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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549


Form 10-K

FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO

SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934


|                                                |  |                                                                                             
|----------------------------------------------- |  | --------------------------------------------------------------------------------------------
|þ                                               |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|                                               
|For the fiscal year ended December 31,
    2003
|                                               
|or                                             
|                                               
|o                                               |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|                                               
|Commission File Number: 000-49755              

Quinton Cardiology Systems, Inc.

(Exact Name of Registrant as Specified in its
Charter)


|                                                                                  |  |                                         
|--------------------------------------------------------------------------------- |  | ----------------------------------------
|Delaware                                                                          |  | 94-3300396                              
|(State or Other Jurisdiction of
    Incorporation or Organization)                |  | (I.R.S. Employer
    Identification No.)
|                                                                                 
|3303 Monte Villa Parkway, Bothell, WA(Address of Principal Executive
    Offices) |  | 98021(Zip Code)                         
|(425) 402-2000(Registrants Telephone
    Number, Including Area Code)           

Securities Registered Pursuant to
Section 12(b) of the Act: None.

Securities Registered Pursuant to
Section 12(g) of the Act: Common Stock, $0.001 par
value.

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.     þ     Yes          o No

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained, to the best of the registrants knowledge, in
definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any
amendment to this
Form 10-K. þ

Indicate by check mark whether the Registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Act).     þ     Yes          o No

The aggregate market value of the voting and
non-voting common stock held by non-affiliates of the
registrant, based on the closing price of the registrants
Common Stock on June 30, 2003 as reported on the Nasdaq
National market, was approximately $89,255,300. Shares of Common
Stock held by each executive officer and director and by each
shareholder whose beneficial ownership exceeded 5% of the
outstanding Common Stock at June 30, 2003 have been
excluded in that such persons may be deemed to be affiliates.
This determination of status is not necessarily conclusive for
determination for other purposes.

The number of shares of the registrants
Common Stock outstanding at March 1, 2004 was 12,263,664.

DOCUMENTS INCORPORATED BY REFERENCE

The information required by Part III of this
Report, to the extent not set forth herein, is incorporated
herein by reference to the Registrants definitive Proxy
Statement relating to the annual meeting of shareholders to be
held on May 14, 2004, which definitive Proxy Statement
shall be filed with the Securities and Exchange Commission
within 120 days after the end of the fiscal year to which
this Report relates.



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QUINTON CARDIOLOGY SYSTEMS, INC.

2003 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

|              |  |                                                                                           |    |      |    | 
|------------- |  | ----------------------------------------------------------------------------------------- | -- | ---- | -- | 
|              |  |                                                                                           |    | Page
|              |  |                                                                                           |    |     
|PART I       
|Item 1.       |  | Business                                                                                  |    |      | 1  | 
|Item 2.       |  | Properties                                                                                |    |      | 17 | 
|Item 3.       |  | Legal Proceedings                                                                         |    |      | 17 | 
|Item 4.       |  | Submission of Matters to a
    Vote of Shareholders                                       |    |      | 17 | 
|PART II      
|Item 5.       |  | Market for Companys
    Common Stock and Related Shareholder Matters                     |    |      | 18 | 
|Item 6.       |  | Selected Financial Data                                                                   |    |      | 18 | 
|Item 7.       |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations |    |      | 20 | 
|Item 7A       |  | Quantitative and Qualitative
    Disclosures About Market Risk                            |    |      | 33 | 
|Item 8.       |  | Financial Statements and
    Supplementary Data                                           |    |      | 34 | 
|Item 9.       |  | Changes in and Disagreements
    with Accountants on Accounting and Financial Disclosure  |    |      | 35 | 
|Item 9A       |  | Controls and Procedures                                                                   |    |      | 35 | 
|PART III     
|Item 10.      |  | Executive Officers and
    Directors of the Company                                       |    |      | 35 | 
|Item 11.      |  | Executive Compensation                                                                    |    |      | 35 | 
|Item 12.      |  | Security Ownership of
    Certain Beneficial Owners and Management                        |    |      | 35 | 
|Item 13.      |  | Certain Relationships and
    Related Transactions                                        |    |      | 38 | 
|Item 14.      |  | Principal Accountant Fees
    and Services                                                |    |      | 38 | 
|PART IV      
|Item 15.      |  | Exhibits, Financial
    Statements, Schedules and Reports on Form 8-K                     |    |      | 39 | 
|Signatures    |  |                                                                                           | 42 |     
|EXHIBIT 10.5 
|EXHIBIT 10.6 
|EXHIBIT 10.24
|EXHIBIT 10.25
|EXHIBIT 10.26
|EXHIBIT 10.27
|EXHIBIT 23.1 
|EXHIBIT 23.2 
|EXHIBIT 31.1 
|EXHIBIT 31.2 
|EXHIBIT 32.1 
|EXHIBIT 32.2 



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PART 1

This annual report contains forward-looking
statements relating to Quinton Cardiology Systems, Inc. These
are forward-looking statements for purposes of the safe harbor
provisions under the Private Securities Litigation Reform Act of
1995. The words believe, expect,