of US$2.9 million to write down acquired core technology. Of the total
      impairment loss of US$7.4 million, US$6.9 million is related to EXFO
      Burleigh for goodwill and acquired core technology and US$0.6 million is related
      to EXFO Photonic for acquired core technology.





In
      addition, in an effort to simplify our structure and stream-line our operations,
      the operations of EXFO Protocol were merged with those of the Corporation as
      of
      September 1, 2003 and effective December 1, 2003, the operations of
      EXFO Gnubi were merged with those of EXFO America Inc.





In
      fiscal
      2004, EXFO also closed a public offering of 5.2 million subordinate voting
      shares to a syndicate of Canadian-based underwriters for net proceeds of $29.2
      million (CA$38.4 million).





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Furthermore
      in fiscal 2004, we consolidated our protocol test operations (EXFO Protocol
      and
      EXFO Gnubi) in Montreal, Canada to improve efficiency and reduce costs.





In
      March
      2004, we renewed our collective bargaining agreement with unionized
      manufacturing employees in Quebec City, Canada. Such agreement will expire
      in
      February 2009.





During
      fiscal 2005, our Photonics and Life Sciences Division was renamed the Life
      Sciences and Industrial Division to better reflect its market
      focus.





During
      fiscal 2005, we completed the consolidation of our Life Sciences and Industrial
      Division in Toronto and we recorded $482,000 in restructuring expenses.
      Altogether, we incurred $2.5 million in restructuring and other charges since
      the fourth quarter of 2004 in conjunction with this consolidation process.
      Following this process all of the operating activities of EXFO Burleigh were
      transferred mainly in Toronto.





In
      January 2006, we acquired substantially all the assets of Consultronics Limited
      (“Consultronics”), a leading supplier of test equipment for copper-based
      broadband access networks. Consultronics is a privately held company based
      in
      Toronto with subsidiaries in the United Kingdom and Hungary. We acquired all
      of
      the subsidiaries’ respective issued and outstanding shares. Consultronics
      specializes in x-Digital Subscriber Line (xDSL), Internet Protocol TV (IPTV)
      and
      Voice-over-Internet Protocol (VoIP) test solutions for the broadband access
      market. We paid consideration equal to approximately US$19.1 million, including
      debt assumption and other acquisition-related costs.








**B.**  **Business
      Overview**





**Company
      Overview**




EXFO
      is a
      recognized test and measurement expert in the global telecommunications
      industry. The Telecom Division, which represents our main business activity,
      offers fully integrated and complete test solutions to network service providers
      (NSPs), cable TV operators, telecom system vendors and component manufacturers
      in approximately 70 countries. We are the global market leader for portable
      optical test solutions and a leading supplier of protocol and copper access
      test
      solutions to enable triple-play services over converged, IP networks. Our
      PC/Windows-based modular FTB-200; FTB-400 and IQS-500 test platforms host a
      wide
      range of test solutions across optical, physical, data and network layers,
      while
      maximizing technology reuse across several market segments. Our Life Sciences
      and Industrial Division, which leverages several core telecom technologies,
      offers value-added solutions in the life sciences and high-precision assembly
      sectors based on advanced spot-curing, fluorescence microscopy and
      nanopositioning solutions.





We
      were
      founded in 1985 in Quebec City, Canada. Our original products were focused
      on
      the needs of installers and operators of fiber-optic networks. Customers use
      these field-portable testing products for the installation, maintenance,
      monitoring and troubleshooting of optical networks. In 1996, we supplemented
      our
      product portfolio with an extensive line of high-end products that are mainly
      dedicated to research and development as well as manufacturing activities of
      optical component manufacturers and system vendors.







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In
      January 2006, we acquired substantially all the assets of Consultronics Limited,
      a leading supplier of test equipment for copper-based broadband access networks.
      Consultronics, a privately held company based in Toronto with operations in
      the
      United Kingdom and Hungary, specializes in x-Digital
      Subscriber Line (xDSL), Internet Protocol TV (IPTV) and Voice-over-Internet
      Protocol (VoIP) test
      solutions for the broadband access market. We paid consideration equal to
      approximately US$19.1 million, including debt assumption and other
      acquisition-related costs.




This
      acquisition enables us to offer customers an end-to-end solution for their
      broadband access testing needs, extending from the central office to the home
      or
      enterprise. Prior to the acquisition, EXFO did not test the “last mile” in
      fiber-to-the-curb (FTTC) or fiber-to-the-node (FTTN) configurations, which
      use
      copper as a medium of transmission. EXFO intends to leverage Consultronics’
strong product portfolio across its global sales channels and create new test
      solutions by combining the technologies of the respective
      companies.




In
      previous years, we acquired two protocol test businesses to expand our product
      offering and address our customers’ requirements more completely. In November
      2001, we acquired Avantas Networks Corporation (renamed EXFO Protocol Inc.),
      a
      supplier of protocol-testing and optical-network performance management
      equipment for NSPs. This transaction was highly strategic because it enabled
      us
      to combine optical and protocol test modules inside a single field-portable
      test
      platform to help our customers increase revenues and reduce operating costs.
      In
      October 2002, our wholly-owned subsidiary, EXFO Gnubi, purchased substantially
      all the assets of gnubi communications, L.P., a supplier of multi-channel
      telecom and datacom testing solutions for the system manufacturer market. These
      strategic acquisitions, which were consolidated in Montreal in fiscal 2004,
      enabled us to more than double our addressable market, as we expanded from
      optical testing to protocol testing applications, and
      to
      offer a more complete line of test solutions to our customers.




Earlier,
      we had completed two acquisitions to bolster growth in the optical component
      manufacturing market. We acquired Burleigh Instruments, Inc. (renamed EXFO
      Burleigh Products Group Inc.) in December 2000 for its wavelength measurement
      instruments and nanopositioning alignment systems. We also added EFOS Inc.
      (renamed EXFO Photonic Solutions Inc.) in March 2001 for its precision
      light-based, adhesive spot-curing technology. We have since exited the optical
      component manufacturing automation business and consolidated the rest of these
      operations under our Life Sciences and Industrial Division in Toronto.




In
      fiscal
      2006, we launched 18 new products, including
      amongst others, the two-slot FTB-200 Compact Platform for multi-layer and
      multi-medium testing; the handheld AXS-100 OTDR for fiber-to-the-x (FTTx) test
      applications; SONET/SDH test modules reaching transmission rates up to 10 Gb/s
      for the FTB-200 Compact Platform; next-generation SONET/SDH test modules
      reaching 10 Gb/s for the FTB-400 field-test and
      IQS-500 R&D/manufacturing platforms; the next-generation CoLT-450P, a
      handheld IPTV and xDSL test solution for high-speed, copper-based networks;
      and
      the PPM-352B-EG
      Passive Optical Network (PON) Power Meter optimized for Ethernet PON and Gigabit
      PON architectures.




In
      fiscal
      2006, we also continued our dominance in the FTTx
      test
      market by recognizing significant revenue from leading carriers deploying fiber in their access networks. Our top customer accounted for 13.8%
      of sales in 2006.




In
      the
      first quarter of fiscal 2006, we were selected as sole-source supplier for
      all
      fiber deployment test applications — including FTTx — by Deutsche
      Telekom.




In
      the
      third quarter of 2006, EXFO was named recipient of the 2006 Growth Strategy
      Leadership Award by Frost & Sullivan, a leading market research firm in the
      telecommunications test sector. The award is presented annually to the company
      whose organic growth strategy generates the largest market-share gains in the
      global fiber-optic test equipment market in the previous year. Based on a report
      by Frost & Sullivan, we increased our market share from 10.3% in 2004 to
      11.0% in 2005. This marked the third consecutive year that we earned this
      industry award.







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Frost
      & Sullivan also presented EXFO with its Product Differentiation Innovation
      Award in 2006. We received this award in recognition of our ground-breaking
      solutions offered in the next-generation and legacy SONET/SDH test equipment
      market. Basically, we developed a single SONET/SDH solution with a
      multi-platform approach to meet various customer needs, market segments and
      price points.




Finally,
      we recorded a foreign-exchange loss of $0.6 million in fiscal 2006 due to the
      significant increase in the value of the Canadian dollar versus the US dollar
      during that year. In addition to this foreign exchange loss, our P&L
      (profits and losses) line items in 2006 were also negatively affected by the
      appreciation of the Canadian dollar, since a significant portion of our expenses
      are incurred in Canadian dollars while we report our results in US dollars.




**Key
      Industry Trends and Strategy**




Global
      market demand for telecom test and measurement equipment should remain strong
      in
      the years to come as most NSPs are increasing capital expenditures to upgrade
      their networks for converged IP services and triple-play offerings. These market
      forces create needs for differentiated test solutions to help NSPs accelerate
      deployment and ensure service quality in their network
      build-outs.





***Expecting
      IPTV to drive IP migration***





With
      the
      ongoing globalization of the world’s economy and the emergence of new consumer
      markets, NSPs are poised to capitalize on growing demand for communications
      and
      entertainment services. Early in 2006, some small telecom operators launched
      broadcast-quality video services based on IP communications. This technology,
      better known as IPTV, allows telephone companies (telcos) to efficiently offer
      TV, HDTV and interactive TV services to their broadband subscribers. Tier-1
      and
      Tier-2 telcos are expected to launch similar IPTV services on a large-scale
      basis starting in 2007. While Web-based streaming video is offered for free
      on a
      best-effort basis, IPTV, whom many regard as the broadband “killer application,”
will require a high level of performance to assure a quality user experience.
      NSPs, after all, don’t want customer churn to prevent a meaningful return on
      their massive investments.





To
      deliver a wide range of differentiated IP services, NSPs will continue
      transforming their legacy, circuit-switched networks into highly efficient,
      flexible and scalable packet-based IP architectures. Telcos and cablecos have
      already proven they can generate significant revenues from higher-margin
      services on hybrid networks, while reducing operating costs. IPTV should only
      accelerate the migration towards fully converged, IP-based networks, since
      it
      typically allows NSPs to nearly double average revenue per user
      (ARPU).





***Extra
      bandwidth in access networks***





The
      increasing reliance on telecom and IP-related services will continue driving
      bandwidth consumption, thus pushing the deployment of fiber deeper into access
      networks. Competition between telcos and cablecos has intensified as triple-play
      offerings are announced almost daily. Hybrid architectures combining copper
      and
      fiber (FTTC and FTTN) will keep expanding worldwide, since this is the quickest
      and least expensive method to increase bandwidth. To remain competitive with
      cablecos, telcos are migrating from former ADSL, to current ADSL2+, and onto
      future VDSL2+ technologies as interoperability becomes demonstrable. Telcos,
      however, will increasingly opt for all-fiber, PON-based architectures (FTTP)
      to
      meet heightened bandwidth requirements and to future-proof their networks.
      These
      decisions will be taken not only for green-field deployments and high-rise
      buildings, but on a larger scale as operating costs are less than FTTC and
      FTTN
      architectures and cost of deployments are falling. We are still in
      the early stages of building access networks around the world.





***Expanding
      metro and long-haul networks***





Metro
      network deployments, taking advantage of carrier-grade Ethernet and
      metro-Ethernet technologies are moving ahead to handle large increases in
      bandwidth consumption in access networks. These network upgrades, in turn,
      will
      eventually place a strain on long-haul networks, where excess capacity created
      by massive overspending in the late-90s is gradually being consumed. NSPs are
      more than ever committed to deploying next-generation SONET/SDH transport
      technologies, while 40 Gb/s deployments are not far behind.





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***Positioning***





We
      anticipated these market trends and directed a significant part of our R&D
      efforts to bring NSPs the distinctive product offerings they have come to expect
      from EXFO for installation and maintenance applications and, increasingly,
      for
      network quality assurance. In addition, we have increased interaction with
      system vendors, both in terms of partnerships and product offerings, since
      they
      are the key players defining and designing the networks of the future.
      Consequently, we have widened our competitive advantage, based on our FTB-200,
      FTB-400 and IQS-500 modular platforms and broad suite of test modules, and
      developed new test solutions for converged, IP networking. We are confident
      that we will commercially leverage our technological leadership in installation
      and maintenance applications — up to 10 Gb/s Ethernet and 10 Gb/s
      next-generation SONET/SDH testing.





On
      the
      optical testing side, we have strengthened our market position for access
      networks both in terms of new network architectures (FTTH, FTTC, FTTN) and
      technologies (BPON, GPON, EPON). We expect to enhance our presence with an
      expanded offering for twisted copper pair testing of IPTV and VoIP services
      in
      the last mile now that Consultronics has been fully integrated and we
      will
      take advantage of our technical expertise in optical testing for upcoming
      deployments of 40 Gb/s systems in long-haul networks. In general, we will expand
      our product offering from access to core, touching on various levels of the
      network to fuel our long-term growth.





***Expertise
      in life sciences and industrial markets***





On
      the
      life sciences and industrial side, we plan to continue leveraging technologies
      developed or acquired for optical component manufacturing applications in
      non-telecom markets. We have achieved promising results in the life sciences
      and
      industrial markets.





·
            Our
                OmniCure product line, focused on UV spot-curing applications, has
                enjoyed
                significant growth within the medical and optoelectronics
                industries. These diverse markets, largely influenced by the
                miniaturization trend, are expanding worldwide with Asia showing
                the
                largest year-over-year growth.





·
            Our
                X-Cite series, an add-on illumination system for high-end microscopes,
                has
                entrenched itself as a market leader in various research areas. The
                global
                fluorescence microscopy market is growing in mid single digits, while
                live
                cell and quantitative imaging are increasingly gaining
                traction.





·
            Our
                Burleigh nano-positioning product line, mainly designed for cellular
                micromanipulation, continues to demonstrate strong brand-name recognition
                and loyal following with electrophysiologists. It targets a stable
                growth
                market focused on fundamental neuroscience and drug
                discovery.





**Fiscal
      2007 Corporate Objectives**





EXFO
      remains committed to best practices in corporate governance and, as such, we
      are
      pleased to provide the following performance metrics for fiscal 2007. Please
      note that these management goals should not be confused with, and are not
      intended to be, guidance.


·
            **Grow
                revenues by 20% year-over-year.**We
                were among the last companies to be impacted by the telecommunications
                downturn in 2001 and first to recover with sales growth of 20.5%
                in fiscal
                2004, 30.3% in 2005 and 31.9% in 2006, including 12 consecutive
                quarters of growth. This recovery was accomplished mainly through
                market-share gains, since our end-markets reportedly experienced
                negative
                growth in fiscal 2004 and increased in the mid single digits in 2005
                and
                2006. We will strive to maintain a high growth rate in 2007 by seeking
                to
                further increase our market share in telecom testing, especially
                in the
                rapidly growing protocol test segment, and by seeking to leverage
                core
                technologies in targeted life sciences and industrial markets.


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·
            **Generate
                a GAAP earnings from operations of 7%.**Our
                bottom-line improved faster than our top-line in the last few years
                with a
                GAAP earnings from operations of 6.3% in fiscal 2006. We expect that
                our
                GAAP earnings from operations will continue to improve in 2007 as
                we
                expect that higher-margin protocol revenues, better absorption of
                fixed
                costs on higher sales volumes, specific internal initiatives, and
                currency
                stability will come into play.





·
            **Derive
                35% of sales from new products (on the market two years or less).**Despite
                missing this aggressive innovation target in recent years, our new
                products, with their built-in superior performance and lower cost
                of
                goods, contributed significantly to raising our gross margin and
                earnings
                from operations. We are maintaining this innovation metric for 2007
                based
                on our market-driven focus and enhanced portfolio of new products
                (18 new
                products) released in the past
                year.





**The
      EXFO Solution**




We
      offer
      an extensive range of test and measurement solutions to the global
      telecommunications industry. Our success has been largely predicated on our
      core
      expertise in optical telecommunications. We also leverage this expertise to
      develop products for life sciences and high-precision assembly applications.
      Our
      solution is based on the following key attributes:




***Modular
      System Design.*** In
      1996,
      we established an industry-first by launching the original modular optical
      test
      platform. This system design consists of a PC-based, Windows-driven platform
      that can accommodate several test modules performing various types of
      measurements. We have since developed new compatible test platforms and extended
      our test module offering for both NSPs and system manufacturers based on the
      same modular design. Our modular design provides the following
      advantages:




·
            Unlike
                stand-alone units, new test modules can be rapidly developed to address
                changing industry requirements.




·
            As
                customers’ testing requirements change, they can purchase additional
                modules that are compatible with their previously purchased platforms,
                thus protecting their initial
                investments.




·
            Our
                standard graphical user interface reduces training costs because
                customers
                are familiar with previously acquired software
                products.




·
            The
                flexibility of our systems allows customers to develop customized
                and
                automated solutions for their specific test
                requirements.




·
            Our
                test platforms are PC-based and Windows-driven, thus they can support
                third-party software solutions.




***High
      Degree of Technological Innovation.*** We have
      established a strong reputation for technological innovation over the last
      21
      years. In fact, we believe this attribute represents a key differentiator for
      us
      within a competitive marketplace. Following are some of our industry
      firsts:




·
            The
                first PC-based modular test platform for field
                applications;




·
            The
                first all-in-one optical loss test set combining several
                instruments;




·
            The
                first portable polarization mode dispersion (PMD)
                analyzer;




·
            The
                first modular platform to combine optical and protocol test
                solutions;




·
            The
                first line of portable test instruments designed for FTTx testing;
                and




·
            The
                first fully integrated Ethernet-over-SONET test
                solution.







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***High-Quality
      Products.*** Product
      quality is an integral part of our solution. Our Quebec City, Canada, operations
      have maintained ISO 9001 certification since 1994 and they are now certified
      to
      the new 2000 edition of the standard, as are our Toronto, Canada, and Concord,
      Canada, operations. Our manufacturing plant in Montreal, Canada, received
      ISO 9001/2000 certification on November 16, 2005. All of our products meet
      required industry standards, and some of our products meet additional voluntary
      standards, such as those set by Telcordia, formerly Bellcore, IEC, and other
      industry-leading standards bodies. During manufacturing, each product has a
      related quality assurance plan, with rigorous checkpoints, to ensure product
      conformity. Various tasks in the quality assurance process among all our
      facilities include quality control, conformity testing, product documentation,
      product improvement, regulatory compliance, metrology and
      calibration.




Our
      product designs comply with Directive 2002/96/EC, a legislation enacted by
      the
      European Union regarding the disposal of waste electrical and electronic
      equipment (WEEE), for all products exported to Europe. In regard to the
      Directive 2002/96/EC (RoHs), we and other test and measurement manufacturers
      have been warranted an unlimited exemption.




**Products**




Our
      test
      platforms, namely the new FTB-200 Compact Platform, FTB-400 Universal Test
      System (UTS), and IQS-500 Intelligent Test System (ITS), are at the core of
      our
      product portfolio. The FTB-200 Compact Platform, which was launched in January
      2006, is a
      two-slot portable test unit optimized for multi-technology, multi-application
      characterization of metro and access networks. The
      FTB-400 field-testing platform provides NSPs with a simple, yet efficient way
      to
      perform multiple, advanced test operations for installation, maintenance and
      troubleshooting applications. Our IQS-500 ITS, designed for manufacturing and
      R&D applications, tests optical as well as telecom and datacom technologies
      increasingly based on IP technology. All platforms and related test modules
      are
      supported by integrated and highly intuitive graphical user interfaces (GUIs),
      enabling the user to easily store, handle and retrieve a large amount of data.
      In addition, EXFO offers a number of purpose-built hand-held and benchtop test
      and measurement products, some of which are modular in nature. Furthermore,
      EXFO
      offers network monitoring systems and test heads used in third-party network
      monitoring solutions.





The
      following table summarizes the principal types of test instruments for the
      telecommunications industry, typical applications and the formats in which
      we
      offer them:




**Format****Instrument
                Type**
            **Typical
                Application**
            **NSP
                Market**
            **Manufacturer/R&D
                Market****FTB
                400**
              **Modules**
            **FTB
                200****Modules**
            **Handhelds**
            **IQS-500**
              **Modules**
            **Benchtop**
              **Instruments**ADSL/ADSL2+
                Service Verification Tool
            Based
                on a DSL “golden modem”, these units are used to test the function, speed
                and quality of a DSL service at the subscriber premises.
            
            
            XBroadband
                source
            Used
                for testing wavelength-dependent behavior of fiber cables and DWDM
                optical
                components.
            
            
            
            X
            XChromatic
                dispersion analyzer
            Measures
                increasing levels of chromatic dispersion in high-capacity optical
                networks. Chromatic dispersion is a physical phenomenon inherent
                to
                optical fiber and optical components that causes information bits
                to
                spread along a network. This degrades the quality of the transmission
                signal and, in turn, limits the transmission speed carried by optical
                networks.
            XClip-on
                coupling device
            Clips
                to an optical fiber and allows non-invasive testing.
            
            
            X





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**Format****Instrument
                Type**
            **Typical
                Application**
            **NSP
                Market**
            **Manufacturer/R&D
                Market****FTB
                400**
              **Modules**
            **FTB
                200****Modules**
            **Handhelds**
            **IQS-500**
              **Modules**
            **Benchtop**
              **Instruments**Fibre
                Channel tester
            Brings
                FC-0, FC-1 and FC-2 logical layer Fibre Channel testing to services
                delivered viatransportprotocols,
                such as DWDM, SONET/SDHand dark fiber. It provides valuable timing information and buffer
                credit
                estimation for Fibre Channel network deployment.
            X
            
            
            XGigabit
                Ethernet tester
            Measures
                data integrity for high-speed Internet protocol telecommunications
                in
                metro and edge networks.
            X
            X
            
            X10
                Gigabit Ethernet tester
            Benchmarks
                and verifies high-speed 10 Gbit/s Ethernet network performance and
                service-level agreements.
            X
            X
            
            XHDTV,
                SDTV and IPTV service test instrument
            Used
                to test the quality and functionality of standard and high definition
                television signals that are delivered over higher-rate ADSL, ADSL2+
                and
                VDSL2 transmission technologies.
            
            
            XLaser
                wavelength meter
            Performs
                high-accuracy, absolute wavelength measurements of continuous wave
                (CW)
                laser sources.
            
            
            
            
            XLaser
                spectrum analyzer
            Performs
                high-resolution, spectral characterization of continuous CW laser
                sources
            
            
            
            
            XTelephone
                for traditional voice and VoIP service testing
            Used
                by telephone line and DSL installers to test the proper functioning
                of
                both traditional and next-generation voice and data communication
                services.
            
            
            XLive
                fiber detector
            Clips
                on to a fiber and is used to detect the presence and direction of
                a signal
                without interrupting the traffic.
            
            
            XLoss
                test set
            Integrates
                a power meter and a light source to manually or automatically measure
                the
                loss of optical signal along a fiber.
            X
            X
            X
            X
            XMultiwavelength
                meter
            Measures
                the power and drift for multiple wavelengths in a DWDM
                system.
            X
            
            
            X
            XNarrowly
                tunable laser
            A
                laser that can be precisely tuned to simulate a DWDM light sources.
                Used
                primarily for testing optical amplifiers.
            
            
            
            XNext-generation
                SONET/SDH analyzer
            Full
                SONET/SDH protocol testing functionality, including support for GFP,
                V.CAT, and LCAS next generation enhancements.
            X
            
            
            XOptical
                amplifier
            Boosts
                the power of laser sources. Used for the testing and calibration
                of test
                systems.
            
            
            
            XOptical
                coupler
            Used
                in test system to combine sources or signals. Also used as splitters
                to
                monitor signals.
            
            
            
            X








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**Format****Instrument
                Type**
            **Typical
                Application**
            **NSP
                Market**
            **Manufacturer/R&D
                Market****FTB
                400**
              **Modules**
            **FTB
                200****Modules**
            **Handhelds**
            **IQS-500**
              **Modules**
            **Benchtop**
              **Instruments**Optical
                fiber parameter analyzer
            Measures
                the geometric and light guiding properties of an optical fiber. Used
                in
                new fiber research and development and quality control
                applications.
            
            
            
            
            XOptical
                power meter
            Measures
                the power of an optical signal. It is the basic tool for the verification
                of transmitters, amplifiers and optical transmission path
                integrity.
            X
            X
            X
            X
            XOptical
                power reference module
            Provides
                a highly accurate and traceable measurement of power for the calibration
                or verification of other power measurement instruments.
            
            
            
            XOptical
                return loss meter
            Combines
                a laser and a power meter to measure the amount of potentially degrading
                back reflection.
            X
            X
            X
            XOptical
                spectrum analyzer
            Produces
                a graphical representation of power versus wavelength for an optical
                signal. Useful for measuring the drift, power and signal-to-noise
                ratio
                for each wavelength in a DWDM system.
            XOptical
                switch
            Provides
                switching between fibers. Used to provide flexible and automated
                test
                setups such as the measurement of multiple fibers or components with
                multiple ports with one instrument.
            X
            
            
            XOptical
                time domain reflectometer
              (OTDR)
            Like
                a radar, it measures the time of arrival of reflections of an optical
                signal to determine the distance to the breaks or points of excessive
                loss
                in a fiber network.
            X
            X
            XOptical
                waveguide analyzer
            Provides
                the refractive index profile of glass and fused silica-based devices
                used
                in next generation networks.
            
            
            
            
            XPassive
                component analyzer
            Characterizes
                passive wavelength-selective devices, such as multiplexers, demultiplexers
                and add/drop filters, with respect to absolute wavelength in order
                to
                guarantee their performance within DWDM systems.
            
            
            
            
            XPassive
                optical network (PON) power meter
            Determines
                the power level of various signal types, including continuous (e.g.,
                TV
                signal at 1550 nm) and framed (e.g., ATM or Ethernet at 1490 nm or
                1310
                nm) within a passive optical network. Various baud rates are covered,
                ranging from 155 Mbit/s to 2.5 Gbit/s, for both synchronous and
                non-synchronous signals.
            
            
            XPolarization-dependent
                loss meter
            Measures
                the difference in loss of power for the different states of
                polarization.
            
            
            
            XPolarization
                mode dispersion analyzer
            Measures
                the dispersion of light that is caused by polarization. Generally
                used to
                determine the speed-distance limitation of fiber and
                cables.
            XSONET/
                SDH analyzer
            Provide
                accurate bit-error rate and performance analysis of SONET/SDH overhead
                format that reflect the quality of a transmission system.
            X
            X
            
            X








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**Format****Instrument
                Type**
            **Typical
                Application**
            **NSP
                Market**
            **Manufacturer/R&D
                Market****FTB
                400**
              **Modules**
            **FTB
                200****Modules**
            **Handhelds**
            **IQS-500**
              **Modules**
            **Benchtop**
              **Instruments**Stable
                light source
            Emitting
                diode or lasers used in connection with a power meter to measure
                signal
                loss.
            X
            
            X
            X
            XSynchronization
                analyzer
            Portable,
                stand-alone tester for network synchronization analysis and wander
                measurement in wireless and wireline transport networks.
            
            
            
            
            XTalk
                set
            A
                device that attaches to an optical fiber and serves as a temporary
                voice
                link facilitating coordination of work among installation
                crews.
            X
            
            XTelephone
                wire analyzer
            Used
                by telecommunications service providers that have networks that are
                comprised mostly or partially of twisted-pair local loops to ensure
                that
                those loops are of sufficient quality to carry higher-frequency signals
                required for DSL.
            
            
            XVariable
                optical attenuator
            Used
                in network simulation setups to provide calibrated variable reduction
                of
                the strength of an optical signal.
            
            
            X
            X
            XVisual
                fault locator
            A
                visible laser that can be connected to an optical fiber network to
                help
                locate breaks or points of excessive loss.
            X
            X
            XWidely
                tunable laser
            Can
                produce laser light across a broad range of wavelengths. Used to
                test DWDM
                components and value-added optical modules.
            
            
            
            X
            X





*Products
      for Network Service Providers*




We
      offer
      an extensive range of field-portable optical test, measurement and monitoring
      solutions that are mainly used by NSPs, but can also be utilized by system
      vendors. These products are available as handheld test instruments, portable
      platforms with related modules, and as rack-mount chassis with related modules.
      Our handheld instruments are durable, compact and easy to use. Our
      new
      FTB-200 Compact Platform, designed for the “super field technician”, holds up to
      two interchangeable modules that are fully compatible with the highly entrenched
      FTB-400 platform. Test technologies well-suited for the FTB-200 Compact Platform
      include a wide range of singlemode and multimode optical time-domain
      reflectometers (OTDRs), automated optical loss test sets (OLTSs), SONET/SDH
      analyzers from DS0 up to OC-192, as well as Gigabit Ethernet (GigE) testers. Our
      second-generation field-testing platform, the FTB-400 UTS, is available in
      three
      configurations: t he
      two-slot model is ideal for OTDR, OLTS and GigE applications; the
      four-slot model offers a high-speed bus, ideal for extensive datacom testing
      and
      dedicated OTDR, loss  and
      Ethernet (up to 10 Gigabit) testing; the
      seven-slot model is used for dispersion characterization (PMD and CD), DWDM
      testing (OSA and MWM) and protocol (SONET/SDH/datacom) testing; Our newest
      addition, the the eight-slot option,model is a high-performance,
      multiple-protocol configuration that allows users to combine next-generation
      SONET/SDH functions with Ethernet, Fibre Channel and optical-layer testing
      capabilities. Our portable platforms are PC-centric, Windows-based, highly
      flexible and fully scalable. Their large robust touchscreens are very practical
      for field use.




In
      fiscal
      2006, we launched SONET/SDH test solutions for our three platforms ─ namely our
      FTB-200 Compact Platform, FTB-400 Universal Test System and IQS-500 Intelligent
      Test System ─ for transmission rates reaching 10 Gbit/s.





We
      also
      introduced the AXS-100 OTDR for FTTx test applications. This
      handheld instrument delivers EXFO’s leading-edge technology for fault location
      inside a very compact and lightweight unit. Optimized for testing short links
      within access networks, it can be used at the optical network terminal, drop
      terminal, fiber distribution hub (where the splitter is located) or at the
      central office.





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This
      flexible OTDR is offered in various wavelength configurations, including 1550
      nm
      and 1310/1550 nm. Special-filtered 1625 nm and 1650 nm models are also
      available for live-fiber FTTx troubleshooting. One-button, automated testing
      generates acquisitions within five seconds, while as many as 500 acquisitions
      can be stored.





As
      well,
      we released the PPM-352B-EG Passive Optical Network (PON) Power Meter in 2006
      for service
      activation and troubleshooting tasks on broadband PON (BPON), Ethernet
      PON (EPON) and Gigabit PON (GPON) architectures.





As
      a
      result of the acquisition of Consultronics’ assets in January 2006 we added test
      and measurement solutions for copper-based narrowband and broadband networks
      to
      our product portfolio. Consultronics
      not only provides DSL testing solutions and solutions for testing twisted copper
      pair in access networks, but also value-added IPTV, VoIP, and IP Data testing
      technologies which are increasingly required for triple-play deployments. EXFO
      also gained a Network Quality Monitoring System (NQMS) solution from
      Consultronics that is used for the surveillance voice-over-Internet Protocol
      (VoIP) and voice-band services. This solution is being tailored to complement
      EXFO’s Remote Fiber Test System for monitoring a network service provider’s
      fiber plant. Other
      test solutions offered by Consultronics also brought additional experience
      and a
      limited customer base from its Gigabit Ethernet Analyzer offering, as well
      as a
      portable test solution for T1, E1, DS3, and data communications.





Since
      this acquisition, we have introduced the CoLT-450P, a handheld tester for
      service verification and for assessing the Quality of Service of multi-channel
      HDTV based on IPTV as well as the enhanced CoVALT for installing and
      troubleshooting DSL circuits that carry data and VoIP services.





Subsequent
      to the year-end, we launched the LFD-300/TG-300
      FiberFinderTM for the efficient and safe management of live and dark optical
      fibers. This handy device helps field technicians ensure that live fibers are
      not inadvertently disconnected in crowded fiber cabinets and patch
      panels.





*Products
      for System/Component Manufacturers*




Our
      system/component vendor solutions, mainly built around our IQS-500 ITS, are
      available as test modules or stand-alone benchtop instruments. The
      next-generation IQS-500 platform can efficiently run as many as 100 optical
      test
      modules using a single controller unit. The IQS-500 platform is equipped with
      the software and hardware technology to support single-button operation for
      automated testing. Its system-based approach - one box, several test
      modules - combined with an open architecture (PXI, Windows, LabVIEWTM,
      etc.) and ease of programming, produces a highly flexible test
      environment.




The
      IQS-500 also provides backward compatibility with recent IQ-generation test
      modules, while delivering all the power and advantages of a next-generation
      platform. EXFO’s wide selection of high-performance test modules includes
      high-speed power meters, light sources, WDM laser sources, tunable laser
      sources, variable attenuators, multi-wavelength meters, polarization-dependent
      loss (PDL) and optical return loss (ORL) meters, polarization controllers and
      optical switches.




In
      2006,
      we introduced a suite of next-generation SONET/SDH test modules as well as
      10
      Gigabit Ethernet modules targeted for system manufacturing and R&D
      applications. Following the year-end, we released a next-generation IQS-12001B
      Cable Assembly and Component Test System for production testing of short fiber
      assemblies and fiber-to-the-x (FTTx) components.




As
      evidenced by the release of our IQS-12001B Cable Assembly and Component Test
      System, our system/component vendor solutions address testing issues that cannot
      be handled by standard test modules or stand-alone benchtop instruments. We
      have
      developed a number of integrated test systems and offer them as off-the-shelf
      solutions to suit a wide range of customer needs. In addition, we have created
      a
      software development kit for developers who prefer writing their own programs
      for our instruments. Following is a list of integrated test systems that we
      provide for characterizing optical components, subsystems and
      networks:







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·CWDM/FTTH
                passive optical component test system
            Used
                to automatically characterize all critical specifications, including
                spectral insertion loss, polarization-dependent loss and optical
                return
                loss of a CWDM passive component or a FTTH splitter with a high degree
                of
                accuracy, ease of use and speed.·Cable
                assembly and component test system
            Used
                to perform insertion loss and mandrel-free reflection measurements
                with
                the highest degree of accuracy and repeatability on short fiber assemblies
                (including multifiber patchcords, hybrids and fan-out patchcords)
                and
                components like PLC splitters and fiber arrays.·DWDM
                passive component test system
            Used
                to automatically characterize all critical specifications, including
                spectral insertion loss, polarization-dependent loss and optical
                return
                loss of a DWDM passive component with a high degree of accuracy,
                ease of
                use and speed.




*Products
      for life sciences and industrial applications*




Over
      the
      years, we have developed and acquired a number of core technologies that we
      leverage in selected high-precision assembly and life sciences markets. For
      example, we offer several light-based curing solutions for optical component
      manufacturing and have optimized our approach for other industries, such as
      semiconductor, microelectronic, and medical device manufacturing, in order
      to
      maximize revenues. Our Novacure ® ,
      Acticure ® ,
      and
      Omnicure ® systems
      deliver precise doses of the appropriate spectral light onto photosensitive
      adhesives to significantly reduce bonding time and increase repeatability.
      These
      light-based curing systems, supported by patented optical feedback, thermal
      control, and radiometry technology, produce a high-quality bonding solution
      that
      is unmatched in the industry. Our technology and application knowledge place
      us
      at the forefront of this market.




In
      2006,
      we released the new X-Cite ® 120 XL Fluorescence Illumination System for microscope manufacturers. This
      next-generation X-Cite 120 XL system, replacing the highly successful
      X-Cite 120, delivers excellent image quality and at least 2000 hours of lamp
      life, which is over 60% longer than the previous model and up to 10 times longer
      than conventional illumination systems.





The
      X-Cite 120 XL is a self-contained illumination unit separate from a
      microscope. A simple light guide attachment through custom-coupling optics
      ensures a uniform field of view with no heat from the lamp being transferred
      to
      the sample. The output intensity of the X-Cite 120 XL system can also be
      adjusted from the optional front-panel control.





The
      following table summarizes the principal types of high-precision assembly and
      life science solutions we provide and their typical applications:




**Light
                Sources and Accessories*****Product
                Type***
            ***Product***
            ***Typical
                Application***UV
                Light Sources
            Novacure®
              
              Acticure®
              
              Omnicure®
                S1000
              Omnicure®
                S2000
            Used
                to initiate photo chemical reactions in polymer-based materials for
                a
                variety of end use applications. Examples include adhesive curing
                for
                manufacturing of high value-added items such as medical devices,
                micro-electronic and opto-electronic components, displays, and data
                storage devices.Fluorescent
                Light Sources
            X-Cite®
                120XL
              X-Cite®
                120 PC
            Fluorescence
                light source that attaches directly to most microscopes currently
                sold by
                major microscopes manufacturers.








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Computer
                Control Module
            ACS-1000
            Electronic
                interface module used to connect EXFO UV light sources to computers
                or
                computer networks for process automation.Optical
                Accessories
            
            Optional
                custom delivery optics used with EXFO UV light sources to tailor
                the
                properties of the light beam to end-user applications.High
                Power Fiber Light Guide
            
            Provides
                an equal distribution of light energy to multiple cure sites with
                50% more
                throughput than standard fiber guides.**Optical**********Instruments*****Product
                Type***
            ***Product***
            ***Typical
                Application***Radiometer
            R5000
              
              
              R2000
            Handheld,
                broadband optical radiometers used in conjunction with EXFO UV light
                sources to ensure process quality control at the end-user
                location.Cure-Site
                Radiometer
            
            Attachments
                for the R2000 and R5000 radiometers that enable optical measurements
                under
                customer specific configurations. Examples include the cure-ring
                radiometer, which measures the output power of light from an EXFO
                cure
                ring; ideal for applications that requires a uniform 360°
                exposure.Precise
                Motors/Stages
            IW-700
                Inchworm Motors
            High-resolution
                optical alignment, fiber-optic alignment, semiconductor positioning,
                materials research.TSE-820
                Inchworm StagesUHVL
                Inchworm Motors**Precision
                Positioning Instruments*****Product
                Type***
            ***Product
                Line***
            ***Typical
                Application***Micromanipulators
            PCS-6000
                Micromanipulators
            Electrophysiology
                research such as patch clamp recording experiments on cells from
                the brain
                and central nervous system.PCS-5000
                MicromanipulatorsMicroscope
                Platforms
            Gibraltar
                Platform/Stage
            Stable
                mechanical platforms that facilitate cellular research with
                micropositioning and microinjection systems.Microinjection
                Systems
            MIS-5000
                Microinjection Manipulator
            Microinjection
                and nuclear transfer for genetics and reproductive sciences
                research.PiezoDrill
                Inertial Impact DrillMicroelectrode
                Positioner
            LSS-8000
                Inchworm System
            Electrophysiology
                research such as intracellular recording experiments










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**Research
      and Development**




We
      believe that our future success largely depends on our ability to maintain
      and
      enhance our core technology and product functionality. To keep developing new
      products and enhancements, it is important that we retain and recruit highly
      skilled personnel. Our Telecom Division’s research and development department is
      headed by a Vice-President of Research and Development, while our Life Sciences
      and Industrial Division has a Director of Research and Development. As of
      November 1, 2006, our research and development departments included
      264 full-time engineers, scientists and technicians, of whom 46 hold
      post-graduate degrees. Gross research and development expenditures in fiscal
      2006 reached $19.5 million, compared to $15.9 million in 2005 and
      $15.7  million
      in 2004. We launched 18 new products in fiscal 2006 compared to 15 in 2005
      and
      20 in 2004. Approximately 37% of sales in fiscal 2006 originated from products
      that have been on the market two years or less compared to 42% in 2005 and
      32%
      in 2004.




Through
      market-oriented product portfolio review processes at our telecom sites in
      Quebec City, Canada, Montreal, Canada, and most recently, Concord, Canada,
      following the acquisition of Consultronics in 2006, we ensure that our
      investments in research and development are aligned with our market
      opportunities and customers’ needs. This process enables us to maximize our
      returns on R&D investments by focusing our resources on prioritized
      projects. Quarterly product portfolio review meetings enable us to choose a
      realistic, balanced mix of new products and allocate the necessary resources
      for
      their development. All our projects, including those already underway, are
      reviewed, given a priority rating and allocated budgets and resources. Our
      existing projects can be stopped or substantially redefined if there have been
      significant changes in market conditions, or if the project development schedule
      or budget have significantly changed.




To
      manage
      our research projects once they are underway, we use a structured management
      process known as the stage-gate approach. The stage-gate approach is based
      on a
      systematic review of a project’s progress at various stages of its life cycle.
      The following are the key review stages of the stage-gate approach:




·
            market
                study and research feasibility;


·
            product
                definition;


·
            development
                feasibility;


·
            development;


·
            qualification;
                and


·
            transfer
                to production.




At
      each
      stage, we review our project risks, costs and estimated completion time. We
      compare our design to anticipated market needs and ensure that our new product
      development is synchronized with other internal departments and external
      industry events. Adherence to these inter-related portfolio review and
      stage-gate processes enabled us to be named winners of the Outstanding Corporate
      Innovator Award in 2000 by the U.S.-based Product Development and Management
      Association.




We
      also
      maintain research and development programs for our life science and industrial
      activities in Toronto, Canada. The product development process is managed using
      a similar stage-gate process, and projects are reviewed and approved through
      a
      quarterly portfolio review. The future success of our life science and
      industrial operations largely depends on our ability to maintain and enhance
      our
      core technology in light-based curing, fluorescence illumination systems and
      piezoelectric positioning.




Strong
      R&D capabilities at our Life Sciences and Industrial Division site in
      Toronto have made it possible to bring a number of successful new products
      to
      market quickly and retain customer intimacy. In the process, it has enhanced
      our
      ability to customize products for special applications and to develop original
      equipment manufacturing (OEM) products under partnerships and exclusive
      contracts. Outside consultants are often used for added support in areas like
      software development, mechanical design and rapid prototyping.







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**Customers**




Our
      global and diversified telecom customer base relies on our test and measurement
      solutions to enable optical networks to perform impeccably during their complete
      life cycles: research, development, manufacturing, installation, maintenance
      and
      real-time monitoring. We also have selected customers in high-precision assembly
      and life science sectors that require our solutions to render them more
      efficient in their respective fields. Our telecom customers include carriers,
      cable television companies, public utilities, private network operators
      third-party installers, equipment rental companies, system manufacturers,
      component vendors and laboratory researchers. Our life science and industrial
      customers consist of major manufacturers of medical devices, microelectronics,
      optical displays, electronic storage systems, photonic components and
      microscopes, as well as universities, medical schools, governments, and private
      and industrial research laboratories. In fiscal 2006, our top customer accounted
      for 13.8% of our sales and our top three customers represented 19.4% of our
      sales. In comparison, in 2005 our top customer accounted for 23.3% of sales
      and
      our top three customers represented 28.4%,
      while in 2004, our top customer accounted for 13.8% of sales and our top three
      customers represented 20.8%.




With
      regard to geographic distribution, sales to customers in the Americas (US,
      Canada and Central & South America) represented 60% of our sales in fiscal
      2006, while sales to customers in EMEA (Europe, Middle East and Africa) and
      Asia-Pacific accounted for 25% and 15% of sales, respectively. In comparison,
      the Americas, EMEA and Asia-Pacific accounted for 68%, 20% and 12% of sales,
      respectively, in 2005, and 66%, 18% and 16%, respectively, in 2004.




**Sales**




We
      sell
      our telecom test and measurement solutions through direct and indirect sales
      channels in North America and around the world.




In
      North
      America, we use a hybrid model, combining key account management with direct
      and
      indirect sales coverage. We typically use key account managers to serve large
      customers that generate high sales volumes or might potentially represent high
      sales volumes in the future. These key account managers are supplemented by
      regional sales managers, sales engineers, sales representatives and distributors
      in US metropolitan areas and regional sales managers in Canada.




We
      opt
      for a direct sales approach when selling higher-end, highly technical products
      to sophisticated buyers. Sales of low- to medium-level complexity products
      to
      less stringent technical buyers are usually done through a manufacturer
      representative organization supported by regional sales managers. Our main
      sales
      offices and service centers in North America are located in Addison, Texas,
      Quebec City, Canada, and Concord, Canada. They are supplemented by a regional
      presence in cities across the US and Canada.




On
      the
      international front, we have sales personnel covering strategic areas such
      as
      EMEA (Europe, Middle East and Africa), APAC (Asia-Pacific region) and Latin
      America. Our sales network in EMEA is supported by a main office and service
      center in Southampton, UK, which maintains our head of European sales operations
      and also provides repair and calibration services for our EMEA customers. We
      also have additional sales offices in multiple countries across EMEA to serve
      and support our various customers and distributors.




As
      for
      APAC, our main sales offices for South East Asia is located in Singapore, while
      our main sales representative office for mainland China is located in Beijing,
      China, which also acts as a service center to better serve our customer base
      in
      that geographic area. In addition, we have other sales offices in strategic
      locations around the world to support our network of distributors and various
      customers.




We
      rely
      on a network of more than 90 distributors worldwide to work with us in
      supporting mostly our international sales and to participate in a large number
      of our international events. We believe that the local presence and cultural
      attributes of our distributors allow us to better serve our global
      markets.







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Our
      direct telecom sales team consists of a Vice-President of North American Sales
      and a Vice-President of International Sales. They are supported by seven
      regional sales directors that are leading a widely distributed team of more
      than
      65 people acting as key account managers, regional sales managers, sales
      engineers and application engineers. They are located throughout major
      metropolitan areas around the world. This group of sales professionals has
      on
      average more than 12 years of experience in the fields of telecommunications,
      fiber optics, or test and measurement. We also have an in-house Customer Service
      Group to meet the needs of existing and new customers. This group is responsible
      for providing quotations to customers, supporting our sales force, managing
      demonstration units, order management, technical support and training as well
      as
      calibration and repair services.




The
      main
      office for our Life Sciences and Industrial Division is located in Toronto,
      Canada. We use mixed sales channels to serve various markets supported by this
      division, depending on product line and geography. Optical light sources and
      related accessories used for industrial applications are sold in North America
      through a network of more than 10 manufacturer representatives and,
      internationally, through a network of more than 20 distributors. The X-Cite
      120
      Fluorescence Illumination System is sold through value-added reseller agreements
      with major microscope companies and system integrators in North America and
      Europe; negotiations are underway to extend these agreements worldwide.
      Nanopositioning products are sold directly to customers in North America, which
      includes the United States and Canada, and internationally through a network
      of
      technical distributors. To gain additional access to the nanopositioning life
      science research market in the United States and Canada, distributor agreements
      are in place with major microscope manufacturers, which include Leica, Nikon,
      Olympus and Zeiss. These companies often combine the sale of their microscopes
      with our product.




**Product
      Management, Marketing/Communications and Customer Support**




*Product
      Management*




Our
      telecom Product Management Group consists of two Vice-Presidents - one
      responsible for our Optical and Protocol product lines and the other for Copper
      Access product lines - as well as product managers who have various degrees
      in
      engineering, science and business administration. Product managers, under the
      direction of the respective Vice-Presidents, are responsible for all aspects
      of
      our telecom marketing program including product strategy, new product
      introductions, definition of new features and functions, pricing, product
      launches and advertising campaigns. We follow up our marketing initiatives
      by
      attending industry trade shows. Furthermore, we have a customer relationship
      management (CRM) system to compile market and customer information including
      forecasts, opportunities, leads and competitive data. We use this information
      to
      make strategic business decisions. Finally, strategic marketing specialists
      analyze our markets, compile competitive information and identify macro-trends
      in our sector.




Our
      Life
      Sciences and Industrial Group consists of a Director - responsible for both
      life
      sciences and precision assembly sectors - as well as product managers who have
      various degrees in engineering, science and business administration. Product
      managers, under the direction of the Director, are responsible for all aspects
      of their business line marketing programs including product strategy, new
      product introductions, definition of new features and functions, pricing,
      product launches and advertising campaigns.




*Marketing/Communications*





The
      Telecom Division’s Marketing-Communications team, which consists mainly of
      project managers, marketing writers, translators and graphic artists, supports
      our Product Management Group by producing marketing and corporate documentation.
      Literature includes specification sheets, application notes, product catalogues,
      advertising copy and an electronic corporate newsletter. This
      Marketing-Communications team is also responsible for all sales tools required
      by our worldwide sales force and for updating the marketing contents of our
      Website.







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The
      Life
      Sciences & Industrial Division’s Marketing-Communications team shares a
      variety of marketing initiatives.  This group is assisted by product
      managers, who provide the technical data and collaborative support required
      to
      produce product specification sheets, catalogues, application notes and
      multimedia marketing tools. This Marketing-Communications team is also
      responsible for all advertising material, Website updates, events planning
      (including trade shows) and direct promotional marketing such as mass mailings
      and telemarketing.  This team also provides the sales tools required by the
      Life Sciences and Industrial Division’s worldwide sales channels, including
      maintaining our elite partner program.




*Customer
      Support*




Customer
      support is deemed a corporate mandate at EXFO. As such, our Customer Support
      Group handles requests from customers worldwide. Our Customer Support Department
      consists of three distinct units: Inside Sales, Technical Support and
      After-Sales Service.




Inside
      Sales is mainly responsible for guiding customers in purchasing the correct
      equipment for their respective applications, issuing quotations and promoting
      our Flexcare service program. In order to provide customers with one central
      point of contact, our service representatives work with the customer from
      purchasing equipment to helping them service the equipment, if necessary. These
      services are provided in English, French, Spanish and Chinese.




Within
      our Technical Support team, we have agents who provide troubleshooting support
      to our customers as well as trainers and installers who offer on-site servicing
      for more complex equipment.




To
      offer
      superior after-sales service worldwide, we have service centers based in North
      America, Europe and Asia. These service centers provide technical support,
      software upgrades, calibration and repairs for our customers.




**Manufacturing**




Our
      telecom manufacturing operations consist mainly of material planning,
      procurement, sub-assembly, final assembly and test, software loading,
      calibration, quality assurance, shipping, billing and customs management. As
      of
      November 1, 2006, we had 294 employees involved in our telecom
      manufacturing operations. Most of our manufacturing activities, which occupy
      a
      total of approximately 115,000 square feet, are spread among four buildings
      in
      three cities.




Our
      Telecom Division occupies 96,000 square feet in Quebec City, Canada, spanning
      two sites, 7,000 square feet in Montreal, Canada, and 12,000 square feet in
      Concord, Canada. These manufacturing operations include the following
      responsibilities:




·
            ***Production.***From production planning to product shipment, our production department
                is
                responsible for manufacturing high-quality products on time. Factories
                are
                organized in work cells; each cell consists of specialized technicians
                and
                equipment and has full responsibility over a product family. Technicians
                are cross-trained and versatile enough, so that they can carry out
                specific functions in more than one cell. This allows shorter lead
                times
                by alleviating bottlenecks.




·
            ***Product
                Engineering and Quality.***This department, which supports our production cells, acts like a
                gatekeeper to ensure the quality of our products and the effectiveness
                of
                our manufacturing processes. It is responsible for the transfer of
                products from research and development to manufacturing, product
                improvement, documentation, metrology, and the quality assurance
                and
                regulatory compliance process. Quality assurance represents a key
                element
                in our manufacturing operations. Quality is assured through product
                testing at numerous stages in the manufacturing process to ensure
                that our
                products meet stringent industry requirements and our customers’
                performance requirements. Our quality assurance program has been
                certified
                ISO 9001/2000 at all Telecom sites.




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·
            ***Supply-Chain
                Management.***This department is responsible for sales forecasting, raw material
                procurement, material-cost reduction and vendor performance management.
                Our products consist of optical, electronic and mechanical parts,
                which
                are purchased from suppliers around the world. Approximately one-third
                of
                our parts are manufactured to our specifications. Materials represent
                the
                biggest portion of our cost of goods and will continue to grow as
                we rely
                more and more on outsourcing our manufacturing. Our performance is
                tightly
                linked to vendor performance, requiring greater emphasis on this
                critical
                aspect of our business.




Our
      Life
      Sciences and Industrial Division’s manufacturing operations occupy 8,000 square
      feet in Toronto, Canada. This group manufactures light sources and related
      accessories, fluorescence illumination systems and precise positioning equipment
      for the life sciences and high-precision assembly markets. Operations consist
      of
      manufacturing, procurement, warehousing, quality control and document control
      managed by various elements of the ISO 9001 certified quality system.
      Recognizing the importance of reduced time-to-market for our solutions, we
      have
      focused efforts on designing products with an emphasis on standardization,
      modularity, as well as ease of fabrication and assembly. Following are key
      manufacturing responsibilities in Toronto:




**Manufacturing** -
      consists primarily of assembly and test capabilities in which all major
      manufacturing elements are subcontracted to various key suppliers. These
      components are integrated into assemblies and tested in order to ensure all
      operating specifications have been met for each product manufactured.
      Cross-training of assembly technicians for each product group ensures
      scalability of manufacturing to meet customer demand. In addition, this group
      is
      responsible for capacity and production planning, which are necessary on an
      on-going basis to ensure that adequate resources are available to meet
      forecasted and actual demand.




**Supply
      Chain Management** -
      is
      responsible for the planning of materials required by manufacturing and
      developing key-supplier relationships to ensure materials have been manufactured
      to our specifications. This group’s main focus is to work with our worldwide
      supplier base to find effective manufacturing and logistic solutions in order
      reduce costs and cycle time. Paramount to this process is an effective
      communication system that provides timely feedback to our suppliers and forms
      an
      important element of our supplier evaluation system.




**Manufacturing
      Engineering and Quality Assurance** - is
      responsible for product integrity throughout the manufacturing cycle. From
      the
      release of new products, through our new product introduction process, and
      configuration management to manage engineering change, we ensure consistent
      manufacturing processes throughout the product life cycle. In conjunction with
      the above process, quality is maintained by performing quality tests at incoming
      receiving and final product verification. The responsibility for product quality
      is shared by all team members throughout the company and does not reside solely
      with the quality group.




**Competition**




The
      telecommunications test and measurement industry is highly competitive and
      subject to rapid change as a result of technological developments and market
      conditions. We compete with many different companies, depending on product
      family and geographical market. We believe that the main competitive factors
      in
      the industry include the following:




·
            product
                performance and reliability;


·
            price;


·
            level
                of technological innovation;


·
            product
                lead times;


·
            breadth
                of product offerings;


·
            ease
                of use;


·
            brand-name
                recognition;


·
            customer
                service and technical support;


·
            strength
                of sales and distribution relationships;
                and


·
            financial
                stability.







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Generally,
      competitors fall into two categories. The first category consists of global
      test
      and measurement vendors, who complement their broad range of products with
      telecom test and measurement equipment. These companies include Agilent
      Technologies, Inc., Anritsu Corporation, JDS Uniphase Corporation, Spirent
      plc,
      Tektronix, Inc., and Yokogawa.




The
      second category refers to niche companies in the telecom test and measurement
      industry. These companies typically have limited product lines and in some
      cases
      may be geographically limited in their customer base. Such companies include
      Digital Lightwave Inc., Fluke Networks, an operating division within Danaher
      Corporation, IXIA, and Sunrise Telecom Inc.




Competition
      for our life sciences and industrial solutions is quite varied, depending upon
      product line. Competitors that sell light-based curing products include
      Hamamatsu, Ushio and Matsushita (Panasonic) in Asia, with Hamamatsu increasing
      its presence in North America. With regard to our X-Cite 120 Fluorescence
      Illumination System, main competitors consist of microscope manufacturers who
      have developed lamp housings for low-wattage mercury burners in-house. Finally,
      our motion control Life Science instruments, which are designed for various
      life
      science applications, compete against products from companies like Sutter
      Instruments and Narishige.




Regulatory
      Environment





In
      most
      countries where our products are sold, our products must comply with the
      regulations of one or more governmental entities. These regulations often are
      complex and vary from country to country. Depending upon the country and the
      relevant product, the applicable regulations may require product testing,
      approval, registration, marking and unique design restrictions. Accordingly,
      we
      have appointed a team of engineers who are responsible for ensuring that our
      products comply with all applicable regulations.





In
      the
      United States, our products must comply with the regulations of several agencies
      of the U.S. federal government, including the Federal Communications Commission
      (FCC), the Food and Drug Administration (FDA) and the Occupational Safety and
      Health Administration (OSHA). Under the FCC’s regulations, our products must
      comply with certain electro magnetic compatibility (EMC) requirements to insure
      they do not generate and are immune from electrical noise which could possibly
      cause undesirable operation, as well as affect other surrounding devices.
      Depending upon the product, compliance with these rules may necessitate applying
      for and obtaining an FCC equipment authorization prior to importing into the
      United States, or marketing, any units of the relevant product. Additionally,
      some of our products must comply with the FDA’s non-medical **** performance
      standards and related rules concerning light-emitting products, such as lasers.
      The FDA’s regulations are intended to promote safety by limiting human exposure
      to harmful non-iodizing radiation. Similarly, our products must comply with
      safety standards adopted by OSHA.





Similar
      regulations apply in other countries. For example, in Canada our products must
      comply with the applicable standards adopted by the Standards Council of Canada
      (SCC). These include product safety standards developed by the Canadian
      Standards association as well as EMC requirements adopted by Industry Canada.
      Countries in the European Union require product compliance as dictated by an
      applicable directive, often referred to as CE marking. This includes testing
      to
      ensure compliance with harmonized European Norm (EN) standards for both product
      safety and EMC requirements. Other significant types of regulations not
      described in this annual report also may apply, depending upon the relevant
      product and country of destination.





In
      Europe, with the implementation of the WEEE directives for recycling of
      electronic products in selected European Countries (2002-96-CE), we have
      appointed a task force committee consisting of our management and employees,
      distributors and other partners as the case may be, to ensure full compliance
      with regulations and oversee the management, logistics, recycling rate, disposal
      services and activities related to recycling of electronic equipment and
      products within the member states.




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**Intellectual
      Property**





Our
      success and ability to compete are dependent in part on our ability to develop
      and protect our proprietary technology. We file U.S. and international
      applications to protect technology, inventions and improvements important to
      the
      development of our business. We also rely on a combination of copyright,
      trademark, trade secret rights, licensing and confidentiality
      agreements.





As
      of
      August 31, 2006, EXFO held 27 actively maintained granted patents from the
      U.S.
      (including one “design” patent), eight from Canada, two from Germany, two from
      the United Kingdom, two from France, and one from China. In addition, EXFO
      has 15 US patent applications in process, 14 Canadian patent applications in
      process, two from China, one from Germany and three Patent Cooperation
      Treaty patent applications pending. These issued and pending patents cover
      various aspects of our products and processes. The expiration dates of our
      issued patents range from October 3, 2008 to October 5, 2025.





We
      consider eight of our inventions for which patents have either been granted or
      are pending to be material. These inventions are:





·
            a
                method and apparatus for “non-intrusive” live-fiber detection and
                monitoring, for which a PCT patent application has been filed. This
                invention permits a fiber “clip-on” device to be attached to a cabled
                fiber, essentially guaranteeing that the induced bending loss to
                a
                live-traffic link will never exceed 1 dB. This is a key invention
                for our
                new LFD-250, LFD-300, and TG-300 products, announced in September
                2006,
                subsequent to the end of the 2006 fiscal year.





·
            the
                measurement of attenuation of optical fibers using bidirectional
                transmission of information via the fiber for which patents were
                granted
                in the United States and Canada. This invention forms the basis of
                our
                FOT-930 and FTB-3920 products;





·
            a
                method and apparatus for characterizing optical power levels in
                three-wavelength, bidirectional fiber-to-the-home systems. This invention
                describes how the optical power can be measured at the two-downstream
                and
                one upstream wavelengths used to connect a residence or business
                customer,
                while maintaining the signal continuity necessary to keep the home-based
                Optical Network Terminal operating. US and PCT patent applications
                have
                been filed and are in process. This invention forms the basis of
                the
                two-port version of our PPM-350B PON Power Meter.





·
            an
                optical spectrum analyzer using optical fibers as input and output
                “slits”. This invention forms the basis of our FTB-5240, FTB-5240B and
                IQ-5250 products. A patent has been granted in the US, UK, Germany,
                France, and China, and an application is in process in Canada.





·
            a
                light-curing system with closed-loop control and work-piece recording
                which is at the heart of the spot-curing systems manufactured by
                EXFO
                Photonic Solutions and for which patents were granted in the United
                States
                and Canada;





·
            a
                special optical design used in some of the X-Cite adaptors to prevent
                structure in the beam from reducing the uniformity of illumination
                at the
                microscope objective plane, which is a key patent for our X-Cite
                fluorescent illumination system. A US patent has recently been granted.





·
            portable
                test gear for TDM and packet-based communications for which patent
                applications have been filed in Canada, the United States and pursuant
                to
                the Patent Cooperation Treaty form the basis of the technology used
                by
                EXFO Protocol for a number of its protocol testing
                products.





·
            a
                method and apparatus to determine the theoretical and practical data
                rates
                for a cable under test. This invention forms the basis of the EXFO
                CableSHARK product, describing how two test
                devices, communicating with each other via the cable under
                test,  can predict the performance of a pair of ADSL (Asymmetric
                Digital Subscriber Line) modems, and in case of problems, analyze
                the
                cause of the modems failing to synchronize. This patent has been
                granted
                in the US and in Canada.





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Confidentiality
      and proprietary information agreements with our senior management, employees
      and
      others generally stipulate that all confidential information developed or made
      known to these individuals by us during the course of their relationship is
      to
      be kept confidential and not disclosed to third parties, except in specific
      circumstances. The agreements also generally provide that all intellectual
      property developed by the individual in the course of rendering services to
      us
      belongs exclusively to us. These efforts afford only limited
      protection.





**C.**  **Organizational
      Structure**





As
      of
      November 1, 2006, the following chart presents our corporate structure, the
      jurisdiction of incorporation of our subsidiaries and the percentage of shares
      that we hold in those subsidiaries.














**D.**  **Property,
      Plant and Equipement**





Our
      head
      offices and facilities are located in Quebec City, Canada where we occupy two
      buildings. These buildings house our executive and administrative offices,
      research and development facilities and production facilities. We also have
      facilities in Montreal, Canada (formerly EXFO Protocol), in Concord, Ontario,
      Canada (formerly Consultronics Limited), in Toronto, Canada (EXFO Photonic)
      and
      our Copper Access business unit (Telecom Division) has operations in Budapest,
      Hungary and Southampton, United Kingdom. EXFO Burleigh’s facilities located in
      Victor, New York, were sold on August 31, 2006.





In
      addition, we maintain sales offices and/or have regional sales managers located
      in China, France, Germany, Great Britain, Japan, Mexico, Singapore, Spain,
      United Arab Emirates and the United States.





In
      September 2002, we obtained ownership of one of the buildings housing production
      facilities in Quebec City that was previously leased from a company controlled
      by EXFO’s president and chief executive officer. In September 2003, due to
      down-sizing efforts, we were able to move all of our Quebec City activities
      into
      two buildings, rather than three. Though we no longer occupy the facilities
      at
      465 Godin Avenue in Quebec City, we remain bounded by the lease until November
      30, 2006. However, on September 1, 2004, we were released from our obligations
      under the lease with a final payment of $194,000 (CA$250,000).





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The
      following table sets forth information with respect to the main facilities
      that
      we occupy as of November 1, 2006.




**Location**
              **Use
                  of Space**
              **Square
                  Footage**
              **Type
                  of Interest**436
                  Nolin Street
                Quebec
                  (Quebec)
              Manufacturing
                  of telecom products
              44,164
              Owned400
                  Godin Avenue
                Quebec
                  (Quebec)
              Research
                  and development, manufacturing, management and
                  administration
              128,800
              Owned2260
                  Argentia Road
                Mississauga
                  (Ontario)
              Partially
                  occupied for research and development, manufacturing of life science
                  and
                  industrial products and administration
              25,328(1)
              Leased2650
                  Marie-Curie, St-Laurent (Quebec)
              Research
                  and development, manufacturing and administration
              26,000
              Leased160
                  Drumlin Circle
                Concord
                  (Ontario)
              Fully
                  occupied building for research and development, manufacturing of
                  EXFO’s
                  Copper Access Business Unit products, product management,
                  administration
              23,500
              OwnedVármegye
                  utca 3-5 (Ausztria Ház)
                Budapest,
                  Hungary
              Research
                  and development, services (installation, training, support and
                  maintenance) and administration
              2,500
              LeasedOmega
                  Enterprise Park
                Electron
                  Way, Chandlers Ford, Hampshire
                England
              Partially
                  occupied for European customer service, sales management, administration
                  and research and development
              10,000
              Leased




(1)
            10,672
                square feet have been subleased to a third party. The total square
                footage
                leased is 36,000.







**Item
      4A** . **Unresolved
      Staff Comments**





Not
      applicable.








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**Item
      5.**  **Operating
      and Financial Review and Prospects**




The
      following discussion and analysis of the consolidated financial condition and
      results of operations of EXFO Electro-Optical Engineering Inc. for the fiscal
      years ended August 31, 2004, 2005 and 2006, should be read in
      conjunction with our consolidated financial statements and the related notes
      included elsewhere in this annual report. Our consolidated financial statements
      have been prepared in accordance with generally accepted accounting principles
      in Canada, or Canadian GAAP. Significant differences in measurement and
      disclosure from generally accepted accounting principles in the United States,
      or U.S. GAAP, are set out in note 20 to our consolidated financial
      statements. Our measurement currency is the Canadian dollar although we report
      our financial statements in US dollars.





The
      following discussion and analysis of financial condition and results of
      operations is dated November 1, 2006.





All
      dollar amounts are expressed in US dollars, except as otherwise
      noted.








**INDUSTRY
      OVERVIEW**





Global
      market demand for telecom test and measurement equipment should remain strong
      in
      the years to come as most network service providers (NSPs) are increasing
      capital expenditures to upgrade their networks for converged Internet protocol
      (IP) services and triple-play (voice, data and video) offerings. These market
      forces create needs for differentiated test solutions to help NSPs accelerate
      deployment and ensure service quality in their network
      build-outs.





With
      the
      ongoing globalization of the world’s economy and the emergence of new consumer
      markets, NSPs are poised to capitalize on growing demand for communications
      and
      entertainment services. Early in 2006, some smaller telecom operators launched
      broadcast-quality video services based on IP communications. This technology,
      better known as IPTV, allows telephone companies (telcos) to efficiently offer
      TV, HDTV and interactive TV services to their broadband subscribers. Tier-1
      and
      Tier-2 telcos are expected to launch similar IPTV services on a large-scale
      basis starting in 2007. While Web-based streaming video is offered for free
      on a
      best-effort basis, IPTV, whom many regard as the broadband “killer application,”
will require a high level of performance to ensure a quality user experience.
      NSPs, after all, don’t want customer churn to prevent a meaningful return on
      their massive investments.





To
      deliver a wide range of differentiated IP services, NSPs will continue
      transforming their legacy, circuit-switched networks into highly efficient,
      flexible and scalable packet-based IP architectures. Telcos and cablecos have
      already proven that they can generate significant revenues from higher-margin
      services on hybrid networks, while reducing operating costs. IPTV should only
      accelerate the migration towards fully converged, IP-based networks, since
      it
      typically allows NSPs to nearly double average revenue per user (ARPU).





The
      increasing reliance on telecom and IP-related services will continue driving
      bandwidth consumption, thus pushing the deployment of fiber deeper into access
      networks. Competition between telcos and cablecos has intensified as triple-play
      offerings are announced almost daily. Hybrid architectures combining copper
      and
      fiber (fiber-to-the-curb, or FTTC and fiber-to-the-node, or FTTN), will keep
      expanding worldwide, since this is the quickest and least expensive method
      to
      increase bandwidth. To remain competitive with cablecos, telcos are migrating
      from former asymmetric digital subscriber line (ADSL), to current ADSL2+, and
      onto future very-high-data-rate digital subscriber line 2+ (VDSL2+) technologies
      as interoperability becomes demonstrable. Telcos, however, will increasingly
      opt
      for all-fiber, passive optical network (PON)-based architectures
      (fiber-to-the-premises, or FTTP) to meet heightened bandwidth requirements
      and
      to future-proof their networks. These decisions will apply not only to
      green-field deployments and high-rise buildings, but also to larger-scale
      rollouts as operating costs are less than FTTC and FTTN and cost of deployments
      are falling. We are still in
      the early stages of building access networks around the world.





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Metro
      network deployments, taking advantage of carrier-grade Ethernet and
      metro-Ethernet technologies are moving ahead to handle large increases in
      bandwidth consumption in access networks. These network upgrades, in turn,
      will
      eventually place a strain on long-haul networks, where excess capacity created
      by massive overspending in the late-90s is gradually being consumed. NSPs are
      more than ever committed to deploying next-generation SONET/SDH transport
      technologies, while 40 Gb/s deployments are not far behind.





These
      key
      market trends affected multiple segments of the global telecommunications supply
      chain in fiscal 2006. System vendors benefited from orders by both telcos and
      cablecos for next-generation, converged IP networks as well as from major
      investments by telcos in access networks. Component vendors saw increased demand
      for optical components that support FTTx and IP-based systems. Some test and
      measurement equipment vendors attracted the attention of telcos, cablecos,
      system manufacturers and component
      vendors, especially ones offering test solutions for IP networking and/or FTTx applications.







**COMPANY
      OVERVIEW**





EXFO
      is a
      recognized test and measurement expert in the global telecommunications
      industry. The Telecom Division, which represents our main business activity,
      offers fully integrated and complete test solutions to network service providers
      (NSPs), cable TV operators, telecom system vendors and component manufacturers
      in approximately 70 countries. We are the global market leader for portable
      optical test solutions and a leading supplier of protocol and copper access
      test
      solutions to enable triple-play services over converged, IP networks. Our
      PC/Windows-based modular FTB-200, FTB-400 and IQS-500 test platforms host a
      wide
      range of test solutions across optical, physical, data and network layers,
      while
      maximizing technology reuse across several market segments. Our Life Sciences
      and Industrial Division, which leverages several core telecom technologies,
      offers value-added solutions in the life sciences and high-precision assembly
      sectors, such as those required for microelectronics and optoelectronics. These
      solutions are based on advanced spot-curing, fluorescence microscopy and
      nanopositioning solutions.





We
      were
      founded in 1985 in Quebec City, Canada. Our original products were focused
      on
      the needs of installers and operators of fiber-optic networks. Customers use
      these field-portable testing products for the installation, maintenance,
      monitoring and troubleshooting of optical networks. In 1996, we supplemented
      our
      product portfolio with an extensive line of high-end products that are mainly
      dedicated to research and development as well as manufacturing activities of
      optical component manufacturers and system vendors.





Over
      the
      past several years, we have enhanced our competitive position through the
      acquisition of two protocol test businesses in order to expand our product
      offering and address our customers’ requirements more completely. In November
      2001, we acquired Avantas Networks Corporation (renamed EXFO Protocol Inc.),
      a
      supplier of protocol-testing and optical-network performance management
      equipment for NSPs. This transaction was highly strategic because it enabled
      us
      to combine optical and protocol test modules inside a single field-portable
      test
      platform to help our customers increase revenues and reduce operating costs.
      In
      October 2002, our wholly-owned subsidiary, EXFO Gnubi, purchased substantially
      all the assets of *gnubi
      communications, L.P.* ,
      a
      supplier of multi-channel telecom and datacom testing solutions for the system
      manufacturer market. These strategic acquisitions, which were consolidated
      in
      Montreal, Canada, in fiscal 2004, enabled us to more than double our addressable
      market, as we expanded from optical testing to protocol testing applications,
      and to offer a more complete line of test solutions to our
      customers.





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During
      the second quarter of 2006, we announced and subsequently completed the
      acquisition of substantially all the assets of Consultronics Limited. Based
      in
      Toronto, Canada, and with operations in Southampton, United Kingdom, and
      Budapest, Hungary, Consultronics is a leading supplier of test
      equipment for copper-based broadband access networks. It ranked among the top
      three vendors in handheld x-digital subscriber line (xDSL) testing with a global
      market share of 13.4%, according to an industry report from Frost &
Sullivan, a
      leading authority in the fiber-optic test and measurement industry. Consultronics also boasts a rich product portfolio for testing next-generation
      technologies, such as IPTV (Internet Protocol TV) and VoIP (Voice-over-Internet
      Protocol), which are critical for network service providers in their deployment
      of triple-play services (voice, data, video) over optical and copper links
      in
      access networks. Other test solutions offered by Consultronics include network
      monitoring probes for VoIP and legacy telephone networks, Gigabit Ethernet
      analyzers for remote testing applications, as well as protocol and physical
      characterization instruments for local copper loops (copper access networks).
      This acquisition is a strategic initiative to position EXFO as a genuine
      one-stop shop for broadband access and triple-play testing, since it greatly
      complements our market leadership in the FTTx market.





This
      acquisition was settled for a total cash consideration valued at $19.1 million,
      or $18.8 million net of cash acquired. Total consideration included
      acquisition-related costs of $1.5 million. The estimated fair value of
      acquired intangible assets amounts to $8.7 million. These intangible assets,
      namely core technology, are amortized on a straight-line basis over their
      estimated useful life of five years. Consultronics, which is now part of our
      Telecom Division, contributed about seven months to our consolidated financial
      results in fiscal 2006.





Previously,
      we had completed two acquisitions to bolster growth in the optical component
      manufacturing market. We acquired Burleigh Instruments, Inc. (renamed EXFO
      Burleigh Products Group Inc.) in December 2000 for its wavelength measurement
      instruments and nanopositioning alignment systems. We also added EFOS Inc.
      (renamed EXFO Photonic Solutions Inc.) in March 2001 for its precision
      light-based, adhesive spot-curing technology. We have since exited the optical
      component manufacturing automation business and EXFO Burleigh’s operations have
      been mostly consolidated with those of EXFO Photonic in Toronto,
      Canada.





During
      the first quarter of 2006, we were selected as sole-source supplier by Deutsche
      Telekom for
      all
      its fiber deployment test applications - including FTTx.





Early
      in
      the fourth quarter of 2006, Frost & Sullivan released new market-share
      numbers for calendar 2005. According to the industry report, EXFO was the only
      company to report significant organic growth in the global fiber-optic test
      equipment (FOTE) market, moving from 10.3% in 2004 to 11.0% in 2005 for third
      place overall in the FOTE market. Based on this report, we estimate that we
      improved our leadership position in our core installation and maintenance test
      market segment from 22.2% in 2004 to 23.0% in 2005.





We
      launched 18 new products in fiscal 2006, including among others the two-slot
      FTB-200 Compact Platform for multi-layer and multi-medium testing; the handheld
      AXS-100 OTDR for fiber-to-the-x (FTTx) test applications; SONET/SDH test modules
      measuring transmission rates up to 10 Gb/s for the FTB-200 Compact Platform;
      next-generation SONET/SDH test modules for the FTB-400 field-test and
      IQS-500 R&D/manufacturing platforms; 10 Gigabit Ethernet and Fibre
      Channel test solutions for our IQS-500 R&D/manufacturing platform; the
      next-generation CoLT-450P, a handheld IPTV and xDSL test solution for
      high-speed, copper-based networks; and the PPM-352B-EG Passive Optical Network
      (PON) Power Meter, optimized for Ethernet PON and Gigabit PON architectures.





In
      fiscal
      2006, in addition to reporting significant growth in sales with $128.3 million,
      compared to $97.2 million in 2005, we renewed with GAAP profitability and
      reported GAAP net earnings of $8.1 million, or $0.12 per diluted share,
      compared to a net loss of $1.6 million, or $0.02 per diluted share in 2005.
      Also, the fourth quarter of fiscal 2006 marked the seventh consecutive quarter
      of GAAP profitability. GAAP net earnings in fiscal 2006 included $4.4 million
      in
      amortization of intangible assets, $1.0 million in stock-based compensation
      costs, $604,000 in impairment of long-lived assets and non-recurring grant
      revenue of $1.3 million.





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**Sales**





We
      sell
      our products to a diversified customer base in approximately 70 countries
      through our direct sales force and channel partners like sales representatives
      and distributors. Most of our sales are denominated in US dollars and
      Euros.





Over
      the
      last three fiscal years, we had one customer that accounted for more than 10%
      of
      our global sales with 13.8%, 23.3% and 13.8% in fiscal 2006, 2005 and 2004,
      respectively. We
      believe the significant sales concentration in fiscal 2005 was largely due
      to
      our leadership position in the FTTx test market, as a large portion of our
      sales
      to our top customer was for a series of products related to FTTx deployment.
      Although this sales concentration significantly decreased in fiscal 2006, as
      this customer migrated to lower-priced test solutions, we still maintained
      our
      leadership position with this customer, while strongly developing other
      accounts, especially on the international scene. This allowed us to reach a
      level of concentration closer to our historical pattern, which reflects **** the
      improved diversification of our customer base. All in all, our year-over-year
      sales growth in fiscal 2006 stands at 48.2% (excluding the major account
      mentioned above). We expect this sales concentration to further decrease in
      fiscal 2007, as we continue efforts to diversify our customer base and expend
      on
      international markets.





We
      believe that we have a vast array of products and a diversified customer base,
      both in terms of industry sector and geographical area, which provides us with
      reasonable protection against concentration of sales and credit
      risk.





**Cost
      of Sales**





Cost
      of
      sales includes raw materials, salaries and related expenses for direct and
      indirect manufacturing personnel (net of government grants) as well as overhead
      costs. Excess, obsolete and scrapped materials are also included in cost of
      sales. However, cost of sales is exclusive of amortization, which is shown
      separately in the statements of earnings.





**Operating
      Expenses**





We
      classify our operating expenses into three main categories: selling and
      administrative expenses, research and development expenses and amortization
      expenses.





Selling
      and administrative expenses consist primarily of salaries and related expenses
      for personnel, sales commissions, travel expenses, marketing programs,
      professional services, information systems, human resources and other corporate
      expenses.





Gross
      research and development expenses consist primarily of salaries and related
      expenses for engineers and other technical personnel, material component costs
      as well as fees paid to third-party consultants. We are eligible to receive
      research and development tax credits and government grants on research and
      development activities carried out in Canada. All related research and
      development tax credits and government grants are recorded as a reduction of
      gross research and development expenses.





Operating
      charges related to our restructuring plans and impairment of long-lived assets
      are recorded as a separate component of operating expenses. Charges related
      to
      restructuring plans consist primarily of severance expenses, costs to exit
      leased facilities as well as write-offs of long-lived assets.








**OUR
      STRATEGY**





**Strategic
      Objectives for Fiscal 2006**





In
      our
      fiscal 2005 annual report, we had established three strategic objectives for
      fiscal 2006. We planned to increase sales through market-share gains, maximize
      profitability and focus on innovation. The following section reviews our
      strategic objectives for fiscal 2006 and the results achieved for each of these
      objectives.





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*Increase
      sales through market-share gains*





In
      fiscal
      2006, we focused on continued market-share gains to achieve medium- and
      long-term growth. We posted our second-best sales performance in history,
      growing sales 31.9% to $128.3 million in 2006, thus outperforming our revised
      growth metric of 25%. Given strong sales growth in our two Divisions and the
      Consultronics acquisition, we raised our growth metric from 15% to 25% midway
      through the fiscal year. Considering that the telecommunications market
      increased in the mid single digits in fiscal 2006, this is a clear indication
      that we gained market share overall. For fiscal 2006, our Telecom Division
      and
      our Life Sciences and Industrial Division reported strong sales increases of
      34.0% and 22.1%, respectively.





*Maximize
      profitability*





Returning
      to profitability was a top priority for EXFO in fiscal 2006. During the year,
      we
      posted earnings from operations of $8.1 million, or 6.3% of sales, compared
      to a
      loss from operations of $199,000 in 2005. This also compares to our stated
      goal
      of earnings from operations of 5% for fiscal 2006. This marks the first year
      where EXFO generated earnings from operations since fiscal 2001, when the
      telecommunications industry went through a major downturn. To that point, EXFO
      had historically been profitable. This significant improvement in earnings
      from
      operations is even more impressive considering the strengthening of the Canadian
      dollar compared to the US dollar (7.3% increase in fiscal 2006 in terms of
      average rate), and the significant pricing pressure we faced during the year.
      Also, earnings from operations for fiscal 2006 included additional amortization
      expenses for intangible assets of $1.0 million following the acquisition of
      Consultronics in January 2006. However, earnings from operations of 2006
      included a non-recurring gain of $703,000, comprised of grant revenue of $1.3
      million, and an impairment loss for long-lived assets of $604,000.





*Focus
      on innovation*





In
      fiscal
      2006, innovation was a key driver at EXFO. We maintained a significant level
      of
      research and development investments and introduced 18 new products to the
      marketplace. We invested $19.5 million, or 15.2% of sales, in gross
      research and development expenses, compared to $15.9 million, or 16.3% of sales
      in 2005. Net of research and development tax credits, those expenses stand
      at
      12.0 % and 12.5% in fiscal 2006 and 2005, respectively. In fiscal 2006, 37.1%
      of
      our sales originated from products that have been on the market for two years
      or
      less, which is below our aggressive goal of 40% for fiscal 2006 and the 42.4%
      level reached in 2005. Our successful FTTx products, moving down to the
      denominator part of the ratio as they have been on the market for more than
      two
      years, still strongly contributed to our sales performance. However, we believe
      this innovation mark reached in fiscal 2006 is well above the market average.





**Strategic
      Objectives for Fiscal 2007**





Global
      market demand for telecom test and measurement equipment should remain strong
      in
      the years to come as most network service providers (NSPs) are increasing
      capital expenditures to upgrade their networks for converged IP services and
      triple-play offerings. These market forces create needs for differentiated
      test
      solutions to help NSPs accelerate deployment and ensure service quality in
      their
      network build-outs. In fiscal 2007, we will strengthen our competitive position
      by leveraging revenue and earnings from operations, both organically and through
      strategic and selected acquisitions if stringent criteria are met.





As
      we
      remain committed to best practice in financial reporting, once again this year,
      we are providing our investors with our strategic objectives for fiscal 2007
      along with key performance metrics. The strategic objectives for fiscal 2007
      are
      the continuity of those of 2006. As always, we are highly focused on creating
      value for our shareholders, providing the highest degree of profitable growth.
      In fiscal 2007, we intend to maintain our long-term focus on profitable growth
      by increasing sales in both divisions through market-share gains; maximize
      profitability through proper execution and efficiency of our cost-reduction
      programs; and focus on innovation to positively position the organization for
      the long-term growth opportunities that exist in our space.





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*Increase
      sales through market-share gains*





In
      fiscal
      2007, we intend to continue increasing sales through market-share gains. We
      were
      among the last companies to be impacted by the telecommunications downturn
      in
      2001 and the first to recover with significant sales growth of 20.5% in fiscal
      2004, 30.3% in 2005 and 31.9% in 2006, including 12 consecutive quarters of
      growth. This remarkable recovery was accomplished mainly through market-share
      gains, since our end-markets reportedly experienced negative growth in fiscal
      2004 and increased in the mid single digits in 2005 and 2006. On the strength
      of
      our past and current research and development investment as well as our market
      position in key areas, we intend to maintain a high growth rate in 2007; more
      specifically, we aim to achieve this by further increasing our market share
      in
      telecom testing - especially in the rapidly growing protocol test segment -
      and
      by leveraging core technologies in targeted life sciences and industrial
      markets.





*Maximize
      profitability*





In
      fiscal
      2007, we will focus on accelerating our profitability by increasing our earnings
      from operations, according to our expected sales growth and our strong focus
      on
      operations. **** In
      the
      last few years, our bottom-line improved even faster than our top-line with
      earnings from operations of 6.3% of sales in fiscal 2006, which included a
      non-recurring gain of 0.5%. We remain confident that our earnings from
      operations will continue to improve as various factors are expected to come
      into
      play namely, higher-margin protocol and copper access revenues; better
      absorption of fixed costs on higher sales volumes; specific internal
      initiatives; and currency stability. This assumes no acquisitions.





*Focus
      on innovation*





For
      fiscal 2007, we will keep our focus on innovation by devoting significant
      efforts to the development of new and differentiated solutions that support
      long-term growth and profitability as well as deliver added-value to our
      customers. Over the past few years, our new products, with their built-in
      superior performance and lower cost of goods, contributed significantly to
      raising our gross margin and earnings from operations, while being able to
      overcome considerable pricing pressure in our industry. In fiscal 2007, we
      intend to significantly increase our investment in research and development
      activities in dollars and slightly as a percentage of sales. We also intend
      to
      increasingly take advantage of talent pools around the world to cost-effectively
      design innovative test solutions. Our numerous but focused research and
      development initiatives should enable our new products to continue gaining
      traction with customers and lead to further growth, market-share gains and
      increased profitability in the coming years.





**Key
      Performance Indicators**





As
      measures to assess the realization of our strategic plan and its objectives,
      we
      have set out three consolidated key performance indicators for fiscal 2007.
      They
      are summarized as follows:





**Strategic
                objectives for fiscal 2007**
            **Key
                performance indicators for fiscal 2007**Increase
                sales through market-share gains
            20%
                sales growth year-over-yearMaximize
                profitability
            7%
                in earnings from operationsFocus
                on innovation
            35%
                of sales from new products(on
                the market two years or less)





**Capability
      to Deliver Results**





At
      EXFO,
      we believe that we have the capabilities to deliver expected results thanks
      to
      outstanding products, an excellent reputation in the marketplace, a sound
      financial position, as well as an experienced workforce and management
      team.








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**CRITICAL
      ACCOUNTING POLICIES AND ESTIMATES**





Management’s
      discussion and analysis of financial conditions and results of operations is
      based on our consolidated financial statements included elsewhere in this annual
      report. As previously mentioned, they have been prepared in accordance with
      Canadian GAAP. The preparation of financial statements in accordance with GAAP
      requires management to make estimates and assumptions that affect the reported
      amounts of assets and liabilities and the disclosures of contingent assets
      and
      liabilities at the date of the financial statements, as well as the reported
      amounts of revenues and expenses during the reporting years. On an ongoing
      basis, we evaluate these estimates and assumptions, including those related
      to
      revenue recognition, the allowance for doubtful accounts, the amount of tax
      credits recoverable, the allowance for excess and obsolete inventories, the
      useful lives of capital assets, the valuation of long-lived assets, the
      valuation allowance of future income tax assets, the amount of certain accrued
      liabilities and deferred revenue as well as stock-based compensation costs.
      We
      base our estimates and assumptions on historical experience and on other factors
      that we believe to be reasonable under the circumstances, the result of which
      form the basis for making judgments about the carrying values of assets and
      liabilities that are not readily apparent from other sources. Actual results
      could differ from these estimates.





The
      following summarizes our critical accounting policies as well as other policies
      that require the most significant judgment and estimates in the preparation
      of
      our consolidated financial statements.





*Revenue
      recognition.* For
      products in which software is incidental, we recognize revenue when persuasive
      evidence of an arrangement exists, the product has been delivered, the price
      is
      fixed and determinable and collection of the resulting receivable is reasonably
      assured. In addition, provisions are made for estimated returns, warranties
      and
      support obligations.





For
      products in which software is not incidental, revenues are separated into two
      categories: product and post-contract customer support (PCS) revenues, based
      upon vendor-specific objective evidence of fair value. Product revenues for
      these sales are recognized as described above. PCS revenues are deferred and
      recognized ratably over the years of the support arrangement. PCS revenues
      are
      recognized at the time the product is delivered when provided within one year
      of
      delivery; the costs of providing this support are insignificant (and accrued
      at
      the time of delivery) and no software upgrades are provided.





For
      all
      sales, we use a binding purchase order as evidence that a sales arrangement
      exists.





Delivery
      generally occurs when the product is handed over to a transporter for
      shipment.





At
      the
      time of the transaction, we assess whether the price associated with our revenue
      transaction is fixed and determinable, and whether or not collection is
      reasonably assured. We assess whether the price is fixed and determinable based
      on the payment terms associated with the transaction. We assess collection
      based
      on a number of factors, including past transaction history and the
      creditworthiness of the customer. Generally, collateral or other security is
      not
      requested from customers.





Most
      sales arrangements do not generally include acceptance clauses. However, if
      a
      sales arrangement does include an acceptance provision, acceptance occurs upon
      the earliest of the receipt of a written customer acceptance or the expiration
      of the acceptance period. For these sales arrangements, the sale is recognized
      when acceptance occurs.





Revenue
      for extended warranties is recognized on a straight-line basis over the warranty
      period.





*Allowance
      for doubtful accounts.* We
      estimate collectibility of accounts receivable on an ongoing basis by reviewing
      balances outstanding over a certain period of time. We determine our allowance
      for doubtful accounts receivable based on our historical accounts receivable
      collection experience and on the information that we have about the status
      of
      our accounts receivable balances. If the financial conditions of our customers
      deteriorate, resulting in an impairment of their ability to make required
      payments, additional allowance may be required, which could adversely affect
      our
      future results.





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*Allowance
      for excess and obsolete inventories.* We state
      our inventories at the lower of cost, determined on an average cost basis and
      replacement cost or net realizable value, and we provide reserves for excess
      and
      obsolete inventories. We determine our reserves for excess and obsolete
      inventories based on the quantities we have on hand versus expected needs for
      these inventories, so as to support future sales of our products. It is possible
      that additional inventory reserves may occur if future sales are less than
      our
      forecasts or if there is a significant shift in product mix compared to our
      forecasts, which could adversely affect our future results.





*Research
      and development tax credits and government grants.* We
      record research and development tax credits and government grants based on
      our
      interpretation of tax laws and grant programs, especially regarding related
      eligible projects and expenses, and when there is reasonable assurance that
      we
      have complied and will continue to comply with all conditions and laws. Also,
      our judgment and estimates are based on historical experience. It is possible,
      however, that the tax authorities or the sponsors of the grant programs have
      a
      different interpretation of laws and application of conditions related to the
      programs or that we do not comply with all conditions related to grants in
      the
      future, which could adversely affect our future results. Furthermore, a
      significant part of our tax credits are refundable against income taxes payable,
      causing their ultimate realization to be dependent upon the generation of
      taxable income. If we obtain information that causes our forecast of future
      taxable income to change or if actual taxable income differs from our forecast,
      we may have to revise the carrying value of these tax credits, which would
      affect our results in the period in which the change was made. We review the
      recoverability of such tax credits on a quarterly basis.





*Impairment
      of long-lived assets and goodwill.* We
      assess impairment of goodwill on an annual basis, or more frequently, if events
      or circumstances indicate that it might be impaired. Recoverability of goodwill
      is determined at the reporting-unit level using a two-step approach. First,
      the
      carrying value of a reporting unit is compared to its fair value, which is
      determined based on a combination of discounted future cash flows and a market
      approach. If the carrying value of a reporting unit exceeds its fair value,
      the
      second step is performed. In this step, the amount of impairment loss, if any,
      represents the excess of the carrying value of goodwill over its fair value
      and
      the loss is charged to earnings in the period in which it is incurred. For
      the
      purposes of this impairment test, the fair value of goodwill is estimated in
      the
      same way as goodwill is determined in business combinations; that is, the excess
      of the fair value of a reporting unit over the estimated fair value of its
      net
      identifiable assets.





We
      assess
      impairment of long-lived assets when events or circumstances indicate that
      costs
      may not be recoverable. Impairment exists when the carrying value of an asset,
      or a group of assets, is greater than the pre-tax undiscounted future cash
      flows
      expected to be provided by the asset or the group of assets. The amount of
      impairment loss, if any, is the excess of the carrying value over the fair
      value. We assess fair value of long-lived assets based on discounted future
      cash
      flows. ****





*Future
      income taxes.* We
      account for income taxes using the liability method of tax allocation. Under
      this method, future income tax assets and liabilities are determined based
      on
      deductible or taxable temporary differences between financial statement values
      and tax values of assets and liabilities, using enacted income tax rates for
      the
      years in which the differences are expected to reverse. In assessing the
      recoverability of our future income tax assets, we consider whether it is more
      likely than not that some or all of the future income tax assets will not be
      realized. The ultimate realization of our future income tax assets is dependent
      upon the generation of future taxable income during the periods in which those
      temporary differences will become deductible. As at August 31, 2006, we had
      established a full valuation allowance against our future income tax assets.
      The
      valuation allowance will be reversed once management will have concluded that
      realization of future income tax assets is more likely than not.





*Stock-based
      compensation costs.* We
      account for all forms of employee stock-based compensation using the fair
      value-based method. This method requires that we make estimates about the
      risk-free interest rate, the expected volatility of our shares and the expected
      life of the awards.





In
      January 2005, the Canadian Institute of Chartered Accountants (CICA) issued
      four
      new accounting standards in relation to financial instruments: Section 3855,
      "Financial Instruments - Recognition and Measurement"; Section 3865, "Hedges";
      Section 1530, "Comprehensive Income"; and Section 3251, "Equity".





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Section
      3855 expands on Section 3860, "Financial Instruments - Disclosure and
      Presentation", by prescribing when a financial instrument is to be recognized
      on
      the balance sheet and at what amount. It also specifies how financial instrument
      gains and losses are to be presented in the financial statements.





Section
      3865 provides an alternative to Section 3855 for entities that choose to
      designate qualifying transactions as hedges for accounting purposes. It replaces
      and expands on Accounting Guideline 13, "Hedging Relationships", and on the
      hedging guidance in Section 1650, "Foreign Currency Translation", by specifying
      how hedge accounting is applied and what disclosures it requires.





Section
      1530, "Comprehensive Income", introduces a new requirement to temporarily
      present certain gains and losses outside net income.





Consequently,
      Section 3250, "Surplus", has been revised as Section 3251, "Equity".





Sections
      1530, 3251, 3855 and 3865 apply to fiscal years beginning on or after
      October 1, 2006. We will adopt these new standards on September 1,
      2007. While we are currently assessing the effects of these new standards,
      impacts consistent with the adjustments described under note 20 item b) of
      these
      consolidated financial statements are expected.





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**RESULTS
        OF OPERATIONS**
 
 The
        following table sets forth certain Canadian GAAP consolidated financial
        statements data in thousands of US dollars, except per share data and as
        a
        percentage of sales for the years indicated:
 
 **Consolidated
                  statements of earnings data:**
              
              
              **2006**
              
              
              2005
              
              
              2004
              
              
              **2006**
              
              
              2005
              
              
              2004Sales
              
              **$**
              **128,253**
              
              $
              97,216
              
              $
              74,630
              
              
              **100.0**
              **%**
              
              100.0
              %
              
              100.0
              %Cost
                  of sales(1)
              
              
              **57,275**
              
              
              44,059
              
              
              34,556
              
              
              **44.7**
              
              
              45.3
              
              
              46.3Gross
                  margin
              
              
              **70,978**
              
              
              53,157
              
              
              40,074
              
              
              **55.3**
              
              
              54.7
              
              
              53.7Operating
                  expensesSelling
                  and administrative
              
              
              **40,298**
              
              
              31,782
              
              
              25,890
              
              
              **31.4**
              
              
              32.7
              
              
              34.7Net
                  research and development
              
              
              **15,404**
              
              
              12,190
              
              
              12,390
              
              
              **12.0**
              
              
              12.5
              
              
              16.6Amortization
                  of property, plant and equipment
              
              
              **3,523**
              
              
              4,256
              
              
              4,935
              
              
              **2.7**
              
              
              4.4
              
              
              6.6Amortization
                  of intangible assets
              
              
              **4,394**
              
              
              4,836
              
              
              5,080
              
              
              **3.4**
              
              
              5.0
              
              
              6.8Impairment
                  of long-lived assets
              
              
              **604**
              
              
              **−**
              
              
              620
              
              
              **0.5**
              
              
              **−**
              
              
              0.8Government
                  grants
              
              
              **(1,307**
              **)**
              
              **−**
              
              
              **−**
              
              
              **(1.0**
              **)**
              
              **−**
              
              
              **−**Restructuring
                  and other charges
              
              
              **−**
              
              
              292
              
              
              1,729
              
              
              **−**
              
              
              0.3
              
              
              2.3Total
                  operating expenses
              
              
              **62,916**
              
              
              53,356
              
              
              50,644
              
              
              **49.0**
              
              
              54.9
              
              
              67.8Earnings
                  (loss) from operations
              
              
              **8,062**
              
              
              (199
              )
              
              (10,570
              )
              
              **6.3**
              
              
              (0.2
              )
              
              (14.1
              )Interest
                  and other income
              
              
              **3,253**
              
              
              2,524
              
              
              1,438
              
              
              **2.5**
              
              
              2.6
              
              
              1.9Foreign
                  exchange loss
              
              
              **(595**
              **)**
              
              (1,336
              )
              
              (278
              )
              
              **(0.5**
              **)**
              
              (1.4
              )
              
              (0.4
              )Earnings
                  (loss) before income taxes
              
              
              **10,720**
              
              
              989
              
              
              (9,410
              )
              
              **8.3**
              
              
              1.0
              
              
              (12.6
              )Income
                  taxes
              
              
              **2,585**
              
              
              2,623
              
              
              (986
              )
              
              **2.0**
              
              
              2.7
              
              
              (1.3
              )Net
                  earnings (loss) for the year
              
              **$**
              **8,135**
              
              $
              (1,634
              )
              $
              (8,424
              )
              
              **6.3**
              **%**
              
              (1.7
              )%
              
              (11.3
              )%Basic
                  and diluted net earnings (loss) per share
              
              **$**
              **0.12**
              
              $
              (0.02
              )
              $
              (0.13
              )Segment
                  informationSales:Telecom
                  Division
              
              **$**
              **107,376**
              
              $
              80,120
              
              $
              58,882
              
              
              **83.7**
              **%**
              
              82.4
              %
              
              78.9
              %Life
                  Sciences and Industrial Division
              
              
              **20,877**
              
              
              17,096
              
              
              15,748
              
              
              **16.3**
              
              
              17.6
              
              
              21.1**$**
              **128,253**
              
              $
              97,216
              
              $
              74,630
              
              
              **100.0**
              **%**
              
              100.0
              %
              
              100.0
              %Operating
                  earnings (loss):Telecom
                  Division
              
              **$**
              **6,679**
              
              $
              763
              
              $
              (5,557
              )
              
              **5.2**
              **%**
              
              0.8
              %
              
              (7.4)%Life
                  Sciences and Industrial Division
              
              
              **1,383**
              
              
              (962
              )
              
              (5,013
              )
              
              **1.1**
              
              
              (1.0
              )
              
              (6.7
              )**$**
              **8,062**
              
              $
              (199
              )
              $
              (10,570
              )
              
              **6.3**
              **%**
              
              (0.2
              )%
              
              (14.1
              )%Research
                  and development dataGross
                  research and development
              
              **$**
              **19,488**
              
              $
              15,878
              
              $
              15,668
              
              
              **15.2**
              **%**
              
              16.3
              %
              
              21.0
              %Net
                  research and development
              
              **$**
              **15,404**
              
              $
              12,190
              
              $
              12,390
              
              
              **12.0**
              **%**
              
              12.5
              %
              
              16.6
              %**Consolidated
                  balance sheets data:**Total
                  assets
              
              **$**
              **219,159**
              
              $
              190,957
              
              $
              172,791(1)The
                  cost of sales is exclusive of amortization, shown
                  separately.
 
 
 **SALES**
 
 ***Fiscal
        2006 vs. 2005***
 
 In
        fiscal
        2006, our global sales increased 31.9% to $128.3 million from $97.2 million
        in
        2005, with an 84%-16% split in favor of our Telecom Division.
 
 *Telecom
        Division*
 
 In
        fiscal
        2006, sales of our Telecom Division increased 34.0% to $107.4 million from
        $80.1 million in 2005.




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In
      fiscal
      2006, we leveraged our portfolio of new products and an increased demand for
      our
      test solutions, especially in Europe, Middle East and Africa (EMEA) and
      Asia-Pacific (APAC), to increase our year-over-year sales in our Telecom
      Division. We also consolidated our dominant FTTx market position in the Americas
      by enabling a Tier-1 carrier to migrate to less expensive test solutions.
      Although revenues were down at this customer year-over-year, we maintained
      our
      market share through the sales of cost-effective test solutions, such as our
      handheld AXS-100 OTDR, to help it reduce cost of deployments. In
      addition, the positive spending environment, as well as the market share we
      believe that we gained in fiscal 2006 for our optical and protocol products,
      helped us increase our sales of that Division year-over-year. Also, Consultronics
      contributed about seven months to our Telecom Division, which had a positive
      impact on our consolidated sales during fiscal 2006. Consultronics’ results have
      been included in our consolidated statement of earnings since the closing of
      the
      acquisition on January 26, 2006. Finally,
      in fiscal 2006, our top customer accounted for 16.5% of our Telecom sales,
      compared to 28.2% of sales in 2005, reflecting the diversification of our
      customer base. In fact,
      excluding sales to our top customer, our sales to this Division would have
      increased 56.0% in fiscal 2006, compared to 2005.





Although,
      in the past few years, our market share in the protocol test market has been
      modest, our protocol-product results in the second half of fiscal 2006 increased
      substantially year-over-year, making this sector our fastest-growing line of
      business. We expect continued strong growth in fiscal 2007 based on our solid
      product offering in next-generation solutions, which are at the basis of the
      whole trend toward IP convergence. During the second half of fiscal 2006, we
      reached a key milestone for our protocol-product development program. More
      specifically, this consisted in the launch of legacy and next-generation
      SONET/SDH network test modules for our FTB-200, FTB-400 and IQS-500 platforms.
      These latest product launches, combined with our existing offering for Ethernet
      testing (from 10 Mb/s up to 10 Gb/s), Gigabit Ethernet, Fibre Channel test
      solutions, provide us with an extensive product portfolio to compete against
      the
      incumbent players in protocol testing, especially in the network service
      provider (NSP) market segment, but also to a lesser degree, with system vendors.
      Among many key differentiators, we believe EXFO now offers the most complete
      and
      advanced compact test solutions combining legacy and next-generation SONET/SDH
      as well as Ethernet test modules for rates up to 10 Gb/s within the same
      portable platform (i.e., our FTB-400 mainframe and GP-404 module receptacle).
      In
      fiscal 2006, sales of our protocol products, which almost doubled compared
      to
      2005, increased to their highest historical levels, representing well above
      10%
      of our optical sales. Based on these data points and given the much larger
      addressable market for protocol test solutions, we believe that protocol test
      revenues will increase and grow faster than our optical revenues. On a medium-
      to long-term basis, we anticipate that revenues from these segments will
      eventually be equal.





As
      our
      newly acquired copper access product line is now better leveraged by EXFO’s
      global sales channels and improved innovation processes, we intend to strengthen
      our offering in this market segment.





*Life
      Sciences and Industrial Division*




In
      fiscal
      2006, sales of our Life Sciences and Industrial Division increased 22.1% to
      $20.9 million from $17.1 million in 2005. The increase in sales in fiscal
      2006, compared to 2005, is mainly due to increased sales activities in the
      curing market as well as market-share gains in the fluorescence illumination
      market, following our efforts to expand international markets, mainly in Europe
      and Asia.





Overall,
      for the two divisions, net accepted orders increased 27.2% to $129.4 million
      in
      fiscal 2006 from $101.7 million in 2005, for a book-to-bill ratio of 1.01 in
      fiscal 2006. Our increase of 27.2% in net accepted orders in fiscal 2006,
      compared to 2005 reflects the impact of the Consultronics acquisition, an
      increased demand for our test solutions (especially in EMEA and APAC regions),
      market-share gains in the telecommunications and life sciences markets as well
      as the improvement in the telecommunications market environment.





***Fiscal
      2005 vs. 2004***





In
      fiscal
      2005, our global sales increased 30.3% to $97.2 million from $74.6 million
      in
      2004, with an 82%-18% split in favor of our Telecom Division.





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*Telecom
      Division*





In
      fiscal
      2005, sales of our Telecom Division increased 36.1% to $80.1 million from $58.9
      million in 2004. Since the second half of fiscal 2004, we have benefited from
      an
      increased demand for our test solutions following the deployment of fiber deeper
      into access networks (FTTx). In fiscal 2005, we consolidated our leadership
      position in the FTTx test market by recognizing significant revenue from two
      leading U.S. carriers deploying fiber in their access networks. Our top
      customer, who purchased several orders of FTTx test equipment, accounted for
      28.2% of telecom sales in fiscal 2005 (17.5% in 2004). In addition, the positive
      spending environment helped us increase our sales in 2005.





Although
      sales of our protocol test products increased sequentially each quarter in
      fiscal 2005 and reached more than 10% of Telecom Division revenues in the fourth
      quarter of 2005, they still fell below 10% for the whole fiscal year.





*Life
      Sciences and Industrial Division*





In
      fiscal
      2005, sales of our Life Sciences and Industrial Division increased 8.6% to
      $17.1
      million from $15.7 million in 2004. The increase in sales in fiscal 2005,
      compared to 2004, is mainly due to market-share gains in the fluorescence
      illumination market as well as increased sales activities in the curing
      market.





***Geographic
      distribution***





***Fiscal
      2006 vs. 2005***





During
      fiscal 2006, sales to the Americas, Europe-Middle East-Africa (EMEA) and
      Asia-Pacific (APAC) accounted for 60%, 25% and 15% of global sales,
      respectively, compared to 68%, 20% and 12%, respectively in 2005. Although
      our
      sales increased in dollars in every geographic area, we made greater progress
      in
      EMEA and APAC in fiscal 2006, compared to 2005, where we gained market share
      in
      both Divisions. Global sales to these two markets increased 66.9% and 66.4%,
      respectively in fiscal 2006, compared to 2005. In comparison, our sales to
      the
      Americas increased 15.6% year-over-year.





The
      significant increase in sales in the EMEA market is mainly due to improved
      market penetration by both divisions, following our efforts to develop this
      market in the last several quarters. Namely, since the second quarter of fiscal
      2006, we were selected as sole-source supplier by a Tier-1 network service
      provider for all its fiber deployment test applications - including FTTx,
      further increasing our sales to this market year-over-year.





Over
      the
      last several quarters, we strengthened our product offering in APAC,
      specifically by implementing a multi-tiered platform strategy to meet different
      customer demands and different price points and by expanding our sales and
      marketing activities in this region. Our increased focus on and interaction
      with
      this market, combined with our enhanced capability to win tenders (which may
      vary in number and importance) contributed to our growth in the APAC region.





In
      the
      Americas, sales to our top customer, who is located in the United States,
      decreased in fiscal 2006, compared to 2005 as it migrated to lower-priced test
      solutions, thus affecting our sales to the Americas year-over-year. However,
      we
      were able to leverage our customer base and increase our sales to this region
      in
      fiscal 2006, compared to 2005. Also, Consultronics, whose customers are mainly
      in the Americas, helped increase our sales to the Americas in fiscal 2006.
      In
      fact, excluding sales to our top customer, our sales to the Americas would
      have
      increased 35.1% year-over-year, which is quite remarkable considering that
      our
      end-markets increased in mid single digits in 2006.





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***Fiscal
      2005 vs. 2004***





During
      fiscal 2005, sales to the Americas, EMEA and APAC accounted for 68%, 20% and
      12%
      of global sales, respectively, compared to 66%, 18% and 16%, respectively in
      2004. Our sales to the Americas, which increased 34% year-over-year, benefited
      from the recent deployments of fiber deeper in access networks (mainly in the
      United States). Our sales to EMEA increased more significantly (42%)
      year-over-year, mainly due to market-share gains in both divisions, following
      our efforts to develop this important end-market. Finally, our sales to APAC
      remained flat in dollars year-over-year. A significant portion of our sales
      to
      this region of the world are made through price-driven tenders that may vary
      in
      number and importance from quarter to quarter. Also, the competitive landscape
      in this market led to pricing pressure, which prevented us from increasing
      our
      sales year-over-year.





Through
      our two divisions, we sell our products to a broad range of customers, including
      NSPs, cable TV operators, optical system and component manufacturers, as well
      as
      customers in the life sciences and high-precision assembly sectors. In fiscal
      2006, our top customer accounted for 13.8% of our total sales, compared to
      23.3%
      in 2005 and 13.8% in 2004. In fiscal 2006, our top three customers accounted
      for
      19.4% of our global sales, compared to 28.4% in fiscal 2005 and 20.8% in 2004.
      Our significant sales increase, despite the fact that our revenue from our
      top
      customer was significantly reduced is a good sign that we continued to
      strengthen our market acceptance, diversify our customer base and reduce our
      sales concentration with a single customer. This also indicates that our
      second and third most important customers, who may vary from quarter to
      quarter, have gained in importance as we continue our diversification
      efforts.








**GROSS
      MARGIN**





Gross
      margin amounted to 55.3%, 54.7% and 53.7% of sales for fiscal 2006, 2005 and
      2004, respectively.





***Fiscal
      2006 vs. 2005***





The
      increase in our gross margin in fiscal 2006, compared to 2005 can be explained
      by the following factors. First, we succeeded in increasing the market
      acceptance of our new products (designed in the last few years) on which we
      had
      focused our research and development efforts to simultaneously create lower
      cost
      of goods and the most advanced solutions. Second, the significant rise in sales
      year-over-year resulted in an increase in manufacturing activities, allowing
      us
      to better absorb our fixed manufacturing costs. Also, we were able to reduce
      our
      cost of goods sold by better leveraging our supplier base. Furthermore,
      streamlined operations following our consolidation action in fiscal 2005 and
      continued cost-reduction programs allowed us to further improve our gross
      margin. However, the shift in the geographic distribution of our sales resulted
      in more sales, in percentage of total sales **,** made to
      the EMEA and APAC markets, where gross margins tend to be lower as most of
      our
      sales to these markets are made through distribution channels. In addition,
      we
      are facing aggressive pricing pressure worldwide. Furthermore, in fiscal 2006,
      we incurred one-time charges related to the integration of Consultronics
      manufacturing activities, which reduced our gross margin year-over-year.
      Finally, a stronger Canadian dollar, compared to the US dollar, prevented us
      from further improving our gross margin as some cost of sales items are
      denominated in Canadian dollars. ****





On
      an
      ongoing basis, we adjust the design of our products and, over the past few
      years, we experienced higher sales than expected. Consequently, we were able
      to
      reuse excess inventories that were written off during the telecom downturn
      in
      2001 and 2002. Excess inventory reuse accounted for approximately $1.2 million,
      or 0.9% of sales in fiscal 2006, compared to approximately $1.6 million, or
      1.7%
      of sales in 2005 and approximately $600,000, or 0.8% of sales in 2004. Inventory
      write-offs recorded during the telecom downturn were based on our best estimate
      at that time.





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***Fiscal
      2005 vs. 2004***





The
      increase in our gross margin in fiscal 2005, compared to 2004, can be explained
      by the following factors. First, we were able to reduce our cost of goods sold
      by better leveraging our supplier base and by developing innovative new products
      with a cost-effective design. Also, the significant rise in sales resulted
      in an
      increase in manufacturing activities, allowing us to better absorb our fixed
      manufacturing costs. Furthermore, streamlined operations following our
      consolidation actions in fiscal 2004 and 2005 and cost-reduction programs
      allowed us to further improve our gross margin. In addition, the shift in the
      geographic distribution of our sales resulted in more sales made to the Americas
      market, where gross margins tend to be higher because we sell direct to the
      customers. However, a stronger Canadian dollar, compared to the US dollar,
      prevented us, to some extent, from further improving our gross margin as some
      cost of sales elements are denominated in Canadian dollars. As well, the
      different customer mix and aggressive pricing pressure observed in fiscal 2005
      also prevented us from further improving our gross margin.





***Outlook
      for Fiscal 2007***





Considering
      the expected sales growth in fiscal 2007, the expected increase in sales of
      protocol products (which tend to generate higher margins), the cost-effective
      design of our products, our tight control on operating costs as well as the
      full
      contribution of Consultronics, whose products have slightly higher margin than
      our existing ones, we expect our gross margin to improve in 2007 and beyond.
      However, our gross margin may fluctuate quarter-over-quarter as our sales may
      fluctuate. Furthermore, our gross margin can be negatively affected by increased
      competitive pricing pressure, customer concentration and/or consolidation,
      increased obsolescence costs, shifts in customer and product mix,
      under-absorption of fixed manufacturing costs and increases in product offerings
      by other suppliers in our industry. Finally, any further increase in the
      strength of the Canadian dollar would have a negative impact on our gross margin
      in fiscal 2007.








**SELLING
      AND ADMINISTRATIVE**





Selling
      and administrative expenses were $40.3 million, $31.8 million and $25.9 million
      for fiscal 2006, 2005 and 2004, respectively. As a percentage of sales, selling
      and administrative expenses amounted to 31.4%, 32.7% and 34.7% for fiscal
      2006, 2005 and 2004, respectively.





***Fiscal
      2006 vs. 2005***





The
      increase in our selling and administrative expenses in dollars in fiscal 2006,
      compared to 2005, is mainly due to our decision to increase our sales activities
      to better leverage the significant research and development investments of
      the
      prior years, which resulted in higher sales and marketing expenditures
      (including number of employees). In addition, our commission expenses increased
      year-over-year due to the increase in sales. Furthermore, a stronger Canadian
      dollar, compared to the US dollar year-over-year, caused our selling and
      administrative expenses to increase, as more than half of these are incurred
      in
      Canadian dollars. Finally, in fiscal 2006, Consultronics contributed about
      seven
      months to our selling and administrative expenses, increasing these expenses
      year-over-year.





***Fiscal
      2005 vs. 2004***





During
      fiscal 2005, we also significantly increased our sales activities around the
      world, which resulted in higher sales and marketing expenditures. In addition,
      increased sales activities, especially in the Americas market, resulted in
      higher commission expenses year-over-year. Furthermore, as witnessed in fiscal
      2006, the strengthening of the Canadian dollar, compared to the US dollar
      year-over-year, caused our selling and administrative expenses to increase.
      Also, stock-based compensation costs were higher in fiscal 2005 ($626,000)
      than
      in 2004 ($265,000), further increasing our selling and administrative expenses
      year-over-year. Finally, costs to comply with Section 404 of the Sarbanes-Oxley
      Act further increased our selling and administrative expenses
      year-over-year.





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For
      both
      fiscal 2005 and 2006, we were able to mitigate the increase in our selling
      and
      administrative expenses as well as reduce these expenses in percentage of sales
      year-over-year due to tight cost-control measures. In addition, our significant
      increase in revenues allowed us to reduce our selling and administrative
      expenses on a percentage basis.





***Outlook
      for Fiscal 2007***





For
      fiscal 2007, we expect our selling and administrative expenses to increase
      in
      dollars, while remaining relatively stable as a percentage of sales. In
      particular, in fiscal 2007, we will have the full impact of the acquisition
      of
      Consultronics on our selling and administrative expenses. Also, we expect our
      commission expenses to increase as sales volume increases. Furthermore,
      considering our goal of becoming the leading player in the telecom test and
      measurement space, we will intensify our sales and marketing efforts, both
      domestic and international, which will also cause our expenses to rise. Finally,
      any further increase in the strength of the Canadian dollar would also cause
      our
      selling and administrative expenses to increase, as more than half of these
      expenses are incurred in Canadian dollars.








**RESEARCH
      AND DEVELOPMENT**





**Gross
      research and development expenses**





Gross
      research and development expenses totaled $19.5 million, $15.9 million and
      $15.7
      million for fiscal 2006, 2005 and 2004, respectively. As a percentage of sales,
      gross research and development expenses amounted to 15.2%, 16.3% and 21.0%
      for
      fiscal 2006, 2005 and 2004, respectively, while net research and development
      expenses accounted for 12.0%, 12.5% and 16.6% of sales for these respective
      periods.





***Fiscal
      2006 vs. 2005***





The
      increase in our gross research and development expenses in dollars in fiscal
      2006, compared to 2005, is due to the following reasons. First, in fiscal 2006,
      Consultronics contributed about seven months to our gross research and
      development expenses, which caused these expenses to increase year-over-year.
      In
      addition, in fiscal 2006, our gross research and development expenses were
      negatively affected by the increased strength of the Canadian dollar, compared
      to the US dollar year-over-year. This can be explained by the fact that,
      following the consolidation of most of our research and development activities
      in Canada, the majority of our expenses are incurred in Canadian dollars.
      Finally, mix and timing of research and development projects in fiscal 2006
      resulted in more gross research and development expenses during that year
      compared to 2005 for both divisions.





The
      decrease in gross research and development expenses as a percentage of sales
      in
      fiscal 2006, compared to 2005, is directly related to the significant increase
      in sales year-over-year.





***Fiscal
      2005 vs. 2004***





As
      mentioned above, we incur most of our gross research and development expenses
      in
      Canadian dollars. Consequently, the significant increase in the strength of
      the
      Canadian dollar, compared to the US dollar year-over-year, caused our gross
      research and development expenses to increase in fiscal 2005, compared to 2004.
      However, this increase was mostly offset by the decrease in our gross research
      and development expenses in our Life Sciences and Industrial Division following
      the consolidation of this division in Toronto. The decrease in our gross
      research and development expenses as a percentage of sales in fiscal 2005
      compared to 2004, is directly attributable to the significant increase in sales
      year-over-year while these expenses remained relatively flat.





**Tax
      credits and grants**





Tax
      credits and grants from the Canadian federal and provincial governments for
      research and development activities were $4.1 million, $3.7 million and $3.3
      million for fiscal 2006, 2005 and 2004, respectively. As a percentage of gross
      research and development expenses, tax credits and grants amounted to 21.0%,
      23.2% and 20.9% for fiscal 2006, 2005 and 2004, respectively.





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***Fiscal
      2006 vs. 2005***





The
      increase in our tax credits in dollars in fiscal 2006, compared to 2005, is
      mainly related to the increase in our eligible gross research and development
      expenses in Canada, since we were also entitled to similar grant programs and
      tax credits year-over-year. In addition, the increased strength of the Canadian
      dollar, compared to the US dollar, year-over-year, resulted in higher tax
      credits since these credits are earned in Canada. However, our tax credits
      decreased as a percentage of gross research and development expense. Indeed,
      following the acquisition of Consultronics, we incurred less gross expenses
      entitling to tax credits since a part of Consultronics research and development
      activities were held outside Canada and Quebec. In addition, a mix of research
      and development projects resulted in a lower proportion of expenses being
      eligible to tax credits in fiscal 2006, compared to 2005.





***Fiscal
      2005 vs. 2004***





The
      increase in our tax credits in fiscal 2005, compared to 2004, is mainly related
      to the increase in our eligible gross research and development expenses in
      Canada, since we were entitled to similar grant programs and tax credits
      year-over-year. Following the consolidation of our research and development
      activities in Canada, we incurred most of our research and development expenses
      in Canada, where we are entitled to research and development tax credits. In
      addition, the increased strength of the Canadian dollar, compared to the US
      dollar, year-over-year, resulted in higher tax credits since these credits
      are
      earned in Canada.





We
      still
      invested significantly in research and development activities in fiscal 2006
      as
      we firmly believe that innovation and new product introductions are key in
      gaining market share in the current economic environment and ensuring the
      long-term growth and profitability of EXFO.





***Outlook
      for Fiscal 2007***





For
      fiscal 2007, we intend to significantly increase our research and development
      expenses in dollars and slightly in percentage of sales, given our focus on
      innovation, our desire to gain market share, our goal to exceed customer needs
      and expectations and the full impact of the acquisition of Consultronics. We
      also intend to increasingly take advantage of talent pools around the world
      to
      cost-effectively design innovative test solutions. Finally, any further increase
      in the strength of the Canadian dollar would cause our net research and
      development expenses to increase, as most of these are incurred in Canadian
      dollars.








**AMORTIZATION
      OF PROPERTY, PLANT AND EQUIPMENT**





For
      fiscal 2006, amortization of property, plant and equipment was $3.5 million,
      compared to $4.3 million in 2005 and $4.9 million in 2004. The decrease in
      amortization expenses over the last two fiscal years, despite the increase
      in
      the strength of the Canadian dollar compared to the US dollar as well as the
      acquisition of Consultronics in 2006 is mainly due to the fact that some of
      our
      property, plant and equipment became fully amortized over the last three
      years.





***Outlook
      for Fiscal 2007***





For
      fiscal 2007, despite a potential increase in the strength of the Canadian dollar
      and the full impact of the acquisition of Consultronics, we expect the
      amortization of property, plant and equipment to decrease compared to 2006
      considering that some of these assets became fully amortized in 2006 or will
      become fully amortized in 2007.





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**AMORTIZATION
      OF INTANGIBLE ASSETS**





In
      conjunction with the business combinations we completed over the past several
      years, we recorded intangible assets, primarily consisting of core technology.
      These intangible assets resulted in amortization expenses of $4.4 million,
      $4.8
      million and $5.1 million for fiscal 2006, 2005 and 2004, respectively. The
      decrease in amortization expenses in the last two fiscal years, despite the
      increased strength of the Canadian dollar compared to the US dollar and the
      acquisition of Consultronics in 2006 is mainly due to the fact that some of
      our
      core technologies became fully amortized during fiscal 2005 and 2006; namely,
      those related to the acquisition of EXFO Burleigh and EXFO Photonics
      Solutions.





***Outlook
      for Fiscal 2007***





For
      fiscal 2007, despite a potential increase in the strength of the Canadian dollar
      and the full impact of the acquisition of Consultronics, we expect the
      amortization of intangible assets to approximate $3.0 million considering that
      some core technologies will become fully amortized in 2007; namely, those
      related to our protocol business. This assumes no acquisitions will be made
      during this period.








**IMPAIRMENT
      OF LONG-LIVED ASSETS**





***Fiscal
      2006***





In
      June
      2006, we entered into an agreement to sell our building located in Rochester,
      New York, along with some equipment and we recorded an impairment charge of
      $604,000 in the third quarter of fiscal 2006, representing the excess of the
      carrying value of these assets over the net expected selling price of $1.2
      million. The sale of these assets was finalized in the fourth quarter of 2006
      for the net expected selling price. This amount is included in the other
      receivables in the balance sheet as at August 31, 2006, and will be recovered
      in
      the first quarter of fiscal 2007. These assets report to the Life Sciences
      and
      Industrial Division. As at August 31, 2005, this building was shown as a
      long-lived asset held for sale in the balance sheet.





***Fiscal
      2004***





In
      fiscal
      2004, we put one of our buildings located in Quebec City, Canada, up for sale
      and received, at the beginning of 2005, a formal purchase offer for this
      building. Based on that offer, we concluded that the building was impaired
      and
      we recorded an impairment charge of $620,000 in fiscal 2004, representing the
      excess of the carrying value of the building over its expected selling price.
      However, during the first quarter of fiscal 2005, some conditions of the formal
      offer were not met and the offer was declined. During fiscal 2005, we withdrew
      the building from the market. This building reports to the Telecom
      Division.





In
      May of
      each of the reporting years, we performed our annual impairment test for
      goodwill and concluded that it was not impaired. Goodwill will be reviewed
      for
      impairment in May 2007, or prior if events or circumstances indicate it might
      be
      impaired.








**GOVERNMENT
      GRANTS**





During
      1998, we entered into an agreement with the Quebec Minister of Industry,
      Commerce, Science and Technology (“The Minister”). Pursuant to this agreement,
      the Minister agreed to contribute, in the form of grants, up to CA$2.2 million
      (US$2.0 million) over the period from January 1, 1998, through December 31,
      2002, payable based on the number of full-time jobs created during that
      period.





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Since
      the
      beginning of the program, we have claimed and received the maximum amount of
      CA$2.2 million. However, these grants were subject to the condition that
      jobs created pursuant to the agreement be maintained for a period of at least
      five years from the date of creation. Since the beginning of the program, we
      deferred in the balance sheet CA$1.5 million (US$1.3 million) until we
      received the final approval by the sponsor of the program related to jobs
      created. In fiscal 2006, the sponsor of the program granted us with its final
      approval and we recorded non-recurring revenue of CA$1.5 million (US$1.3
      million) in the earnings from operations in the statement of earnings of that
      period.








**RESTRUCTURING
      AND OTHER CHARGES**





***Fiscal
      2004 and 2005***




In
      fiscal
      2004, the Board of Directors approved a restructuring plan to consolidate the
      operations of our Life Sciences and Industrial Division, transferring our
      Rochester, New York, operations mainly to EXFO Photonic Solutions facilities
      in
      Toronto. The consolidation process, which started in August 2004, was completed
      during fiscal 2005.





Overall,
      for that process, we incurred $2.5 million in restructuring and other charges,
      from which $2.0 million was recorded in fiscal 2004 and the remaining of
      $482,000 was recorded in fiscal 2005. The overall costs, which were recorded
      in
      the restructuring and other charges in the statements of earnings of the
      corresponding years, are detailed as follows: $855,000 for severance expenses
      for the layoff of all employees at the Rochester facilities; $1.3 million
      mainly for the impairment of the EXFO Burleigh building; and the remaining
      $399,000 for other expenses such as training and recruiting expenses and
      transfer of assets.





Finally,
      in fiscal 2005 and 2004, we recorded adjustments of $190,000 and $304,000,
      respectively, to the fiscal 2003 and 2001 plans because actual charges, mainly
      for leased equipment, were lower than expected.





Our
      restructuring plans and cost-reduction measures represented our best efforts
      to
      respond to the difficult market conditions of recent years. Although we believe
      that such restructuring actions were appropriate and delivered the expected
      results, changes in market or industry conditions may lead us to incur
      additional restructuring actions and cost-reduction measures in the coming
      years.







**INTEREST
      AND OTHER INCOME**





Our
      interest income mainly resulted from our short-term investments, less interests
      and bank charges. Interest and other income amounted to $3.3 million, $2.5
      million and $1.4 million for fiscal 2006, 2005 and 2004, respectively. The
      increase in our interest income in fiscal 2006, compared to 2005, is mainly
      due
      to the increase in interest rates year-over-year. Also, despite the cash payment
      of $18.1 million for the acquisition of Consultronics in January 2006, our
      average cash position increased in fiscal 2006 due to cash flows from operating
      activities, which contributed to the further increase in interest revenue
      year-over-year.





The
      increase in interest income in fiscal 2005, compared to 2004, is due in part
      to
      the increase in our average cash position following our public offering in
      February 2004, the cash flows from operating activities and the increase in
      interest rates year-over-year.





***Outlook
      for fiscal 2007***





Assuming
      no acquisitions are made in fiscal 2007, we expect our interest income to remain
      relatively flat, compared to 2006, assuming stability in interest rates.





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**FOREIGN
      EXCHANGE LOSS**





Foreign
      exchange gains and losses are the result of the translation of operating
      activities denominated in currencies other than the Canadian
      dollar.





Foreign
      exchange loss amounted to $595,000, $1.3 million and $278,000 for fiscal 2006,
      2005 and 2004, respectively.





The
      significant exchange losses recorded in fiscal 2005 and 2006 are the result
      of
      the significant increase in the value of the Canadian dollar, compared to the
      US
      dollar, during these periods. However, the increase in the value of the Canadian
      dollar was more significant in fiscal 2005, compared to 2006, which resulted
      in
      a higher exchange loss in 2005. For instance, the year-end exchange rate was
      CA$1.3167 = US$1.00 in fiscal 2004, compared to CA$1.1889 = US$1.00 in 2005,
      representing an increase of 10.7% year-over-year. This compares to a year-end
      exchange rate of CA$1.1066 = US$1.00 in fiscal 2006, which resulted in an
      increase of 7.4%, compared to 2005. Also, the average exchange rate was
      CA$1.2315 = US$1.00 in fiscal 2005, compared to CA$1.1481 = US$1.00 in 2006.
      On
      the other hand, higher levels of activity in fiscal 2006, compared to 2005,
      contributed to the increase in exchange loss in 2006.





During
      fiscal 2004, the Canadian dollar value remained relatively stable compared
      to
      the US dollar, throughout the year, resulting in a slight exchange loss
      during that year.





It
      should
      be noted that additional foreign exchange rate fluctuations flow through the
      P&L line items as a significant portion of our operating items are
      denominated in Canadian dollars, and we report our results in US dollars.





We
      manage
      our exposure to currency risks with forward exchange contracts. In addition,
      some of our Canadian entities’ operating activities are denominated in US
      dollars or other currencies, which further hedges these risks. However, any
      further increase in the value of the Canadian dollar, compared to the US dollar,
      would have a negative impact on our operating results.








**INCOME
      TAXES**





Our
      income tax expense was $2.6 million in fiscal 2006 and 2005, compared to an
      income tax recovery of $986,000 in 2004.





Most
      of
      the income tax expenses recorded in fiscal 2005 and 2006 represent income taxes
      payable at the Canadian federal level, which are reduced by research and
      development tax credits that are recorded against gross research and development
      expenses in the statements of earnings.





The
      income tax recovery recorded in fiscal 2004 is mainly due to the $1.4 million
      of
      unusual income tax recovery recorded during that year, offset in part by income
      taxes payable in some specific tax jurisdictions, mainly at the Canadian federal
      level. The income taxes payable at the Canadian federal level, were also reduced
      by research and development tax credits recorded against gross research and
      development expenses. The unusual tax recovery was due to the receipt, during
      that period, of income taxes paid in previous periods following the reception
      of
      a tax assessment.





We
      record
      a full valuation allowance against our future income tax assets because it
      is
      more likely than not that these assets will not be recovered. The valuation
      allowance will be reversed once we will have concluded that realization of
      future income tax assets is more likely than not. Consequently, our income
      tax
      rates are distorted compared to statutory rates. Please refer to note 16 of
      our
      consolidated financial statements included elsewhere in this annual report
      for a
      full reconciliation of the income tax provision.





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**LIQUIDITY
      AND CAPITAL RESOURCES**


***Cash
        Requirements and Capital Resources***
 
 As
        at
        August 31, 2006, cash and short-term investments consisted of $111.3 million,
        almost flat compared to 2005, while our working capital was at $144.0 million.
        During fiscal 2006, operating activities generated $12.3 million in cash.
        In addition, we recorded an unrealized foreign exchange gain of $7.9 million
        on
        our cash and short-term investments. This unrealized foreign exchange gain
        resulted from the translation, in US dollars, of our
        Canadian-dollar-denominated cash and short-term investments and was recorded
        in
        the cumulative translation adjustment in the balance sheet. On the other
        hand,
        we made cash payments of $18.1 million and $3.4 million for the acquisition
        of
        Consultronics and for the purchase of property, plant and equipment,
        respectively.
 
 Our
        short-term investments consist of commercial paper issued by nine (six as
        of
        August 31, 2005) quality, high-credit corporations and trusts;
        therefore, we consider the risk of non-performance of these financial
        instruments to be remote. For the purposes of managing our cash position,
        we
        have established a cash management policy, which we follow and monitor on
        a
        regular basis. These short-term investments will be used for working capital
        and
        other general corporate purposes, including other potential
        acquisitions.
 
 We
        believe that our cash balances and short-term investments will be sufficient
        to
        meet our liquidity and capital requirements for the foreseeable future. In
        addition to these assets, we have unused available lines of credit of $11.2
        million for working capital and other general corporate purposes and an unused
        line of credit of $11.2 million for foreign currency exposure related to
        forward exchange contracts. However, possible operating losses and/or possible
        investments in or acquisitions of complementary businesses, products or
        technologies may require additional financing. There can be no assurance
        that
        additional debt or equity financing will be available when required or, if
        available, that it can be secured on satisfactory terms. Our lines of credit
        bear interest at prime rate.
 
 The
        following table summarizes our commitments as at August 31, 2006:
  **Year
                    ending August 31,**
                
                
                **2007**
                
                
                **2008**
                
                
                **2009**
                
                
                **2010**
                
                
                **2011
                    and later**
                
                
                **Total**Long-term
                    debt
                
                $
                107,000
                
                $
                113,000
                
                $
                118,000
                
                $
                123,000
                
                $
                −
                
                $
                461,000Operating
                    leases
                
                
                1,748,000
                
                
                1,223,000
                
                
                1,177,000
                
                
                1,200,000
                
                
                1,540,000
                
                
                6,888,000Total
                    commitments
                
                $
                1,855,000
                
                $
                1,336,000
                
                $
                1,295,000
                
                $
                1,323,000
                
                $
                1,540,000
                
                $
                7,349,000
  ***Sources
          and Uses of Cash***
 
 We
        finance our operations and meet our capital expenditure requirements mainly
        through cash flows from operating activities, the use of our cash and short-term
        investments as well as the issuance of subordinate voting shares.
 
 *Operating
        Activities*
 
 Cash
        flows provided by operating activities were $12.3 million in fiscal 2006,
        compared to $14.0 million in 2005 and $751,000 in 2004. Cash flows provided
        by operating activities in fiscal 2006 were mainly attributable to the net
        earnings before items not affecting cash of $16.9 million, less the
        negative net change in non-cash operating items of $4.7 million. Our accounts
        receivable and our inventories increased in fiscal 2006, resulting in negative
        effects on cash flows of $2.6 million and $2.3 million, respectively. The
        increase in sales year-over-year explains the increase in accounts receivable.
        Also, larger sales activities in fiscal 2006 resulted in higher inventory
        levels
        in 2006 in order to sustain these increased sales activities.







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Cash
      flows provided by operating activities in fiscal 2005 were mainly attributable
      to the net earnings before items not affecting cash of $9.1 million and the
      positive net change in non-cash operating items of $4.9 million. This net
      change in non-cash operating items is mainly due to the decrease of $6.1 million
      in our income taxes and tax credits recoverable following the recovery, during
      that year, of income taxes and tax credits from previous periods. On the other
      hand, our accounts receivable and our inventories increased by $838,000 and
      $699,000, respectively. The increase in our accounts receivable is related
      to
      the increase in sales year-over-year. Our inventories slightly increased despite
      the significant rise in sales due to tight inventory management.





*Investing
      Activities*





Cash
      flows used by investing activities were $13.2 million in fiscal 2006, compared
      to $13.0 million in 2005 and $29.7 million in 2004.





In
      fiscal
      2006, we made cash payments of $18.1 million and $3.4 million for the
      acquisition of Consultronics and the purchase of property, plant and equipment,
      respectively. In order to finance a part of these payments, we disposed of
      $8.2
      million worth of short-term investments. We paid the remaining with cash flows
      from operating activities and cash on hand.





In
      fiscal
      2005, we acquired $11.5 million worth of short-term investments with cash flows
      from operating activities and cash on-hand and paid $1.5 million for the
      purchase of property, plant and equipment as well as intangible assets.








**FORWARD
      EXCHANGE CONTRACTS**





We
      utilize forward exchange contracts to manage our foreign currency exposure.
      Our
      policy is not to utilize those derivative financial instruments for trading
      or
      speculative purposes.





Our
      forward exchange contracts, which are used to hedge anticipated
      US-dollar-denominated sales, qualify for hedge accounting; therefore, foreign
      exchange translation gains and losses on these contracts are recognized as
      an
      adjustment of the revenues when the corresponding sales are
      recorded.





As
      at
      August 31, 2006, we held forward exchange contracts to sell US dollars at
      various forward rates, which are summarized as follows:


**Expiry
                  dates:**
              
              **Contractual
                  amounts**
              
              **Weighted
                  average contractual forward rates**September
                  2006 to August 2007
              
              $
              37,000,000
              
              1.1676September
                  2007 to June 2009
              
              
              26,800,000
              
              1.1261




As
      at
      August 31, 2006, the fair value of our forward exchange contracts, which
      represents the difference between their contractual amounts and their current
      trading value, amounted to an unrecognized gain of $5.5 million ($2.9 million
      as
      at August 31, 2005).








**CONTINGENCY**




As
        discussed in note 12 to our consolidated financial statements included elsewhere
        in this annual report, EXFO was named as a defendant in a U.S. securities
        class action related to its initial public offering (IPO) in June 2000. The
        complaints allege that the prospectus and the registration statement for
        the IPO
        failed to disclose that the underwriters allegedly received excessive
        commissions and that the underwriters and some investors collaborated in
        order
        to inflate the price of EXFO’s stock in the after-market.





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In
      June
      2003, a committee of the EXFO’s Board of Directors conditionally approved a
      proposed settlement between the issuer defendants, the individual defendants,
      and the plaintiffs. If approved, the settlement would provide, among other
      things, a release of EXFO and of the individual defendants for the conduct
      alleged in the action to be wrongful in the amended complaint. EXFO would agree
      to undertake other responsibilities under the settlement, including agreeing
      to
      assign away, not assert, or release certain potential claims EXFO may have
      against its underwriters. Any direct financial impact of the proposed settlement
      is expected to be borne by EXFO’s insurance carriers.





On
      June 25, 2004, the Plaintiffs moved for preliminary approval of the
      settlement. The court granted the preliminary approval motion on February 15,
      2005, subject to certain modifications.  On August 31, 2005, the court
      issued a preliminary order further approving the modifications to the settlement
      and certifying the settlement classes.  The court also appointed the Notice
      Administrator for the settlement and ordered that notice of the settlement
      be
      distributed to all settlement class members beginning on November 15,
      2005.  A settlement fairness hearing was held on April 24, 2006; however,
      no ruling has been issued yet by the court. If the court determines that the
      settlement is fair to the class members, the settlement will be
      approved. **** The
      settlement provides that, if the plaintiffs do not obtain any
      recovery from the underwriter defendants, the members of the class
      action would receive an amount not expected to exceed $2,507,678. Any direct
      financial impact plus any legal fees are expected to be borne by EXFO’s
      insurance carriers. However, there can be no assurance that this proposed
      settlement would be approved and implemented in its current form, or at
      all.  Therefore, it is not possible to predict the final outcome of the
      case, nor to determine the amount of any possible losses. If the settlement
      process fails, EXFO will continue to defend its position in this litigation
      that
      the claims against it, and its officers, are without merit. Accordingly, no
      provision for this case has been made in the consolidated financial statements
      as at August 31, 2006.








**SHARE
      CAPITAL AND** **STOCK** **-BASED
      COMPENSATION** **PLANS**





**Share
      capital**





As
      at
      November 1, 2006, EXFO had 37,143,000 multiple voting shares outstanding,
      entitling to 10 votes each and 31,632,857 subordinate voting shares outstanding.
      The multiple voting shares and the subordinate voting shares are unlimited
      as to
      number and without par value.





**Long-Term
      Incentive Plan and Deferred Share Unit Plan**





The
      aggregate number of subordinate voting shares covered by stock options,
      restricted share units (RSUs) and deferred share units (DSUs) granted under
      the
      Long-Term Incentive Plan and the Deferred Share Unit Plan was 2,882,369 as
      at
      November 1, 2006. The maximum number of subordinate voting shares issuable
      under
      these two plans cannot exceed 6,306,153 shares. The following tables
      summarize information about stock options, RSUs and DSUs granted to the members
      of our Board of Directors and to Management and Corporate Officers of us and
      our
      subsidiaries as at November 1, 2006:


**Stock
                      Options**
                  
                  **Number**
                  
                  **%
                      of issued and outstanding**
                  
                  **Weighted
                      average exercise price**Chairman
                      of the Board, President and CEO (one individual)
                  
                  179,642
                  
                  7%
                  
                  $
                  9.05Board
                      of Directors (five individuals)
                  
                  194,375
                  
                  8%
                  
                  $
                  6.23Management
                      and Corporate Officers (eight individuals)
                  
                  313,836
                  
                  13%
                  
                  $
                  15.42**687,853**
                  
                  **28%**
                  
                  **$**
                  **11.16**


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**Restricted
                  Share Units (RSUs)**
              
              **Number**
              
              **%
                  of issued and outstanding**Chairman
                  of the Board, President and CEO (one individual)
              
              59,913
              
              14%Management
                  and Corporate Officers (ten individuals)
              
              255,616
              
              60%**315,529**
              
              **74%**
  **Deferred
                    Share Units (DSUs)**
                
                **Number**
                
                **%
                    of issued and outstanding**Board
                    of Directors (five individuals)
                
                **43,290**
                
                **100%**


**OFF-BALANCE
        SHEET ARRANGEMENTS**
 
 As
        at
        August 31, 2006, our off-balance sheet arrangements consisted of letters
        of
        guarantee and forward exchange contracts. These off-balance sheet arrangements
        are respectively described in detail in notes 12 and 18 to our consolidated
        financial statements, included elsewhere in this annual report.
 
 
 **VARIABLE
        INTEREST ENTITY**
 
 As
        of
        August 31, 2006, we did not have interests in any variable interest
        entities.




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**Item
              6.**
            **Directors,
                Senior Management and Employees******




**A.**
            **Directors
                and Senior Management**





The
      following table sets forth information about our executive officers, senior
      managers and Directors as of November 1, 2006.





**Name
                and Municipality of Residence**
            
            **Positions
                with EXFO**STEPHEN
                BULL
              Quebec
                City, Quebec
            
            Vice-President,
                Research and Development, Telecom DivisionNORMAND
                DUROCHER
              St-Sauveur,
                Quebec
            
            Vice-President,
                Human ResourcesALLAN
                FIRHOJ
              Georgestown,
                Ontario
            
            Vice-President
                and General Manager, Life Sciences and Industrial
                DivisionROBERT
                FITTS
              Minesing,
                Ontario
            
            Vice-President,
                Product Management - Copper Access ProductsÉTIENNE
                GAGNON
              Quebec
                City, Quebec
            
            Vice-President,
                Product Management - Optical and Protocol ProductsLUC
                GAGNON
              St-Augustin-de-Desmaures,
                Quebec
            
            Vice-President,
                Telecom Manufacturing OperationsJUAN-FELIPE
                GONZÁLEZ
              Montreal,
                Quebec
            
            Vice-President,
                Telecom Sales - InternationalGERMAIN
                LAMONDE
              Quebec
                City, Quebec
            
            Chairman
                of the Board, President and Chief Executive OfficerPIERRE
                MARCOUILLER
              Magog,
                Quebec
            
            Independent
                DirectorGUY
                MARIER
              Lakefield
                Gore, Quebec
            
            Independent
                DirectorPIERRE
                PLAMONDON, CA
              Quebec
                City, Quebec
            
            Vice-President,
                Finance and Chief Financial OfficerBENOIT
                RINGUETTE
              Quebec
                City, Quebec
            
            Corporate
                Secretary and Legal CounselDAVID
                A. THOMPSON
              Newton,
                North Carolina
            
            Independent
                DirectorANDRÉ
                TREMBLAY
              Outremont,
                Quebec
            
            Independent
                DirectorMICHAEL
                UNGER
              Richmond
                Hill, Ontario
            
            Independent
                Lead DirectorDANA
                YEARIAN
              Lake
                Forest, Illinois
            
            Vice-President,
                Telecom Sales - North America





The
      address of each of our executive officers, senior managers and Directors is
      c/o
      EXFO Electro-Optical Engineering Inc., 400 Godin Avenue, Quebec, Quebec, Canada.
      The following is a brief biography of each of our executive officers, senior
      managers and Directors.





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*Stephen
      Bull* was
      appointed our Vice-President, Research and Development in December 1999. He
      joined us in July 1995 and held the positions of Assistant Director-Engineering
      from September 1997 to December 1999 and Group Leader (Engineering Management)
      from July 1995 to September 1997. From June 1990 to March 1995, Mr. Bull held
      the position of General Manager and Managing Director for Space Research
      Corporation, a military engineering company in Belgium. Mr. Bull holds a
      bachelor’s degree in Electrical Engineering from Laval University in Quebec
      City, Canada.





*Normand
      Durocher* was
      appointed Vice-President of Human Resources in April 2004. In addition to
      managing our human resources team, his main responsibility is to develop and
      implement a human resources plan that supports EXFO’s business strategy. Mr.
      Durocher began his career in labor relations in the Cable division of Nortel
      and
      then took on several key roles at Nortel Networks and Nordx/CDT, all relating
      to
      human resources and operations. Since then, Normand Durocher has accumulated
      more than 25 years’ experience in operations and human resources management
      within the telecommunications industry. Prior to joining EXFO, Mr. Durocher
      ran his own human resources consulting business. Normand Durocher holds a
      Bachelor of Science from the Université de Montréal and also completed the
      Advanced Human Resources program at Dalhousie University in Halifax, Nova
      Scotia, Canada





*Allan
      Firhoj* was
      appointed Vice-President and General Manager, Life Sciences and Industrial
      Division in July 2003. Prior to that, he held the position of General Manager
      of
      EXFO Photonic Solutions Inc. since November 2001. He is responsible for the
      overall strategic direction and management of the Life Sciences and Industrial
      Division. Mr. Firhoj joined EFOS Inc. in 1996, where he was responsible for
      Sales, Marketing and Business Development of the Dental Curing-Products
      Division. Following the sale of this division to Dentsply International in 1997,
      he was appointed Director of Marketing and Business Development. Mr. Firhoj
      continued in this capacity until being appointed to the position of General
      Manager of EXFO Photonic Solutions Inc. Prior to joining us, Mr. Firhoj
      spent six years with The Horn Group, a plastics business involved in medical
      devices/instrumentation and office communication equipment. He successively
      held
      the positions of ISO 9000 Implementation Manager, Technical Sales Manager as
      well as Marketing and Business Development Manager. In this latter role, he
      successfully contributed to increasing sales in their medical market by an
      annual average of 60% during a three-year period. Mr. Firhoj holds a
      bachelor’s degree in Political Science from Bishop’s University in Lennoxville,
      Quebec.





Robert
      Fitts has been Vice-President,
      Product Management - Copper Access Products ,
      since
      our acquisition of Consultronics in January 2006. His main role is to establish
      the marketing direction of the copper access product line, which includes
      defining the features of these products so as to ensure their success with
      customers. Prior to his appointment with us, Mr. Fitts was Executive
      Vice-President at Consultronics, where he began his accomplished and
      long-standing career 23 years earlier. Mr. Fitts has extensive experience in
      the
      telecommunications testing industry and, more specifically, has been an active
      participant in the field of local-loop testing, DSL, IPTV and VoIP. Robert
      Fitts
      attended the University of Guelph in Ontario, Canada, and has a degree in
      electrical engineering (computer option) technology from Fleming College, near
      Toronto, Canada. Mr. Fitts is also a graduate of the executive program at Queens
      University School of Business, located in Kingston, Ontario.





*Étienne
      Gagnon* was
      appointed Vice-President,
      Product Management - Optical and Protocol Products in June
      2006. Prior to that he had been our Vice-President of Optical-Layer Product
      Management and Customer Service since May 2003. Mr. Étienne Gagon is not related
      to Mr. Luc Gagnon. He is responsible for EXFO’s general marketing direction, on
      both the product level and communications level, and also oversees our customer
      service department. For nearly three years, before returning to EXFO in early
      2003, Mr. Gagnon was Vice-President of Sales and Marketing at TeraXion, an
      optical component manufacturer based in Quebec City. Mr. Gagnon began his career
      as a design engineer for Bombardier/Canadair, where he worked on the Canadian
      Regional Jet project between 1990 and 1993. Later, he held the position of
      Business Development Manager for France Telecom in Hungary. In 1994, he joined
      EXFO’s European office as a Regional Sales Manager, and in 1996, he was brought
      back to Quebec City to head the OSP marketing group. Mr. Gagnon then went on
      to
      become the Director of our Outside Plant division in 1998, and remained in
      that
      function until he joined TeraXion in 2000. Mr. Gagnon holds a bachelor’s
      degree in Mechanical Engineering from the Ecole Polytechnique School of
      Engineering (University of Montreal), and a master’s degree in European Business
      from the Ecole nationale supérieure des télécommunications in
      France.





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*Luc
      Gagnon* was
      appointed Vice-President, Telecom Manufacturing Operations in May 2003.
      Mr. Luc Gagnon is not related to Mr. Étienne Gagnon. He is responsible
      for ensuring the smooth operation of all manufacturing activities, which include
      production, purchasing, product engineering, quality assurance, planning,
      manufacturing engineering, product configuration, transportation and customs,
      as
      well as material resources. Prior to his recent nomination, Mr. Gagnon held
      the position of Production Director since 2000. Before joining EXFO, he had
      similar roles in several other high-technology companies. He worked for Mendes
      from 1999 to 2000, for C-MAC from 1997 to 1999, for STERIS from 1993 to 1997
      and
      for MITEL from 1991 to 1993. Mr. Gagnon holds a bachelor’s degree in electrical
      engineering and master’s degree in engineering, both from the Université de
      Sherbrooke, in Canada.





*Juan-Felipe
      González* was
      appointed Vice-President, Telecom Sales - International in August 2006. Prior
      to
      that he had been our Vice-President, Global Telecom Sales since July 2003 and
      our Vice-President, International Sales since September 1998. From January
      1997
      to September 1998, he was our International Sales Director and, from September
      1993 to January 1997, our Sales Manager for Latin America and the Caribbean.
      Prior to joining us in September 1993, Mr. González was Marketing and Sales
      Director at Reyde, Barcelona, a plastics technical product corporation in Spain.
      Mr. González holds a bachelor’s degree in Industrial Chemistry from Complutense
      University of Madrid in Spain and a master’s degree in Business Administration
      from the School of Industrial Organization in Spain.





*Germain
      Lamonde* ,
      a
      company founder, has been
      Chairman of the Board, President and
      CEO
      of EXFO since its inception in 1985. Mr.
      Lamonde is responsible for the overall management and direction of EXFO and
      its
      subsidiaries. Mr. Lamonde has
      served on the boards of several organizations such as
      the Canadian Institute for Photonic Innovations, the Pole QCA Economic
      Development Corporation and the National Optics Institute of Canada. He is
      also
      a founding member and Governor of the Canadian-based International Institute
      of
      Telecommunications and an Emeritus Member of the Canadian Academy of
      Engineering. Mr. Lamonde holds a bachelor’s degree in physics engineering
      from the University of Montreal’s School of Engineering, a master’s degree in
      optics from Laval University, and is also a graduate of the Ivey Executive
      Program offered by the University of Western Ontario.





*Pierre
      Marcouiller* has
      served as our Director since May 2000. Mr.
      Marcouiller is Chairman of the Board and Chief Executive Officer of Camoplast
      Inc., an international manufacturer specialized in industrial manufacturing
      of
      rubber tracks, molded composite and thermoplastic components and off-road
      tracked vehicles. He is the founder and has been the sole shareholder of
      Nexcap Inc., an investment company in the manufacturing sector, since December
      1996. Mr. Marcouiller worked with Venmar Ventilation Inc., a private ventilation
      equipment manufacturer, from January 1983 to December 1996. From 1991 to 1996,
      he was the controlling shareholder of Venmar, where he also held the position
      of
      President and General Manager from 1986 to 1996. Mr. Marcouiller is also a
      Director of Héroux-Devtek Inc., a public company specialized
      in the design, development and manufacturing of aerospace, defense and
      industrial products; more specifically in landing gear, aerostructure and gas
      turbine components .
      Mr.
      Marcouiller also holds Directorships in other privately held companies. Pierre
      Marcouiller holds a bachelor’s degree in business administration from Université
du Québec in Trois-Rivières and a MBA from Université de Sherbrooke, both in
      Canada.





*Guy
      Marier* has
      served as our Director since January 2004. Formerly President of Bell Québec
      between 1999 and 2003, Guy Marier completed his successful 33-year career at
      Bell as Executive Vice-President of the Project Management Office of Bell
      Québec, before retiring at the end of 2003. Mr. Marier began at Bell Canada in
      1970 and quickly became an executive. From 1988 to 1990, he headed up Bell
      Canada International’s investments and projects in Saudi Arabia and, for the
      three following years, served as President of Télébec, a subsidiary of Bell
      Canada. He then returned to the parent company to hold various senior management
      positions. Mr. Marier was appointed to our Board of Directors in January 2004
      and also sits on the Board of Bell Nordiq, a wholly-owned subsidiary of Bell
      Canada that manages the business and affairs of both Télébec L.P. and
      NorthernTel L.P. Mr. Marier holds a bachelor of Arts from the University of
      Montreal and a Bachelor of Business Administration from the *Université
      du Québec à Montréal.*





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*Pierre
      Plamondon* has
      been
      our Vice-President, Finance and Chief Financial Officer since January 1996
      and
      was a Director from December 1999 to May 2000. Prior to joining us, Mr.
      Plamondon served as senior manager for Price Waterhouse, from September 1981
      to
      December 1995 in Canada and France. Mr. Plamondon holds a bachelor’s degree in
      Business Administration and a license in Accounting, both from Laval University
      in Quebec City, Canada. Mr. Plamondon has been a member of the Canadian
      Institute of Chartered Accountants since 1983 and
      a
      member of the Board of Directors of SOVAR Inc. (Société de valorisation des
      applications de la recherche de l’Université Laval) since
      December 2000 .





*Benoit
      Ringuette*  has
      been
      our in-house Legal Counsel and Corporate Secretary since April
      2004. Prior to joining EXFO, Mr. Ringuette practiced mainly in commercial,
      corporate and securities law from 1998 to 2003 as an associate in the law firms
      of O’Brien, Flynn Rivard in Quebec City and Desjardins Ducharme in Quebec
      City. Mr. Ringuette has been a member of the Quebec Bar since 1998.
      Mr. Ringuette holds a bachelor’s degree in Civil Law from Laval University in
      Quebec City, Canada.





*David
      A. Thompson* has
      served as our Director since June 2000. Dr. David A. Thompson ** is
      currently Vice-President and Director of Hardware & Equipment Technology
      Strategy at Corning Cable Systems, where he has held this position since January
      2002. Prior to this nomination, he acted as Corning Incorporated’s Division
      Vice-President for the Strategic Planning & Innovation Effectiveness in
      Research, Development and Engineering. Dr. Thompson first joined Corning
      Incorporated’s Research and Development Division in 1976 as a Senior Chemist in
      glass research. He then took on several technology Directorship and strategic
      planning roles for Corning’s Component and Photonics Technologies Divisions
      between 1988 and 1998; and, in 1999, he was appointed technical leader for
      the
      creation of the new Samsung-Corning Micro-Optics joint venture. David A.
      Thompson holds a Bachelor of Science in chemistry from Ohio State University
      and
      a doctorate in inorganic chemistry from the University of Michigan. He holds
      13
      patents and has over 20 technical publications in the areas of inorganic
      chemistry, glass technology and telecommunications.





*André
      Tremblay* has
      served as our Director since June 2000. ** Mr.
      Tremblay is a Founder and Managing Partner of Trio Capital Inc, a private equity
      fund management company. He has more than 20 years experience in the
      telecommunications industry, having been actively involved in the conception,
      financing and management of several companies. As a special advisor to the
      President of Telesystem Ltd., and as President of Telesystem Enterprises Ltd.
      from 1992 to 1998, he managed a portfolio of telecommunication companies. For
      almost 10 years, he served as President and Chief Executive Officer of Microcell
      Telecommunications, a wireless network and service provider, which he led from
      its inception on through the different phases of its evolution. During that
      time, he has also provided early-stage financing, along with strategic advice
      and direction, for start-up technology firms. In 2005, he was appointed by
      Canada’s Industry Minister as member of the Telecommunications Policy Review
      Panel to make recommendations on how to modernize Canada’s telecommunication
      policies and regulatory framework. André Tremblay holds bachelor’s degrees in
      management and in accounting from Laval University, a master’s degree in
      taxation from Université de Sherbrooke, and is also a graduate of Harvard
      Business School’s Advanced Management Program.





*Michael
      Unger* has
      served as our Director since May 2000. He worked with Nortel Networks Limited,
      now Nortel Networks Corporation, from 1962 to 2000. Mr. Unger’s most recent
      position was President of Nortel’s Optical Networks Business Unit, a position he
      held from May 1998 to April 2000. Prior to this appointment, Mr. Unger was
      Nortel’s Group Vice-President, Transport Networks from March 1990 to May 1998.
      Mr. Unger also serves on the Board of Directors and Human Resources Committee
      of
      Tundra Semiconductor Corporation, a publicly traded company with its shares
      listed on The Toronto Stock Exchange that designs, develops and markets
      networking and network access technology for use by communications
      infrastructure equipment companies. He also chairs the Audit Committee of Nakina
      Systems and serves on the Boards and Committees of several other privately-held
      companies active in the areas of photonic and optical components, optical
      network systems and solutions for cable operators and other communications
      service providers. Mr. Unger holds a Bachelor of Science from Concordia
      University and has successfully completed several accounting credits, also
      given
      by Concordia University in Montreal, Canada. In addition, Mr. Unger holds an
      executive MBA from the University of Western Ontario.





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Dana
      Yearian was appointed our Vice President, Telecom Sales − North America in
      August, 2006. He is responsible for managing telecom sales, both direct and
      indirect, and the execution of sales strategies across North America. Mr.
      Yearian oversees all sales-related functions for EXFO North America including
      sales operations, global account management, and partner programs. As a member
      of the Strategy and Management committees, he also develops corporate
      strategy for us. From 2005 to 2006, Mr. Yearian held the position of
      Vice-President of Sales at Spirent Communications Service Assurance
      Division. In 2003, Mr. Yearian founded The Katrixx Group which provided
      consulting and contracting services to high-technology companies. Before
      founding his company, Mr. Yearian worked as Vice President of Sales at
      Acterna Corp from 1991 to 2003. He led both North American and International
      sales and support operations of Acterna’s multiple testing solutions. Prior to
      working for Acterna, Mr. Yearian held various executive positions at
      Toshiba America, Silicon Sensors (Advanced Photonix, Inc.), and Impell
      Corporation (ABB Ltd.). Dana Yearian holds a bachelor's degree in electrical
      engineering from the Illinois Institute of Technology, Chicago, Illinois and
      has
      completed MBA course work at DePaul University.





**Term
      of Executive Officers**





Executive
      officers are appointed annually by the Board of Directors and serve until their
      successors are appointed and qualified or until earlier resignation or
      removal.








**B.**  **Compensation**





**Director
      Compensation**





In
      the
      financial year ended August 31, 2006, each director who was not an employee
      of
      the Corporation or any of its subsidiaries received the level of compensation
      set forth in the table below as annual compensation payable in a combination
      of
      cash and Deferred Share Units (“DSU”) as chosen by the Director pursuant to the
      Deferred Share Unit Plan.




Annual
                    Retainer for Directors:(1)
                CA$50,000(2)
                US$43,550(3)Annual
                    Retainer for Committee Chairman:
                CA$5,000
                US$4,355(3)Annual
                    Retainer for Committee Members:
                CA$3,000
                US$2,613(3)Fees
                    for all Meetings Attended per day in Person:
                CA$1,000
                US$871(3)Fees
                    for all Meetings Attended per day by Telephone:
                CA$500
                US$436(3)
 (1)
              All
                  the Directors elected to receive 50% of their Annual Retainer in
                  form of
                  Deferred Share Units. (2)
              The
                  Annual Retainer for Mr. David A. Thompson is US$50,000
                  (CA$57,405). (3)
              The
                  compensation information has been converted from Canadian dollars
                  to U.S.
                  dollars based upon an average foreign exchange rate of CA$1.1481
                  = US$1.00
                  for 2006.


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In
      the
      financial year ended August 31, 2006, the Directors who were not employees
      received the following compensation in the form indicated:


**Name**
              **Annual
                  Compensation Paid in Cash (US$)****(1)**
              **Annual
                  Compensation Paid in DSUs (#)****(2)**
              **Estimated
                  Value of DSUs at the time of grant (US$)****(3)**
              **Total
                  Attendance Fees Paid in Cash (US$)****(1)**Pierre
                  Marcouiller(4)
              27,001
              3,812
              21,775
              6,533Guy
                  Marier(4)
              27,001
              3,812
              21,775
              6,968David
                  A. Thompson(5)
              27,613
              4,308
              25,000
              3,049André
                  Tremblay(6)
              28,743
              3,812
              21,775
              6,097Michael
                  Unger(7)
              28,743
              3,812
              21,775
              6,533
 
 
 (1)
            The
                compensation information has been converted from Canadian dollars
                to U.S.
                dollars based upon an average foreign exchange rate of CA$1.1481
                = US$1.00
                for 2006, except for Mr. David A. Thompson who is paid in U.S. dollars
                for
                the portion of his annual retainer for Director. The Annual Compensation
                includes, as the case may be, the retainer for Director, Committee
                Members
                and Committee Chairman. (2)
            Indicates
                the number of Subordinate Voting Shares granted under the Deferred
                Share
                Unit Plan. A DSU is converted in a Subordinate Voting Share when
                a
                Director ceases to be a member of the
                Board. (3)
            The
                estimated value at the time of grant of a DSU is determined based
                on the
                highest of the closing prices of the Subordinate Voting Shares on
                the
                Toronto Stock Exchange and the NASDAQ National Market on the last
                trading
                day preceding the grant date, using the noon buying rate of the Federal
                Reserve Bank of New York on the grant date to convert the NASDAQ
                National
                Market closing price to Canadian dollars, as required. The value
                at
                vesting of a DSU is equivalent to the market value of a Subordinate
                Voting
                Share when a DSU is converted to such Subordinate Voting
                Share. (4)
            Member
                of the Audit Committee and the Human Resources
                Committee. (5)
            Member
                of the Human Resources Committee. (6)
            Member
                of the Human Resources Committee and Chairman of the Audit
                Committee. (7)
            Member
                of the Audit Committee, Chairman of the Human Resources Committee
                and Lead
                Director. **Executive
        Compensation**




The
      table
      below shows compensation information during the three most recently completed
      financial years for Mr. Germain Lamonde, the Chairman of the Board,
      President and Chief Executive Officer of the Corporation, Mr. Pierre
      Plamondon, the Vice-President Finance and Chief Financial Officer, the three
      other most highly compensated executive officers of the Corporation and its
      subsidiaries who were serving the Corporation at the end of the financial year
      (collectively, the "Named Executive Officers"). This information includes the
      US
      dollar value of base salaries, bonus awards and long-term incentive plan
      payments, the number of options or Restricted Share Units (“RSUs”) granted, and
      other compensation, if any, whether paid or deferred.


**Name
                    and Principal**
                  **Position**
                **Financial**
                  **Years**
                **Salary****(1)****($)**
                **Bonus****(2)****($)**
                **Other
                    Annual Compensation ($)**
                **Securities
                    Under Options****(3)****(#)**
                **Restricted
                    Share Units****(4)****(#)**
                **All
                    Other**
                  **Compensation**
                  **($)**Germain
                    Lamonde,
                  President
                    and Chief Executive Officer
                2006
                271,753(US)
                  312,000(CA)
                147,558(US)
                  169,412(CA)
                −
                11,218
                21,477
                −2005
                243,605(US)
                  300,000(CA)
                121,729(US)
                  149,909(CA)
                −
                17,942
                13,089
                −2004
                206,751(US)
                  275,000(CA)
                57,115(US)
                  75,969(CA)
                −
                −
                −
                −Pierre
                    Plamondon,
                  Vice-President
                    Finance and Chief Financial Officer
                2006
                165,691(US)
                  190,230(CA)
                60,167(US)
                  69,078(CA)
                −
                3,653
                6,994
                4,283(US)
                    (5)
                  4,918(CA)2005
                151,441(US)
                  186,500(CA)
                48,735(US)
                  60,017(CA)
                −
                5,383
                33,927
                2,316(US)
                    (5)
                  2,852(CA)2004
                135,328(US)
                  180,000(CA)
                17,451(US)
                  23,211(CA)
                −
                −
                −
                1,429(US)
                    (5)
                  1,901(CA)








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**Name
                    and Principal**
                  **Position**
                **Financial**
                  **Years**
                **Salary****(1)****($)**
                **Bonus****(2)****($)**
                **Other
                    Annual Compensation ($)**
                **Securities
                    Under Options****(3)****(#)**
                **Restricted
                    Share Units****(4)****(#)**
                **All
                    Other**
                  **Compensation**
                  **($)**Juan-Felipe
                    Gonzalez,
                  Vice-President
                    Telecom Sales - International
                2006
                272,518(US)
                  312,878(CA)
                12,891(US)
                  14,800(CA)
                −
                3,505
                6,716
                −2005
                246,323(US)
                  303,347(CA)
                6,015(US)
                  7,407(CA)
                −
                5,482
                33,998
                −2004
                231,597(US)
                  308,047(CA)
                563,867(US)
                  750,000(CA)
                    (6)
                −
                −
                −
                −Allan
                    Firhoj,
                  Vice-President
                    and General Manager, Life Sciences and Industrial Division
                2006
                139,361(US)
                  160,000(CA)
                40,632(US)
                  46,650(CA)
                −
                2,404
                4,602
                −2005
                123,153(US)
                  151,663(CA)
                18,355(US)
                  22,604(CA)
                −
                2,512
                12,443
                −2004
                107,796(US)
                  143,379(CA)
                18,890(US)
                  25,125(CA)
                −
                −
                −
                −Dana
                    Yearian,
                  Vice-President
                    Telecom Sales - North America
                2006
                173,424(US)
                    (7)
                  199,109(CA)
                −
                  −
                −
                −
                5,000
                236(US)
                    (5)
                  270(CA)2005
                −
                  −
                −
                  −
                −
                −
                −
                -2004
                -
                  -
                -
                  -
                -
                -
                -
                -


(1)
            The
                compensation information for Canadian residents has been converted
                from
                Canadian dollars to U.S. dollars based upon an average foreign exchange
                rate of CA$1.1481 = US$1.00 for 2006, CA$1.2315 = US$1.00 for 2005
                and
                CA$1.3301 = US$1.00 for 2004. The currency conversions cause these
                reported salaries to fluctuate from year-to-year because of the
                fluctuation in exchange rate.


(2)
            A
                portion of the bonus amounts is paid in cash in the year for which
                they
                are awarded and the balance is paid in cash in the year following
                the
                financial year for which they are
                awarded.


(3)
            Indicates
                the number of Subordinate Voting Shares underlying the options granted
                under the Long-Term Incentive Plan during the financial year
                indicated.


(4)
            Indicates
                the number of Restricted Share Units granted under the Long-Term
                Incentive
                Plan during the financial year
                indicated.


(5)
            Indicates
                the amount contributed by the Corporation during the financial year
                indicated to the Deferred Profit Sharing Plan, as applicable, for
                the
                benefit of the Named Executive Officer. Mr. Lamonde is not eligible
                to
                participate in the Deferred Profit Sharing Plan and Mr. Gonzalez did
                not participate.


(6)
            Pursuant
                to the terms of his employment agreement, Mr. Juan-Felipe Gonzalez
                receive
                a cash payment of CA$750,000 because he did not voluntarily resign
                and was
                not dismissed with cause prior to September 2003. An amount of CA$500,000
                was disbursed on October 17 2003 and the remaining CA$250,000
                was disbursed on January 25, 2004.


(7)
            This
                amount represents Mr. Yearian’s annual base salary. Since Mr. Yearian
                joined the Corporation on August 14, 2006, the base salary paid to
                Mr.
                Yearian for the financial year ended August 31, 2006 amounted to
                US$7,851
                (CA$9,014).





**Employment
      Agreements**





We
      have
      an employment agreement with Mr. Germain Lamonde. The agreement is for an
      indeterminate period and the compensation is reviewed annually. In the event
      of
      the termination of Mr. Lamonde’s employment without cause, Mr. Lamonde will
      be entitled to severance payments (in no case exceeding 24 months of
      remuneration) and the vesting of all stock options and RSUs. In addition, in
      the
      event that Mr. Lamonde’s employment is terminated following a merger or an
      acquisition by a third party of substantially all of the Corporation’s assets or
      of the majority of our share capital or if Mr. Lamonde voluntarily resigns,
      he will be entitled to the vesting of all stock options and RSUs.





We
      also
      have employment
      agreements with Mr. Pierre Plamondon, Mr. Juan-Felipe Gonzalez,
      Mr. Dana Yearian and Mr. Allan Firhoj.





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The
      employment agreement with Mr. Pierre Plamondon, our Vice-President, Finance
      and
      Chief Financial Officer is for an indeterminate period and the compensation
      is
      reviewed annually. In the event of termination of Mr. Plamondon’s
      employment without cause, Mr. Plamondon will be entitled to severance
      payments which in no case exceeding 18 months of the current base salary. In
      addition, in the event Mr. Plamondon’s employment is terminated following a
      merger or an acquisition by a third party of substantially all of our assets
      or
      of the majority of its share capital, he will be entitled to the immediate
      vesting of all stock options and RSUs.





The
      agreement with Mr. Gonzalez provided for Mr. Gonzalez’s employment as
      Vice-President Telecom Sales - International. In the event Mr. Gonzalez’s
      employment terminates for any reason whatsoever and he is unable to accept
      new
      employment due to his non-competition obligations to us, Mr. Gonzalez may
      receive compensation for a period of 18 months following the date of termination
      in amounts varying from 5% to 50% of his base monthly salary at the time of
      termination depending on the cause of the termination. The employment agreement
      is for an indeterminate period and compensation is reviewed
      annually.





The
      employment agreement with Mr. Allan Firhoj, our Vice-President and General
      Director, Life Sciences and Industrial Division is for an indeterminate period
      and the compensation is reviewed annually. In the event of termination of Mr.
      Firhoj’s employment without cause, Mr. Firhoj will be entitled to severance
      payments (in no case exceeding 12 months of the current base salary). In
      addition, in the event Mr. Firhoj’s employment is terminated following a merger
      or an acquisition by a third party of substantially all of the Corporation’s
      assets or of the majority of its share capital, he will be entitled to the
      immediate vesting of all stock options and RSUs.





The
      employment agreement with Mr. Dana Yearian, our Vice-President, Telecom Sales
      -
      North America is for an indeterminate period and the compensation is reviewed
      annually. In the event of termination of Mr. Yearian’s employment without cause,
      Mr. Yearian will be entitled to severance payments (in no case exceeding 18
      months of the current base salary). In addition, in the event Mr. Yearian’s
      employment is terminated following a merger or an acquisition by a third party
      of substantially all of the Corporation’s assets or of the majority of its share
      capital, he will be entitled to the immediate vesting of all stock options
      and
      RSUs.





**Key
      Elements and Policies for Compensation of Executive
      Officers**





Our
      executive compensation plans are designed to attract, retain and motivate key
      executives who directly impact our long-term success and the creation of
      shareholder value. In determining executive compensation, the Committee
      considers the following four principles:





·
            **Performance-based:**Executive compensation levels reflect both corporation and individual
                results based on specific quantitative and qualitative objectives
                established at the start of each financial year in keeping with our
                long-term strategic objectives.





·
            **Aligned
                with shareholder interests:**A
                significant proportion of incentive compensation for executives is
                composed of equity awards to ensure that executives are aligned with
                the
                principles of sustained long-term shareholder value
                growth.





·
            **Market
                competitive:**Compensation of executives is designed to be externally competitive
                when
                compared against executives of comparable peer companies, and in
                consideration of our results relative to the results of
                peers.





·
            **Individually
                equitable:**Compensation levels are also designed to reflect individual factors
                such
                as scope of responsibility, experience, and performance against individual
                measures.





The
      key
      elements of our 2006 executive compensation program were base salary, the Short
      Term Incentive Plan, and stock-based incentive compensation delivered through the
      Long Term Incentive Plan .
      To determine appropriate compensation levels for each pay component, the
      Committee considered all elements of the executive compensation program. The
      Committee did not assign specific weightings to any key element of our 2006
      executive compensation program.





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**Base
      Salaries**




In
      establishing the base salaries of senior officers, including the President
      and
      Chief Executive Officer, we take into consideration responsibilities, job
      descriptions and salaries paid by other similar Canadian organizations for
      positions similar in magnitude, scope and complexity. The Committee’s objective
      is to align executive compensation levels with the median compensation offered
      within a reference group of comparable companies that are similar in size to
      the
      Corporation, with a particular focus on those within the
      high-technology/telecommunications and manufacturing-durable goods industries.
      The Committee reviews the base salary of each senior officer on an annual basis
      and recommends that our Board approve appropriate adjustments, if required,
      within the salary range in order to maintain a competitive position within
      the
      market place.





**Short-Term
      Incentive Compensation**




The
      short-term incentive plan (“STIP”) provides senior executives with the
      opportunity to earn annual bonuses based on our financial performance and the
      achievement of strategic corporate and business unit objectives established
      on a
      yearly basis.





Target
      payout levels for Named
      Executive Officers eligible for incentive bonuses in the year ended
      August 31, 2006 were
      established to be in line with the objective of the Committee to align
      compensation with the median compensation offered in the reference group. The
      minimum, target and maximum payouts to senior officers under the STIP (expressed
      as a percentage of their base salary) for 2006 were as follows:




Our
      President and Chief Executive Officer, Mr. Germain Lamonde, has a short term
      incentive target of 50% of his annual base salary. That bonus is based on the
      achievement of financial, strategic and individual objectives as shown in the
      following table.




Our
      Chief
      Financial Officer, Mr. Pierre Plamondon, has a short term incentive target
      of
      35% of his annual base salary. That bonus is based on the achievement of
      financial, strategic and individual objectives as shown in the following table.




Our
      Vice-President and General Manager, Life Sciences and Industrial Division,
      Mr.
      Allan Firhoj, has a short term incentive target of 30% of his annual base
      salary. That bonus is based on the achievement of financial, strategic and
      individual objectives as shown in the following table.




**Measure**
            **Weighting
                Mr. Lamonde and Mr. Plamondon**
            **Weighting
                Mr. Firhoj**Sales
            35%
            30%Earnings
            15%
            25%Gross
                margin
            25%
            25%Customer
                satisfaction (quality and on time delivery)
            25%
            20%Personal
                objectives (multiplier)
            0%
                - 125%
            0%
                - 125%





Our
      Vice-President, Telecom Sales - International, Mr. Juan-Felipe Gonzalez, and
      Vice-President, Telecom Sales - North America, Mr. Dana Yearian, do not
      participate in the short term incentive plan that is available to our other
      senior executives. Instead, Mr. Gonzalez and Mr. Yearian participate in our
      sales incentive plan (SIP). Under the SIP, Mr. Gonzales and Mr. Yearian have
      target incentives of 40% of their annual base salaries. The SIP is based 40%
      on
      the achievement of revenue targets (billings), 40% on margin targets and 20%
      on
      sales quotas achievements.





**Long-Term
      Incentive Compensation**





*Long-Term
      Incentive Plan*





We
      have a
      Long-Term Incentive Plan for our Directors, executive officers, employees and
      consultants and those of our subsidiaries as determined by our Board of
      Directors, to attract and retain competent Directors, executive officers,
      employees and consultants motivated to work toward ensuring our success and
      to
      encourage them to acquire our shares. A copy of the Long-Term Incentive Plan
      has
      been filed as exhibit 4.35 to last year annual report.





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The
      principal component of the long-term incentive compensation that we
      offer is made
      up of the Long-Term Incentive Plan for directors, officers ,
      employees and consultants of  us
      and
      our subsidiaries.





Introduced
      in May 2000, amended in October 2004 and effective in January 2005, the
      Long-Term Incentive Plan is designed to provide directors, officers, employees
      and consultants with an incentive to create value and accordingly ensures that
      their interests are aligned with those of our shareholders. The LTIP is subject
      to Human Resources Committee review to ensure maintenance of its market
      competitiveness. Our Board has full and complete authority to interpret the
      Plan
      and to establish the rules and regulations applying to it and to make all other
      determinations it deems necessary or useful for the administration of the Plan,
      provided that such interpretations, rules, regulations and determinations are
      consistent with the rules of all stock exchanges on which our securities are
      then traded and with all relevant securities legislation.




The
      Long-Term Incentive Plan provides for the issuance of options to purchase
      Subordinate Voting Shares and the issuance of Restricted Share Units (“RSUs”)
      redeemable for actual Subordinate Voting Shares or the equivalent in cash to
      directors, officers, employees and consultants. Our Board of Directors, upon
      recommendation of the Human Resources Committee, designates the recipients
      of
      options or RSUs and determines the number of Subordinate Voting Shares covered
      by each option or RSU, the dates of vesting, the expiry date and any other
      conditions relating to these options or RSUs, in each case in accordance with
      the applicable legislation of the securities regulatory authorities. During
      the
      financial year ended August 31, 2006, target awards for eligible officers
      under the LTIP were established to be in line with the objective of the
      Committee to align compensation with the median compensation offered in the
      reference group .
      A
      portion of the target RSU awards are fixed, in order to encourage executive
      retention over the longer term, and the balance are made at, above, or
      below target levels based on merit, as determined by each executive's individual
      performance over the previous year.





The
      exercise price of the options is determined by our Board of Directors at the
      time of granting the options, subject to compliance with the rules of all stock
      exchanges on which the Subordinate Voting Shares are listed and with all
      relevant securities legislation. In any event, the price at which the
      Subordinate Voting Shares may be purchased may not be lower than the highest
      of
      the closing prices of the Subordinate Voting Shares on the Toronto Stock
      Exchange and the NASDAQ National Market on the last trading day preceding the
      grant date, using the noon buying rate of the Federal Reserve Bank of New York
      on the grant date to convert the NASDAQ National Market closing price to
      Canadian dollars. Any option issued is non-transferable. At the end of our
      financial year ended August 31, 2006, there were a total of 2,439,375 options
      granted and outstanding pursuant to the Long-Term Incentive Plan having a
      weighted average exercise price of US$13.56 (CA$20.26).





The
      fair
      value at the time of grant of a RSU is equal to the market value of Subordinate
      Voting Shares at the time RSUs are granted. At the end of financial year ended
      August 31, 2006, there were a total of 327,877 RSUs granted and outstanding
      pursuant to the Long-Term Incentive Plan having a weighted average fair value
      at
      the time of grant of US$5.03 (CA$5.95) per RSU.





The
      maximum number of Subordinate Voting Shares that are issuable under the Plan
      shall not exceed 6,306,153 Subordinate Voting Shares, which represents 9.2%
      of our issued and outstanding voting shares as of November 1, 2006. The maximum
      number of Subordinate Voting Shares that may be granted to any one individual
      shall not exceed 5% of the number of outstanding Subordinate Voting
      Shares.





Some
      options granted to Directors and employees vest on the first anniversary date
      of
      their grant. Some options granted in the financial year ended August 31, 2004
      and 2005 vest at a rate of 12.5% six (6) months after the date of grant, 12.5%
      twelve (12) months after the date of grant and 25% annually thereafter
      commencing on the second anniversary date of the grant in October 2005.
      Otherwise all options vest a rate of 25% annually commencing on the first
      anniversary date of the grant. All options may be exercised in whole or in
      part
      once vested. All of the options that are granted under the Plan must be
      exercised within a maximum period of ten (10) years following the date of their
      grant or they will be forfeited.





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All
      RSUs
      first vesting cannot be earlier than the third anniversary date of their grant.
      Some RSUs granted in the financial year ended August 31, 2006 vest at a rate
      of
      1/2 annually commencing on the third anniversary date of the grant in February
      2006 and in June 2006 and others at a rate of 1/3 annually commencing on the
      third anniversary date of the grant in August 2006. Some RSUs granted in the
      financial year ended August 31, 2005 vest at a rate of 1/3 annually commencing
      on the third anniversary date of the grant in February 2005 and others at a
      rate
      of 55%, 35% and 10%, on the third, fourth and fifth anniversary dates of the
      grant in January 2005. Some RSUs granted in the financial years ended August
      31,
      2006 and August 31, 2005 vest on the fifth anniversary date of the grant
      respectively in December 2005 and in January 2005 but are subject to early
      vesting on the third and fourth anniversary dates of the grant on the attainment
      of performance objectives as determined by our Board of Directors. Accordingly,
      subject to the attainment of performance objectives, the first early vesting
      is
      up to 1/3 of the units on the third anniversary date of the grant and the second
      early vesting is up to 50% of the remaining units on the fourth anniversary
      date
      of the grant. If such vesting date falls into any black-out period or any other
      restrictive period during which the RSU holder is not entitled to trade our
      Subordinate Voting Shares, then the units shall vest on the first trading day
      the RSU holder is entitled to trade after such black-out period or restrictive
      period.





Any
      option granted pursuant to the Long-Term Incentive Plan will lapse (i)
      immediately upon the termination of the relationship with us or one of our
      subsidiaries for a good and sufficient cause for employees or officers or at
      the
      date on which an employee or an officer resigns or leaves his employment with
      us
      or one of our subsidiaries (or within 30 days if the holder’s employment is
      terminated for reasons not related to cause); and (ii) 30 days after a
      Director ceases to be a member of our Board of Directors or one of our
      subsidiaries. In the event of retirement or disability, any option held by
      an
      employee lapses 30 days after the date of any such disability or retirement.
      In
      the event of death, any option held by the optionee lapses 6 months after the
      date of death.





Any
      RSU
      granted pursuant to the Long-Term Incentive Plan will lapse (i) immediately,
      where vesting of a unit is subject to the attainment of performance objectives,
      if such performance objectives have not been attained (or postponed at a
      further vesting date as determined by our Board of Directors.); (ii)
      immediately, whether or not subject to attainment of performance objectives,
      upon the termination of the relationship with us or one of our subsidiaries
      for
      a good and sufficient cause for employees or officers or at the date on which
      an
      employee or an officer resigns or leaves his employment with us or one of our
      subsidiaries.





Any
      RSU
      granted pursuant to the Long-Term Incentive Plan will vest immediately, to
      a
      certain proportion as determined by the Plan, upon the termination of the
      relationship of an employee or officer with us or one of our subsidiaries (i)
      for reasons not related to cause; (ii) because of death or permanent disability
      and (iii) retirement.





The
      following table summarizes information about stock options granted to the
      members of our Board of Directors, and to Management and Corporate Officers
      of
      us and our subsidiaries as at August 31, 2006:


**Number
                  of Options**
              **%
                  of Issued and Outstanding Options**
              **Weighted
                  Average Exercise Price ($US/Security)**President
                  and CEO (one individual)
              179,642
              7.36%
              9.05Board
                  of Directors (five individuals)
              194,375
              7.97%
              6.23Management
                  and Corporate Officers (eight individuals)
              313,836
              12.87%
              15.42


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The
      following table summarizes information about RSUs granted to the members of
      the
      Board of Directors and to Management and Corporate Officers of us and our
      subsidiaries as at August 31, 2006:


**Number
                  of RSUs**
              **%
                  of Issued and**
                **Outstanding
                  RSUs**
              **Weighted
                  Average Fair Value at the Time of Grant
                  $US/RSU**President
                  and CEO (one individual)
              34,566
              10.54%
              4.73Board
                  of Directors (five individuals)
              -
              -
              -Management
                  and Corporate Officers (ten individuals)
              184,161
              56,17%
              4.66


**Compensation
      of Chief Executive Officer**





In
      establishing Mr. Lamonde’s compensation for the year ending August 31, 2006, the
      Corporation relied on a study completed by an independent consulting firm
      (Mercer Human Resource Consulting). Such study indicated average salaries and
      bonuses, median salaries and bonuses and maximum salaries and bonuses paid
      to
      chief executive officers by Canadian and American computer hardware and software
      companies as well as by a specific group of companies active in the fiber optics
      industry identified by the Corporation that it considers to be the best
      available comparisons. It was decided that Mr. Lamonde’s compensation
      should reflect the median of Canadian computer hardware and software companies
      and of the specific group of companies in fiber optics identified by the
      Corporation. In the financial year ended August 31, 2006, Mr.
      Lamonde’s compensation was adjusted accordingly.





In
      the
      financial year ended August 31, 2006, the bonus portion of Mr. Lamonde’s
      compensation was tied to the financial and strategic objectives of the
      Corporation based on the following factors:





**Measure**
            **Weighting
                ALL**Sales
            35%Earnings
            15%Gross
                margin
            25%Customer
                satisfaction (quality and on time delivery)
            25%Personal
                objectives (multiplier)
            0%
                - 125%





Mr. Lamonde’s
      bonus is payable in the same proportion at which the Corporation attains such
      objectives. When the objectives are exceeded, the bonus is higher; when
      objectives are not met, the bonus is lower.





**Deferred
      Share Unit Plan**





Introduced
      in October 2004 and effective as of January 2005, the Deferred Share Unit Plan
      is designed to align more closely the interests of its non-employee Directors
      with those of our shareholders. A copy of the Deferred Share Unit Plan has
      been
      filed as exhibit 4.36 to last year annual report.





Under
      the
      Deferred Share Unit Plan, non-employee Directors shall receive up to 100 %
      of
      their retainer fees in the form of Deferred Share Units (“DSUs”), each of which
      has a fair value at the time of grant equal to the market value of a Subordinate
      Voting Share at the time DSUs are credited to the Directors. The value of a
      DSU,
      when converted to Subordinate Voting Shares, is equivalent to the market value
      of a Subordinate Voting Share at the time the conversion takes place. DUSs
      attract dividends in the form of additional DSUs at the same rate as dividends
      on Subordinate Voting Share. When a Director ceases to be a member of our Board
      of Directors, the DSUs are either converted and paid in Subordinate Voting
      Shares purchased on the open market or issued by us. Such Subordinate Voting
      Shares issued by us will be issued from the same pool of Subordinate Voting
      Shares reserved for issuance pursuant to the Long-Term Incentive Plan, which
      is
      9.2% of the total issued and outstanding voting shares.





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The
      following table summarizes information about DSUs granted to the non-employee
      members of our Board of Directors as at August 31, 2006:




**Number
                  of DSUs**
              **%
                  of Issued and Outstanding DSUs**
              **Weighted
                  Average Fair Value at the Time of Grant
                  $US/DSU**Board
                  of Directors (five individuals)
              43,290
              100%
              5.07


**Deferred
      Share Unit Grants in Last Financial Year**





The
      aggregate number of Deferred Share Units (“DSUs”) credited to non-employee
      directors during the financial year ended August 31, 2006 was 19,556. The
      estimated value at the time of grant of a DSU is determined based on the highest
      of the closing prices of the Subordinate Voting Shares on the Toronto Stock
      Exchange and the NASDAQ National Market on the last trading day preceding the
      grant date, using the noon buying rate of the Federal Reserve Bank of New York
      on the grant date to convert the NASDAQ National Market closing price to
      Canadian dollars, as required. The value at vesting of a DSU is equivalent
      to
      the market value of a Subordinate Voting Share when a DSU is converted to such
      Subordinate Voting Share. At the end of the financial year ended August 31,
      2006, there were a total of 43,290 DSUs credited to directors pursuant to the
      Deferred Share Unit Plan having an estimated value at the time of grant of
      US$219,662 (CA$258,617).





DSUs
      attract dividends in the form of additional DSUs at the same rate as dividends
      on Subordinate Voting Shares. The DSUs are converted and paid in Subordinate
      Voting Shares at the time a director ceases to be a member of our Board of
      Directors.





Therefore,
      the value at vesting of a DSU, when converted to Subordinate Voting Shares,
      is
      equivalent to the market value of a Subordinate Voting Share at the time the
      conversion takes place. The table below shows information regarding DSU grants
      made under the Deferred Share Unit Plan during the financial year ended August
      31, 2006.





During
      the financial year ended August 31, 2006, the following DSUs were granted to
      the
      directors:





**DSUs
                #**
            **Weighted
                Average Fair Value at the Time of Grant US$/DSU**
            **Vesting**19,556
            5.81
            At
                the time Director cease to be a member of the Board of the
                Corporation





**Restricted
      Share Unit Grants in Last Financial Year**





The
      aggregate number of Restricted Share Units (RSUs) granted during the financial
      year ended August 31, 2006 was 173,803, having a weighted average fair
      value at the time of grant of US$5.39 (CA$6.18) per RSU. The fair value at
      the
      time of grant of a RSU is equal to the market value of Subordinate Voting Shares
      at the time RSUs are granted. At the end of the financial year ended
      August 31, 2006, there were a total of 327,877 RSUs granted and
      outstanding pursuant to the Long-Term Incentive Plan having a weighted average
      fair value at the time of grant of US$5.03 (CA$5.95) per RSU. All RSUs first
      vesting can not be earlier than the third anniversary date of their grant.
      Some
      RSUs granted in the financial year ended August 31, 2006, vest at a rate of
      1/2
      annually commencing on the third anniversary date of the grant in February
      2006
      and in June 2006 and others at a rate of 1/3 annually on the third, fourth
      and fifth anniversary dates of the grant in August 2006. Some RSUs granted
      in
      the financial year ended August 31, 2005 vest at a rate of 1/3 annually
      commencing on the third anniversary date of the grant in February 2005 and
      others at a rate of 55%, 35% and 10%, on the third, fourth and fifth anniversary
      dates of the grant in January 2005. Some RSUs granted in the financial years
      ended August 31, 2006 and August 31, 2005 vest on the fifth
      anniversary date of the grant respectively in December 2005 and in January
      2005
      but are subject to early vesting on the third and fourth anniversary dates
      of
      the grant on the attainment of performance objectives as determined by our
      Board
      of Directors. Accordingly, subject to the attainment of performance objectives,
      the first early vesting is up to 1/3 of the units on the third anniversary
      date
      of the grant and the second early vesting is up to 50% of the remaining units
      on
      the fourth anniversary date of the grant.





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RSUs
      attract dividends in the form of additional RSUs at the same rate as dividends
      on Subordinate Voting Shares. The RSUs are redeemed for actual Subordinate
      Voting Shares or the equivalent in cash at the discretion of our Board of
      Directors on the vesting dates established by our Board of Directors at the
      time
      of grant in its sole discretion.





Therefore,
      the value at vesting of a RSU, when converted to Subordinate Voting Shares,
      is
      equivalent to the market value of a Subordinate Voting Share at the time the
      conversion takes place. The table below shows information regarding RSU grants
      made under the Long-Term Incentive Plan during the financial year ended
      August 31, 2006.





During
      the financial year ended August 31, 2006, the following RSUs were
      granted:


**RSUs
                    #**
                **Fair
                    Value at the Time of Grant US$/RSU**
                **Vesting****(1)**61,253
                4.76
                100%
                    on the fifth anniversary date of the grant in December 2005 subject
                    to
                    early vesting up to 1/3 on the third anniversary date of the
                    grant and up
                    to 50% of the remaining units on the fourth anniversary date
                    of the grant
                    if the performance objectives are fully attained.(2)86,700
                5.59
                50%
                    on the third and fourth anniversary dates of the grant in February
                    2006.(3)1,500
                6.50
                50%
                    on the third and fourth anniversary dates of the grant in February
                    2006.(3)13,850
                6.58
                50%
                    on the third and fourth anniversary dates of the grant in February
                    2006.(3)3,500
                5.90
                50%
                    on the third and fourth anniversary dates of the grant in June
                    2006.(4)2,000
                6.27
                50%
                    on the third and fourth anniversary dates of the grant in June
                    2006.(4)5,000
                5.16
                1/3
                    on each of the third, fourth and fifth anniversary dates of the
                    grant in
                    August 2006(5)
 
 
 (1)
              All
                  RSUs first vesting cannot be earlier than the third anniversary
                  date of
                  their grant. (2)
              Those
                  RSUs granted in the financial year ended August 31, 2006 vest on
                  the fifth
                  anniversary date of the grant in December 2005 but are subject
                  to early
                  vesting on the third and fourth anniversary dates of the grant
                  on the
                  attainment of performance objectives as determined by our Board
                  of
                  Directors. Accordingly, subject to the attainment of performance
                  objectives, the first early vesting is up to 1/3 of the units on
                  the third
                  anniversary date of the grant and the second early vesting is up
                  to 50% of
                  the remaining units on the fourth anniversary date of the
                  grant. (3)
              Those
                  RSUs granted in the financial year ended August 31, 2006 vest at
                  a rate of
                  1/2 annually commencing on the third anniversary date of the grant
                  in
                  February 2006. (4)
              Those
                  RSUs granted in the financial year ended August 31, 2006 vest at
                  a rate of
                  1/2 annually commencing on the third anniversary date of the grant
                  in June
                  2006. (5)
              Those
                  RSUs granted in the financial year ended August 31, 2006 vest at
                  a rate of
                  1/3 annually commencing on the third anniversary date of the grant
                  in
                  August 2006.


During
      the financial year ended August 31, 2006, the following RSUs were granted to
      the
      following Named Executive Officers:


**Name**
              **RSUs
                  #**
              **Percentage
                  of Net Total of RSUs Granted to Employees in Financial
                  Year**
                **(%)**
              **Fair
                  Value at the Time of Grant US$/RSU**
              **Vesting****(1)**Germain
                  Lamonde
              21,477
              12.36
              4.76
              100%
                  on the fifth anniversary date of the grant in December 2005 subject
                  to
                  early vesting up to 1/3 on the third anniversary date of the grant
                  and up
                  to 50% of the remaining units on the fourth anniversary date of
                  the grant
                  if the performance objectives are fully attained.(2)Pierre
                  Plamondon
              6,994
              4.02
              4.76
              100%
                  on the fifth anniversary date of the grant in December 2005 subject
                  to
                  early vesting up to 1/3 on the third anniversary date of the grant
                  and up
                  to 50% of the remaining units on the fourth anniversary date of
                  the grant
                  if the performance objectives are fully attained.(2)





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**Name**
              **RSUs
                  #**
              **Percentage
                  of Net Total of RSUs Granted to Employees in Financial
                  Year**
                **(%)**
              **Fair
                  Value at the Time of Grant US$/RSU**
              **Vesting****(1)**Juan-Felipe
                  Gonzalez
              6,716
              3.86
              4.76
              100%
                  on the fifth anniversary date of the grant in December 2005 subject
                  to
                  early vesting up to 1/3 on the third anniversary date of the grant
                  and up
                  to 50% of the remaining units on the fourth anniversary date of
                  the grant
                  if the performance objectives are fully attained.(2)Allan
                  Firhoj
              4,602
              2.65
              4.76
              100%
                  on the fifth anniversary date of the grant in December 2005 subject
                  to
                  early vesting up to 1/3 on the third anniversary date of the grant
                  and up
                  to 50% of the remaining units on the fourth anniversary date of
                  the grant
                  if the performance objectives are fully attained.(2)Dana
                  Yearian
              5,000
              2.88
              5.16
              1/3
                  on each of third, fourth and fifth anniversary dates of the grant
                  in
                  August 2006.(3)
 
 
 (1)
            All
                RSUs first vesting cannot be earlier than the third anniversary date
                of
                their grant. (2)
            Those
                RSUs granted in the financial year ended August 31, 2006 vest on
                the fifth
                anniversary date of the grant in December 2005 but are subject to
                early
                vesting on the third and fourth anniversary date of the grant on
                the
                attainment of performance objectives as determined by our Board of
                Directors. Accordingly, subject to the attainment of performance
                objectives, the first early vesting is up to 1/3 of the units on
                the third
                anniversary date of the grant and the second early vesting is up
                to 50% of
                the remaining units on the fourth anniversary date of the
                grant. (3)
            Those
                RSUs granted in the financial year ended August 31, 2006 vest at
                a rate of
                1/3 annually commencing on the third anniversary date of the grant
                in
                August 2006.




**Number
      of Subordinate Voting Shares reserved for future issuance**





During
      the financial year ended August 31, 2006, 19,556 Deferred Share Units, 173,803
      Restricted Share Units and 31,992 options were granted to directors, officers
      and employees. Such awards were issued from the same pool of Subordinate Voting
      Shares reserved for issuance pursuant to the Long-Term Incentive Plan which
      is
      9,2% of the total and outstanding voting shares as of November 1, 2006.
      Therefore, as of November 1, 2006 the number of Subordinate Voting Shares
      reserved for future issuance is 3,423,784.





**Share
      Purchase Plan**





In
      September 1998, we established a stock purchase plan for officers, Directors
      and
      key employees as amended in April 2000. A total of 707,264 subordinate voting
      shares were issued and fully paid under the 1998 Stock Purchase Plan, having
      a
      weighted average cash consideration of $0.67 (CA$0.98) per share. The plan
      provides that all shares issued under the plan are restricted as to sale and
      transferability for a minimum period of five years upon the date of
      acquisition.





On
      April
      3, 2000, we adopted a share plan that replaced the 1998 Stock Purchase Plan.
      No
      additional shares will be issued under the share plan. The share plan
      established restrictions on the rights of the holders of subordinate voting
      shares who hold those shares as a result of the conversion of the Class “F”
shares issued under the 1998 Stock Purchase Plan. The share plan also required
      the subordinate voting shares to be held in trust by a trustee until
      August 31, 2004, except for 249,977 subordinate voting shares that
      were released between October 21, 2003 and January 20, 2004. The share plan
      also
      provided for the earlier release of shares in the event that the employment
      of a
      holder of shares is terminated or upon the occurrence of a change of control.
      The share plan did not permit any transfer, except within the trust to a
      registered retirement savings plan or a registered retirement income fund or
      to
      a trustee in bankruptcy. The share plan also established the conditions pursuant
      to which the shares of a shareholder are to be sold by the trustee on the public
      market. As of August 31, 2004, all the remaining subordinate voting
      shares that were held in trust under the share plan were released.




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**Restricted
      Stock Award Plan**





The
      EXFO
      Electrical-Optical Engineering Restricted Stock Award Plan (the "RSAP") was
      established to provide a means through which employees of EXFO Burleigh Products
      Group Inc. can be granted awards of restricted shares ("Restricted Shares")
      of
      Subordinate Voting Shares to promote retention and foster identity of interest
      between stockholders and employees of EXFO Burleigh Products Group
      Inc.





The
      effective date of the RSAP was December 20, 2000. The expiration date of the
      RSAP is the business day next following the final grant of Restricted Shares
      under the RSAP, which was December 20, 2000. However, the administration of
      the
      RSAP did continue until all awards of Restricted Shares have been forfeited
      or
      settled. The aggregate number of shares subject to the RSAP was 360,000. Stock
      awards granted under the RSAP vest over a 4 year period, with 25% vesting
      on an annual basis commencing on the first anniversary of the date of grant.
      The
      last vesting occurred on December 20, 2004, the Human Resources Committee
      administered the RSAP until that date. Therefore the administration of the
      RSAP
      terminated on December 20, 2004.





Awards
      of
      Restricted Shares were subject to forfeiture and restrictions on transfer until
      the Restricted Shares became vested at which point a stock certificate was
      issued to a participant with respect to the number of vested shares, which
      are
      then freely transferable. Restricted Shares become vested, subject to a
      participant's continued employment with us or our affiliates, on each of the
      first four anniversaries of the date of grant of an award of Restricted
      Shares.





Upon
      a
      participant's termination of employment with us or any of our affiliates due
      to
      the participant's death, disability or retirement on or after age 60, the
      participant's award of restricted shares became fully vested and was no longer
      subject to forfeiture. However, the transfer restrictions remained in place
      until the occurrence of the vesting dates originally contemplated by the
      award.





Upon
      the
      voluntary resignation of a participant, the termination of a participant's
      employment for cause, the termination of a participant who is not designated
      a
      member of EXFO Burleigh Products Group Inc. "Management Team" without cause
      prior to a change in control of us or a termination without cause of a
      participant who is designated a member of EXFO Burleigh Products Group Inc.
      Management Team that is initiated by EXFO Burleigh Products Group Inc. prior
      to
      a change in control of us, the unvested portion of the participant's award
      of
      Restricted Shares were forfeited. However the RSAP provided discretion to the
      Human Resources Committee in the application of the forfeiture provisions where
      a change in circumstances rendered such action appropriate. During the financial
      year ended August 31, 2005, EXFO Burleigh Products Group Inc. was
      required to lay off the remaining of the participants (excluding a few that
      were
      transferred to our other offices) as a result of a consolidation due to a sharp
      downturn in its market. The Human Resources Committee decided that the awards
      of
      RSAP participants affected by the lay-offs would not be subject to forfeiture,
      though the transfer restrictions remained in place until the occurrence of
      the
      vesting dates originally contemplated by the award.





Upon
      the
      termination without cause of a participant who was designated a member of EXFO
      Burleigh Products Group Inc. Management Team that was initiated by us or a
      termination of a participant's employment without cause following a change
      in
      control of us, a participant's award of Restricted Stock became fully vested
      and
      all restrictions lapsed.





In
      the
      event of a change in control, the committee administering the RSAP could in
      its
      discretion remove restrictions on Restricted Shares or provide for the
      cancellation of awards in exchange for payment in respect of the Restricted
      Shares subject to an award.




**Stock
      Appreciation Rights Plan**




On
      August
      4, 2001, we established a Stock Appreciation Rights Plan (“SAR Plan”) for the
      benefit of certain employees residing in countries where the granting of options
      under the Stock Option Plan is not feasible in our opinion. The Board has full
      and complete authority to interpret the SAR Plan and to establish the rules
      and
      regulations applying to it and to make all other determinations it deems
      necessary or useful for the administration of the SAR Plan.





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Under
      the
      SAR Plan, eligible employees are entitled to receive a cash amount equivalent
      to
      the difference between the market price of the Subordinate Voting Shares on
      the
      date of exercise and the exercise price determined on the date of grant. No
      Subordinate Voting Shares are issuable under the SAR Plan.




Our
      Board
      of Directors has delegated to Management the task of designating the recipients
      of stock appreciation rights, the date of vesting, the expiry date and other
      conditions. Under the terms of the SAR Plan, the exercise price of the stock
      appreciation rights may not be lower than the highest of the closing prices
      of
      the Subordinate Voting Shares on the Toronto Stock Exchange and on the NASDAQ
      National Market on the last trading day preceding the grant date, using the
      noon
      buying rate of the Federal Reserve Bank of New York on the grant date to convert
      the NASDAQ National Market closing price to Canadian dollars. Stock appreciation
      rights are non-transferable.




The
      stock
      appreciation rights vest over a four-year period, with 25% vesting annually
      commencing on the first anniversary date of the date of grant. Once vested,
      stock appreciation rights may be exercised between the second and the fifteenth
      business day following each release of our quarterly financial results. All
      of
      the stock appreciation rights that are granted under the SAR Plan may be
      exercised within a maximum period of 10 years following the date of their
      grant. Any stock appreciation rights granted under the SAR Plan will lapse
      immediately upon the termination of the relationship with us or one of our
      subsidiaries for a good and sufficient cause or at the date on which an employee
      resigns or leaves his employment with us or one of our subsidiaries (or within
      30 days if the holder is dismissed without cause). In the event of
      retirement or disability, any stock appreciation right held by an employee
      lapses 30 days after the date of any such disability or retirement. In the
      event of death, any stock appreciation right lapses 6 months after the date
      of
      death.





As
      of
      November 1, 2006, there were 24,500 SAR’s outstanding.





**Deferred
      Profit Sharing Plan**





We
      maintain a deferred profit sharing plan for certain eligible Canadian resident
      employees. Under this plan, we may contribute an amount equal to 1% until May
      31, 2005 and 2% starting June 1, 2005, of each employee’s gross salary
      to that employee’s individual deferred profit sharing plan to the extent that
      such employee contributes at least 2% of his or her gross salary to his or
      her
      individual tax-deferred registered retirement savings plan. In the year ended
      August 31, 2006, the aggregate amount of contributions under the plan was
      $316,000 (CA$363,000). Mr. Germain Lamonde is not entitled to participate
      in this plan.




**401(k)
      Plan**





We
      maintain a 401(k) plan for eligible United States resident employees of our
      subsidiaries. Employees become eligible to participate in the 401(k) plan on
      the
      first day of the month following the completion of three months of continuous
      service. Employees may elect to defer their current compensation up to the
      lesser of 1% of eligible compensation or the statutorily prescribed annual
      limit
      and have the deferral contributed to the 401(k) plan. The 401(k) plan permits,
      but does not require us to make additional matching contributions to the 401(k)
      plan on behalf of the eligible participants, subject to a maximum of 50% of
      the
      first 6% of the participant’s current compensation subject to certain legislated
      maximum contribution limits. In the year ended August 31, 2006, we made an
      aggregate of $126,000 in matching contributions to the 401(k) plan.
      Contributions by employees or by us to the 401(k) plan and income earned on
      plan
      contributions are generally not taxable to the employees until withdrawn and
      contributions by us are generally deductible by us when made. At the direction
      of each participant, the trustees of the 401(k) plan invest the assets of the
      401(k) plan in selected investment options.






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   **Indemnification
        of Directors and Executive Officers and Limitation of
        Liability**





Our
      by-laws require us, subject to the limitations provided by law, to indemnify
      our
      present or former Directors and officers or any persons who act or acted at
      our
      request as Directors or officers of a body corporate **** for
      all
      costs, losses, charges and expenses that arose or may arise by reason of their
      status as Directors or officers of us or such body corporate. A policy of
      Directors’ and officers’ liability insurance is maintained by us which insures
      our Directors and officers and those of our subsidiaries against liability
      incurred by, arising from or against them for certain of their acts, errors
      or
      omissions. Accordingly, we maintain insurance protection against liability
      incurred by our officers and Directors as well as those of our subsidiaries
      in
      the performance of their duties. The entire premium, amounting to US$228,000
      from September 30, 2006 to September 30, 2007, is paid by us. The aggregate
      limit of liability in respect of any and all claims is US$10 million per year.
      The policy provides for the indemnification of Directors and officers in the
      case of claims for which we have not indemnified or are not permitted by law
      to
      indemnify them, and for the reimbursement of us, subject to a deductible of
      US$100,000, except for securities claims where the deductible is
      US$500,000.








**C.**  **Board
      Practices** ****





**Board
      of Directors**





Our
      Directors are elected at the annual meeting of shareholders for one-year terms
      and serve until their successors are elected or appointed, unless they resign
      or
      are removed earlier. Our articles of incorporation provide for a Board of
      Directors of a minimum of three (3) and a maximum of twelve (12) Directors.
      Our
      Board of Directors presently consists of six Directors. Under the *Canada
      Business Corporations Act,* twenty-five percent of the Directors and of the members of any committee of
      the
      Board of Directors must be resident Canadians. We have no arrangements with
      any
      of our Directors providing for the payment of benefits upon their termination
      of
      service as Director except for the vesting of their respective Deferred Share
      Units as detailed above.





The
      following table and notes set out the name of each of the individuals who served
      as a director of the Corporation during the last year term, all other positions
      and offices with the Corporation and its subsidiaries now held by each such
      individual, if any, the principal occupation or employment of each such
      individual, their respective period of service as a director.


**Name
                  and Position or Office with the Corporation**
              **Principal
                  Occupation or Employment**
              **Residence**
              **Director
                  Since**Germain
                  Lamonde
                Chairman
                  of the Board, President and Chief Executive Officer
              Chairman
                  of the Board, President and Chief Executive Officer, EXFO Electro-Optical
                  Engineering Inc.
              Quebec
                  City, Quebec,
                Canada
              September
                  1985Pierre
                  Marcouiller(1)
                  (2)
                Independent
                  Director
              Chairman
                  of the Board and Chief Executive Officer,
                Camoplast
                  Inc. (a supplier of automotive and recreational vehicle
                  parts)
              Magog,
                  Quebec,
                Canada
              May
                  2000Guy
                  Marier(1)
                  (2)
                Independent
                  Director
              Executive
                  Consultant
              Lakefield
                  Gore, Quebec,
                Canada
              January
                  2004André
                  Tremblay(2)
                  (3)
                Independent
                  Director
              Founder
                  and Managing Partner,
                Trio
                  Capital Inc. (a private equity fund management company)
              Outremont,
                  Quebec,
                Canada
              May
                  2000Dr.
                  David A. Thompson, Ph.D.(2)
                Independent
                  Director
              Vice-President&
                  Director, Hardware & Equipment Technology Strategy, Corning Cable
                  Systems (involved in manufacturing innovative products for the
                  telecommunications industry)(5)
              Newton,
                  North Carolina,
                USA
              June
                  2000Michael
                  Unger(1)
                  (4)
                Independent
                  Lead Director
              Executive
                  Consultant
              Richmond
                  Hill,
                  Ontario,
                Canada
              May
                  2000




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(1)
            Member
                of the Audit Committee. (2)
            Member
                of the Human Resources Committee. (3)
            Chair
                of the Audit Committee. (4)
            Chair
                of the Human Resources Committee. (5)
            Corning
                Incorporated is a diversified technology company that concentrate
                its
                efforts on high-impact growth opportunities. Corning combines its
                expertise in specialty glass, ceramic materials, polymers and the
                manipulation of the properties of light, with strong process and
                manufacturing capabilities to develop, engineer and commercialize
                significant innovative products for the telecommunications, flat
                panel
                display, environmental, semiconductor, and life sciences
                industries.




Since
      September 1, 2005 until November 1, 2006, the Board met a total of eight (8)
      times. Attendance at all meetings was perfect, except Mr. David A. Thompson
      who
      was absent three (3) times and Mr. André Tremblay who was absent one
      time.





**Committees
      of the Board of Directors**





Our
      Board
      of Directors has established an audit committee, a human resources committee
      and
      a disclosure committee.





Our
      audit
      committee will recommend a firm to be appointed as independent auditors to
      audit
      financial statements and to perform services related to the audit, review the
      scope and results of the audit with the independent auditors, review with
      management and the independent auditors our annual operating results and
      consider the adequacy of the internal accounting procedures and the effect
      of
      the procedures relating to the auditors’ independence. Further to changes to
      NASDAQ corporate governance rules and Securities and Exchange rules flowing
      from
      the adoption of the *Sarbanes-Oxley
      Act* ,
      our
      audit committee charter is being revised every financial year to ensure that
      we
      comply with all new requirements. Accordingly, in March 2005, the Board updated
      and adopted an Audit Committee Charter. A copy of this Audit Committee Charter
      has been filed as Exhibit 11.6 to last year annual report and is also readily
      available from EXFO’s website at www.exfo.com .
      The
      audit committee revised such Charter in October 2006 but no amendment was
      required. The audit committee is composed of four independent Directors: André
Tremblay, Michael Unger, Guy Marier and Pierre Marcouiller. The chairperson
      of
      the audit committee is André Tremblay.





During
      the fiscal year ended August 31, 2006, the Audit Committee met a total of five
      (5) times and attendance was perfect at all meetings, except Mr. Michael Unger
      who was absent one time.





Our
      human
      resources committee will evaluate, review and supervise our procedures with
      regards to human resources and will assess the performance of our executive
      officers and the chief executive officer. This committee will also review
      annually the remuneration of the Directors and will recommend to the Board
      of
      Directors general remuneration policies regarding salaries, bonuses and other
      forms of remuneration for our Directors, executive officers and employees as
      a
      whole. Finally, the human resources committee will review our organizational
      structure annually and the development and maintenance of a succession plan.
      Accordingly, in March 2005, the Board updated and adopted a Human Resources
      Committee Charter which integrates the Compensation Committee Charter and the
      Nominating and Governance Committee Charter. A copy of this Human Resources
      Committee Charter has been filed as Exhibit 11.7 to last year annual report
      and
      is also readily available from EXFO’s website at www.exfo.com .
      The
      human resources committee is composed of five independent Directors: Pierre
      Marcouiller, Guy Marier, David A. Thompson, André Tremblay and Michael
      Unger. The chairperson of the human resources committee is Michael
      Unger.





During
      the fiscal year ended August 31, 2006, the Human Resources committee met a
      total
      of five (5) times and attendance was perfect at all meetings, except Mr. David
      A. Thompson who was absent four (4) times and Mr. André Tremblay who was
      absent one time.





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The
      disclosure committee is responsible for overseeing our disclosure practices.
      This committee consists of the chief executive officer, the chief financial
      officer, the manager of investor relations, the manager of financial reporting
      and accounting as well as our legal counsel and corporate
      secretary.





In
      addition, in order to deal with issues arising from our implication in the
      IPO
      class action suit, in October 2002, our Board of Directors appointed a
      litigation committee composed of four of our independent Directors.








**D.**  **Employees** ****





We
      have
      fostered a corporate culture where growth and change are strongly encouraged.
      In
      fact, employees are constantly evolving with the rapid pace of technology to
      meet new challenges and realities. We believe that we possess a good
      cross-section of experience and youth to handle these inevitable changes in
      the
      industry.





As
      of
      November 1, 2006, we had a total of 862 employees, up from a total of 685 on
      November 1, 2005. We have 762 employees in Canada, primarily based in Quebec,
      and 100 employees based outside of Canada. 264 are involved in
      research and development, 294 in manufacturing, 163 in sales and marketing,
      81
      in general administrative positions and 60 in communications and customer
      support. We have agreements with almost all of our employees covering
      confidentiality and non-competition. Only manufacturing employees based in
      Quebec City plants are represented by a collective bargaining agreement, which
      expires in 2009. We have never experienced a work stoppage. We believe that
      relations with our employees and bargaining unit are good.







**E.**  **Share
      Ownership** ****





The
      following table presents information regarding the ownership of Subordinate
      Voting Shares, Exercisable “in-the-money” and “out-the-money” options and the
      beneficial ownership of our share capital as of November 1, 2006 by our Chief
      Executive Officer, Chief Financial Officer, our Directors, our three other
      most
      highly compensated executive officers, our other executive officers as a group
      and all of our Directors and executive officers as a group.





Each
      multiple voting share is convertible at the option of the holder into one
      subordinate voting share. Holders of our subordinate voting shares are entitled
      to one (1) vote per share and holders of our multiple voting shares are entitled
      to ten (10) votes per share.


**Name**
                **Subordinate
                    Voting Shares Owned**
                **Currently
                    Exercisable Options Owned as of November 1, 2006**
                **Total
                    Subordinate Voting Shares Beneficially Owned****(3)**
                **Multiple
                    Voting Shares Beneficially Owned****(3)**
                **Total
                    Percentage**
                  **of
                    Voting Power****In-the-money****(1)**
                **Out-the-money****(2)****Number**
                **Percent**
                **Number**
                **Percent**
                **Number**
                **Percent**
                **Number**
                **Percent**
                **Number**
                **Percent**
                **Percent**Germain
                    Lamonde(4)
                483,500
                *
                50,000
                *
                104,968
                *
                638,468
                *
                37,143,000
                100
                92.3Pierre
                    Plamondon
                35,427(5)
                *
                20,000
                *
                54,631
                *
                110,058
                *
                −
                −
                *Pierre
                    Marcouiller
                5,000
                *
                21,875
                *
                23,882
                *
                50,757
                *
                −
                −
                *Guy
                    Marier
                1,000
                *
                −
                *
                6,250
                *
                7,250
                *
                −
                −
                *David
                    A. Thompson
                2,100
                *
                21,875
                *
                17,734
                *
                41,709
                *
                −
                −
                *André
                    Tremblay
                6,650(6)
                *
                21,875
                *
                19,691
                *
                48,216
                *
                −
                −
                *Michael
                    Unger
                −
                *
                21,875
                *
                20,568
                *
                42,443
                *
                −
                −
                *






78
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**Name**
              **Subordinate
                  Voting Shares Owned**
              **Currently
                  Exercisable Options Owned as of November 1, 2006**
              **Total
                  Subordinate Voting Shares Beneficially Owned****(3)**
              **Multiple
                  Voting Shares Beneficially Owned****(3)**
              **Total
                  Percentage**
                **of
                  Voting Power****In-the-money****(1)**
              **Out-the-money****(2)****Number**
              **Percent**
              **Number**
              **Percent**
              **Number**
              **Percent**
              **Number**
              **Percent**
              **Number**
              **Percent**
              **Percent**Juan-Felipe
                  Gonzalez
              40,100
              *
              7,500
              *
              85,271
              *
              132,871
              *
              −
              −
              *Allan
                  Firhoj
              −
              *
              3,750
              *
              18,837
              *
              22,587
              *
              −
              −
              *Dana
                  Yearian
              −
              *
              −
              *
              −
              *
              −
              *
              −
              −
              *Other
                  executive officers as a group
              35,025
              *
              35,000
              *
              50,764
              *
              120,789
              *
              −
              −
              *All
                  of our Directors and executive officers as a group
              608,802
              *
              203,750
              *
              402,596
              1.3
              1,215,148
              3.8
              37,143,000
              100
              92.5




*
            Less
                than 1%.


(1)
            “In-the-money”
                options are options for which the market value of the underlying
                securities is higher than the price at which such securities may
                be bought
                from the Corporation. As of November 1, 2006 the market value of
                a
                Subordinate Voting Share was
                US$4.90.


(2)
            “Out-the-money”
                options are options for which the market value of the underlying
                securities is lower than the price of which such securities may be
                bought
                from the Corporation.


(3)
            Beneficial
                ownership is determined in accordance with the rules of the SEC and
                generally includes voting or investment power with respect to securities.
                Options that are currently exercisable (including options that have
                an
                exercise price above the market price) are deemed to be outstanding
                and to
                be beneficially owned by the person holding such options for the
                purpose
                of computing the percentage ownership of such person, but are not
                treated
                as outstanding for the purpose of computing the percentage ownership
                of
                any other person. Accordingly, DSUs and RSUs are not
                included.


(4)
            The
                number of shares held by Germain Lamonde includes 1,900,000 multiple
                voting shares held of record by Fiducie Germain Lamonde, 35,243,000
                multiple voting shares and 483,500 subordinate voting shares held
                of
                record by G. Lamonde Investissements Financiers
                inc.


(5)
            The
                number of shares held by Pierre Plamondon includes 6,874 subordinate
                voting shares held of record by Fiducie Pierre
                Plamondon.


(6)
            The
                number of subordinate voting shares held of record by André Tremblay is
                held by 9104-5559 Québec Inc, a company controlled by Mr.
                Tremblay.





The
      following table presents information regarding stock options held as of
      November 1, 2006 **** by
      our
      Chief Executive Officer, Chief Financial Officer, our Directors, our three
      other
      most highly compensated executive officers and our other executive officers
      as a
      group.




**Name**
              **Securities
                  Under Options Granted****(1)****(#)**
              **Exercise
                  Price****(2)****(US$/Security)**
              **Expiration
                  Date**Germain
                  Lamonde
              25,402
                5,080
                70,000
                50,000
                17,942
                11,218
              $26.00
                $22.25
                $9.13
                $1.58
                $4.51
                $4.76
              June
                  29, 2010
                January
                  10, 2011
                October
                  10, 2011
                September
                  25, 2012
                February
                  1, 2015
                December
                  6, 2015Pierre
                  Plamondon
              8,700
                10,000
                5,000
                9,240
                19,000
                25,000
                5,383
                3,653
              $26.00
                $45.94
                $34.07
                $22.25
                $9.13
                $1.58
                $5.13
                $4.76
              June
                  29, 2010
                September
                  13, 2010
                October
                  11, 2010
                January
                  10, 2011
                October
                  10, 2011
                September
                  25, 2012
                October
                  26, 2014
                December
                  6, 2015


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**Name**
              **Securities
                  Under Options Granted****(1)****(#)**
              **Exercise
                  Price****(2)****(US$/Security)**
              **Expiration
                  Date**Pierre
                  Marcouiller
              2,000
                400
                17,966
                1,037
                2,479
                12,500
                12,500
              $26.00
                $22.25
                $9.13
                $12.69
                $5.65
                $1.58
                $3.51
              June
                  29, 2010
                January
                  10, 2011
                October
                  10, 2011
                December
                  1, 2011
                March
                  1, 2012
                September
                  25, 2012
                October
                  27, 2013Guy
                  Marier
              12,500
              $4.65
              March
                  24, 2014David
                  A. Thompson
              2,000
                400
                15,334
                12,500
                12,500
              $26.00
                $22.25
                $9.13
                $1.58
                $3.51
              June
                  29, 2010
                January
                  10, 2011
                October
                  10, 2011
                September
                  25, 2012
                October
                  27, 2013André
                  Tremblay
              2,000
                400
                17,291
                12,500
                12,500
              $26.00
                $22.25
                $9.13
                $1.58
                $3.51
              June
                  29, 2010
                January
                  10, 2011
                October
                  10, 2011
                September
                  25, 2012
                October
                  27, 2013Michael
                  Unger
              2,000
                400
                18,168
                12,500
                12,500
              $26.00
                $22.25
                $9.13
                $1.58
                $3.51
              June
                  29, 2010
                January
                  10, 2011
                October
                  10, 2011
                September
                  25, 2012
                October
                  27, 2013Juan
                  Felipe Gonzalez
              6,900
                15,000
                15,000
                15,630
                15,000
                15,000
                7,500
                5,482
                3,505
              $26.00
                $45.94
                $34.07
                $22.25
                $9.13
                $12.22
                $1.58
                $5.13
                $4.76
              June
                  29, 2010
                September
                  13, 2010
                October
                  11, 2010
                January
                  10, 2011
                October
                  10, 2011
                January
                  3, 2012
                September
                  25, 2012
                October
                  26, 2014
                December
                  6, 2015Allan
                  Firhoj
              10,000
                8,000
                3,750
                2,512
                2,404
              $23.40
                $9.13
                $1.58
                $5.13
                $4.76
              March
                  15, 2011
                October
                  10, 2011
                September
                  25, 2012
                October
                  26, 2014
                December
                  6, 2015Dana
                  Yearian
              −
              −
              −Other
                  Executive Officers as a group
              900
                8,000
                4,000
                6,180
                25,000
                30,000
                10,000
                12,369
                2,000
                8,728
              $26.00
                $45.94
                $34.07
                $22.25
                $9.13
                $1.58
                $3.19
                $5.13
                $4.51
                $4.76
              June
                  29, 2010
                September
                  13, 2010
                October
                  11, 2010
                January
                  10, 2011
                October
                  10, 2011
                September
                  25, 2012
                January
                  7, 2013
                October
                  26, 2014
                February
                  1, 2015
                December
                  6, 2015
 
 
 (1) Underlying
        securities: subordinate voting shares
 (2) The
        exercise price of options granted is determined based on the highest of the
        closing prices of the subordinate voting shares on the Toronto Stock Exchange
        and the NASDAQ National Market on the last trading day preceding the grant
        date,
        using the noon buying rate of the Federal Reserve Bank of New York on the
        grant
        date to convert the NASDAQ National Market closing price to Canadian dollars,
        as
        required.




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The
      following table presents information regarding Deferred Share Units and
      Restricted Share Units held by our Chief Executive Officer, our Chief Financial
      Officer, our Directors, our three other most highly compensated executive
      officers, our other executive officers as a group and all of our Directors
      and
      executive officers as a group as of November 1, 2006.


**Name**
                **DSUs**
                **RSUs****Number**
                **Percentage**
                **Estimated
                    Average Value at the time of grant US$/DSU****(1)**
                **Number**
                **Percentage**
                **Fair
                    Value at the time of grant US$/RSU****(2)**Germain
                    Lamonde
                −
                −
                −
                13,089(3)
                3.1%
                4.69−
                −
                −
                21,477(4)
                5.0%
                4.76−
                −
                −
                25,347(5)
                5.9%
                6.02Pierre
                    Plamondon
                −
                −
                −
                3,927(3)
                1.0%
                4.69−
                −
                −
                30,000(6)
                7.0%
                4.69−
                −
                −
                6,994(4)
                1.6%
                4.76−
                −
                −
                8,430(5)
                2.0%
                6.02−
                −
                −
                4,500(7)
                1.1%
                6.02Pierre
                    Marcouiller
                8,349(8)
                19.3%
                5.07
                −
                −
                −Guy
                    Marier
                8,349(8)
                19.3%
                5.07
                −
                −
                −David
                    A. Thompson
                9,894(8)
                22.8%
                5.07
                −
                −
                −André
                    Tremblay
                8,349(8)
                19.3%
                5.07
                −
                −
                −Michael
                    Unger
                8,349(8)
                19.3%
                5.07
                −
                −
                −Juan-Felipe
                    Gonzalez
                −
                −
                −
                3,998(3)
                0.9%
                4.69−
                −
                −
                30,000(6)
                7.0%
                4.69−
                −
                −
                6,716(4)
                1.6%
                4.76Allan
                    Firhoj
                −
                −
                −
                2,443(3)
                0.6%
                4.69−
                −
                −
                10,000(6)
                2.3%
                4.69−
                −
                −
                4,602(4)
                1.1%
                4.76−
                −
                −
                6,145(5)
                1.4%
                6.02Dana
                    Yearian
                −
                −
                −
                5,000(9)
                1.2%
                5.16−
                −
                −
                6,645(5)
                1.6%
                6.02Other
                    executive officers as a group
                −
                −
                −
                9,023(3)
                2.1%
                4.69−
                −
                −
                51,500(6)
                12.1%
                4.69−
                −
                −
                16,708(4)
                3.9%
                4.76−
                −
                −
                25,235(5)
                5.9%
                6.02−
                −
                −
                20,500(7)
                4.8%
                6.02All
                    of the directors and executive officers as a group
                −
                −
                −
                32,480(3)
                7.6%
                4.69−
                −
                −
                121,500(6)
                28.4%
                4.69−
                −
                −
                56,497(4)
                13.2%
                4.76−
                −
                −
                71,802(5)
                16.8%
                6.0243,290
                100%
                5.07
                25,000(7)
                5.9%
                6.02


(1)
            The
                estimated average value at the time of grant of a DSU is the average
                of
                the estimated value at the time of grant of a DSU which is determined
                based on the highest of the closing prices of the Subordinate Voting
                Shares on the Toronto Stock Exchange and the NASDAQ National Market
                on the
                last trading day preceding the grant date, using the noon buying
                rate of
                the Federal Reserve Bank of New York on the grant date to convert
                the
                NASDAQ National Market closing price to Canadian dollars, as required.
                The
                value at vesting of a DSU is equivalent to the market value of a
                Subordinate Voting Share when a DSU is converted to such Subordinate
                Voting Share.


(2)
            The
                fair value at the time of grant of a RSU is equal to the market value
                of
                Subordinate Voting Shares at the time RSUs are
                granted.


(3)
            Those
                RSUs will vest on the fifth anniversary date of the grant in January
                2005
                but are subject to early vesting on the third and fourth anniversary
                date
                of the grant on the attainment of performance objectives as determined
                by
                the Board of Directors. Accordingly, subject to the attainment of
                performance objectives, the first early vesting is up to 1/3 of the
                units
                on the third anniversary date of the grant and the second early vesting
                is
                up to 50% of the remaining units on the fourth anniversary date of
                the
                grant.


(4)
            Those
                RSUs will vest on the fifth anniversary date of the grant in December
                2005
                but are subject to early vesting on the third and fourth anniversary
                date
                of the grant on the attainment of performance objectives as determined
                by
                the Board of Directors. Accordingly, subject to the attainment of
                performance objectives, the first early vesting is up to 1/3 of the
                units
                on the third anniversary date of the grant and the second early vesting
                is
                up to 50% of the remaining units on the fourth anniversary date of
                the
                grant.


(5)
            Those
                RSUs will vest on the fifth anniversary date of the grant in October
                2006
                but are subject to early vesting on the third and fourth anniversary
                date
                of the grant on the attainment of performance objectives as determined
                by
                the Board of Directors. Accordingly, subject to the attainment of
                performance objectives, the first early vesting is up to 1/3 of the
                units
                on the third anniversary date of the grant and the second early vesting
                is
                up to 50% of the remaining units on the fourth anniversary date of
                the
                grant.


(6)
            Those
                RSUs will vest at a rate of 55%, 35% and 10%, on the third, fourth
                and
                fifth anniversary dates of the grant in January
                2005.


(7)
            Those
                RSUs will vest at a rate of 1/3 annually commencing on the third
                anniversary date of the grant in
                October 2006.


(8)
            Those
                DSUs will vest at the time Director cease to be a member of the Board
                of
                the Corporation.


(9)
            Those
                RSUs will vest at a rate of 1/3 annually commencing on the third
                anniversary date of the grant in August
                2006.





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**Escrowed
      Securities**





The
      following table presents information regarding the number of securities of
      each
      class of the Corporation held, to our knowledge as of November 1, 2006, in
      escrow and the percentage outstanding securities of that class.


**Designation
                  of Class**
              
              **Number
                  of Securities held in escrow**
              
              **Percentage
                  of Class**Subordinate
                  Voting Shares
              
              nil
              
              nilMultiple
                  Voting Shares
              
              nil
              
              nil






82
 Table
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**Item
      7.**  **Major
      Shareholders and Related Party Transactions**




**A.**  **Major
      Shareholders** ****





The
      following table presents information regarding the beneficial ownership of
      our
      share capital as of November 1, 2006 by persons or groups of affiliated persons
      known by us to own more than 5% of our voting shares.


**Multiple
                  Voting****Shares Beneficially Owned****(1)**
              
              **Subordinate
                  Voting Shares Beneficially Owned****(1)**
              
              **Total
                  Percentage of**
                **Voting
                  Power****Name**
              
              **Number**
              
              **Percent**
              
              **Number**
              
              **Percent**
              
              **Percent**Germain
                  Lamonde(2)
              
              
              37,143,000
              
              
              100
              %
              
              483,500
              
              
              1.53
              %
              
              92.27
              %Fiducie
                  Germain Lamonde(3)
              
              
              1,900,000
              
              
              5
              %
              
              Nil
              
              
              Nil
              
              
              4.71
              %G.
                  Lamonde Investissements Financiers inc.(4)
              
              
              35,243,000
              
              
              95
              %
              
              Nil
              
              
              Nil
              
              
              87.44
              %FMR
                  Corporation(5)
              
              
              Nil
              
              
              Nil
              
              
              4,624,700
              
              
              14.62
              %
              
              1.15
              %Kern
                  Capital Management, LLC(6)
              
              
              Nil
              
              
              Nil
              
              
              4,596,700
              
              
              14.53
              %
              
              1.14
              %





* Less
      than
      1% (1) Beneficial
        ownership is determined in accordance with the rules of the SEC and generally
        includes voting or investment power with respect to securities. Options that
        are
        currently exercisable (including options that have an exercise price above
        the
        market price) are deemed to be outstanding and to be beneficially owned by
        the
        person holding such options for the purpose of computing the percentage
        ownership of such person, but are not treated as outstanding for the purpose
        of
        computing the percentage ownership of any other person.
 (2)
            The
                number of shares held by Germain Lamonde includes 1,900,000 multiple
                voting shares held of record by Fiducie Germain Lamonde and 35,243,000
                multiple voting shares and 483,500 subordinate voting shares held
                of
                record by G. Lamonde Investissements Financiers
                inc.. (3)
            Fiducie
                Germain Lamonde is a family trust for the benefit of Mr. Lamonde
                and
                members of his family. (4)
            G.
                Lamonde Investissements Financiers inc. is a company controlled by
                Mr.
                Lamonde. (5)
            As
                of September 30, 2006, Fidelity Management and Research Company,
                a wholly
                owned subsidiary of FMR Corporation, is the beneficial owner of this
                number of subordinate voting shares as a result of acting as investment
                advisor to various investment companies. (6)
            As
                of September 30, 2006, Kern Capital Management LLC controls the voting
                rights attached to this number of subordinate voting shares through
                relationships with several clients and does not beneficially own
                directly
                this number of subordinate voting
                shares.




Each
      multiple voting share is convertible at the option of the holder into one
      subordinate voting share. Holders of our subordinate voting shares are entitled
      to one vote per share and holders of our multiple voting shares are entitled
      to
      ten votes per share.





As
      of
      November 21, 2006, 31,648,107 subordinate voting shares were outstanding.
      Approximately 96% (30,579,891) of our subordinate voting shares were held in
      bearer form and the remainder (1,068,216 subordinate voting shares) was held
      by
      165 record holders. As of November 21, 2006, we believe approximately 57% of
      our
      outstanding subordinate voting shares were held in the United States.








**B.**  **Related
      Party Transactions** ****





**Indebtedness
      of Directors, Executive Officers and Employees**





We
      have
      guaranteed the repayment of a loan granted to an employee by a financial
      institution for the purchase of our Class “F” shares that were converted into
      subordinate voting shares immediately prior to our initial public offering.
      As
      of August 31, 2006 and November 1, 2006, the total principal amount
      guaranteed by us was $37,400.





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Except
      as
      disclosed in this section, none of our Directors, executive officers, associates
      or affiliates had any material interest in any transaction with us during the
      past three years or in any proposed transaction which has materially affected
      or
      could materially affect us.





**Leases**





Until
      September 1, 2004, we had a lease agreement with G. Lamonde Investissements
      financiers inc., a company controlled by Mr. Germain Lamonde, for premises
      located at 465 Godin Avenue in Quebec City, Quebec. Until September 1, 2003,
      these premises were used for our executive and administrative offices which
      were, since then, moved into a building that we own. For fiscal year 2004,
      this
      space was unoccupied. **** This
      lease was renewed in December 2001 for five years, with all terms and conditions
      remaining the same. However, on September 1, 2004, we were released from our
      obligations under the lease with a final payment of $194,000 (CA$250,000).
      The
      annual rent for this lease was $CA144,000.





**Location**
            **Square
                Footage**
            **Annual
                Rent**
            **Expiry
                Date**465
                Godin
            24,000
            CA$144,000
            November
                30, 2006





Based
      on
      third-party valuations of the property values, we believe this lease agreement
      was at prevailing market terms.





In
      September 2002, we acquired from G. Lamonde Investissements financiers inc.
      the
      building located at 436 Nolin Street that houses some of our manufacturing
      activities. Previous to this acquisition, we had a lease agreement with this
      company for these premises. We paid CA$1,450,000 for the building and this
      purchase price is based on an independent third party valuation and the
      transaction was approved by our audit committee and the Board of Directors
      with
      Mr. Lamonde abstaining.











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**Item
      8.**  **Financial
      Information**




**A.**
            **Consolidated Statements and Other Financial
                Information**





See
      Item
      18, “Financial Statements” for certain other information required by this
      item.





**Valuation
      and qualifying accounts are as follows (in thousands of US dollars):**





***Allowance
      for doubtful accounts***





**Years
                ended August 31,****2006**
            
            
            **2005**
            
            
            **2004**Balance
                - Beginning of year
            
            $
            352
            
            $
            510
            
            $
            568Addition
                charged to earnings
            
            
            108
            
            
            316
            
            
            403Write-offs
                of uncollectible accounts
            
            
            (123
            )
            
            (23
            )
            
            (48
            )Recovery
                of uncollectible accounts
            
            
            (111
            )
            
            (464
            )
            
            (456
            )Business
                combination
            
            
            218
            
            
            −
            
            
            −Foreign
                currency translation adjustment
            
            
            7
            
            
            13
            
            
            43Balance
                - End of year
            
            $
            451
            
            $
            352
            
            $
            510





***Valuation
      allowance on future income tax assets***





**Years
                ended August 31,****2006**
            
            
            **2005**
            
            
            **2004**Balance
                - Beginning of year
            
            $
            38,406
            
            $
            32,613
            
            $
            28,846Addition
                (reduction) charged to earnings
            
            
            (1,877
            )
            
            3,375
            
            
            3,954Foreign
                currency translation adjustment
            
            
            2,014
            
            
            2,418
            
            
            (187
            )Balance
                - End of year
            
            $
            38,543
            
            $
            38,406
            
            $
            32,613





**Export
      Sales**





Export
      and domestic sales in thousands of US dollars and as a percentage of total
      sales
      are as follows:


**Years
                  ended August 31,****2006**
              
              **2005**
              
              **2004**Export
                  Sales
              
              $
              119,486
              
              
              93
              %
              $
              90,386
              
              
              92
              %
              $
              68,812
              
              
              92
              %Domestic
                  Sales
              
              
              8,767
              
              
              7
              
              
              6,830
              
              
              8
              
              
              5,818
              
              
              8$
              128,253
              
              
              100
              %
              $
              97,216
              
              
              100
              %
              $
              74,630
              
              
              100
              %







85
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**Legal
      Proceedings**





On
      November 27, 2001, a class action suit was filed in the United States District
      Court for the Southern District of New York against the company, four of the
      underwriters of its Initial Public Offering and some of its executive officers
      pursuant to the Securities Exchange Act of 1934 and Rule 10b-5 promulgated
      thereunder and Sections 11, 12 and 16 of the Securities Act of 1933. This class
      action alleges that the company’s registration statement and prospectus filed
      with the Securities and Exchange Commission on June 29, 2000, contained material
      misrepresentations and/or omissions resulting from (i) the underwriters
      allegedly soliciting and receiving additional, excessive and undisclosed
      commissions from certain investors in exchange for which they allocated material
      portions of the shares issued in connection with the company’s Initial Public
      Offering; and (ii) the underwriters allegedly entering into agreements with
      customers whereby shares issued in connection with the company’s Initial Public
      Offering would be allocated to those customers in exchange for which customers
      agreed to purchase additional amounts of shares in the after-market at
      pre-determined prices.





On
      April
      19, 2002, the plaintiffs filed an amended complaint containing master
      allegations against all of the underwriters in all of the 310 cases included
      in
      this class action and also filed an amended complaint containing allegations
      specific to four of the company’s underwriters, the company and two of its
      executive officers. In addition to the allegations mentioned above, the amended
      complaint alleges that the underwriters (i) used their analysts to manipulate
      the stock market; and (ii) implemented schemes that allowed issuer insiders
      to sell their shares rapidly after an initial public offering and benefit from
      high market prices. As concerns the company and its two executive officers
      in
      particular, the amended complaint alleges that (i) the company’s registration
      statement was materially false and misleading because it failed to disclose the
      additional commissions and compensation to be received by underwriters; (ii)
      the
      two named executive officers learned of or recklessly disregarded the alleged
      misconduct of the underwriters; (iii) the two named executive officers had
      motive and opportunity to engage in alleged wrongful conduct due to personal
      holdings of the company’s stock and the fact that an alleged artificially
      inflated stock price could be used as currency for acquisitions; and (iv) the
      two named executive officers, by virtue of their positions with the company,
      controlled the company and the contents of the registration statement and had
      the ability to prevent its issuance or cause it to be corrected. The plaintiffs
      in this suit seek an unspecified amount for damages suffered.





In
      July
      2002, the issuers filed a motion to dismiss the plaintiffs’ amended complaint
      and a decision was rendered on February 19, 2003. Only one of the claims against
      the company was dismissed. On October 8, 2002, the claims against its
      officers were dismissed pursuant to the terms of Reservation of Rights and
      Tolling Agreements entered into with the plaintiffs.





In
      June
      2003, a committee of the company’s Board of Directors conditionally approved a
      proposed settlement between the issuer defendants, the individual defendants,
      and the plaintiffs. If approved, the settlement would provide, among other
      things, a release of the company and of the individual defendants for the
      conduct alleged in the action to be wrongful in the amended complaint. The
      company would agree to undertake other responsibilities under the settlement,
      including agreeing to assign away, not assert, or release certain potential
      claims the company may have against its underwriters.








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 Table
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On
      June 25, 2004, the Plaintiffs moved for preliminary approval of the
      settlement. The court granted the preliminary approval motion on February 15,
      2005, subject to certain modifications.  On August 31, 2005, the court
      issued a preliminary order further approving the modifications to the settlement
      and certifying the settlement classes.  The court also appointed the Notice
      Administrator for the settlement and ordered that notice of the settlement
      be
      distributed to all settlement class members beginning on November 15,
      2005.  A settlement fairness hearing was held on April 24, 2006; however,
      no ruling has been issued yet by the court. If the court determines that the
      settlement is fair to the class members, the settlement will be
      approved. **** The
      settlement provides that, if the plaintiffs do not obtain any
      recovery from the underwriter defendants, the members of the class
      action would receive an amount not expected to exceed $2,507,678. Any direct
      financial impact plus any legal fees are expected to be borne by the company’s
      insurance carriers. However, there can be no assurance that this proposed
      settlement would be approved and implemented in its current form, or at
      all.  Therefore, it is not possible to predict the final outcome of the
      case, nor to determine the amount of any possible losses. If the settlement
      process fails, the company will continue to defend its position in this
      litigation that the claims against it, and its officers, are without merit.
      Accordingly, no provision for this case has been made in the consolidated
      financial statements as at August 31, 2006.





There
      are
      no other legal or arbitration proceedings pending or threatened of which we
      are
      aware which may have or have had a significant effect on our financial
      position.





**Dividend
      Policy**




We
      do not
      currently anticipate paying dividends for at least the three next years. Our
      current intention is to reinvest any earnings in our business long-term growth.
      Any future determination by us to pay dividends will be at the discretion of
      our
      Board of Directors and in accordance with the terms and conditions of any
      outstanding indebtedness and will depend on our financial condition, results
      of
      operations, capital requirements and such other functions as our Board of
      Directors considers relevant.







**B.**
            **Significant changes**




No
        significant changes occurred since the date of our annual consolidated financial
        statements included elsewhere in this annual report.








87
 Table
            of Contents







**Item
      9.** **Offer
      and Listing**





Not
      Applicable, except for Item 9A (4) and Item 9C.


**Nasdaq
                  (US$)**
              
              **TSX
                  (CA$)****High**
              
              **Low**
              
              **High**
              
              **Low**September
                  1, 2001 to August 31, 2002
              
              
              15.00
              
              
              1.35
              
              
              23.80
              
              
              2.05September
                  1, 2002 to August 31, 2003
              
              
              3.63
              
              
              1.40
              
              
              5.60
              
              
              2.30September
                  1, 2003 to August 31, 2004
              
              
              7.09
              
              
              2.71
              
              
              9.15
              
              
              3.75September
                  1, 2004 to August 31, 2005
              
              
              5.51
              
              
              3.92
              
              
              6.90
              
              
              4.92September
                  1, 2005 to August 31, 2006
              
              
              8.69
              
              
              4.32
              
              
              9.60
              
              
              5.152005
                  1st Quarter
              
              
              5.51
              
              
              4.27
              
              
              6.90
              
              
              5.732005
                  2nd Quarter
              
              
              5.24
              
              
              4.29
              
              
              6.42
              
              
              5.352005
                  3rd Quarter
              
              
              4.99
              
              
              3.93
              
              
              6.05
              
              
              4.952005
                  4th Quarter
              
              
              5.00
              
              
              3.92
              
              
              6.10
              
              
              4.922006
                  1st Quarter
              
              
              5.05
              
              
              4.32
              
              
              5.92
              
              
              5.152006
                  2nd Quarter
              
              
              6.70
              
              
              4.39
              
              
              7.64
              
              
              5.162006
                  3rd Quarter
              
              
              8.69
              
              
              6.44
              
              
              9.60
              
              
              7.182006
                  4th Quarter
              
              
              7.01
              
              
              4.86
              
              
              7.80
              
              
              5.452006
                  May
              
              
              8.69
              
              
              6.44
              
              
              9.56
              
              
              7.182006
                  June
              
              
              7.01
              
              
              5.21
              
              
              7.80
              
              
              5.812006
                  July
              
              
              6.03
              
              
              5.20
              
              
              6.72
              
              
              5.852006
                  August
              
              
              5.66
              
              
              4.86
              
              
              6.30
              
              
              5.452006
                  September
              
              
              5.85
              
              
              5.32
              
              
              6.63
              
              
              5.912006
                  October
              
              
              6.13
              
              
              4.93
              
              
              6.90
              
              
              5.552006
                  November
              
              
              5.73
              
              
              4.89
              
              
              6.60
              
              
              5.55


(until
      November 21)




Our
        subordinate voting shares have been quoted on the NASDAQ National Market
        under
        the symbol EXFO and listed on The Toronto Stock Exchange under the symbol
        EXF
        since our initial public offering on June 29, 2000. Prior to that time, there
        was no public market for our subordinate voting shares. The following table
        sets
        forth, for the periods indicated, the high and low closing sales prices per
        subordinate voting share as reported on the NASDAQ National Market and the
        Toronto Stock Exchange.
 
 On
        November 21, 2006, the last reported sale price for our subordinate voting
        shares on the NASDAQ National Market was US$5.57 per share and the last reported
        sale price for our subordinate voting shares on the Toronto Stock Exchange
        was
        CA$6.39 per share.
 
 88
 Table
            of Contents
   **Item
        10.**  **Additional
        Information** ****
 
 **A.**
              **Share
                  Capital**
  Not
        Applicable
 
 
 **B.**  **Memorandum
        and Articles of Association**
 
 Incorporated
        by reference to our registration statement on Form F-1 dated
        June 9, 2000 (File No. 333-38956).
 
 
 **C.**  **Material
        Contracts**
 
 Except
        as
        otherwise disclosed in this annual report and our financial statements and
        notes
        included elsewhere in this annual report, we have no other material contracts.
 
 
 **D.**  **Exchange
        Controls**
 
 Subject
        to the following paragraph, there is no law or governmental decree or regulation
        in Canada that restricts the export or import of capital, or affects the
        remittance of dividends, interest or other payments to non-resident holders
        of
        our subordinate voting shares, other than withholding tax requirements.
 
 There
        is
        no limitation imposed by Canadian law or by our articles of incorporation
        or our
        other charter documents on the right of a non-resident to hold or vote
        subordinate voting shares, other than as provided by the *Investment
        Canada Act,* the *North
        American Free Trade Agreement Implementation Act* (Canada)
        and the *World
        Trade Organization Agreement Implementation Act* .
        The *Investment
        Canada Act* requires
        notification and, in certain cases, advance review and approval by the
        Government of Canada of an investment to establish a new Canadian business
        by a
        non-Canadian or of the acquisition by a “non-Canadian” of “control” of a
“Canadian business”, all as defined in the *Investment
        Canada Act* .
        Generally, the threshold for review will be higher in monetary terms for
        a
        member of the World Trade Organization or North American Free Trade Agreement.
 
 **E.**  **Taxation** ****
 
 **United
        States Taxation**
 
 The
        information set forth below under the caption “United States Taxation” is a
        summary of the material U.S. federal income tax consequences of the ownership
        and disposition of subordinate voting shares by a U.S. Holder, as defined
        below. These discussions are not a complete analysis or listing of all of
        the
        possible tax consequences of such transactions and do not address all tax
        considerations that may be relevant to particular holders in light of their
        personal circumstances or to persons that are subject to special tax rules.
        In
        particular, the information set forth under the caption “United States Taxation”
deals only with U.S. Holders that hold subordinate voting shares as capital
        assets within the meaning of Section 1221 of the Internal Revenue Code of
        1986,
        as amended, and who do not at any time own individually, nor are treated
        as
        owning 10% or more of the total combined voting power of all classes of our
        stock entitled to vote. In addition, this description of U.S. tax consequences
        does not address the tax treatment of special classes of U.S. Holders, such
        as
        financial institutions, regulated investment companies, traders in securities
        who elect to mark-to-market their securities, tax-exempt entities, insurance
        companies, partnerships, persons holding subordinate voting shares as part
        of a
        hedging, integrated or conversion transaction or as part of a “straddle,” U.S.
        expatriates, persons subject to the alternative minimum tax, persons who
        acquired their subordinate voting shares through the exercise or cancellation
        of
        employee stock options or otherwise as compensation for services, dealers
        or
        traders in securities or currencies and holders whose “functional currency” is
        not the U.S. dollar. This summary does not address estate and gift tax
        consequences or tax consequences under any foreign, state or local laws other
        than as provided in the section entitled “Canadian Federal Income Tax
        Considerations” provided below.
 
 89
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   As
        used
        in this section, the term “U.S. Holder” means a beneficial owner of subordinate
        voting shares that is for U.S. federal income tax purposes:
 
 (a)
              an
                  individual citizen or resident of the United
                  States;
 (b)
              a
                  corporation created or organized under the laws of the United States
                  or
                  any state thereof and the District of
                  Columbia;
 (c)
              an
                  estate the income of which is subject to United States federal
                  income
                  taxation regardless of its source;
 (d)
              a
                  trust if (1) a court within the United States is able to exercise
                  primary
                  jurisdiction over its administration and one or more U.S. persons
                  have
                  authority to control all substantial decisions of the trust or
                  (2) the
                  trust has a valid election in effect under applicable U.S. Treasury
                  regulations to be treated as a U.S. person;
                  or
 (e)
              any
                  other person whose worldwide income or gain is otherwise subject
                  to U.S.
                  federal income taxation on a net income basis;
 
 If
        a
        partnership or other flow-through entity holds subordinate voting shares,
        the
        U.S. federal income tax treatment of a partner will generally depend upon
        the
        status of the partner or other owner and upon the activities of the partnership
        or other flow-through entity. If you are a partner of a partnership holding
        subordinate voting shares, you should consult your tax advisor.
 
 Holders
        of subordinate voting shares who are not U.S. Holders, sometimes referred
        to as
“Non-U.S. Holders”, should also consult their own tax advisors, particularly as
        to the applicability of any tax treaty.
 
 The
        following discussion is based upon:
 
 ·
              the
                  Internal Revenue Code;
 ·
              U.S.
                  judicial decisions;
 ·
              administrative
                  pronouncements;
 ·
              existing
                  and proposed Treasury regulations;
                  and
 ·
              the
                  Canada - U.S. Income Tax Treaty.
 
 Any
        of
        the above is subject to change, possibly with retroactive effect, so as to
        result in U.S. federal income tax consequences different from those discussed
        below. We have not requested, and will not request, a ruling from the U.S.
        Internal Revenue Service with respect to any of the U.S. federal income tax
        consequences described below, and as a result, there can be no assurance
        that
        the U.S. Internal Revenue Service will not disagree with or challenge any
        of the
        conclusions we have reached and describe here.
 
 The
        following discussion is for general information only and is not intended
        to be,
        nor should it be construed to be, legal or tax advice to any holder of
        subordinate voting shares and no opinion or representation with respect to
        the
        U.S. federal income tax consequences to any holder is made. Holders of
        subordinate voting shares are urged to consult their tax advisors as to the
        particular consequences to them under U.S. federal, state, local and applicable
        foreign tax laws of the acquisition, ownership and disposition of subordinate
        voting shares.
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   *Dividends*
 
 Subject
        to the discussion of passive foreign investment companies below, the gross
        amount of any distribution paid by us to a U.S. Holder will generally be
        subject
        to U.S. federal income tax as foreign source dividend income to the extent
        paid
        out of our current or accumulated earnings and profits, as determined under
        U.S. federal income tax principles. Such income will be includable in the
        gross income of a U.S. Holder on the day received by the U.S. Holder. The
        amount
        of any distribution of property other than cash will be the fair market value
        of
        such property on the date of the distribution. In the case of a taxable
        corporate U.S. Holder, such dividends will be taxable as ordinary income
        and
        will not be eligible for the corporate dividends received deduction, which
        is
        generally allowed to U.S. corporate shareholders on dividends received from
        a
        domestic corporation. In the case of an individual U.S. Holder, under recently
        enacted tax legislation such dividends should generally be eligible for a
        maximum tax rate of 15% for dividends received before January 1, 2011, provided
        such holder holds the subordinate voting shares for at least 60 days and
        certain
        other conditions are satisfied, including, as we believe to be the case,
        that we
        are not a “passive foreign investment company”. To the extent that an amount
        received by a U.S. Holder exceeds such holder’s allocable share of our current
        and accumulated earnings and profits, such excess will be applied first to
        reduce such U.S. Holder’s tax basis in his subordinate voting shares, thereby
        increasing the amount of gain or decreasing the amount of loss recognized
        on a
        subsequent disposition of the subordinate voting shares. Then, to the extent
        such distribution exceeds such U.S. Holder’s tax basis, it will be treated as
        capital gain. We do not currently maintain calculations of our earnings and
        profits for U.S. federal income tax purposes.
 
 The
        gross
        amount of distributions paid in Canadian dollars, or any successor or other
        foreign currency, will be included in the income of such U.S. Holder in a
        U.S.
        dollar amount calculated by reference to the spot exchange rate in effect
        on the
        day the distributions are paid regardless of whether the payment is in fact
        converted into U.S. dollars. If the Canadian dollars, or any successor or
        other foreign currency, are converted into U.S. dollars on the date of the
        payment, the U.S. Holder should not be required to recognize any foreign
        currency gain or loss with respect to the receipt of Canadian dollars as
        distributions. If, instead, the Canadian dollars are converted at a later
        date,
        any currency gains or losses resulting from the conversion of the Canadian
        dollars will be treated as U.S. source ordinary income or loss for foreign
        tax credit purposes. U.S. Holders are urged to consult their own tax advisors
        concerning the U.S. tax consequences of acquiring, holding and disposing
        of
        Canadian dollars.
 
 A
        U.S.
        Holder may be entitled to deduct, or claim a foreign tax credit for, Canadian
        taxes that are withheld on dividends received by the U.S. Holder, subject
        to
        applicable limitations in the Code. Any amounts recognized as dividends will
        generally constitute foreign source “passive income” or, in the case of certain
        U.S. Holders, “financial services income” for U.S. foreign tax credit purposes.
        A U.S. Holder will have a basis in any Canadian dollars distributed
        equal to their U.S. dollar value on the payment date. The rules governing
        the
        foreign tax credit are complex, and additional limitations on the credit
        apply
        to individuals receiving dividends from foreign corporations if the dividends
        are eligible for the 15% maximum tax rate on dividends described above. U.S.
        Holders are urged to consult their tax advisors regarding the availability
        of
        the foreign tax credit under their particular circumstances.
 
 A
        Non-U.S. Holder of subordinate voting shares generally will not be subject
        to
        U.S. federal income or withholding tax on dividends received on subordinate
        voting shares unless such income is effectively connected with the conduct
        by
        such Non-U.S. Holder of a trade or business in the United
        States.
 
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   *Sale
        or Exchange*
 
 A
        U.S.
        Holder’s initial tax basis in the subordinate voting shares will generally be
        cost to the holder. A U.S. Holder’s adjusted tax basis in the
        subordinate voting shares will generally be the same as cost, but may differ
        for
        various reasons including the receipt by such holder of a distribution that
        was
        not made up wholly of earnings and profits as described above under the heading
        “Dividends.” Subject to the discussion of passive foreign investment companies
        below, gain or loss realized by a U.S. Holder on the sale or other disposition
        of subordinate voting shares will be subject to U.S. federal income taxation
        as
        capital gain or loss in an amount equal to the difference (if any) between
        the
        U.S. Holder’s adjusted tax basis (determined in U.S. dollars) in the subordinate
        voting shares and the U.S. dollar value of the amount realized on the
        disposition of such subordinate voting shares. Capital gains of non-corporate
        taxpayers, including individuals, derived with respect to a sale, exchange
        or
        other disposition prior to January 1, 2011 of subordinate voting shares held
        for
        more than one year are subject to a maximum federal income tax rate of 15%.
        The
        deductibility of capital losses is subject to limitations. In the case of
        a
        non-corporate U.S. Holder, the federal tax rate applicable to capital gains
        will
        depend upon:
 
 ·
              the
                  holder’s holding period for the subordinate voting shares, with a
                  preferential rate available for subordinate voting shares held
                  for more
                  than one year; and
 ·
              the
                  holder’s marginal tax rate for ordinary
                  income.
 
 Any
        gain
        realized will generally be treated as U.S. source gain and loss realized
        by
        a U.S. Holder generally also will be treated as from sources within the
        United States.
 
 The
        ability of a U.S. Holder to utilize foreign taxes as a credit to offset U.S.
        taxes is subject to complex limitations and conditions. The consequences
        of the
        separate limitation calculation will depend upon the nature and sources of
        each
        U.S. Holder’s income and the deductions allocable thereto. Alternatively, a U.S.
        Holder may elect to claim all foreign taxes paid as an itemized deduction
        in
        lieu of claiming a foreign tax credit. A deduction does not reduce U.S. tax
        on a
        dollar-for-dollar basis like a tax credit, but the availability of the deduction
        is not subject to the same conditions and limitations applicable to foreign
        tax
        credits.
 
 If
        a U.S.
        Holder receives any foreign currency on the sale of subordinate voting shares,
        such U.S. Holder may recognize ordinary income or loss as a result of currency
        fluctuations between the date of the sale of subordinate voting shares and
        the
        date the sale proceeds are converted into U.S. dollars.
 
 A
        Non-U.S. Holder of subordinate voting shares generally will not be subject
        to
        U.S. federal income or withholding tax on any gain realized on the sale or
        exchange of such subordinate voting shares unless:
 
 ·
              such
                  gain is effectively connected with the conduct by such Non-U.S.
                  Holder of
                  a trade or business in the United States;
                  or
 ·
              in
                  the case of any gain realized by an individual Non-U.S. Holder,
                  such
                  Non-U.S. Holder is present in the United States for 183 days or more
                  in the taxable year of such sale and certain other conditions are
                  met.
 
 *Foreign
        Personal Holding Company*
 
 Under
        recently enacted legislation, the foreign personal holding company rules
        are
        repealed for taxable years of U.S. shareholders ending after December 31,
        2004.
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   *Passive
        Foreign Investment Company*
 
 We
        believe that our subordinate voting shares should not currently be treated
        as
        stock of a passive foreign investment company for United States federal income
        tax purposes, but this conclusion is a factual determination made annually
        and
        thus may be subject to change based on future operations as well as the
        composition and valuation of our assets. In particular, a significant portion
        of
        our gross assets are comprised of cash and short-term investments, which
        the
        PFIC rules treat as passive without regard to the purpose for which we hold
        those assets. If the proportion of these passive assets were to increase
        relative to the fair market value of our other assets, we may be treated
        as a
        passive foreign investment company. In general, we will be a passive foreign
        investment company with respect to a U.S. Holder if, for any taxable year
        in
        which the U.S. Holder holds our subordinate voting shares, either:
 
 ·
              at
                  least 75% of our gross income for the taxable year is passive income;
                  or
 ·
              at
                  least 50% of the average value of our assets is attributable to
                  assets
                  that produce or are held for the production of passive income.
 
 For
        this
        purpose, passive income includes income such as:
 
 ·
              dividends;
 ·
              interest;
 ·
              rents
                  or royalties, other than certain rents or royalties derived from
                  the
                  active conduct of trade or business;
 ·
              annuities;
                  or
 ·
              gains
                  from assets that produce passive income.
 
 If
        a
        foreign corporation owns at least 25% by value of the stock of another
        corporation, the foreign corporation is treated for purposes of the passive
        foreign investment company tests as owning its proportionate share of the
        assets
        of the other corporation and as receiving directly its proportionate share
        of
        the other corporation’s income.
 
 If
        we are
        treated as a passive foreign investment company, a U.S. Holder that did not
        make
        a qualified electing fund election or, if available, a mark-to-market election,
        as described below, would be subject to special rules with respect to:
 
 ·
              any
                  gain realized on the sale or other disposition of subordinate voting
                  shares; and
 ·
              any
                  “excess distribution” by us to the U.S. Holder.
 
 Generally,
        “excess distributions” are any distributions to the U.S. Holder in respect of
        the subordinate voting shares during a single taxable year that are greater
        than
        125% of the average annual distributions received by the U.S. Holder in respect
        of the subordinate voting shares during the three preceding taxable years
        or, if
        shorter, the U.S. Holder’s holding period for the subordinate voting shares.
 
 Under
        the
        passive foreign investment company rules,
 
 ·
              the
                  gain or excess distribution would be allocated ratably over the
                  U.S.
                  Holder’s holding period for the subordinate voting shares;
 ·
              the
                  amount allocated to the taxable year in which the gain or excess
                  distribution was realized would be taxable as ordinary income;
 ·
              the
                  amount allocated to each prior year, with certain exceptions, would
                  be
                  subject to tax at the highest tax rate in effect for that year;
                  and
 ·
              the
                  interest charge generally applicable to underpayments of tax would
                  be
                  imposed in respect of the tax attributable to each such year.
 
 
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   A
        U.S.
        Holder owning actually or constructively “marketable stock” of a passive foreign
        investment company may be able to avoid the imposition of the passive foreign
        investment company tax rules described above by making a mark-to-market
        election. Generally, pursuant to this election, such holder would include
        in
        ordinary income, for each taxable year during which such stock is held, an
        amount equal to the increase in value of the stock, which increase will be
        determined by reference to the value of such stock at the end of the current
        taxable year compared with their value as of the end of the prior taxable
        year.
        Holders desiring to make the mark-to-market election should consult their
        tax
        advisors with respect to the application and effect of making such election.
 
 In
        the
        case of a U.S. Holder who does not make a mark-to-market election, the special
        passive foreign investment company tax rules described above will not apply
        to
        such U.S. Holder if the U.S. Holder makes an election to have us treated as
        a qualified electing fund and we provide certain required information to
        holders. For a U.S. Holder to make a qualified electing fund election, we
        would
        have to satisfy certain reporting requirements. We have not determined whether
        we will undertake the necessary measures to be able to satisfy such requirements
        in the event that we were treated as a passive foreign investment company.
 
 A
        U.S.
        Holder that makes a qualified electing fund election will be currently taxable
        on its pro rata share of our ordinary earnings and net capital gain, at ordinary
        income and capital gains rates, respectively, for each of our taxable years,
        regardless of whether or not distributions were received. The U.S. Holder’s
        basis in the subordinate voting shares will be increased to reflect taxed
        but
        undistributed income. Distributions of income that had previously been taxed
        will result in a corresponding reduction of basis in the subordinate voting
        shares and will not be taxed again as a distribution to the U.S. Holder.
        U.S.
        Holders desiring to make a qualified electing fund election should consult
        their
        tax advisors with respect to the advisability of making such
        election.
 
 **United
        States Backup Withholding and Information Reporting**
 
 A
        U.S.
        Holder will generally be subject to information reporting with respect to
        dividends paid on, or proceeds of the sale or other disposition of, our
        subordinate voting shares that are paid within the United States or through
        some
        U.S. related financial intermediaries to U.S. Holders, unless the U.S. Holder
        is
        a corporation or comes within certain other categories of exempt recipients.
        A U.S. Holder that is not an exempt recipient will generally be subject to
        backup withholding with respect to the proceeds from the sale or the disposition
        of, or with respect to dividends on, subordinate voting shares unless the
        U.S.
        Holder provides a taxpayer identification number and otherwise complies with
        applicable requirements of the backup withholding rules. In addition, backup
        withholding may apply if the U.S. Holder fails to provide an accurate taxpayer
        identification number, or to report interest and dividends required to be
        shown
        on its federal income tax returns. Backup withholding is not an additional
        tax.
        Any amount withheld under these rules will be creditable against the U.S.
        Holder’s U.S. federal income tax liability or refundable to the extent that it
        exceeds such liability. A U.S Holder who does not provide a correct taxpayer
        identification number may be subject to penalties imposed by the United States
        Internal Revenue Service.
 
 Non-U.S.
        Holders will generally be subject to information reporting and possible backup
        withholding with respect to the proceeds of the sale or other disposition
        of
        subordinate voting shares effected within the United States, unless the holder
        certifies to its foreign status or otherwise establishes an exemption and
        the
        broker does not have actual knowledge or reason to know that the holder is
        a
        U.S. holder. Payments of dividends on or proceeds from the sale of subordinate
        voting shares within the United States by a payor within the United States
        to a
        non-exempt U.S. or Non-U.S. Holder will be subject to backup withholding if
        such holder fails to provide appropriate certification. In the case of such
        payments by a payor within the United States to a foreign partnership other
        than
        a foreign partnership that qualifies as a “withholding foreign partnership”
within the meaning of such Treasury regulations, the partners of such
        partnership will be required to provide the certification discussed above
        in
        order to establish an exemption from backup withholding tax and information
        reporting requirements.
 
 **Canadian
        Federal Income Tax Considerations**
 
 The
        following is a summary of the material Canadian federal income tax
        considerations generally applicable to a U.S. person who holds subordinate
        voting shares and who, for the purposes of the *Income
        Tax Act* (Canada)
        (the “ITA”), and the *Canada-United
        States Income Tax Convention* (1980)
        (the “Convention”), as applicable and at all relevant times:
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   ·
              is
                  resident in the United States and not resident in Canada,
 ·
              holds
                  the subordinate voting shares as capital property,
 ·
              does
                  not have a “permanent establishment” or “fixed base” in Canada, as defined
                  in the Convention; and
 ·
              deals
                  at arm’s length with us. Special rules, which are not discussed below,
                  may
                  apply to “financial institutions”, as defined in the ITA, and to
                  non-resident insurers carrying on an insurance business in Canada
                  and
                  elsewhere.
 
 This
        discussion is based on the current provisions of the ITA and the Convention
        and
        on the regulations promulgated under the ITA, all specific proposals to amend
        the ITA or the regulations promulgated under the ITA announced by or on behalf
        of the Canadian Minister of Finance prior to the date of this annual report
        and
        the current published administrative practices of the Canada Customs and
        Revenue
        Agency. It does not otherwise take into account or anticipate any changes
        in law
        or administrative practice nor any income tax laws or considerations of any
        province or territory of Canada or any jurisdiction other than Canada, which
        may
        differ from the Canadian federal income tax consequences described in this
        document.
 
 Under
        the
        ITA and the Convention, dividends paid or credited, or deemed to be paid
        or
        credited, on the subordinate voting shares to a U.S. person who owns less
        than
        10% of the voting shares will be subject to Canadian withholding tax at the
        rate
        of 15% of the gross amount of those dividends or deemed dividends. If a U.S.
        person is a corporation and owns 10% or more of the voting shares, the rate
        is
        reduced from 15% to 5%. Subject to specified limitations, a U.S. person may
        be
        entitled to credit against U.S. federal income tax liability for the amount
        of
        tax withheld by Canada.
 
 Under
        the
        Convention, dividends paid to specified religious, scientific, charitable
        and
        similar tax exempt organizations and specified organizations that are resident
        and exempt from tax in the United States and that have complied with specified
        administrative procedures are exempt from this Canadian withholding
        tax.
 
 A
        capital
        gain realized by a U.S. person on a disposition or deemed disposition of
        the
        subordinate voting shares will not be subject to tax under the ITA unless
        the
        subordinate voting shares constitute taxable Canadian property within the
        meaning of the ITA at the time of the disposition or deemed disposition.
        In
        general, the subordinate voting shares will not be “taxable Canadian property”
to a U.S. person if they are listed on a prescribed stock exchange, which
        includes The Toronto Stock Exchange, unless, at any time within the five-year
        period immediately preceding the disposition, the U.S. person, persons with
        whom
        the U.S. person did not deal at arm’s length, or the U.S. person together with
        those persons, owned or had an interest in or a right to acquire more than
        25%
        of any class or series of our shares.
 
 If
        the
        subordinate voting shares are taxable Canadian property to a U.S. person,
        any
        capital gain realized on a disposition or deemed disposition of those
        subordinate voting shares will generally be exempt from tax by virtue of
        the
        Convention if the value of the subordinate voting shares at the time of the
        disposition or deemed disposition is not derived principally from real property,
        as defined by the Convention, situated in Canada. The determination as to
        whether Canadian tax would be applicable on a disposition or deemed disposition
        of the subordinate voting shares must be made at the time of the disposition
        or
        deemed disposition.
 
 Holders
        of subordinate voting shares are urged to consult their own tax advisors
        to
        determine the particular tax consequences to them, including the application
        and
        effect of any state, local or foreign income and other tax laws, of the
        acquisition, ownership and disposition of subordinate voting
        shares.
 
 **F.**  **Dividends
        and Paying Agents**
 
 Not
        Applicable.
 
 
 **G.**  **Statement
        by Experts**
 
 Not
        Applicable.
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   **H.**  **Documents
        on Display**
 
 Any
        statement in this annual report about any of our contracts or other documents
        is
        not necessarily complete. If the contract or document is filed as an exhibit
        to
        the registration statement, the contract or document is deemed to modify
        the
        description contained in this annual report. You must review the exhibits
        themselves for a complete description of the contract or document.
 
 You
        may
        review a copy of our filings with the SEC, including exhibits and schedules
        filed with it, at the SEC’s public reference facilities at 100 F Street, N.E.,
        Washington, D.C. 20549 and at the regional offices of the SEC located at
        233
        Broadway, New York, New York 10279 and at the Northwestern Atrium Center,
        500
        West Madison Street, Suite 1400, Chicago, Illinois 60661. You may also obtain
        copies of such materials from the Public Reference Section of the SEC, Room
        1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, at
        prescribed rates. You may call the SEC at 1-800-SEC-0330 for further information
        on the public reference rooms. The SEC maintains a Web site *(http://www.sec.gov)* that
        contains reports, proxy and information statements and other information
        regarding registrants that file electronically with the SEC. Although we
        make
        many of our filings with the SEC electronically as a foreign private issuer,
        we
        are not obligated to do so.
 
 You
        may
        read and copy any reports, statements or other information that we file with
        the
        SEC at the addresses indicated above and you may also access them electronically
        at the Web site set forth above. These SEC filings are also available to
        the
        public from commercial document retrieval services.
 
 We
        are
        required to file reports and other information with the SEC under the Securities
        Exchange Act of 1934. Reports and other information filed by us with the
        SEC may
        be inspected and copied at the SEC’s public reference facilities described
        above. As a foreign private issuer, we are exempt from the rules under the
        Exchange Act prescribing the furnishing and content of proxy statements and
        our
        officers, Directors and principal shareholders are exempt from the reporting
        and
        short-swing profit recovery provisions contained in Section 16 of the Exchange
        Act. Under the Exchange Act, as a foreign private issuer, we are not required
        to
        publish financial statements as frequently or as promptly as United States
        companies.
 
 **I.**  **Subsidiary
        Information**
 
 See
        Item
        4.C. of this annual report.
 
 
 
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   **Item
        11.**  **Qualitative
        and Quantitative Disclosures about Market Risk**
 
 **Market
        Risk**
 
 *Currency
        Risk*
 
 Our
        measurement currency is the Canadian dollar. We are exposed to currency risks
        due to the export of our Canadian-manufactured products, the large majority
        of
        which are denominated in US dollars. These risks are partially hedged by
        operating expenses denominated in US dollars, the purchase of raw materials
        in US dollars and forward exchange contracts. The increased strength of the
        Canadian dollar, compared to the US dollar, over the last couple of years
        caused
        our operating expenses, as well as our foreign exchange loss, to increase.
        Any
        further increase in the value of the Canadian dollar in the upcoming months
        will
        negatively affect our results of operations.
 
 We
        enter
        into forward exchange contracts to manage the risk of exchange rate fluctuations
        between the Canadian and US dollar on cash flows related to anticipated future
        revenue streams denominated in US dollars. We do not enter into forward exchange
        contracts for hedging purposes.
 
 Considering
        the significant increase in the value of the Canadian dollar compared to
        the US
        dollar during fiscal 2005, we entered into additional forward exchange contracts
        to protect our results of operations. As at August 31, 2005, we held forward
        exchange contracts to sell US dollars at various forward exchange rates
        with a contractual value of $33.6 million compared to $63.8 million as at
        August
        31, 2006.
 
 The
        following table summarizes the forward exchange contracts in effect as at
        August 31, 2006, classified by expected transaction dates, none of which
        exceed three fiscal years, as well as the notional amounts of such contracts
        (in
        thousands of US dollars) along with the weighted average contractual exchange
        rates under such contracts. The notional amounts of such contracts are used
        to
        calculate the contractual payments to be made under these
        contracts.
 
 **Years
                  ending August 31,****2007**
              
              **2008**
              
              **2009**Forward
                  exchange contracts to sell US dollars in exchange for Canadian
                  dollars
                Contractual
                  amounts
              
              $
              37,000
              
              $
              17,800
              
              $
              9,000Weighted
                  average contractual exchange rates
              
              
              1.1676
              
              
              1.1388
              
              
              1.1010
 
 *Fair
        Value*
 
 The
        fair
        value of forward exchange contracts, which represents the difference between
        their contractual amounts and their current trading values, amounted to an
        unrecognized gain of $5,451,000 as at August 31, 2006 ($2,937,000 as at August
        31, 2005).
 
 *Interest
        rate risk*
 
 We
        are
        exposed to the impact of interest rate changes and changes in the market
        values
        of our short-term investments. We do not use derivative financial instruments
        for our short-term investments. As at August 31, 2006, our short-term
        investments consist of debt instruments issued by nine (six in 2005) high-credit
        quality corporations and trusts. These debt instruments bear interest at
        fixed
        rates and may have their fair market value adversely impacted due to a rise
        in
        interest rates. However, due to their very short-term maturity, we consider
        this
        risk to be insignificant. For the purposes of managing our cash position,
        we
        have established a cash management policy, which we follow and monitor on
        a
        regular basis. These short-term investments will be used for working capital
        and
        other general corporate purposes, including potential acquisitions.
 
 
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              of Contents
   *Credit
        risk*
 
 Financial
        instruments that potentially subject us to credit risk consist primarily
        of our
        cash, our short-term investments, our accounts receivable and our forward
        exchange contracts. As mentioned in the interest rate risk section, our
        short-term investments consist of debt instruments issued by high credit
        quality, corporations and trusts. Our cash and forward exchange contracts
        are
        held with or issued by high credit quality, financial institutions; therefore,
        we consider the risk of non-performance on these instruments to be
        remote.
 
 Generally,
        we do not require collateral or other security from customers for trade accounts
        receivable; however, credit is extended to customers following an evaluation
        of
        creditworthiness. In addition, we perform ongoing credit reviews of all our
        customers and establish an allowance for doubtful accounts receivable when
        accounts are determined to be uncollectible. Allowance for doubtful accounts
        amounted to $352,000 and $451,000 as at August 31, 2005 and 2006,
        respectively.
 
 98
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              of Contents
   Item
        12.Description
        of Securities Other than Equity Securities
 
 Not
        Applicable.
 
 
 
 PART
        II.
 
 Item
        13.Defaults,
        Dividends Arrearages and Delinquencies
 
 Not
        Applicable.
 
 Item
        14.Material
        Modifications to the Rights of Security Holders and Use of
        Proceeds
 
 Not
        Applicable.
 
 Item
        15.Controls
        and Procedures
 
 **(a)
        Evaluation of Disclosure Controls and Procedures**
 
 Under
        the
        supervision and with the participation of our management, including the Chief
        Executive Officer and Chief Financial Officer, we have evaluated the
        effectiveness of our disclosure controls and procedures as at the end of
        the
        period covered by this annual report. Based on that evaluation, the Chief
        Executive Officer and Chief Financial Office have concluded that these
        disclosure controls and procedures are effective.
 
 **(b)
        Management’s Annual Report on Internal Control over Financial
        Reporting**
 
 EXFO
          management is responsible for establishing and maintaining adequate internal
          control over financial reporting. EXFO’s internal control over financial
          reporting is a process designed to provide reasonable assurance regarding
          the
          reliability of financial reporting and the preparation of financial statements
          for external purposes in accordance with generally accepted accounting
          principles in Canada.1
  EXFO’s
            internal control over financial reporting includes those policies and
            procedures
            that (i) pertain to the maintenance of records that, in reasonable detail,
            accurately and fairly reflect the transactions and dispositions of the
            assets of
            EXFO; (ii) provide reasonable assurance that transactions are recorded
            as
            necessary to permit preparation of financial statements in accordance
            with
            generally accepted accounting principles generally accepted in Canada,
            and that
            receipts and expenditures of the company are being made only in accordance
            with
            authorizations of management and directors of EXFO; and (iii) provide
            reasonable
            assurance regarding prevention or timely detection of unauthorized acquisition,
            use, or disposition of EXFO’s assets that could have a material effect on the
            financial statements.
  Because
            of its inherent limitations, internal control over financial reporting
            may not
            prevent or detect misstatements. Also, projections of any evaluation
            of
            effectiveness to future periods are subject to the risk that controls
            may become
            inadequate because of changes in conditions, or that the degree of compliance
            with the policies or procedures may deteriorate.
  1  Our
                consolidated financial statements are prepared in accordance with
                generally
                accepted accounting principles in Canada (“Canadian GAAP”) and significant
                differences in measurement and disclosure from generally accepted
                accounting
                principles in United States (“U.S. GAAP”) are set out in note 20 to our
                consolidated financial statements included elsewhere in this annual
                report.
 
 99
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              of Contents
  
 The
        recent acquisition of Consultronics Limited has been excluded from management’s
        assessment of internal controls as at August 31, 2006, because it was acquired
        by the company on January 26, 2006, and it was not possible for management
        to
        conduct an assessment of Consultronics’ internal control over financial
        reporting in the period between the consummation date and the date of
        management’s assessment. The acquired business of Consultronics represented less
        than 10% of the company’s total consolidated assets and revenues as at and for
        the year ended August 31, 2006.
 
 Management
        conducted an evaluation of the effectiveness of EXFO’s internal control over
        financial reporting based on the criteria established in *Internal
        Control - Integrated Framework* issued
        by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
        Based on this evaluation, management concluded that EXFO’s internal control over
        financial reporting was effective as at August 31, 2006.
 
 **(c)
        Changes in Internal Control over Financial Reporting**
 
 There
        were no changes in our internal control over financial reporting during the
        period covered by this annual report that have materially affected, or are
        reasonably likely to materially affect, our internal control over financial
        reporting.
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              of Contents
   **Item
        16.**  **** **[Reserved]**
 
 **Item
        16A.**  **Audit
        Committee Financial Expert**
 
 Our
        Board
        of Directors has determined that Mr. André Tremblay, CA, chairman of our audit
        committee is an audit committee financial expert. Mr. Tremblay is independent
        of
        management. For a description of Mr. Tremblay’s education and experience,
        please refer to Item 6A. The other members of the Audit Committee are Mr.
        Pierre
        Marcouiller, Mr. Guy Marier and Mr. Michael Unger which are all Independent.
        For
        a description of their respective education and experience, please also refer
        to
        Item 6A.
 
 **Item
        16B.**  **Code
        of Ethics**
 
 In
        2003,
        we adopted a code of ethics that applies to our chief executive officer,
        our
        chief financial officer and our manager of financial reporting and accounting.
        A
        copy of this code of ethics has been filed as exhibit 11.1 to last year annual
        report. In March 2005, the Board updated and adopted the following policies:
 
 ·
              Board
                  of Directors Corporate Governance
                  Guidelines;
 ·
              Code
                  of Ethics for our Principal Executive Officer and Senior Financial
                  Officers;
 ·
              Ethics
                  and Business Conduct Policy;
 ·
              Statement
                  of Reporting Ethical Violations (Whistle
                  Blower).
 
 A
        copy of
        those policies has been filed respectively as exhibits 11.2 through 11.5
        inclusively to last year annual report. All these policies are also readily
        available on our website at www.exfo.com .
        Accordingly, we believe that our corporate governance practices are in alignment
        to current regulatory requirements.
 
 As
        reported at item 7B of this annual report, previous to the coming into force
        of
        the requirement for a code of ethics, we had entered into a lease agreement
        with
        G. Lamonde Investissements financiers inc., a company controlled by our chief
        executive officer, for premises located at 465 Godin Avenue in Quebec City,
        Quebec and on September 1, 2004, we were released from our obligations under
        this lease with a final payment of $194,000. In addition, in September 2002,
        we
        acquired from G. Lamonde Investissements financiers inc. the building located
        at
        436 Nolin Street. The purchase price paid was based on an independent third
        party valuation and the transaction was approved by our audit committee and
        Board of Directors with Mr. Lamonde abstaining.
 
 **Item
        16C.**  **Principal
        Accountant Fees and Services**
 
 **Audit
        Fees**
 
 During
        the financial years ended August 31, 2005 and August 31, 2006, our principal
        accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $214,000
        and $247,000 respectively for the audit of our annual consolidated financial
        statements and services in connection with statutory and regulatory
        filings.
 
 **Audit-Related
        Fees**
 
 During
        the financial years ended August 31, 2005 and August 31, 2006, our principal
        accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $62,000
        and $148,000, respectively for services mainly related to Sarbanes-Oxley
        Act.
 
 **Tax
        Fees**
 
 During
        the financial years ended August 31, 2005 and August 31, 2006, our principal
        accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $185,000
        and $210,000, respectively for services related to tax compliance, tax advice
        and tax planning.
 
 **All
        Other Fees**
 
 Not
        applicable.
 
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              of Contents
  
 **Audit
        Committee Pre-Approval Policies and Procedures**
 
 On
        September 25, 2002, our audit committee adopted a policy requiring prior
        approval by the audit committee of the annual audit plan and fees which has
        been
        integrated in the Audit Committee Charter (refer to Item 6C for further details
        on the Audit Committee Charter. In the event any adjustments to audit fees
        may
        be required during the course of a financial year, such adjustments shall
        be
        approved by the chairman of the audit committee, acting alone, and shall
        be
        reported to the full audit committee at its next meeting.
 
 In
        the
        case of non-audit fees (excluding tax matters), the policy provides that
        proposals shall be submitted to the chairman of the audit committee and our
        chief financial officer at the same time and the chairman of the audit committee
        will be responsible for approval of such proposal, subject to any modifications
        that he may require. The chairman will make a report to the full audit committee
        at its next meeting.
 
 As
        concerns tax services to be provided by our principal accountant, our policy
        provides that the principal accountant will present to the audit committee
        for
        pre-approval, on or before the beginning of each financial year, an engagement
        for tax matters that are foreseeable for the upcoming year and the audit
        committee shall be responsible for pre-approval thereof, subject to any
        modifications it may make to such proposals. In the event tax services are
        required that were not pre-approved by the audit committee, the procedure
        set
        forth in the previous paragraph will apply.
 
 During
        the financial year ended on August 31, 2006, 100% of tax fees were approved
        by
        the audit committee pursuant to this policy. During the financial year ended
        on
        August 31, 2006, only full-time permanent employees of our principal accountant,
        PricewaterhouseCoopers LLP, performed work to audit our financial
        statements.
 
 **Item
        16D.**  **Exemptions
        from the Listing Standards for Audit Committees**
 
 Not
        Applicable.
  **Item
        16E.**  **Purchases
        of Equity Securities by the Issuer and Affiliated
        Purchasers**
 
 Not
        Applicable.
  
  **PART
        III.**  ****
  **Item
        17.**  **Financial
        Statements**
 
 Not
        Applicable.
 
 **Item
        18.**  **Financial
        Statements**
 
 See
        pages
        F-2 to F-42.
  102
 Table
            of Contents
   **Item
        19.**  **Exhibits**
  **Number**
                **Exhibit**1.1
                Amended
                    Articles of Incorporation of EXFO (incorporated by reference
                    to Exhibit
                    3.1 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000,
                    File No. 333-38956).1.2
                Amended
                    By-laws of EXFO (incorporated by reference to Exhibit 1.2 of
                    EXFO’s annual
                    report on Form-20F dated January 15, 2003, File No.
                    000-30895).1.3
                Amended
                    and Restated Articles of Incorporation of EXFO (incorporated
                    by reference
                    to Exhibit 1.3 of EXFO’s annual report on Form 20-F dated January 18,
                    2001, File No. 000-30895).2.1
                Form
                    of Subordinate Voting Share Certificate (incorporated by reference
                    to
                    Exhibit 4.1 of EXFO’s Registration Statement on Form F-1 filed on June 9,
                    2000, File No. 333-38956).2.2
                Form
                    of Registration Rights Agreement between EXFO and Germain Lamonde
                    dated
                    July 6, 2000 ) (incorporated by reference to Exhibit 10.13 of
                    EXFO’s
                    Registration Statement on Form F-1 filed on June 9, 2000, File
                    No.
                    333-38956).3.1
                Form
                    of Trust Agreement among EXFO, Germain Lamonde, GEXFO Investissements
                    Technologiques inc., Fiducie Germain Lamonde and G. Lamonde
                    Investissements Financiers inc. (incorporated by reference to
                    Exhibit 4.2
                    of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File
                    No. 333-38956).4.1
                Agreement
                    of Merger and Plan of Reorganization, dated as of November 4,
                    2000, by and
                    among EXFO, EXFO Sub, Inc., EXFO Burleigh Instruments, Inc.,
                    Robert G.
                    Klimasewki, William G. May, Jr., David J. Farrell and William
                    S. Gornall
                    (incorporated by reference to Exhibit 4.1 of EXFO’s annual report on Form
                    20-F dated January 18, 2001, File No. 000-30895).4.2
                Amendment
                    No. 1 to Agreement of Merger and Plan of Agreement, dated as
                    of December
                    20, 2000, by and among EXFO, EXFO Sub, Inc., EXFO Burleigh Instruments,
                    Inc., Robert G. Klimasewski, William G. May, Jr., David J. Farrell
                    and
                    William S. Gornall (incorporated by reference to Exhibit 4.2
                    of EXFO’s
                    annual report on Form 20-F dated January 18, 2001, File No.
                    000-30895).4.3
                Agreement
                    of Merger, dated as of August 20, 2001, by and among EXFO, Buyer
                    Sub, and
                    Avantas Networks Corporation and Shareholders of Avantas Networks
                    corporation (incorporated by reference to Exhibit 4.3 of EXFO’s annual
                    report on Form 20-F dated January 18, 2002, File No.
                    000-30895).4.4
                Amendment
                    No. 1 dated as of November 1, 2002 to Agreement of Merger, dated
                    as of
                    August 20, 2001, by and among EXFO, 3905268 Canada Inc., Avantas
                    Networks
                    Corporation and Shareholders of Avantas Networks (incorporated
                    by
                    reference to Exhibit 4.4 of EXFO’s annual report on Form 20-F dated
                    January 18, 2002, File No. 000-30895).4.5
                Offer
                    to purchase shares of Nortech Fibronic Inc., dated February 6,
                    2000 among
                    EXFO, Claude Adrien Noel, 9086-9314 Québec inc., Michel Bédard, Christine
                    Bergeron and Société en Commandite Capidem Québec Enr. and Certificate of
                    Closing, dated February 7, 2000 among the same parties (including
                    summary
                    in English) (incorporated by reference to Exhibit 10.2 of EXFO’s
                    Registration Statement on Form F-1 filed on June 9, 2000, File
                    No.
                    333-38956).4.6
                Share
                    Purchase Agreement, dated as of March 5, 2001, among EXFO Electro-Optical
                    Engineering, Inc., John Kennedy, Glenn Harvey and EFOS Corporation
                    (incorporated by reference to Exhibit 4.1 of EXFO’s Registration Statement
                    on Form F-3 filed on July 13, 2001, File No. 333-65122).4.7
                Amendment
                    Number One, dated as of March 15, 2001, to Share Purchase Agreement,
                    dated
                    as of March 5, 2001, among EXFO Electro-Optical Engineering,
                    Inc., John
                    Kennedy, Glenn Harvey and EFOS Corporation. (incorporated by
                    reference to
                    Exhibit 4.2 of EXFO’s Registration Statement on Form F-3 filed on July 13,
                    2001, File No. 333-65122).4.8
                Share
                    Purchase Agreement, dated as of November 2, 2001 between JDS
                    Uniphase Inc.
                    and 3905268 Canada Inc. (incorporated by reference to Exhibit
                    4.8 of
                    EXFO’s annual report on Form 20-F dated January 18, 2002, File No.
                    000-30895).4.9
                Intellectual
                    Property Assignment and Sale Agreement between EFOS Inc., EXFO
                    Electro-Optical Engineering, Inc., John Kennedy, Glenn Harvey
                    and EFOS
                    Corporation. (incorporated by reference to Exhibit 4.3 of EXFO’s
                    Registration Statement on Form F-3 filed on July 13, 2001, File
                    No.
                    333-65122).
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   4.10
                Offer
                    to acquire a building, dated February 23, 2000, between EXFO
                    and Groupe
                    Mirabau inc. and as accepted by Groupe Mirabau inc. on February
                    24, 2000
                    (including summary in English) (incorporated by reference to
                    Exhibit 10.3
                    of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File
                    No. 333-38956).4.11
                Lease
                    Agreement, dated December 1, 1996, between EXFO and GEXFO Investissements
                    Technologiques inc., as assigned to 9080-9823 Québec inc. on September 1,
                    1999 (including summary in English) (incorporated by reference
                    to Exhibit
                    10.4 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000,
                    File No. 333-38956).4.12
                Lease
                    Agreement, dated March 1, 1996, between EXFO and GEXFO Investissements
                    Technologiques inc., as assigned to 9080-9823 Québec inc. on September 1,
                    1999 (including summary in English) (incorporated by reference
                    to Exhibit
                    10.5 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000,
                    File No. 333-38956).4.13
                Lease
                    renewal of the existing leases between 9080-9823 Québec inc. and EXFO,
                    dated November 30, 2001(incorporated by reference to Exhibit
                    4.13 of
                    EXFO’s annual report on Form 20-F dated January 18, 2002, File No.
                    000-30895).4.14
                Loan
                    Agreement between EXFO and GEXFO Investissements Technologiques
                    inc.,
                    dated May 11, 1993, as assigned to 9080-9823 Québec inc. on September
                    1, 1999 (including summary in English) (incorporated by reference
                    to
                    Exhibit 10.9 of EXFO’s Registration Statement on Form F-1 filed on June 9,
                    2000, File No. 333-38956).4.15
                Resolution
                    of the Board of Directors of EXFO, dated September 1, 1999, authorizing
                    EXFO to acquire GEXFO Distribution Internationale inc. from GEXFO
                    Investissements Technologiques inc. (including summary in English)
                    (incorporated by reference to Exhibit 10.10 of EXFO’s Registration
                    Statement on Form F-1 filed on June 9, 2000, File No.
                    333-38956).4.16
                Form
                    of Promissory Note of EXFO issued to GEXFO Investissements Technologiques
                    inc. dated June 27, 2000 ) (incorporated by reference to Exhibit
                    10.12 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000,
                    File No. 333-38956).4.17
                Term
                    Loan Offer, dated March 28, 2000, among EXFO and National Bank
                    of Canada
                    as accepted by EXFO on April 3, 2000 (including summary in English)
                    (incorporated by reference to Exhibit 10.11 of EXFO’s Registration
                    Statement on Form F-1 filed on June 9, 2000, File No.
                    333-38956).4.18
                Employment
                    Agreement of Germain Lamonde dated May 29, 2000 (incorporated
                    by reference
                    to Exhibit 10.15 of EXFO’s Registration Statement on Form F-1 filed on
                    June 9, 2000, File No. 333-38956).4.19
                Employment
                    Agreement of Bruce Bonini dated as of September 1, 2000 (incorporated
                    by
                    reference to Exhibit 4.24 of EXFO’s annual report on Form 20-F dated
                    January 18, 2002, File No. 000-30895).4.20
                Employment
                    Agreement of Juan-Felipe Gonzalez dated as of September 1, 2000
                    (incorporated by reference to Exhibit 4.25 of EXFO’s annual report on Form
                    20-F dated January 18, 2002, File No. 000-30895).4.21
                Employment
                    Agreement of David J. Farrell dated as of December 20, 2000 (incorporated
                    by reference to Exhibit 4.26 of EXFO’s annual report on Form 20-F dated
                    January 18, 2002, File No. 000-30895).4.22
                Deferred
                    Profit Sharing Plan, dated September 1, 1998 (incorporated by
                    reference to
                    Exhibit 10.6 of EXFO’s Registration Statement on Form F-1 filed on June 9,
                    2000, File No. 333-38956).4.23
                Stock
                    Option Plan, dated May 25, 2000 (incorporated by Reference to
                    Exhibit 10.7
                    of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File
                    No. 333-38956).4.24
                Share
                    Plan, dated April 3, 2000 (incorporated by reference to Exhibit
                    10.8 of
                    EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File
                    No.
                    333-38956).4.25
                Directors’
                    Compensation Plan (incorporated by reference to Exhibit 10.17
                    of EXFO’s
                    Registration Statement on Form F-1 filed on June 9, 2000, File
                    No.
                    333-38956).4.26
                Restricted
                    Stock Award Plan, dated December 20, 2000 (incorporated by reference
                    to
                    Exhibit 4.21 of EXFO’s annual report on Form 20-F dated January 18, 2001,
                    File No. 000-30895).4.27
                Asset
                    Purchase Agreement****by
                    and Among EXFO Electro-Optical Engineering Inc., EXFO Gnubi Products
                    Group
                    Inc., gnubi communications, L.P., gnubi communications General
                    Partner,
                    LLC, gnubi communications Limited Partner, LLC, gnubi communications,
                    Inc., Voting Trust created by The Irrevocable Voting Trust Agreement
                    Among
                    Carol Abraham Bolton, Paul Abraham and James Ray Stevens, James
                    Ray
                    Stevens and Daniel J. Ernst dated September 5, 2002 (incorporated
                    by
                    reference to Exhibit 4.30 of EXFO’s annual report on Form 20-F dated
                    January 15, 2003, File No. 000-30895).
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 4.28
                EXFO
                    Protocol Inc. Executive Employment Agreement with Sami Yazdi
                    signed
                    November 2, 2001 (incorporated by reference to Exhibit 4.28 of
                    EXFO’s
                    annual report on Form 20-F dated January 15, 2003, File No.
                    000-30895).4.29
                Second
                    Amending Agreement to the Employment Agreement of Bruce Bonini
                    dated as of
                    September 1, 2002, (incorporated by reference to Exhibit 4.29
                    of EXFO’s
                    annual report on Form 20-F dated January 15, 2004, File No.
                    000-30895).4.30
                Severance
                    and General Release Agreement with Bruce Bonini dated August
                    8, 2003,
                    (incorporated by reference to Exhibit 4.30 of EXFO’s annual report on Form
                    20-F dated January 15, 2004, File No. 000-30895).4.31
                Separation
                    Agreement and General Release with Sami Yazdi dated April 1,
                    2003,
                    (incorporated by reference to Exhibit 4.31 of EXFO’s annual report on Form
                    20-F dated January 15, 2004, File No. 000-30895).4.32
                Executive
                    Employment Agreement of James Stevens dated as of October 4,
                    2003,
                    (incorporated by reference to Exhibit 4.32 of EXFO’s annual report on Form
                    20-F dated January 15, 2004, File No. 000-30895).4.33
                Termination
                    Terms for John Holloran Jr. dated May 28, 2003, (incorporated
                    by reference
                    to Exhibit 4.33 of EXFO’s annual report on Form 20-F dated January 15,
                    2004, File No. 000-30895).4.34
                Employment
                    Agreement of Pierre Plamondon dated as of September 1, 2002,
                    (incorporated
                    by reference to Exhibit 4.34 of EXFO’s annual report on Form 20-F dated
                    January 15, 2004, File No. 000-30895).4.35
                Long-Term
                    Incentive Plan, dated May 25, 2000, amended in October 2004 and
                    effective
                    January 12, 2005 (incorporated by reference to Exhibit 4.35 of
                    EXFO’s
                    annual report on Form 20-F dated November 29, 2005, File No.
                    000-30895).4.36
                Deferred
                    Share Unit Plan, effective January 12, 2005 (incorporated by
                    reference to
                    Exhibit 4.36 of EXFO’s annual report on Form 20-F dated November 29, 2005,
                    File No. 000-30895).4.37
                Asset
                    Purchase Agreement by and Among EXFO Electro-Optical Engineering
                    Inc.,
                    Consultronics Limited., Andre Rekai, Consultronics Europe Limited,
                    Consultronics Development Kft. and Consultronics Inc. dated January
                    5,
                    2006.8.1
                Subsidiaries
                    of EXFO (list included in Item 4C of this annual report).11.1
                Code
                    of Ethics for senior financial officers, (incorporated by reference
                    to
                    Exhibit 11.1 of EXFO’s annual report on Form 20-F dated January 15, 2004,
                    File No. 000-30895).11.2
                Board
                    of Directors Corporate Governance Guidelines (incorporated by
                    reference to
                    Exhibit 11.2 of EXFO’s annual report on Form 20-F dated November 29, 2005,
                    File No. 000-30895).11.3
                Code
                    of Ethics for our Principal Executive Officer and Senior Financial
                    Officers (incorporated by reference to Exhibit 11.3 of EXFO’s annual
                    report on Form 20-F dated November 29, 2005, File No.
                    000-30895).11.4
                Ethics
                    and Business Conduct Policy (incorporated by reference to Exhibit
                    11.4 of
                    EXFO’s annual report on Form 20-F dated November 29, 2005, File No.
                    000-30895).11.5
                Statement
                    of Reporting Ethical Violations (Whistle Blower) (incorporated
                    by
                    reference to Exhibit 11.5 of EXFO’s annual report on Form 20-F dated
                    November 29, 2005, File No. 000-30895).11.6
                Audit
                    Committee Charter (incorporated by reference to Exhibit 11.6
                    of EXFO’s
                    annual report on Form 20-F dated November 29, 2005, File No.
                    000-30895).11.7
                Human
                    Resources Committee Charter (incorporated by reference to Exhibit
                    11.7 of
                    EXFO’s annual report on Form 20-F dated November 29, 2005, File No.
                    000-30895).12.1
                Certification
                    of the Chief Executive Officer Pursuant to Section 302 of the
                    Sarbanes-Oxley Act of 2002.12.2
                Certification
                    of the Chief Executive Officer Pursuant to Section 906 of the
                    Sarbanes-Oxley Act of 2002.13.1
                Certification
                    of the Chief Financial Officer Pursuant to Section 302 of the
                    Sarbanes-Oxley Act of 2002.13.2
                Certification
                    of the Chief Financial Officer Pursuant to Section 906 of the
                    Sarbanes-Oxley Act of 2002.
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   **SIGNATURES**
 
  The
          registrant hereby certifies that it meets all of the requirements for filing
          on
          Form 20 -F and that it has duly caused and authorized the
          undersigned to sign this annual report on its behalf.


EXFO
        ELECTRO-OPTICAL ENGINEERING INC.
 
 
 
 
 By:  /s/ *Germain
        Lamonde*
 Name:  Germain
        Lamonde
 Title:  Chairman
        of the Board, President and
        Chief
        Executive Officer
 
 Date:  November
        23, 2006.






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**Report
          of Independent Auditors**
 
 
 
 **To
          the Shareholders** **of**
 **EXFO
          Electro-Optical Engineering Inc.**
 
 
 We
          have
          audited the consolidated balance
          sheets of **EXFO
          Electro-Optical Engineering Inc.** as at August
          31, 2006 and 2005 and the consolidated statements
          of earnings, deficit and contributed surplus and cash flows for each of
          the years in the
          three-year period ended August 31, 2006 .
          These
          financial statements are the responsibility of the Company's management.
          Our
          responsibility is to express an opinion on these financial statements based
          on
          our audits.
 
 We
          conducted our audits in accordance with Canadian generally accepted auditing
          standards and the standards of the Public Company Accounting Oversight
          Board
          (United States). Those standards require that we plan and perform an audit
          to
          obtain reasonable assurance whether the financial statements are free of
          material misstatement. An audit includes examining, on a test basis, evidence
          supporting the amounts and disclosures in the financial statements. An
          audit
          also includes assessing the accounting principles used and significant
          estimates
          made by management, as well as evaluating the overall financial statement
          presentation.
 
 In
          our
          opinion, these consolidated financial
          statements present fairly, in all material respects, the financial position
          of
          the Company as at August
          31, 2006 and 2005 and the
          results of its operations and its cash flows for each of the years in the
          three-year period ended August 31, 2006 in
          accordance with Canadian generally accepted accounting principles. Furthermore,
          in our opinion, the financial statement schedules on the changes in the
          allowance for doubtful accounts and in the valuation allowance of future
          income
          tax assets included in Form 20-F present fairly, in all material respects,
          the
          information set forth therein when read in conjunction with the related
          consolidated financial statements.
 
 
 
 /s/
          PricewaterhouseCoopers LLP
 **Chartered
          Accountants**
 
 Quebec,
          Quebec, Canada
 October
          25, 2006
 
 
 **Comments
          by Auditors for U.S. Readers on Canada-U.S. Reporting
          Differences**
 
 In
          the
          United States of America, reporting standards for auditors require the
          addition
          of an explanatory paragraph (following the opinion paragraph) when there
          are
          changes in accounting principles that have a material effect on the
          comparability of the Company's financial statements, such as the changes
          described in note 2 to the consolidated financial statements. Our report
          to the
          Shareholders dated October
          25, 2006 is
          expressed in accordance with Canadian reporting standards which do not
          require a
          reference to such changes in accounting principles in the auditors' report
          when
          the changes are properly accounted for and adequately disclosed in the
          financial
          statements.
 
 
 
 /s/
          PricewaterhouseCoopers LLP
 **Chartered
          Accountants**
 
 Quebec,
          Quebec, Canada
 October
          25, 2006


F-1
 Table
          of Contents






**EXFO
        Electro-Optical Engineering Inc.**
 **Consolidated
        Balance Sheets**
  (in
        thousands of US dollars)




**As
                at August 31,****2006**
            
            **2005****Assets****Current
                assets**Cash
            
            $
            6,853
            
            $
            7,119Short-term
                investments (notes 8 and 18)
            
            
            104,437
            
            
            104,883Accounts
                receivable (notes 8 and 18)Trade
            
            
            20,891
            
            
            13,945Other
                (note 4)
            
            
            2,792
            
            
            2,007Income
                taxes and tax credits recoverable (note 8)
            
            
            2,201
            
            
            2,392Inventories
                (notes 5 and 8)
            
            
            24,623
            
            
            17,749Prepaid
                expenses
            
            
            1,404
            
            
            1,112163,201
            
            
            149,207**Income
                taxes recoverable**
            
            
            476
            
            
            459**Property,
                plant and equipment**(notes
                4, 6 and 8)
            
            
            17,392
            
            
            13,719**Long-lived
                asset held for sale**(note
                4)
            
            
            −
            
            
            1,600**Intangible
                assets**(notes
                7 and 8)
            
            
            10,948
            
            
            5,602**Goodwill**(note
                7)
            
            
            27,142
            
            
            20,370$
            219,159
            
            $
            190,957**Liabilities****Current
                liabilities**Accounts
                payable and accrued liabilities (note 9)
            
            $
            17,337
            
            $
            12,201Deferred
                revenue
            
            
            1,772
            
            
            1,584Current
                portion of long-term debt
            
            
            107
            
            
            13419,216
            
            
            13,919**Deferred
                revenue**
            
            
            2,632
            
            
            1,568**Government
                grants**(note
                15)
            
            
            723
            
            
            1,872**Long-term
                debt**(note
                10)
            
            
            354
            
            
            19822,925
            
            
            17,557**Commitments**(note 11)**Contingencies**(note 12)**Shareholders’
                Equity**Share
                capital (note 13)
            
            
            148,921
            
            
            521,875Contributed
                surplus
            
            
            3,776
            
            
            2,949Deficit
                (note 13)
            
            
            −
            
            
            (381,846
            )Cumulative
                translation adjustment
            
            
            43,537
            
            
            30,422196,234
            
            
            173,400$
            219,159
            
            $
            190,957








The
            accompanying notes are an integral part of these consolidated financial
            statements.


F-2
 Table
            of Contents






**EXFO
      Electro-Optical Engineering Inc.**


**Consolidated
      Statements of Earnings**




(in
      thousands of US dollars, except share and per share data)





**Years
                ended August 31,****2006**
            
            **2005**
            
            **2004****Sales**(note 19)
            
            $
            128,253
            
            $
            97,216
            
            $
            74,630**Cost
                of sales**(1,2)
            
            
            57,275
            
            
            44,059
            
            
            34,556**Gross
                margin**
            
            
            70,978
            
            
            53,157
            
            
            40,074**Operating
                expenses**Selling
                and administrative(1)
            
            
            40,298
            
            
            31,782
            
            
            25,890Net
                research and development(1)(note
                15)
            
            
            15,404
            
            
            12,190
            
            
            12,390Amortization
                of property, plant and equipment
            
            
            3,523
            
            
            4,256
            
            
            4,935Amortization
                of intangible assets
            
            
            4,394
            
            
            4,836
            
            
            5,080Impairment
                of long-lived assets (note 4)
            
            
            604
            
            
            −
            
            
            620Government
                grants (note 15)
            
            
            (1,307
            )
            
            −
            
            
            −Restructuring
                and other charges (note 4)
            
            
            −
            
            
            292
            
            
            1,729**Total
                operating expenses**
            
            
            62,916
            
            
            53,356
            
            
            50,644**Earnings
                (loss) from operations**
            
            
            8,062
            
            
            (199
            )
            
            (10,570
            )Interest
                and other income
            
            
            3,253
            
            
            2,524
            
            
            1,438Foreign
                exchange loss
            
            
            (595
            )
            
            (1,336
            )
            
            (278
            )**Earnings
                (loss) before income taxes**(note
                16)****
            
            
            10,720
            
            
            989
            
            
            (9,410
            )**Income
                taxes**(note
                16)
            
            
            2,585
            
            
            2,623
            
            
            (986
            )**Net
                earnings (loss) for the year**
            
            $
            8,135
            
            $
            (1,634
            )
            $
            (8,424
            )**Basic
                and diluted net earnings (loss) per share**
            
            $
            0.12
            
            $
            (0.02
            )
            $
            (0.13
            )**Basic
                weighted average number of shares outstanding
                (000’s)**
            
            
            68,643
            
            
            68,526
            
            
            66,020**Diluted
                weighted average number of**
              **shares
                outstanding (000’s)**(note
                17)
            
            
            69,275
            
            
            68,981
            
            
            66,615(1)**Stock-based
                compensation costs included in:**Cost
                of sales
            
            $
            127
            
            $
            143
            
            $
            62Selling
                and administrative
            
            
            701
            
            
            626
            
            
            265Net
                research and development
            
            
            204
            
            
            194
            
            
            122$
            1,032
            
            $
            963
            
            $
            449(2)The
                cost of sales is exclusive of amortization, shown separately.








The
                accompanying notes are an integral part of these consolidated financial
                statements.
 F-3
 Table
            of Contents




**EXFO
        Electro-Optical Engineering Inc.**
 **Consolidated
        Statements of Deficit and Contributed Surplus**
  (in
        thousands of US dollars)


**Deficit****Years
                ended August 31,****200****6**
            
            **200****5**
            
            **200****4****Balance
                - Beginning of year**
            
            $
            (381,846
            )
            $
            (380,212
            )
            $
            (371,788
            )**Deduct
                (add)**Net
                earnings (loss) for the year
            
            
            8,135
            
            
            (1,634
            )
            
            (8,424
            )Elimination
                of deficit by reduction of share capital (note 13)
            
            
            373,711
            
            
            −
            
            
            −**Balance
                - End of year**
            
            $
            −
            
            $
            (381,846
            )
            $
            (380,212
            )











**Contributed
                surplus****Years
                ended August 31,****200****6**
            
            **200****5**
            
            **200****4****Balance
                - Beginning of year**
            
            $
            2,949
            
            $
            1,986
            
            $
            1,519**Add
                (deduct)**Stock-based
                compensation costs
            
            
            1,027
            
            
            963
            
            
            449Reclassification
                of stock-based compensation costs to share capital upon exercise
                of stock
                awards (note 13)
            
            
            (200
            )
            
            −
            
            
            −Premium
                on resale of share capital
            
            
            −
            
            
            −
            
            
            18**Balance
                - End of year**
            
            $
            3,776
            
            $
            2,949
            
            $
            1,986














The
                accompanying notes are an integral part of these consolidated financial
                statements.
 F-4
 Table
            of Contents




**EXFO
        Electro-Optical Engineering Inc.**
 **Consolidated
        Statements of Cash Flows**
  (in
        thousands of US dollars)


**Years
                ended August 31,****2006**
            
            **2005**
            
            **2004****Cash
                flows from operating activities**Net
                earnings (loss) for the year
            
            $
            8,135
            
            $
            (1,634
            )
            $
            (8,424
            )Add
                (deduct) items not affecting cashDiscount
                on short-term investments
            
            
            (229
            )
            
            (302
            )
            
            197Stock-based
                compensation costs
            
            
            1,032
            
            
            963
            
            
            449Amortization
            
            
            7,917
            
            
            9,092
            
            
            10,015Impairment
                of long-lived assets
            
            
            604
            
            
            −
            
            
            620Restructuring
                and other charges
            
            
            −
            
            
            −
            
            
            1,261Government
                grants
            
            
            (1,307
            )
            
            −
            
            
            154Deferred
                revenue
            
            
            786
            
            
            977
            
            
            1,40416,938
            
            
            9,096
            
            
            5,676Change
                in non-cash operating itemsAccounts
                receivable
            
            
            (2,637
            )
            
            (838
            )
            
            (2,677
            )Income
                taxes and tax credits
            
            
            329
            
            
            6,096
            
            
            (2,464
            )Inventories
            
            
            (2,287
            )
            
            (699
            )
            
            1,016Prepaid
                expenses
            
            
            79
            
            
            544
            
            
            (449
            )Accounts
                payable and accrued liabilities
            
            
            (144
            )
            
            (164
            )
            
            (351
            )12,278
            
            
            14,035
            
            
            751**Cash
                flows from investing activities**Additions
                to short-term investments
            
            
            (673,289
            )
            
            (585,665
            )
            
            (653,348
            )Proceeds
                from disposal and maturity of short-term investments
            
            
            681,500
            
            
            574,207
            
            
            624,722Additions
                to property, plant and equipment and intangible assets
            
            
            (3,378
            )
            
            (1,501
            )
            
            (851
            )Business
                combinations, net of cash acquired
            
            
            (18,054
            )
            
            −
            
            
            (241
            )(13,221
            )
            
            (12,959
            )
            
            (29,718
            )**Cash
                flows from financing activities**Repayment
                of long-term debt
            
            
            (415
            )
            
            (121
            )
            
            (109
            )Net
                proceeds of offering (note 13)
            
            
            −
            
            
            −
            
            
            29,164Exercise
                of stock options
            
            
            557
            
            
            148
            
            
            254Share
                issue expenses
            
            
            −
            
            
            (6
            )
            
            (137
            )Redemption
                of share capital
            
            
            −
            
            
            −
            
            
            (5
            )Resale
                of share capital
            
            
            −
            
            
            −
            
            
            23142
            
            
            21
            
            
            29,190**Effect
                of foreign exchange rate changes on cash**
            
            
            535
            
            
            863
            
            
            (430
            )**Change
                in cash**
            
            
            (266
            )
            
            1,960
            
            
            (207
            )**Cash
                - Beginning of year**
            
            
            7,119
            
            
            5,159
            
            
            5,366**Cash
                - End of year**
            
            $
            6,853
            
            $
            7,119
            
            $
            5,159**Supplementary
                information**Interest
                paid
            
            $
            65
            
            $
            30
            
            $
            408Income
                taxes paid (recovered)
            
            $
            2,541
            
            $
            (669
            )
            $
            120






The
                accompanying notes are an integral part of these consolidated financial
                statements.
 F-5
 Table
            of Contents




**EXFO
        Electro-Optical Engineering Inc.**
 **Notes
        to Consolidated Financial Statements**
 
 (tabular
        amounts in thousands of US dollars, except share and per share data and as
        otherwise noted)
  **1**  **Nature
        of Activities**
 
 EXFO
        Electro-Optical Engineering Inc. (“EXFO”) designs, manufactures and markets
        a comprehensive line of test and measurement solutions for the global
        telecommunications industry. The Telecom Division, which represents the
        company’s main business activity, offers integrated test solutions to network
        service providers, cable operators, system vendors and optical component
        manufacturers. The Life Sciences and Industrial Division mainly leverages
        core
        telecom technologies to offer value-added solutions for life sciences
        applications and high-precision assembly processes, such as those required
        for
        microelectronics, optoelectronics and medical devices. EXFO’s products are sold
        in approximately 70 countries around the world.
 
 
 **2**  **Summary
        of Significant Accounting Policies**
 
 **Basis
        of presentation**
 
 These
        consolidated financial statements have been prepared in accordance with
        generally accepted accounting principles (“GAAP”) in Canada and significant
        differences in measurement and disclosure from U.S. GAAP are set out in note
        20.
        These consolidated financial statements include the accounts of the company
        and
        its domestic and international subsidiaries. All significant intercompany
        accounts and transactions have been eliminated.
 
 **Accounting
        estimates**
 
 The
        preparation of financial statements in accordance with generally accepted
        accounting principles requires management to make estimates and assumptions
        that
        affect the reported amounts of assets and liabilities and the disclosures
        of
        contingent assets and liabilities at the date of the financial statements,
        as
        well as the reported amounts of revenues and expenses during the reporting
        years. Significant estimates include the allowance for doubtful accounts
        receivable, the amount of tax credits recoverable, the provision for excess
        and
        obsolete inventories, the useful lives of capital assets, the valuation of
        long-lived assets, the future income taxes valuation allowance, the amount
        of
        certain accrued liabilities and deferred revenue as well as stock-based
        compensation costs. Actual results could differ from those estimates.
 
 **Reporting
        currency**
 
 The
        measurement currency of the company is the Canadian dollar. The company has
        adopted the US dollar as its reporting currency. The financial statements
        are translated into the reporting currency using the current rate method.
        Under
        this method, the financial statements are translated into the reporting currency
        as follows: assets and liabilities are translated at the exchange rate in
        effect
        on the date of the balance sheet, while revenues and expenses are translated
        at
        the monthly average exchange rate. Foreign exchange gains and losses arising
        from such translation are included in the cumulative translation adjustment
        in
        shareholders’ equity.
 
 In
        the
        event that management decides to declare dividends, such dividends would
        be
        declared in Canadian dollars.
 
 
 F-6
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **Foreign
        currency translation**
 
 *Foreign
        currency transactions*
 
 Transactions
        denominated in currencies other than the measurement currency are translated
        into the measurement currency as follows: monetary assets and liabilities
        are
        translated at the exchange rate in effect on the date of the balance sheet,
        and
        revenues and expenses are translated at the exchange rate in effect on the
        date
        of the transaction. Non-monetary assets and liabilities are translated at
        historical rates. Foreign exchange gains and losses arising from such
        translation are reflected in the statements of earnings.
 
 *Foreign
        subsidiaries*
 
 The
        financial statements of integrated foreign operations are remeasured into
        the
        measurement currency using the temporal method. Under this method, monetary
        assets and liabilities are remeasured at the exchange rate in effect on the
        date
        of the balance sheet. Non-monetary assets and liabilities are remeasured
        at
        historical rates, unless such assets and liabilities are carried at market,
        in
        which case, they are remeasured at the exchange rate in effect on the date
        of
        the balance sheet. Revenues and expenses are remeasured at the monthly average
        exchange rate. Foreign exchange gains and losses arising from such remeasurement
        are reflected in the statements of earnings. The company has no self-sustaining
        foreign subsidiary for which the functional currency is not the
        US dollar.
 
 *Forward
        exchange contracts*
 
 Forward
        exchange contracts are utilized by the company to manage its foreign currency
        exposure. The company’s policy is not to utilize those derivative financial
        instruments for trading or speculative purposes.
 
 The
        company’s forward exchange contracts, which are used to hedge anticipated
        US-dollar-denominated sales, qualify for hedge accounting; therefore, foreign
        exchange translation gains and losses on these contracts are recognized as
        an
        adjustment of the revenues when the corresponding hedged sales are
        recorded.
 
 Realized
        and unrealized foreign exchange gains or losses associated with forward exchange
        contracts, which have been terminated or cease to be effective prior to
        maturity, are deferred in the balance sheet and recognized in the earnings
        of
        the period in which the underlying hedged transaction is
        recognized.
 
 **Short-term
        investments**
 
 Short-term
        investments are valued at the lower of cost and market value. Cost consists
        of
        acquisition cost plus amortization of discount or less amortization of premium.
        All investments with original maturity of three months or less and that are
        not
        required for the purposes of meeting short-term cash requirements are classified
        as short-term investments.
 
 
 F-7
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **Inventories**
 
 Inventories
        are valued on an average cost basis, at the lower of cost and replacement
        cost
        for raw materials and at the lower of cost and net realizable value for work
        in
        progress and finished goods.
 
 **Property,
        plant and equipment and amortization**
 
 Property,
        plant and equipment are recorded at cost less related government grants and
        research and development tax credits. Amortization is provided on a
        straight-line basis over the estimated useful lives as follows:
 
 **Term**Land
                  improvements
              
              5
                  yearsBuildings
              
              25
                  yearsEquipment
              
              2
                  to 10 yearsLeasehold
                  improvements
              
              The
                  lesser of useful life and remaining lease
                  term
 
 **Intangible
        assets, goodwill and amortization**
 
 Intangible
        assets primarily include the cost of core technology and software, net of
        accumulated amortization. Core technology represents the existing technology
        acquired in business combinations that has reached technological feasibility.
        Amortization is provided on a straight-line basis over the estimated useful
        lives of five years for core technology and four and ten years for
        software.
 
 Goodwill
        represents the excess of the purchase price of acquired businesses over the
        estimated fair value of net identifiable assets acquired. Goodwill is not
        amortized but must be tested for impairment on an annual basis or more
        frequently if events or circumstances indicate that it might be impaired.
        Recoverability of goodwill is determined at the reporting unit level using
        a
        two-step approach. First, the carrying value of a reporting unit is compared
        to
        its fair value, which is determined based on a combination of discounted
        future
        cash flows and a market approach. If the carrying value of a reporting unit
        exceeds its fair value, the second step is performed. In this step, the amount
        of impairment loss, if any, represents the excess of the carrying value of
        goodwill over its fair value and the loss is charged to earnings in the period
        in which it is incurred. For the purposes of this impairment test, the fair
        value of goodwill is estimated in the same way as goodwill is determined
        in
        business combinations; that is, the excess of the fair value of a reporting
        unit
        over the estimated fair value of its net identifiable assets.
 
 The
        company elected to perform its annual impairment test in May of each fiscal
        year
        for all its existing reporting units.
 
 **Impairment
        of long-lived assets**
 
 Long-lived
        assets are reviewed for impairment when events or circumstances indicate
        that
        cost may not be recoverable. Impairment exists when the carrying value of
        an
        asset or group of assets is greater than the undiscounted future cash flows
        expected to be provided by the asset or group of assets. The amount of
        impairment loss, if any, is the excess of the carrying value over the fair
        value. The company assesses fair value of long-lived assets based on discounted
        future cash flows.
 
 F-8
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **Warranty**
 
 The
        company offers its customers warranties of one to three years, depending
        on the
        specific products and terms of the purchase agreement. The company’s typical
        warranties require it to repair or replace defective products during the
        warranty period at no cost to the customer. Costs related to original warranties
        are accrued at the time of shipment, based upon estimates of expected rework
        and
        warranty costs to be incurred. Costs associated with separately priced extended
        warranties are expensed as incurred.
 
 **Revenue
        recognition**
 
 For
        products in which software is incidental, the company recognizes revenue
        when
        persuasive evidence of an arrangement exists, the product has been delivered,
        the price is fixed and determinable, and collection of the resulting receivable
        is reasonably assured. In addition, provisions are made for estimated returns,
        warranties and support obligations.
 
 For
        products in which software is not incidental, revenues are separated into
        two
        categories: product and post-contract customer support (PCS) revenues, based
        upon vendor-specific objective evidence of fair value. Product revenues for
        these sales are recognized as described above. PCS revenues are deferred
        and
        recognized ratably over the years of the support arrangement. PCS revenues
        are
        recognized at the time the product is delivered when provided within one
        year of
        delivery; the costs of providing this support are insignificant (and accrued
        at
        the time of delivery) and no software upgrades are provided.
 
 For
        all
        sales, the company uses a binding purchase order as evidence that a sales
        arrangement exists.
 
 Delivery
        generally occurs when the product is handed over to a transporter for
        shipment.
 
 At
        the
        time of the transaction, the company assesses whether the price associated
        with
        its revenue transaction is fixed and determinable and whether or not collection
        is reasonably assured. The company assesses whether the price is fixed and
        determinable based on the payment terms associated with the transaction.
        The
        company assesses collection based on a number of factors, including past
        transaction history and the creditworthiness of the customer. Generally,
        collateral or other security is not requested from customers.
 
 Most
        sales arrangements do not generally include acceptance clauses. However,
        when a
        sales arrangement does include an acceptance provision, acceptance occurs
        upon
        the earliest of receipt of a written customer acceptance or expiration of
        the
        acceptance period. For these sales arrangements, the sale is recognized when
        acceptance occurs.
 
 Revenue
        for extended warranties is recognized on a straight-line basis over the warranty
        period.
 
 **Advertising
        costs**
 
 Advertising
        costs are expensed as incurred.
 
 
 F-9
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **Government
        grants**
 
 Grants
        related to operating expenses are included in earnings when the related expenses
        are incurred. Grants related to capital expenditures are deducted from the
        related assets. Grants are included in earnings or deducted from the related
        assets, provided there is reasonable assurance that the company has complied
        and
        will comply with all the conditions related to the grant.
 
 **Research
        and development expenses**
 
 All
        expenses related to research, as well as development activities that do not
        meet
        generally accepted criteria for deferral are expensed as incurred, net of
        related tax credits and government grants. Development expenses that meet
        generally accepted criteria for deferral, in accordance with the Canadian
        Institute of Chartered Accountants (CICA) handbook Section 3450, “Research and
        Development”, are capitalized, net of related tax credits and government grants,
        and are amortized against earnings over the estimated benefit period. Research
        and development expenses are mainly comprised of salaries and related expenses,
        material costs as well as fees paid to third-party consultants.
 
 As
        at
        August 31, 2006, the company had not deferred any development
        costs.
 
 **Income
        taxes**
 
 The
        company provides for income taxes using the liability method of tax allocation.
        Under this method, future income tax assets and liabilities are determined
        based
        on deductible or taxable temporary differences between financial statement
        values and tax values of assets and liabilities, using enacted income tax
        rates
        for the years in which the differences are expected to reverse.
 
 The
        company establishes a valuation allowance against future income tax assets
        if,
        based on available information, it is more likely than not that some or all
        of
        the future income tax assets will not be realized. Since 2003, the company
        records a full valuation allowance against future income tax assets (note
        16).
 
 **Earnings
        per share**
 
 Basic
        earnings per share are determined using the weighted average number of common
        shares outstanding during the year.
 
 Diluted
        earnings per share are determined using the weighted average number of common
        shares outstanding during the year, plus the effect of dilutive potential
        common
        shares outstanding during the year. This method requires that diluted earnings
        per share be calculated (using the treasury stock method) as if all dilutive
        potential common shares had been exercised at the latest at the beginning
        of the
        year or on the date of issuance, as the case may be, and that the funds obtained
        thereby (plus an amount equivalent to the unamortized portion of related
        stock-based compensation costs) be used to purchase common shares of the
        company
        at the average market price of the common shares during the year.
 
 
 F-10
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **Stock-based
        compensation costs**
 
 Since
        September 1, 2003, the company accounts for all forms of employee stock-based
        compensation using the fair value-based method. Stock-based compensation
        costs
        are amortized to expense over the vesting periods.
 
 Prior
        to
        fiscal 2004, no stock-based compensation costs were recognized for employee
        stock-based compensation. However, the company is required to disclose pro
        forma
        information with respect to net earnings (loss) and net earnings (loss) per
        share as if stock-based compensation costs were recognized in the financial
        statements for all reporting years using the fair value-based method for
        outstanding stock options granted prior to September 1, 2003
        (note 14).
 
 **New
        accounting standards and pronouncements**
 
 In
        January 2005, the CICA issued four new accounting standards in relation to
        financial instruments: Section 3855, "Financial Instruments - Recognition
        and
        measurement"; Section 3865, "Hedges"; Section 1530, "Comprehensive Income";
        and
        Section 3251, "Equity".
 
 Section
        3855 expands on Section 3860, "Financial Instruments - Disclosure and
        Presentation", by prescribing when a financial instrument is to be recognized
        on
        the balance sheet and at what amount. It also specifies how financial instrument
        gains and losses are to be presented in the financial statements.
 
 Section
        3865 provides an alternative to Section 3855 for entities that choose to
        designate qualifying transactions as hedges for accounting purposes. It replaces
        and expands on Accounting Guideline 13, "Hedging Relationships", and on the
        hedging guidance in Section 1650, "Foreign Currency Translation", by specifying
        how hedge accounting is applied and what disclosures it requires.
 
 Section
        1530, "Comprehensive Income", introduces a new requirement to temporarily
        present certain gains and losses outside net income.
 
 Consequently,
        Section 3250, "Surplus", has been revised as Section 3251, "Equity".
 
 Sections
        1530, 3251, 3855 and 3865 apply to fiscal years beginning on or after October
        1,
        2006. The company will adopt these new standards on September 1, 2007. While
        the
        company is currently assessing the effects of these new standards, impacts
        consistent with the adjustments described under note 20 item b) of these
        consolidated financial statements are expected.
 
 
 F-11
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **3**  **Business
        Combination**
 
 On
        January 26, 2006, the company acquired substantially all the assets of
        Consultronics Limited. Based in Toronto, Canada, and with operations in the
        United Kingdom and Hungary, Consultronics was a privately held company
        specializing in x-Digital Subscriber Line (xDSL), Internet Protocol TV and
        Voice-over-Internet Protocol (VoIP) test solutions for broadband access
        networks.
 
 This
        acquisition was settled for a total cash consideration valued at $19,093,000
        or
        $18,838,000 net of $255,000 of cash acquired. The total consideration includes
        severance expenses of $660,000 for the termination of employees of the acquired
        business as well as other acquisition-related costs of $822,000. As at August
        31, 2006, a portion of the total consideration, in the amount of $816,000,
        was
        not yet paid. From this amount, $631,000 is related to severance expenses
        and
        has been recorded as restructuring charges payable (note 4), while the remainder
        of $185,000, relating to acquisition-related costs, has been recorded as
        an
        account payable related to a business combination (note 9). Severance expenses
        will be fully paid in fiscal 2007.
 
 This
        acquisition was accounted for using the purchase method and, consequently,
        the
        results of operations of the acquired business have been included in the
        consolidated statement of earnings of the company since January 26, 2006,
        being
        the date of acquisition.
 
 The
        purchase price, including acquisition-related costs, was allocated based
        on the
        estimated fair value of acquired net assets at the date of acquisition as
        follows:
 
 Assets
                  acquiredCurrent
                  assets
              
              $
              5,135Property,
                  plant and equipment
              
              
              3,115Core
                  technology
              
              
              8,709Current
                  liabilities assumed
              
              
              (2,826
              )Loans
                  assumed
              
              
              (402
              )Net
                  identifiable assets acquired
              
              
              13,731Goodwill
              
              
              5,107Purchase
                  price, net of cash acquired
              
              $
              18,838
 
 Acquired
        core technology is amortized on a straight-line basis over its estimated
        useful
        life of five years.
 
 This
        business, including acquired goodwill, reports to the Telecom Division. Acquired
        goodwill is deductible for tax purposes.
 
 F-12
 Table
            of Contents
  **EXFO
          Electro-Optical Engineering Inc.**
 **Notes
          to Consolidated Financial Statements**
 
 (tabular
          amounts in thousands of US dollars, except share and per share data and
          as
          otherwise noted)
 **4**  **Special
        Charges**
 
 **Impairment
        of long-lived assets**
 
 *Fiscal
        2004*
 
 In
        fiscal
        2004, the company put one of its buildings (located in Quebec City) up for
        sale
        and received, at the beginning of fiscal 2005, a formal purchase offer for
        this
        building. Based on that offer, the company concluded that the building was
        impaired and it recorded an impairment loss of $620,000 in fiscal 2004,
        representing the excess of the carrying value of the building over its expected
        selling price. However, during the first quarter of fiscal 2005, some conditions
        of the formal purchase offer were not met and the offer was declined. During
        fiscal 2005, the company withdrew the building from the market and continued
        to
        use it. This building reported to the Telecom Division.
 
 *Fiscal
        2006*
 
 In
        June
        2006, the company entered into an agreement to sell its building (located
        in
        Rochester, NY) along with some equipment and it recorded an impairment charge
        of
        $604,000 in the third quarter of fiscal 2006, representing the excess of
        the
        carrying value of these assets over the net expected selling price of
        $1,200,000. The sale of these assets was finalized in the fourth quarter
        of 2006
        for the net expected selling price. This amount is included in the other
        receivables in the balance sheet as at August 31, 2006, and it will be recovered
        in the first quarter of fiscal 2007. These assets report to the Life Science
        and
        Industrial Division.
 
 **Restructuring
        and other charges**
 
 *Fiscal
        2004 and 2005*
 
 During
        fiscal 2004, the company approved a restructuring plan to consolidate the
        operations of its Life Sciences and Industrial Division, transferring its
        Rochester, NY, operations mainly to its facilities in Toronto. This
        consolidation process, which started in August 2004, was completed during
        fiscal
        2005.
 
 Overall,
        for that process, the company incurred $2,515,000 in restructuring and other
        charges, from which $2,033,000 was recorded in fiscal 2004 and the remaining
        $482,000 was recorded in 2005. The overall costs, which were recorded in
        the
        restructuring and other charges in the statements of earnings of the
        corresponding years, are detailed as follows: $855,000 for severance expenses
        for the layoff of all employees at the Rochester facilities, $1,261,000 mainly
        for the impairment of the building in Rochester and the remaining $399,000
        for
        other expenses such as training and recruiting expenses and transfer of
        assets.
 
 Finally,
        in fiscal 2005 and 2004, the company recorded adjustments of $190,000 and
        $304,000, respectively to the fiscal 2003 and 2001 plans because actual charges,
        mainly for leased equipment, were lower than expected.
 
 
 F-13
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 The
        following tables summarize changes in the restructuring charges payable since
        August 31, 2003:
 
 **Year
        ended August 31, 2006**


**Balance
                    as at**
                  **August
                    31,**
                  **2005**
                
                **Additions**
                
                **Payments**
                
                **Adjustments**
                
                **Balance
                    as at**
                  **August
                    31,**
                  **2006***Fiscal
                    2006 plan (note 3)*Severance
                    expenses
                
                $
                −
                
                $
                660
                
                $
                (29
                )
                $
                −
                
                $
                631*Fiscal
                    2003 plan*Exited
                    leased facilities
                
                
                150
                
                
                −
                
                
                (90
                )
                
                −
                
                
                60Total
                    for all plans (note 9)
                
                $
                150
                
                $
                660
                
                $
                (119
                )
                $
                −
                
                $
                691
  **Year
          ended August 31, 2005**
  **Balance
                    as at**
                  **August
                    31,**
                  **2004**
                
                **Additions**
                
                **Payments**
                
                **Adjustments**
                
                **Balance
                    as at**
                  **August
                    31,**
                  **2005***Fiscal
                    2004 plan*Severance
                    expenses
                
                $
                467
                
                $
                83
                
                $
                (550
                )
                $
                −
                
                $
                −Other
                
                $
                −
                
                $
                399
                
                $
                (399
                )
                $
                −
                
                $
                −467
                
                
                482
                
                
                (949
                )
                
                −
                
                
                −*Fiscal
                    2003 plan*Severance
                    expenses
                
                
                109
                
                
                −
                
                
                (77
                )
                
                (32
                )
                
                −Exited
                    leased facilities
                
                
                386
                
                
                −
                
                
                (229
                )
                
                (7
                )
                
                150Other
                
                
                197
                
                
                −
                
                
                (46
                )
                
                (151
                )
                
                −692
                
                
                −
                
                
                (352
                )
                
                (190
                )
                
                150*Fiscal
                    2001 plan*Exited
                    leased facilities
                
                
                10
                
                
                −
                
                
                (10
                )
                
                −
                
                
                −Total
                    for all plans (note 9)
                
                $
                1,169
                
                $
                482
                
                $
                (1,311
                )
                $
                (190
                )
                $
                150
    F-14
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **Year
        ended August 31, 2004**
 
 **Balance
                  as at**
                **August
                  31,**
                **2003**
              
              **Additions**
              
              **Payments**
              
              **Adjustments**
              
              **Balance
                  as at**
                **August
                  31,**
                **2004***Fiscal
                  2004 plan*Severance
                  expenses
              
              $
              −
              
              $
              772
              
              $
              (305
              )
              $
              −
              
              $
              467*Fiscal
                  2003 plan*Severance
                  expenses
              
              
              1,233
              
              
              −
              
              
              (870
              )
              
              (254
              )
              
              109Exited
                  leased facilities
              
              
              748
              
              
              −
              
              
              (362
              )
              
              −
              
              
              386Other
              
              
              295
              
              
              −
              
              
              (90
              )
              
              (8
              )
              
              1972,276
              
              
              −
              
              
              (1,322
              )
              
              (262
              )
              
              692*Fiscal
                  2002 plans*Other
              
              
              68
              
              
              −
              
              
              (68
              )
              
              −
              
              
              −*Fiscal
                  2001 plan*Exited
                  leased facilities
              
              
              124
              
              
              −
              
              
              (72
              )
              
              (42
              )
              
              10Total
                  for all plans
              
              $
              2,468
              
              $
              772
              
              $
              (1,767
              )
              $
              (304
              )
              $
              1,169
 
 
 **5**  **Inventories**
 
 **As
                  at August 31,****2006**
              
              
              **2005**Raw
                  materials
              
              $
              14,353
              
              $
              9,373Work
                  in progress
              
              
              1,043
              
              
              934Finished
                  goods
              
              
              9,227
              
              
              7,442$
              24,623
              
              $
              17,749
  
 F-15
 Table
            of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **6**  **Property,
        Plant and Equipment**
 
 **As
                  at August 31,****2006**
              
              **2005****Cost**
              
              
              **Accumulated**
                **amortization**
              
              
              **Cost**
              
              
              **Accumulated**
                **amortization**Land
                  and land improvements
              
              $
              4,249
              
              $
              1,082
              
              $
              3,179
              
              $
              815Buildings
              
              
              14,417
              
              
              6,262
              
              
              9,206
              
              
              2,250Equipment
              
              
              33,562
              
              
              28,263
              
              
              33,216
              
              
              29,553Leasehold
                  improvements
              
              
              2,788
              
              
              2,017
              
              
              2,395
              
              
              1,65955,016
              
              $
              37,624
              
              
              47,996
              
              $
              34,277Less:Accumulated
                  amortization
              
              
              37,624
              
              
              
              
              
              34,277$
              17,392
              
              
              
              
              $
              13,719
 
 As
        at
        August 31, 2005 and 2006, unpaid purchases of property, plant and equipment
        amounted to $111,000 and $176,000, respectively.
 
 
 **7**  **Intangible
        Assets and Goodwill**
 
 **As
                  at August 31,****2006**
              
              **2005****Cost**
              
              
              **Accumulated**
                **amortization**
              
              
              **Cost**
              
              
              **Accumulated**
                **amortization**Core
                  technology
              
              $
              47,629
              
              $
              38,972
              
              $
              35,554
              
              $
              32,214Software
              
              
              6,781
              
              
              4,490
              
              
              6,607
              
              
              4,34554,410
              
              $
              43,462
              
              
              42,161
              
              $
              36,559Less:Accumulated
                  amortization
              
              
              43,462
              
              
              
              
              
              36,559$
              10,948
              
              
              
              
              $
              5,602
 
 
 F-16
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 Amortization
        expenses for intangible assets in each of the next five fiscal years will
        amount
        to $2,877,000 in 2007, $2,337,000 in 2008, $2,252,000 in 2009, $2,200,000
        in
        2010 and $1,099,000 in 2011.
 
 Changes
        in the carrying value of goodwill are as follows:
 
 **As
                  at August 31,****2006**
              
              
              **2005**Balance
                  - Beginning of year
              
              $
              20,370
              
              $
              18,393Addition
                  from business combination (note 3)
              
              
              5,107
              
              
              −Foreign
                  currency translation adjustment
              
              
              1,665
              
              
              1,977Balance
                  - End of year (note 19)
              
              $
              27,142
              
              $
              20,370
 
 
 **8**  **Credit
        Facilities**
 
 The
        company has a line of credit that provides for advances of up to CA$10,000,000
        (US$9,037,000). This line of credit bears interest at prime rate (prime rate
        in
        2005). As at August 31, 2006, this line of credit was unused.
 
 The
        company also has another line of credit, which provides for advances of up
        to
        CA$4,500,000 (US$4,067,000) for letters of guarantee. As at August 31, 2006,
        an
        amount of CA$2,073,000 (US$1,873,000) was reserved from this line of credit
        (note 12).
 
 Finally,
        the company has a third line of credit of $12,000,000 for the foreign currency
        exposure related to its forward exchange contracts. As at August 31, 2006,
        an
        amount of $751,000 was reserved from this line of credit.
 
 These
        lines of credit are renewable annually. Short-term investments, accounts
        receivable, inventories and all tangible and intangible assets of the company
        are pledged as collateral against these lines of credit.
 
 
 **9**  **Accounts
        Payable and Accrued Liabilities**
 
 **As
                  at August 31,****2006**
              
              
              **2005**Trade
              
              $
              7,487
              
              $
              5,781Salaries
                  and social benefits
              
              
              5,991
              
              
              4,526Warranty
              
              
              1,006
              
              
              725Commissions
              
              
              835
              
              
              211Restructuring
                  charges (note 4)
              
              
              691
              
              
              150Business
                  combination (note 3)
              
              
              185
              
              
              −Other
              
              
              1,142
              
              
              808$
              17,337
              
              $
              12,201
 
 
 F-17
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 Changes
        in the warranty provision are as follows:
 
 **As
                  at August 31,****2006**
              
              
              **2005**Balance
                  - Beginning of year
              
              $
              725
              
              $
              390Provision
              
              
              895
              
              
              869Settlements
              
              
              (708
              )
              
              (583
              )Addition
                  from business combination
              
              
              31
              
              
              −Foreign
                  currency translation adjustment
              
              
              63
              
              
              49Balance
                  - End of year
              
              $
              1,006
              
              $
              725
 
 **10**  **Long-Term
        Debt**
 
 **As
                  at August 31,****2006**
              
              
              **2005**Loans
                  collateralized by equipment, bearing interest at 4.9%, repayable
                  in
                  monthly installments of $10,600 including principal and interest,
                  maturing
                  in 2010
              
              $
              461
              
              $
              −Loans
                  collateralized by equipment, bearing interest at 9.6%, fully repaid
                  in
                  fiscal 2006
              
              
              −
              
              
              332461
              
              
              332Less:
                  Current portion
              
              
              107
              
              
              134$
              354
              
              $
              198
 
 As
        at
        August 31, 2006, minimum principal repayments required in each of the next
        four years will amount to $107,000 in 2007, $113,000 in 2008, $118,000 in
        2009
        and $123,000 in 2010.
 
 
 **11**  **Commitments**
 
 The
        company entered into operating leases for certain of its premises and equipment,
        which expire at various dates through September 2013. As at August 31, 2006,
        minimum rentals payable under these operating leases in each of the next
        five
        years will amount to $1,748,000 in 2007, $1,223,000 in 2008, $1,177,000 in
        2009,
        $1,200,000 in 2010 and $990,000 in 2011 for total commitments of
        $6,888,000.
 
 For
        the
        years ended August 31, 2004, 2005 and 2006, rental expenses amounted to
        $1,219,000, $1,370,000 and $1,523,000, respectively.
  F-18
 Table
            of Contents
  **EXFO
          Electro-Optical Engineering Inc.**
 **Notes
          to Consolidated Financial Statements**
 
 (tabular
          amounts in thousands of US dollars, except share and per share data and
          as
          otherwise noted)
 **12**  **Contingencies**
 
 *Class
        action*
 
 On
        November 27, 2001, a class action suit was filed in the United States District
        Court for the Southern District of New York against the company, four of
        the
        underwriters of its Initial Public Offering and some of its executive officers
        pursuant to the Securities Exchange Act of 1934 and Rule 10b-5 promulgated
        thereunder and Sections 11, 12 and 16 of the Securities Act of 1933. This
        class
        action alleges that the company’s registration statement and prospectus filed
        with the Securities and Exchange Commission on June 29, 2000, contained material
        misrepresentations and/or omissions resulting from (i) the underwriters
        allegedly soliciting and receiving additional, excessive and undisclosed
        commissions from certain investors in exchange for which they allocated material
        portions of the shares issued in connection with the company’s Initial Public
        Offering; and (ii) the underwriters allegedly entering into agreements with
        customers whereby shares issued in connection with the company’s Initial Public
        Offering would be allocated to those customers in exchange for which customers
        agreed to purchase additional amounts of shares in the after-market at
        pre-determined prices.
 
 On
        April
        19, 2002, the plaintiffs filed an amended complaint containing master
        allegations against all of the underwriters in all of the 310 cases included
        in
        this class action and also filed an amended complaint containing allegations
        specific to four of the company’s underwriters, the company and two of its
        executive officers. In addition to the allegations mentioned above, the amended
        complaint alleges that the underwriters (i) used their analysts to manipulate
        the stock market; and (ii) implemented schemes that allowed issuer insiders
        to sell their shares rapidly after an initial public offering and benefit
        from
        high market prices. As concerns the company and its two executive officers
        in
        particular, the amended complaint alleges that (i) the company’s registration
        statement was materially false and misleading because it failed to disclose
        the
        additional commissions and compensation to be received by underwriters; (ii)
        the
        two named executive officers learned of or recklessly disregarded the alleged
        misconduct of the underwriters; (iii) the two named executive officers had
        motive and opportunity to engage in alleged wrongful conduct due to personal
        holdings of the company’s stock and the fact that an alleged artificially
        inflated stock price could be used as currency for acquisitions; and (iv)
        the
        two named executive officers, by virtue of their positions with the company,
        controlled the company and the contents of the registration statement and
        had
        the ability to prevent its issuance or cause it to be corrected. The plaintiffs
        in this suit seek an unspecified amount for damages suffered.
 
 In
        July
        2002, the issuers filed a motion to dismiss the plaintiffs’ amended complaint
        and a decision was rendered on February 19, 2003. Only one of the claims
        against
        the company was dismissed. On October 8, 2002, the claims against its
        officers were dismissed pursuant to the terms of Reservation of Rights and
        Tolling Agreements entered into with the plaintiffs.
 
 
 F-19
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 In
        June
        2003, a committee of the company’s Board of Directors conditionally approved a
        proposed settlement between the issuer defendants, the individual defendants,
        and the plaintiffs. If approved, the settlement would provide, among other
        things, a release of the company and of the individual defendants for the
        conduct alleged in the action to be wrongful in the amended complaint. The
        company would agree to undertake other responsibilities under the settlement,
        including agreeing to assign away, not assert, or release certain potential
        claims the company may have against its underwriters.
 
 On
        June 25, 2004, the Plaintiffs moved for preliminary approval of the
        settlement. The court granted the preliminary approval motion on February
        15,
        2005, subject to certain modifications.  On August 31, 2005, the court
        issued a preliminary order further approving the modifications to the settlement
        and certifying the settlement classes.  The court also appointed the Notice
        Administrator for the settlement and ordered that notice of the settlement
        be
        distributed to all settlement class members beginning on November 15,
        2005.  A settlement fairness hearing was held on April 24, 2006; however,
        no ruling has been issued yet by the court. If the court determines that
        the
        settlement is fair to the class members, the settlement will be
        approved. **** The
        settlement provides that, if the plaintiffs do not obtain any
        recovery from the underwriter defendants, the members of the class
        action would receive an amount not expected to exceed $2,507,678. Any direct
        financial impact plus any legal fees are expected to be borne by the company’s
        insurance carriers. However, there can be no assurance that this proposed
        settlement would be approved and implemented in its current form, or at
        all.  Therefore, it is not possible to predict the final outcome of the
        case, nor to determine the amount of any possible losses. If the settlement
        process fails, the company will continue to defend its position in this
        litigation that the claims against it, and its officers, are without merit.
        Accordingly, no provision for this case has been made in the consolidated
        financial statements as at August 31, 2006.
 
 *Letters
        of guarantee*
 
 As
        at
        August 31, 2006, in the normal course of its operations, the company had
        outstanding letters of guarantee of CA$2,073,000 (US$1,873,000), which expire
        at
        various dates through fiscal 2010 and that were reserved from one of the
        lines
        of credit (note 8) .
 
 
 **13**  **Share
        Capital**
 
 Authorized -
        unlimited as to number, without par value
 Subordinate
        voting and participating, bearing a non-cumulative dividend to be determined
        by
        the Board of Directors, ranking pari passu with multiple voting
        shares
 Multiple
        voting and participating, entitling to ten votes each, bearing a non-cumulative
        dividend to be determined by the Board of Directors, convertible at the holder’s
        option into subordinate voting shares on a one-for-one basis, ranking pari
        passu
        with subordinate voting shares
 
 
 F-20
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 The
          following table summarizes the share capital activity since August 31,
          2003:
 
 **Multiple
                    voting shares**
                
                **Subordinate
                    voting shares****Number**
                
                **Amount**
                
                **Number**
                
                **Amount**
                
                **Total
                    amount**Balance
                    as at August 31, 2003
                
                
                37,900,000
                
                $
                1
                
                
                25,139,908
                
                $
                492,451
                
                $
                492,452Public
                    offering(1)
                
                
                −
                
                
                −
                
                
                5,200,000
                
                
                29,164
                
                
                29,164Exercise
                    of stock options (note 14)
                
                
                −
                
                
                −
                
                
                111,071
                
                
                254
                
                
                254Exercise
                    of restricted stock awards (note 14)
                
                
                −
                
                
                −
                
                
                89,504
                
                
                −
                
                
                −Redemption
                
                
                −
                
                
                −
                
                
                (5,340
                )
                
                (5
                )
                
                (5
                )Resale
                
                
                −
                
                
                −
                
                
                5,340
                
                
                5
                
                
                5Share
                    issue expenses
                
                
                −
                
                
                −
                
                
                −
                
                
                (137
                )
                
                (137
                )Balance
                    as at August 31, 2004
                
                
                37,900,000
                
                
                1
                
                
                30,540,483
                
                
                521,732
                
                
                521,733Exercise
                    of stock options (note 14)
                
                
                −
                
                
                −
                
                
                71,699
                
                
                148
                
                
                148Exercise
                    of restricted stock awards (note 14)
                
                
                −
                
                
                −
                
                
                53,592
                
                
                −
                
                
                −Share
                    issue expenses
                
                
                −
                
                
                −
                
                
                −
                
                
                (6
                )
                
                (6
                )Balance
                    as at August 31, 2005
                
                
                37,900,000
                
                
                1
                
                
                30,665,774
                
                
                521,874
                
                
                521,875Exercise
                    of stock options (note 14)
                
                
                −
                
                
                −
                
                
                182,425
                
                
                557
                
                
                557Exercise
                    of restricted share units (note 14)
                
                
                −
                
                
                −
                
                
                4,770
                
                
                −
                
                
                −Conversion
                    of multiple voting shares into subordinate voting shares
                
                
                (757,000
                )
                
                −
                
                
                757,000
                
                
                −
                
                
                −Reclassification
                    of stock-based compensation cost to share capital upon exercise
                    of stock
                    awards
                
                
                −
                
                
                −
                
                
                −
                
                
                200
                
                
                200Elimination
                    of deficit by reduction of share capital(2)
                
                
                −
                
                
                −
                
                
                −
                
                
                (373,711
                )
                
                (373,711
                )Balance
                    as at August 31, 2006
                
                
                37,143,000
                
                $
                1
                
                
                31,609,969
                
                $
                148,920
                
                $
                148,921
 
 (1)
              On
                  February 12, 2004, pursuant to a Canadian public offering, the
                  company
                  issued 5,200,000 subordinate voting shares for net proceeds of
                  $29,164,000
                  (CA$38,438,400), after deduction of underwriting commission of
                  $1,215,000
                  (CA$1,601,000). (2)
              Upon
                  the approval of the Board of Directors dated August 31, 2006, the
                  company
                  eliminated its deficit against its share
                  capital.   F-21
 Table
              of Contents
 **EXFO
              Electro-Optical Engineering Inc.**
 **Notes
              to Consolidated Financial Statements**
 
 (tabular
              amounts in thousands of US dollars, except share and per share data and as
              otherwise noted)
 **14**  **Stock-Based
        Compensation Plans**
 
 The
        maximum number of additional subordinate voting shares issuable under the
        Long-Term Incentive Plan and the Deferred Share Unit Plan cannot exceed
        6,306,153 shares. The maximum number of subordinate voting shares that may
        be
        granted to any individual on an annual basis cannot exceed 5% of the number
        of
        outstanding subordinate voting shares.
 
 **Long-term
        incentive plan**
 
 In
        May
        2000, the company established a Stock Option Plan for directors, executive
        officers and employees and those of the company’s subsidiaries, as determined by
        the Board of Directors. In January 2005, the company made certain amendments
        to
        the existing Stock Option Plan, including the renaming of the plan to Long-Term
        Incentive Plan, which includes stock options and restricted share
        units.
 
 *Stock
        Options*
 
 The
        exercise price of stock options granted under the Long-Term Incentive Plan
        is
        the market price of the common shares on the date of grant. Stock options
        granted under the plan generally expire ten years from the date of grant
        and
        generally vest over a four-year period, with 25% vesting on an annual basis
        commencing on the first anniversary of the date of grant. The Board of Directors
        may accelerate the vesting of any or all outstanding stock options upon the
        occurrence of a change of control.
 
 The
        following table summarizes stock option activity since August 31,
        2003:
  **Years
                    ended August 31,****2006**
                
                **2005**
                
                **2004****Number**
                
                **Weighted
                    average exercise price**
                
                **Number**
                
                **Weighted
                    average exercise price**
                
                **Number**
                
                **Weighted
                    average exercise price****(CA$)**
                
                
                
                **(CA$)**
                
                
                
                **(CA$)**Outstanding
                    - Beginning of year
                
                
                2,763,759
                
                $
                19
                
                
                2,934,518
                
                $
                21
                
                
                3,176,613
                
                $
                23Granted
                
                
                31,992
                
                
                6
                
                
                246,233
                
                
                6
                
                
                536,500
                
                
                5Exercised
                
                
                (182,425
                )
                
                (4
                )
                
                (71,699
                )
                
                (3
                )
                
                (111,071
                )
                
                (3
                )Forfeited
                
                
                (173,951
                )
                
                (18
                )
                
                (345,293
                )
                
                (27
                )
                
                (667,524
                )
                
                (23
                )Outstanding
                    - End of year
                
                
                2,439,375
                
                $
                20
                
                
                2,763,759
                
                $
                19
                
                
                2,934,518
                
                $
                21Exercisable
                    - End of year
                
                
                1,852,870
                
                $
                25
                
                
                1,650,404
                
                $
                28
                
                
                1,331,707
                
                $
                32
   The
        intrinsic value of stock options exercised during the year ended August 31,
        2006, was CA$552,000.
 
 The
        weighted average grant-date fair value of stock options granted during fiscal
        2004, 2005 and 2006 amounted to $2.73, $3.51 and $4.76, respectively.
 
 
 F-22
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 The
          fair
          value of stock awards granted in fiscal 2004, 2005 and 2006 was estimated
          using
          the Black-Scholes options valuation model with the following weighted average
          assumptions:
 
 **Years
                    ended August 31,****2006**
                
                **2005**
                
                **2004**Risk-free
                    interest rate
                
                3.9%
                
                3.6%
                
                2.7%Expected
                    volatility (based on historical volatility)
                
                87%
                
                95%
                
                100%Dividend
                    yield
                
                Nil
                
                Nil
                
                NilExpected
                    life
                
                66
                    months
                
                66
                    months
                
                49
                    months
 
 The
          company is required to make pro forma disclosures of net earnings (loss)
          and net
          earnings (loss) per share for any periods included in the financial statements,
          as if the fair value-based method of accounting had been applied to outstanding
          unvested awards granted prior to September 1, 2003. Consequently, if
          the fair value-based method had been applied to unvested stock options
          granted
          prior to September 1, 2003, and outstanding as at August 31, 2004,
          2005 and 2006, the net earning (loss) per share and the pro forma net earning
          (loss) per share would have been the same for all reporting years.
 
 The
          following table summarizes information about stock options as at August
          31,
          2006:
 
 **Stock
                    options outstanding**
                
                **Stock
                    options exercisable****Exercise
                    price**
                
                
                **Number**
                
                
                **Weighted**
                  **average**
                  **exercise****price**
                
                
                **Aggregate
                    intrinsic value**
                
                
                **Weighted****average****remaining****contractual
                    life**
                
                
                **Number**
                
                
                **Weighted**
                  **average**
                  **exercise****price**
                
                
                **Aggregate
                    intrinsic value****(CA$)**
                
                
                
                
                
                **(CA$**
                **)**
                
                **(CA$**
                **)**
                
                
                
                
                
                
                
                **(CA$**
                **)**
                
                **(CA$**
                **)**$2.50
                    to $3.36
                
                
                419,655
                
                $
                2.50
                
                $
                1,402
                
                
                6.1
                    years
                
                
                273,313
                
                $
                2.50
                
                $
                913$3.96
                    to $5.84
                
                
                547,687
                
                
                5.07
                
                
                422
                
                
                7.6
                    years
                
                
                206,464
                
                
                4.92
                
                
                190$6.22
                    to $9.02
                
                
                193,200
                
                
                6.52
                
                
                −
                
                
                7.4
                    years
                
                
                94,260
                
                
                6.82
                
                
                −$14.27
                    to $20.00
                
                
                476,396
                
                
                15.78
                
                
                −
                
                
                5.2
                    years
                
                
                476,396
                
                
                15.78
                
                
                −$29.70
                    to $43.00
                
                
                564,436
                
                
                36.27
                
                
                −
                
                
                4.2
                    years
                
                
                564,436
                
                
                36.27
                
                
                −$51.25
                    to $68.17
                
                
                199,771
                
                
                65.76
                
                
                −
                
                
                4.0
                    years
                
                
                199,771
                
                
                65.76
                
                
                −$83.66
                
                
                38,230
                
                
                83.66
                
                
                −
                
                
                4.0
                    years
                
                
                38,230
                
                
                83.66
                
                
                −2,439,375
                
                $
                20.26
                
                $
                1,824
                
                
                5.7
                    years
                
                
                1,852,870
                
                $
                25.19
                
                $
                1,103
 
 *Restricted
          Share Units (RSUs)*
 
 RSUs
          are
“phantom” shares that rise and fall in value based on the value of the company’s
          subordinate voting shares and are redeemable for actual subordinate voting
          shares or cash at the discretion of the Board of Directors on the vesting
          dates
          established by the Board of Directors at the time of grant. The vesting
          dates
          are subject to a minimum term of three years and a maximum term of ten
          years
          from the award date. RSUs granted under the plan expire at the latest ten
          years
          from the date of grant.
 
 F-23
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 The
        following table summarizes RSUs activity since January 2005:
 
 **Years
                  ended August 31,****2006**
              
              
              **2005**Outstanding
                  - Beginning of year
              
              
              176,185
              
              
              −Granted
              
              
              173,803
              
              
              176,185Exercised
              
              
              (4,770
              )
              
              −Forfeited
              
              
              (17,341
              )
              
              −Outstanding
                  - End of year
              
              
              327,877
              
              
              176,185
 
 None
        of
        the RSUs outstanding as at August 31, 2005 and 2006 were redeemable. As at
        August 31, 2006, the weighted average remaining contractual life of
        the outstanding RSUs was 8.9 years. The weighted average grant-date fair
        value of RSUs granted during fiscal 2005 and 2006 amounted to $4.68 and $5.39,
        respectively.
 
 **Deferred
        share unit plan**
 
 In
        January 2005, the company established a Deferred Share Unit (DSU) Plan for
        the
        members of the Board of Directors as part of their annual retainer fees.
        Each
        DSU entitles the Board members to receive one subordinate voting share. DSUs
        are
        acquired on the date of grant and will be redeemed in subordinate voting
        shares
        when the Board member will cease to be Director of the company.
 
 The
        following table summarizes DSU activity since January 2005:
 
 **Years
                  ended August 31,****2006**
              
              
              **2005**Outstanding
                  - Beginning of year
              
              
              23,734
              
              
              −Granted
              
              
              19,556
              
              
              23,734Outstanding
                  - End of year
              
              
              43,290
              
              
              23,734
 
 None
        of
        the DSUs outstanding as at August 31, 2005 and 2006 were redeemable. The
        weighted average grant-date fair value of DSUs granted during fiscal 2005
        and
        2006 amounted to $4.47 and $5.81.
 
 **Stock
        appreciation rights plan**
 
 In
        August
        2001, the company established the Stock Appreciation Rights Plan for certain
        employees. Under that plan, eligible employees are entitled to receive a
        cash
        amount equivalent to the difference between the market price of the common
        shares on the date of exercise and the exercise price determined on the date
        of
        grant. Stock appreciation rights granted under the plan generally expire
        ten
        years from the date of grant and vest over a four-year period, with 25% vesting
        on an annual basis commencing on the first anniversary of the date of
        grant.
 
 F-24
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 The
        following table summarizes stock appreciation rights activity since August
        31,
        2003:
 
 **Years
                  ended August 31,****2006**
              
              **2005**
              
              **2004**Number
              
              
              **Weighted****average****exercise****price**
              
              
              **Number**
              
              
              **Weighted****average****exercise****price**
              
              
              **Number**
              
              
              **Weighted****average****exercise****price**Outstanding
                  - Beginning of year
              
              
              19,000
              
              $
              12
              
              
              13,000
              
              $
              16
              
              
              9,000
              
              $
              24Granted
              
              
              5,500
              
              
              6
              
              
              6,000
              
              
              4
              
              
              6,000
              
              
              5Forfeited
              
              
              −
              
              
              −
              
              
              −
              
              
              −
              
              
              (2,000
              )
              
              (19
              )Outstanding
                  - End of year
              
              
              24,500
              
              $
              11
              
              
              19,000
              
              $
              12
              
              
              13,000
              
              $
              16Exercisable
                  - End of year
              
              
              11,000
              
              $
              18
              
              
              7,500
              
              $
              24
              
              
              4,250
              
              $
              30
 
 The
        following table summarizes information about stock appreciation rights as
        at
        August 31, 2006:
 
 **Stock
                  appreciation**
                **rights
                  outstanding**
              
              **Stock
                  appreciation rights exercisable****Exercise
                  price**
              
              
              **Number**
              
              
              **Weighted
                  average remaining contractual life**
              
              
              **Number**$2.21
              
              
              2,000
              
              
              6.6
                  years
              
              
              1,500$4.51
                  to $6.50
              
              
              17,500
              
              
              8.4
                  years
              
              
              4,500$22.25
              
              
              2,500
              
              
              4.4
                  years
              
              
              2,500$45.94
              
              
              2,500
              
              
              4.0
                  years
              
              
              2,50024,500
              
              
              7.4
                  years
              
              
              11,000
 
 **Restricted
        stock award plan**
 
 In
        December 2000, the company established a Restricted Stock Award Plan for
        employees of EXFO Burleigh. This plan expired in December 2004. Each stock
        award
        entitled employees to receive one subordinate voting share at a purchase
        price
        of nil. Stock awards granted under the plan vested over a four-year period,
        with
        25% vesting on an annual basis commencing on the first anniversary of the
        date
        of grant. According to the plan, upon the involuntary termination of a member
        of
        the defined management team, all outstanding restricted stock awards granted
        to
        such an employee automatically vested.
 
 
 F-25
 Table
              of Contents
  **EXFO
          Electro-Optical Engineering Inc.**
 **Notes
          to Consolidated Financial Statements**
 
 (tabular
          amounts in thousands of US dollars, except share and per share data and
          as
          otherwise noted)
 The
        following table summarizes restricted stock awards activity since August
        31,
        2003:
 
 **Years
                  ended August 31,****2005**
              
              
              **2004**Outstanding
                  - Beginning of year
              
              
              53,592
              
              
              143,096Exercised
              
              
              (53,592
              )
              
              (89,504
              )Outstanding
                  - End of year
              
              
              −
              
              
              53,592
 
 
 **15**  **Other
        Disclosures**
 
 **Net
        research and development expenses**
 
 Net
        research and development expenses comprise the following:
 
 **Years
                  ended August 31,****2006**
              
              
              **2005**
              
              
              **2004**Gross
                  research and development expenses
              
              $
              19,488
              
              $
              15,878
              
              $
              15,668Research
                  and development tax credits and grants
              
              
              (4,084
              )
              
              (3,688
              )
              
              (3,278
              )$
              15,404
              
              $
              12,190
              
              $
              12,390
 
 **Government
        grants**
 
 During
        1998, the company entered into an agreement with the Quebec Minister of
        Industry, Commerce, Science and Technology (“The Minister”). Pursuant to this
        agreement, the Minister agreed to contribute, in the form of grants, up to
        CA$2,220,000 (US$1,995,000) over the period from January 1, 1998, through
        December 31, 2002, payable based on the number of full-time jobs created
        during
        that period.
 
 Since
        the
        beginning of the program, the company has claimed and received the maximum
        amount of CA$2,220,000. However, these grants were subject to the condition
        that
        jobs created pursuant to the agreement be maintained for a period of at least
        five years from the date of creation. Since the beginning of the program,
        the
        company deferred in the balance sheet CA$1,450,000 (US$1,307,000) from the
        amounts received until it received the final approval by the sponsor of the
        program related to jobs created. In fiscal 2006, the sponsor of the program
        granted the company with its final approval and the company recorded a
        non-recurring revenue of CA$1,450,000 (US$1,307,000) in the earnings from
        operations in the statement of earnings of fiscal 2006.
 
 
 F-26
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 Furthermore,
        since 2000, companies operating in the Quebec City area are eligible for
        a
        refundable credit granted by the Quebec provincial government. This credit
        is
        earned based on the increase of eligible production and marketing salaries
        incurred in the Quebec City area at a rate of 40%. From the total amount
        received by the company so far under this program, CA$774,000 (US$700,000)
        was
        deferred and was included in government grants in the balance sheet. This
        amount
        will be recognized in the statement of earnings upon the final approval of
        eligible salaries by the sponsor of the program. Should repayments of any
        amounts received pursuant to this program be required, such repayments, less
        related deferred revenue, will be charged to earnings as the amount of any
        repayment becomes known.
 
 Following
        is a summary of the classification of these and certain other grants and
        credits
        (government grants) in the statements of earnings of the reporting
        years.
 
 Cost
        of
        sales for the years ended August 31, 2004, 2005 and 2006, is net of government
        grants of $3,000, $89,000 and $262,000, respectively.
 
 Selling
        and administrative expenses for the years ended August 31, 2004, 2005 and
        2006,
        are net of government grants of $5,000, $32,000 and $76,000,
        respectively.
 
 Research
        and development expenses for the years ended August 31, 2004, 2005 and 2006,
        are
        net of government grants of $80,000, $22,000 and $4,000,
        respectively.
 
 **Defined
        contribution plans**
 
 The
        company maintains separate defined contribution plans for certain eligible
        employees. These plans, which are accounted for on an accrual basis, are
        summarized as follows:
 
 ·
              Deferred
                  profit-sharing plan
 
 The
        company maintains a plan for certain eligible Canadian resident employees,
        under
        which the company may elect to contribute an amount equal to 2% (1% prior
        to
        June 2005) of an employee’s gross salary, provided that the employee has
        contributed at least 2% of his/her gross salary to a tax-deferred registered
        retirement savings plan. Cash contributions to this plan and expenses for
        the
        years ended August 31, 2004, 2005 and 2006, amounted to CA$141,000 (US$106,000),
        CA$221,000 (US$179,000) and CA$363,000 (US$316,000), respectively.
 
 ·
              401K
                  plan
 
 The
        company maintains a 401K plan for eligible U.S. resident employees. Under
        this
        plan, the company must contribute an amount equal to 3% of an employee’s current
        compensation. During the years ended August 31, 2004, 2005 and 2006, the
        company
        recorded cash contributions and expenses totaling $187,000, $134,000 and
        $126,000, respectively.
  F-27
 Table
            of Contents
  **EXFO
          Electro-Optical Engineering Inc.**
 **Notes
          to Consolidated Financial Statements**
 
 (tabular
          amounts in thousands of US dollars, except share and per share data and
          as
          otherwise noted)
 **16**  **Income
        Taxes**
 
 The
        reconciliation of the income tax provision calculated using the combined
        Canadian federal and provincial statutory income tax rate with the income
        tax
        provision in the financial statements is as follows:
 
 **Years
                  ended August 31,****2006**
              
              
              **2005**
              
              
              **20****04**Income
                  tax provision at combined Canadian federal and provincial statutory
                  tax
                  rate (32% in 2006, 31% in 2005 and 32% in 2004)
              
              $
              3,430
              
              $
              307
              
              $
              (3,011
              )Increase
                  (decrease) due to:Foreign
                  income taxed at different rates
              
              
              (85
              )
              
              (580
              )
              
              (767
              )Non-taxable
                  income
              
              
              (207
              )
              
              (827
              )
              
              (128
              )Non-deductible
                  expenses
              
              
              527
              
              
              784
              
              
              1,205Tax
                  deductions
              
              
              −
              
              
              (81
              )
              
              (169
              )Change
                  in enacted rates
              
              
              497
              
              
              −
              
              
              274Effect
                  of consolidation of subsidiaries
              
              
              61
              
              
              (209
              )
              
              (1,384
              )Previous
                  year tax recovery
              
              
              −
              
              
              −
              
              
              (1,406
              )Other
              
              
              239
              
              
              (146
              )
              
              446Change
                  in valuation allowance
              
              
              (1,877
              )
              
              3,375
              
              
              3,954$
              2,585
              
              $
              2,623
              
              $
              (986
              )The
                  income tax provision consists of the following:CurrentCanadian
              
              $
              2,573
              
              $
              2,513
              
              $
              (577
              )Other
              
              
              12
              
              
              110
              
              
              (409
              )2,585
              
              
              2,623
              
              
              (986
              )FutureCanadian
              
              
              2,687
              
              
              (1,445
              )
              
              (1,104
              )United
                  States
              
              
              (601
              )
              
              (1,723
              )
              
              (2,448
              )Other
              
              
              (209
              )
              
              (207
              )
              
              (402
              )1,877
              
              
              (3,375
              )
              
              (3,954
              )Valuation
                  allowanceCanadian
              
              
              (2,687
              )
              
              1,445
              
              
              1,104United
                  States
              
              
              601
              
              
              1,723
              
              
              2,448Other
              
              
              209
              
              
              207
              
              
              402(1,877
              )
              
              3,375
              
              
              3,954$
              2,585
              
              $
              2,623
              
              $
              (986
              )Details
                  of the company’s income taxes:Earnings
                  (loss) before income taxesCanadian
              
              $
              13,202
              
              $
              3,092
              
              $
              (7,740
              )United
                  States
              
              
              (2,103
              )
              
              (953
              )
              
              (5,879
              )Other
              
              
              (379
              )
              
              (1,150
              )
              
              4,209$
              10,720
              
              $
              989
              
              $
              (9,410
              )
 
 Most
        of
        the company’s income tax provision for fiscal 2005 and 2006 represents income
        taxes payable at the Canadian federal level, which are reduced by research
        and
        development tax credits that are recorded against gross research and development
        expenses in the statements of earnings.
 
 F-28
 Table
              of Contents
  **EXFO
          Electro-Optical Engineering Inc.**
 **Notes
          to Consolidated Financial Statements**
 
 (tabular
          amounts in thousands of US dollars, except share and per share data and
          as
          otherwise noted)
 Significant
        components of the company’s future income tax assets and liabilities are as
        follows:
 
 **As
                  at August 31,****2006**
              
              
              **2005**Future
                  income tax assetsLong-lived
                  assets
              
              $
              4,453
              
              $
              4,902Provisions
                  and accruals
              
              
              7,315
              
              
              7,406Government
                  grants
              
              
              −
              
              
              209Deferred
                  revenue
              
              
              486
              
              
              318Share
                  issue expenses
              
              
              531
              
              
              590Research
                  and development expenses
              
              
              8,527
              
              
              7,292Losses
                  carried forward
              
              
              18,118
              
              
              18,42439,430
              
              
              39,141Valuation
                  allowance
              
              
              (38,543
              )
              
              (38,406
              )887
              
              
              735Future
                  income tax liabilitiesResearch
                  and development tax credits
              
              
              (887
              )
              
              (735
              )Future
                  income tax assets, net
              
              $
              −
              
              $
              −
 
 As
        at
        August 31, 2006, the company had available operating losses in several tax
        jurisdictions, against which a full valuation allowance of $18,118,000 was
        recorded. The following table summarizes the year of expiry of these operating
        losses by tax jurisdiction:
  **Canada**
                
                **United
                    States****Year
                    of expiry**
                
                **Federal**
                
                **Provinces**
                
                **and
                    Other**2008
                
                $
                1,252
                
                $
                92
                
                $
                1,8572009
                
                
                5,186
                
                
                394
                
                
                5992010
                
                
                4,677
                
                
                327
                
                
                2662011
                
                
                168
                
                
                86
                
                
                -2013
                
                
                -
                
                
                -
                
                
                8762015
                
                
                1,666
                
                
                1,670
                
                
                -2022
                
                
                -
                
                
                -
                
                
                9,4062023
                
                
                -
                
                
                -
                
                
                11,6212024
                
                
                -
                
                
                -
                
                
                6,7002025
                
                
                -
                
                
                -
                
                
                6,6902026
                
                
                1,694
                
                
                1,696
                
                
                2,737Indefinite
                
                
                1,702
                
                
                1,775
                
                
                1,996$
                16,345
                
                $
                6,040
                
                $
                42,748
  As
        at
        August 31, 2006, in addition to operating losses, the company had available
        research and development expenses in Canada amounting to $33,745,000 at the
        federal level and $15,276,000 at the provincial level, against which a full
        valuation allowance of $8,527,000 was recorded. These expenses can be carried
        forward indefinitely against future years’ taxable income in their respective
        tax jurisdiction.
 
 F-29
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 Finally,
        as at August 31, 2006, the company had available research and development
        tax
        credits at the Canadian federal level in the amount of $3,697,000 that can
        be
        carried forward against future years’ income taxes payable over the next ten
        years. These tax credits were not recorded in the balance sheet as at August
        31,
        2006.
 
 
 **17**  **Earnings
        per Share**
  The
        following table summarizes the reconciliation of the basic weighted average
        number of shares outstanding and the diluted weighted average number of shares
        outstanding:
 
 **Years
                  ended August 31,****200****6**
              
              
              **200****5**
              
              
              **2004**Basic
                  weighted average number of shares
                outstanding
                  (000’s)
              
              
              68,643
              
              
              68,526
              
              
              66,020Plus
                  dilutive effect of:Stock
                  options (000’s)
              
              
              502
              
              
              422
              
              
              502Deferred
                  share units (000’s)
              
              
              31
              
              
              8
              
              
              −Restricted
                  share units (000’s)
              
              
              99
              
              
              8
              
              
              −Restricted
                  stock awards (000’s)
              
              
              −
              
              
              17
              
              
              93Diluted
                  weighted average number of shares outstanding (000’s)
              
              
              69,275
              
              
              68,981
              
              
              66,615Stock
                  awards excluded from the calculation of the diluted weighted average
                  number of shares outstanding because their exercise price was greater
                  than
                  the average market price of the common shares (000’s)
              
              
              1,628
              
              
              1,962
              
              
              2,128
 
 The
        diluted net loss per share for the years ended August 31, 2004 and 2005,
        was the
        same as the basic net loss per share since the dilutive effect of stock options,
        deferred share units, restricted share units and restricted stock awards
        should
        not be included in the calculation; otherwise, the effect would be
        anti-dilutive. Accordingly, diluted net loss per share for those years was
        calculated using the basic weighted average number of shares
        outstanding.
 
 F-30
 Table
            of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **18**  **Financial
        Instruments**
 
 **Short-term
        investments**
 
 Short-term
        investments consist of the following:
 
 **As
                  at August 31,****2006**
              
              
              **2005**Commercial
                  paper denominated in Canadian dollars, bearing interest at annual
                  rates of
                  3.92% to 4.31% in 2006 and 2.44% to 2.75% in 2005, maturing on
                  different
                  dates between September 2006 and January 2007 in fiscal 2006, and
                  September 2005 and January 2006 in fiscal 2005
              
              $
              104,437
              
              $
              104,883
 
 **Fair
        value**
 
 Cash,
        accounts receivable, accounts payable and accrued liabilities as well as
        long-term debt, are financial instruments whose carrying values approximate
        their fair values.
 
 The
        fair
        value of short-term investments, based on market value, amounted to $104,883,000
        and $104,437,000 as at August 31, 2005 and 2006, respectively.
 
 The
        fair
        value of forward exchange contracts, which represents the difference between
        their contractual amounts and their current trading value, amounted to
        unrecognized gains of $2,937,000 and $5,451,000 as at August 31, 2005 and
        2006,
        respectively.
 
 **Credit
        risk**
 
 Financial
        instruments that potentially subject the company to credit risk consist
        primarily of cash, short-term investments, accounts receivable and forward
        exchange contracts. The company’s short-term investments consist of debt
        instruments issued by nine (six in 2005) quality high-credit corporations
        and
        trusts. The company’s cash and forward exchange contracts are held with or
        issued by quality high-credit financial institutions; therefore, the company
        considers the risk of non-performance on these instruments to be
        remote.
 
 Generally,
        the company does not require collateral or other security from customers
        for
        trade accounts receivable; however, credit is extended to customers following
        an
        evaluation of creditworthiness. In addition, the company performs ongoing
        credit
        reviews of all its customers and establishes an allowance for doubtful accounts
        receivable when accounts are determined to be uncollectible. Allowance for
        doubtful accounts amounted to $352,000 and $451,000 as at
        August 31, 2005 and 2006, respectively.
 
 
 F-31
 Table
              of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **Interest
        rate risk**
 
 As
        at
        August 31, 2006, the company’s exposure to interest rate risk is summarized
        as follows:
 
 Cash
              
              Non-interest
                  bearingShort-term
                  investments
              
              As
                  described aboveAccounts
                  receivable
              
              Non-interest
                  bearingAccounts
                  payable and accrued liabilities
              
              Non-interest
                  bearingLong-term
                  debt
              
              As
                  described in note 10
 
 **Forward
        exchange contracts**
 
 The
        company is exposed to currency risks as a result of its export sales of products
        manufactured in Canada, substantially all of which are denominated in US
        dollars. These risks are partially hedged by forward exchange contracts and
        certain operating expenses. As at August 31, 2005 and 2006, the company
        held contracts to sell US dollars at various forward rates, which are summarized
        as follows:
 
 **Contractual
                  amounts**
              
              **Weighted
                  average contractual forward rates**As
                  at August 31, 2005September
                  2005 to August 2006
              
              $
              26,000
              
              
              1.2630September
                  2006 to November 2007
              
              
              7,600
              
              
              1.2500As
                  at August 31, 2006September
                  2006 to August 2007
              
              $
              37,000
              
              
              1.1676September
                  2007 to June 2009
              
              
              26,800
              
              
              1.1261
 
 
 **19**  **Segment
        Information**
  The
        company is organized under two reportable segments: the Telecom Division
        and the
        Life Sciences and Industrial Division. The Telecom Division offers integrated
        test solutions to network service providers, cable operators, system vendors
        and
        component manufacturers throughout the global telecommunications industry.
        The
        Life Sciences and Industrial Division mainly leverages developed and acquired
        core telecom technologies for high-precision assembly and research
        sectors.
 
 The
        reporting structure reflects how the company manages its business and how
        it
        classifies its operations for planning and measuring performance.
   F-32
 Table
            of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 The
          following tables present information by segment:
 
 **Year
                    ended August 31, 2006****Telecom
                    Division**
                
                **Life
                    Sciences and Industrial Division**
                
                **Total**Sales
                
                $
                107,376
                
                $
                20,877
                
                $
                128,253Earnings
                    from operations
                
                $
                6,679
                
                $
                1,383
                
                $
                8,062Unallocated
                    items:Interest
                    and other income
                
                
                
                
                
                
                
                
                3,253Foreign
                    exchange loss
                
                
                
                
                
                
                
                
                (595
                )Earnings
                    before income taxes
                
                
                
                
                
                
                
                
                10,720Income
                    taxes
                
                
                
                
                
                
                
                
                2,585Net
                    earnings for the year
                
                
                
                
                
                
                
                $
                8,135Government
                    grants (note 15)
                
                $
                (1,307
                )
                $
                −
                
                $
                (1,307
                )Amortization
                    of capital assets
                
                $
                6,689
                
                $
                1,228
                
                $
                7,917Stock-based
                    compensation costs
                
                $
                962
                
                $
                70
                
                $
                1,032Impairment
                    of long-lived assets (note 4)
                
                $
                −
                
                $
                604
                
                $
                604Capital
                    expenditures
                
                $
                3,049
                
                $
                329
                
                $
                3,378
   **Year
                      ended August 31, 2005****Telecom
                      Division**
                  
                  **Life
                      Sciences and Industrial Division**
                  
                  **Total**Sales
                  
                  $
                  80,120
                  
                  $
                  17,096
                  
                  $
                  97,216Earnings
                      (loss) from operations
                  
                  $
                  763
                  
                  $
                  (962
                  )
                  $
                  (199
                  )Unallocated
                      items:Interest
                      and other income
                  
                  
                  
                  
                  
                  
                  
                  
                  2,524Foreign
                      exchange loss
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,336
                  )Earnings
                      before income taxes
                  
                  
                  
                  
                  
                  
                  
                  
                  989Income
                      taxes
                  
                  
                  
                  
                  
                  
                  
                  
                  2,623Net
                      loss for the year
                  
                  
                  
                  
                  
                  
                  
                  $
                  (1,634
                  )Amortization
                      of capital assets
                  
                  $
                  6,504
                  
                  $
                  2,588
                  
                  $
                  9,092Stock-based
                      compensation costs
                  
                  $
                  897
                  
                  $
                  66
                  
                  $
                  963Capital
                      expenditures
                  
                  $
                  1,408
                  
                  $
                  93
                  
                  $
                  1,501
 F-33
 Table
              of Contents
 **EXFO
              Electro-Optical Engineering Inc.**
 **Notes
              to Consolidated Financial Statements**
 
 (tabular
              amounts in thousands of US dollars, except share and per share data
              and as
              otherwise noted)
 **Year
                    ended August 31, 2004****Telecom
                    Division**
                
                **Life
                    Sciences and Industrial Division**
                
                **Total**Sales
                
                $
                58,882
                
                $
                15,748
                
                $
                74,630Loss
                    from operations
                
                $
                (5,557
                )
                $
                (5,013
                )
                $
                (10,570
                )Unallocated
                    items:Interest
                    and other income
                
                
                
                
                
                
                
                
                1,438Foreign
                    exchange loss
                
                
                
                
                
                
                
                
                (278
                )Loss
                    before income taxes
                
                
                
                
                
                
                
                
                (9,410
                )Income
                    taxes
                
                
                
                
                
                
                
                
                (986
                )Net
                    loss for the year
                
                
                
                
                
                
                
                $
                (8,424
                )Amortization
                    of capital assets
                
                $
                6,643
                
                $
                3,372
                
                $
                10,015Stock-based
                    compensation costs
                
                $
                417
                
                $
                32
                
                $
                449Impairment
                    of long-lived assets (note 4)
                
                $
                620
                
                $
                −
                
                $
                620Restructuring
                    and other charges (note 4)
                
                $
                −
                
                $
                1,261
                
                $
                1,261Capital
                    expenditures
                
                $
                607
                
                $
                244
                
                $
                851
  
 Total
          assets by reportable segment are detailed as follows:
 
 **As
                    at August 31,****2006**
                
                
                **2005**Telecom
                    Division
                
                $
                93,853
                
                $
                64,655Life
                    Sciences and Industrial Division
                
                
                11,339
                
                
                11,449Unallocated
                    assets
                
                
                113,967
                
                
                114,853$
                219,159
                
                $
                190,957
 
 Unallocated
          assets are comprised of cash, short-term investments and income taxes and
          tax
          credits recoverable.
 
 F-34
 Table
              of Contents
  **EXFO
          Electro-Optical Engineering Inc.**
 **Notes
          to Consolidated Financial Statements**
 
 (tabular
          amounts in thousands of US dollars, except share and per share data and
          as
          otherwise noted)
 Carrying
          value of goodwill by reportable segment is detailed as follows:
 
 **As
                    at August 31,****2006**
                
                
                **2005**Telecom
                    Division
                
                $
                22,545
                
                $
                16,092Life
                    Sciences and Industrial Division
                
                
                4,597
                
                
                4,278$
                27,142
                
                $
                20,370
 
 Sales
          to
          external customers by geographic region are detailed as follows:
 
 **Years
                    ended August 31,****2006**
                
                
                **2005**
                
                
                **2004**United
                    States
                
                $
                59,457
                
                $
                56,282
                
                $
                40,019Canada
                
                
                8,767
                
                
                6,830
                
                
                5,818Latin
                    America
                
                
                8,380
                
                
                3,127
                
                
                3,54776,604
                
                
                66,239
                
                
                49,384Europe,
                    Middle East and Africa
                
                
                32,379
                
                
                19,396
                
                
                13,706Asia-Pacific
                
                
                19,270
                
                
                11,581
                
                
                11,540$
                128,253
                
                $
                97,216
                
                $
                74,630
 
 Sales
          were allocated to geographic regions based on the country of residence
          of the
          related customers. In fiscal 2004, 2005 and 2006, one customer represented
          more
          than 10% of sales with 13.8% of sales ($10,325,000) in fiscal 2004, 23.3%
          of
          sales ($22,629,000) in 2005 and 13.8% of sales ($17,706,000) in 2006. For
          fiscal
          2004, 2005 and 2006, the most important customer purchased from the Telecom
          Division.
 
 Long-lived
          assets by geographic region are detailed as follows:
 
 **As
                    at August 31,****2006**
                
                
                **2005**Canada
                
                $
                51,724
                
                $
                35,690United
                    States
                
                
                3,758
                
                
                5,601$
                55,482
                
                $
                41,291
 
 Long-lived
          assets consist of property, plant and equipment, the long-lived asset held
          for
          sale, intangible assets and goodwill.
 
 F-35
 Table
              of Contents
 **EXFO
              Electro-Optical Engineering Inc.**
 **Notes
              to Consolidated Financial Statements**
 
 (tabular
              amounts in thousands of US dollars, except share and per share data
              and as
              otherwise noted)
 **20** **United
          States Generally Accepted Accounting Principles**
 
 As
          a
          registrant with the Securities and Exchange Commission in the United States
          (SEC), the company is required to reconcile its financial statements for
          significant differences between generally accepted accounting principles
          as
          applied in Canada (Canadian GAAP) and those applied in the United States
          (U.S.
          GAAP). Furthermore, additional significant disclosures required under U.S.
          GAAP
          and Regulation S-X of the SEC are also provided in the accompanying financial
          statements and notes. The following summarizes the significant quantitative
          differences between Canadian and U.S. GAAP, as well as other significant
          disclosures required under U.S. GAAP and Regulation S-X of the SEC not
          already provided in the accompanying financial statements.
 
 **Reconciliation
          of net earnings (loss) to conform to U.S. GAAP**
 
 The
          following summary sets out the significant differences between the company’s
          reported net earnings (loss) and net earnings (loss) per share under Canadian
          GAAP as compared to U.S. GAAP. Please refer to corresponding explanatory
          notes in the Reconciliation Items section.
 
 **Years
                    ended August 31,****2006**
                
                
                **2005**
                
                
                **2004**Net
                    earnings (loss) for the year in accordance with Canadian
                    GAAP
                
                
                
                
                $
                8,135
                
                $
                (1,634
                )
                $
                (8,424
                )Stock-based
                    compensation costs
                
                
                a
                )
                
                −
                
                
                −
                
                
                (867
                )Unrealized
                    losses on forward exchange contracts
                
                
                b
                )
                
                −
                
                
                (1,286
                )
                
                (280
                )Net
                    earnings (loss) for the year in accordance withU.S.
                    GAAP
                
                
                
                
                
                8,135
                
                
                (2,920
                )
                
                (9,571
                )Other
                    comprehensive income (loss)Foreign
                    currency translation adjustment
                
                
                
                
                
                12,322
                
                
                15,669
                
                
                5,969Unrealized
                    gains on forward exchange contracts
                
                
                b
                )
                
                5,394
                
                
                2,313
                
                
                689Reclassification
                    of realized gains on forward exchange contracts in net earnings
                    (loss)
                
                
                b
                )
                
                (2,880
                )
                
                (65
                )
                
                −Comprehensive
                    income (loss)
                
                
                
                
                $
                22,971
                
                $
                14,997
                
                $
                (2,913
                )Basic
                    and diluted net earnings (loss) per share in accordance with
                    U.S.
                    GAAP
                
                
                
                
                $
                0.12
                
                $
                (0.04
                )
                $
                (0.14
                )Basic
                    weighted average number of shares outstanding (000’s)
                
                
                
                
                
                68,643
                
                
                68,526
                
                
                66,020Diluted
                    weighted average number of shares outstanding (000’s)
                
                
                
                
                
                69,275
                
                
                68,981
                
                
                66,615
 
  F-36
 Table
              of Contents
  **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **Reconciliation
          of shareholders’ equity to conform to U.S. GAAP**
 
 The
          following summary sets out the significant differences between the company’s
          reported shareholders’ equity under Canadian GAAP as compared to U.S. GAAP.
          Please refer to the corresponding explanatory note in the Reconciliation
          Items
          section.
 
 **As
                    at August 31,****2006**
                
                
                **2005**
                
                
                **2004**Shareholders’
                    equity in accordance with Canadian GAAP
                
                
                
                
                $
                196,234
                
                $
                173,400
                
                $
                157,327Forward
                    exchange contracts
                
                
                b
                )
                
                5,451
                
                
                2,937
                
                
                1,975Goodwill
                
                
                
                
                
                (11,908
                )
                
                (11,042
                )
                
                (10,008
                )Shareholders’
                    equity in accordance with U.S. GAAP
                
                
                
                
                $
                189,777
                
                $
                165,295
                
                $
                149,294
 
  F-37
 Table
              of Contents
   **EXFO
          Electro-Optical Engineering Inc.**
 **Notes
          to Consolidated Financial Statements**
 
 (tabular
          amounts in thousands of US dollars, except share and per share data and
          as
          otherwise noted)
  The
          following table summarizes the shareholders’ equity activity under U.S. GAAP
          since August 31, 2003:
 **Share
                    capital**
                
                **Contributed
                    surplus**
                
                **Deficit**
                
                **Deferred
                    stock-based compensation costs**
                
                **Other
                    capital**
                
                **Accumulated
                    other comprehensive income**
                
                **Shareholders’
                    equity**Balance
                    as at August 31, 2003
                
                $
                565,291
                
                $
                1,519
                
                $
                (454,588
                )
                $
                (1,278
                )
                $
                5,429
                
                $
                5,219
                
                $
                121,592Net
                    loss for the year
                
                
                −
                
                
                −
                
                
                (9,571
                )
                
                −
                
                
                −
                
                
                −
                
                
                (9,571
                )Stock-based
                    compensation costs
                
                
                1,737
                
                
                −
                
                
                −
                
                
                339
                
                
                (760
                )
                
                −
                
                
                1,316Foreign
                    currency translation adjustment
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                5,969
                
                
                5,969Unrealized
                    gains on forward exchange contracts
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                689
                
                
                689Public
                    offering (note 13)
                
                
                29,164
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                29,164Exercise
                    of stock options (note 13)
                
                
                254
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                254Share
                    issue expenses (note 13)
                
                
                (137
                )
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                (137
                )Premium
                    on resale of share capital
                
                
                −
                
                
                18
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                18Balance
                    as at August 31, 2004
                
                
                596,309
                
                
                1,537
                
                
                (464,159
                )
                
                (939
                )
                
                4,669
                
                
                11,877
                
                
                149,294Net
                    loss for the year
                
                
                −
                
                
                −
                
                
                (2,920
                )
                
                −
                
                
                −
                
                
                −
                
                
                (2,920
                )Stock-based
                    compensation costs
                
                
                1,213
                
                
                −
                
                
                −
                
                
                (776
                )
                
                425
                
                
                −
                
                
                862Foreign
                    currency translation adjustment
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                15,669
                
                
                15,669Unrealized
                    gains on forward exchange contracts
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                2,248
                
                
                2,248Exercise
                    of stock options (note 13)
                
                
                148
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                148Share
                    issue expenses (note 13)
                
                
                (6
                )
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                (6
                )Balance
                    as at August 31, 2005
                
                
                597,664
                
                
                1,537
                
                
                (467,079
                )
                
                (1,715
                )
                
                5,094
                
                
                29,794
                
                
                165,295Net
                    earnings for the year
                
                
                −
                
                
                −
                
                
                8,135
                
                
                −
                
                
                −
                
                
                −
                
                
                8,135Stock-based
                    compensation costs
                
                
                −
                
                
                −
                
                
                −
                
                
                344
                
                
                610
                
                
                −
                
                
                954Foreign
                    currency translation adjustment
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                12,322
                
                
                12,322Unrealized
                    gains on forward exchange contracts
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                2,514
                
                
                2,514Exercise
                    of stock options (note 13)
                
                
                557
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                −
                
                
                557Reclassification
                    of stock-based compensation costs upon exercise of stock awards
                  (note
                    13)
                
                
                200
                
                
                −
                
                
                −
                
                
                −
                
                
                (200
                )
                
                −
                
                
                −Balance
                    as at August 31, 2006
                
                $
                598,421
                
                $
                1,537
                
                $
                (458,944
                )
                $
                (1,371
                )
                $
                5,504
                
                $
                44,630
                
                $
                189,777
   F-38
 Table
            of Contents
 **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 Accumulated
          other comprehensive income is comprised of the following:
 
 **As
                    at August 31,****2006**
                
                
                **2005**
                
                
                **2004**Foreign
                    currency translation adjustmentCurrent
                    year
                
                
                
                
                $
                12,322
                
                $
                15,669
                
                $
                5,969Cumulative
                    effect of prior years
                
                
                
                
                
                26,857
                
                
                11,188
                
                
                5,21939,179
                
                
                26,857
                
                
                11,188Unrealized
                    gains on forward exchange contracts
                
                
                b
                )Current
                    year
                
                
                
                
                
                2,514
                
                
                2,248
                
                
                689Cumulative
                    effect of prior years
                
                
                
                
                
                2,937
                
                
                689
                
                
                −5,451
                
                
                2,937
                
                
                689$
                44,630
                
                $
                29,794
                
                $
                11,877
 
 **Statements
          of cash flows**
 
 For
          the
          years ended August 31, 2004, 2005 and 2006, there were no significant
          differences between the statements of cash flows under Canadian GAAP as
          compared
          to U.S. GAAP, except for the subtotal before change in non-cash operating
          items,
          whose presentation is not permitted under U.S. GAAP.
 
 **Reconciliation
          items**
 
 **a)**  **Accounting
          for stock-based compensation**
 
 Until
          August 31, 2003, and to conform to U.S. GAAP, the company measured stock-based
          compensation costs using the intrinsic value method (APB 25, "Accounting
          for
          Stock Issued to Employees"). However, since September 1, 2003, and as described
          in item e) below, the company accounts for stock-based compensation costs
          for
          awards granted after that date, using the fair value-based method to conform
          to
          Statement of Financial Accounting Standard (SFAS) 123, “Accounting for
          Stock-Based Compensation” and subsequently, SFAS123(R), “Share-Based
          Payments”.
 
 *Stock
          Purchase Plan*
 
 Under
          APB
          25, compensation costs related to the stock purchase plan were measured
          as the
          difference between the fair value of the purchased stock and the purchase
          price
          paid by plan participants. Compensation costs were amortized to expense
          over a
          period of five years, being the restriction period. This plan terminated
          at the
          time of the Initial Public Offering on June 29, 2000. Compensation
          costs related to this plan became fully amortized during fiscal
          2004.
  F-39
 Table
              of Contents
  **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 *Long-Term
          Incentive Plan*
 
 Until
          August 31, 2003, and under APB 25, compensation costs related to the long-term
          incentive plan were measured as the difference between the market price
          of the
          underlying stock at the date of grant and the exercise price of the stock
          option. These compensation costs were amortized to expense over the estimated
          vesting period up to a maximum of four years. Compensation costs related
          to
          stock options granted prior to September 1, 2003, and accounted for under
          APB 25
          became fully amortized during fiscal 2004.
 
 *Restricted
          Stock Award Plan*
 
 Under
          APB
          25, compensation costs related to the restricted stock award plan were
          measured
          as the difference between the market price of the underlying stock at the
          date
          of grant and the exercise price of the stock award, which was nil. These
          compensation costs were amortized to expense over the estimated vesting
          period
          up to a maximum of four years, being the acquisition period. Compensation
          costs
          related to this plan, which were accounted for under APB 25, became fully
          amortized during fiscal 2004.
 
 Until
          August 31, 2003, no compensation costs were recognized for these stock-based
          compensation plans under Canadian GAAP.
 
 **b)**  **Forward
          exchange contracts**
 
 The
          forward exchange contracts entered into by the company prior to September
          1,
          2003, did not qualify for hedge accounting treatment under SFAS 133, “Accounting
          for Derivative Instruments and Hedging Activities”; accordingly, changes in the
          fair value of these derivatives were charged to earnings. However, on September
          1, 2003, the company implemented the documentation for the designation,
          documentation and assessment of the effectiveness of its forward exchange
          contracts, for the purposes of applying hedge accounting. With this
          documentation in place, the forward exchange contracts entered into by
          the
          company since September 1, 2003, qualify for hedge accounting treatment
          under
          U.S. GAAP. Consequently, under U.S. GAAP, changes in the fair value of
          these
          contracts are charged to other comprehensive income. Upon the recognition
          of the
          hedged sales, accumulated changes in fair value are reclassified in the
          statements of earnings.
 
 Under
          Canadian GAAP, foreign exchange translation gains and losses on forward
          exchange
          contracts are recognized as an adjustment of the revenue when the corresponding
          sales are recorded, regardless of whether the contracts were entered into
          before
          or after September 1, 2003.
 
 Based
          on
          the portfolio of forward exchange contracts as at August 31, 2006, the
          company
          estimates that the portion of the unrealized gain on forward exchange contracts
          as of August 31, 2006, and that will be realized and reclassified to
          net earnings over the next fiscal year amounts to $2,872,000.
 
   F-40
 Table
              of Contents
  **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 **c)**  **Research
          and development tax credits**
 
 Under
          Canadian GAAP, all research and development tax credits are recorded as
          a
          reduction of gross research and development expenses in the statements
          or
          earnings. Under U.S. GAAP, tax credits that are refundable against taxable
          income are recorded in the income taxes. These tax credits amounted to
          $1,761,000, $2,169,000 and $2,546,000 for fiscal 2004, 2005 and 2006,
          respectively. This difference has no impact on the net earnings (loss)
          and the
          net earnings (loss) per share figures for the reporting years.
  **d)**
              **Elimination of deficit by reduction of share
                  capital** 
 As
          at
          August 31, 2006, under Canadian GAAP, the company proceeded to eliminate
          its
          deficit against its share capital (note 13). However, under U.S. GAAP,
          such
          elimination is not permitted, which creates a permanent difference of
          $373,711,000 in the deficit and the share capital between the Canadian
          GAAP and
          U.S. GAAP figures. This difference has no impact on the total amount of
          the
          shareholders’ equity.
 
 **e)**
              **New accounting standards and
                  pronouncements** 
 *Adopted
          in fiscal 2006*
 
 In
          November 2004, the Financial Accounting Standard Board (FASB) issued SFAS
          151,
“Inventory Costs”, an amendment to ARB No. 43, Chapter 4. The amendments made by
          SFAS 151 improves financial reporting by clarifying that any abnormal amount
          of
          idle facility expenses, freight, handling costs and wasted materials (spoilage)
          should be recognized as current-period charges and by requiring the allocation
          of fixed production overheads to inventory based on the normal capacity
          of the
          production facilities. This SFAS is effective for inventory costs incurred
          during fiscal years beginning after June 15, 2005. The company adopted
          this new
          statement on September 1, 2005, and its adoption had no significant impact
          on its financial statements.
 
 In
          December 2004, the FASB issued SFAS 123(R), “Share-Based Payments”. This
          statement supersedes ABP 25, “Accounting for Stock Issued to Employees” and
          related implementation guidance, and revises SFAS 123 in a number of areas.
          Under SFAS 123(R), all forms of share-based payment to employees result
          in
          compensation cost recognized in financial statements. This statement is
          effective for fiscal years beginning after June 15, 2005. The company adopted
          this statement on September 1, 2005, using the modified prospective application
          method of transition and its adoption had no significant impact on its
          financial
          statements.
 
 Under
          U.S. GAAP, until August 31, 2003, the company elected to measure compensation
          costs related to grants of stock options and stock awards using the intrinsic
          value method of accounting. In this instance, however, under SFAS 123(R),
          the
          company is required to make pro forma disclosures of net earnings (loss)
          and net
          earnings (loss) per share for any periods included in the financial statements
          that ended prior to the adoption of SFAS 123(R) (i.e., fiscal 2004 and
          2005) as
          if the fair value-based method of accounting had been applied to outstanding
          unvested awards granted prior to September 1, 2003. Consequently, if the
          fair
          value-based method had been applied to these awards, the pro forma net
          earnings
          (loss) per share would have been the same as the net earnings (loss) per
          share
          for all reporting periods.
  F-41
 Table
              of Contents
  **EXFO
            Electro-Optical Engineering Inc.**
 **Notes
            to Consolidated Financial Statements**
 
 (tabular
            amounts in thousands of US dollars, except share and per share data and
            as
            otherwise noted)
 The
          fair
          value of options or awards granted was estimated using the Black-Scholes
          options
          pricing model.
 
 *To
          be
          adopted after fiscal 2006*
 
 In
          May
          2005, the FASB issued SFAS 154, “Accounting Changes and Errors Corrections - a
          replacement of APB Opinion No. 20 and FASB Statement No. 3”. This statement
          replaces APB 20, “Accounting Changes” *,* and SFAS
          3, “Reporting Accounting Changes in Interim Financial Statements” *,* and
          changes the requirements for the accounting for and reporting of a change
          in
          accounting principle. This statement applies to all voluntary changes in
          accounting principle. It also applies to changes required by an accounting
          pronouncement in the unusual instance that the pronouncement does not include
          specific transition provisions. In general, this statement requires a company
          to
          account for the adoption of a new accounting policy by applying the new
          principle to prior accounting periods as if that principle had always been
          adopted. This statement is effective for accounting changes or corrections
          of
          errors in fiscal years beginning after December 15, 2005.
 
 In
          June
          2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting to
          Uncertainty in Income Taxes”, which clarifies the accounting for uncertainties
          in income taxes recognized in accordance with SFAS 109, “Accounting for Income
          Taxes”. The interpretation is effective for fiscal years beginning after
          December 15, 2006. The company will adopt this interpretation on September
          1,
          2007, and has not yet assessed the impact its adoption will have on its
          financial statements.
  F-42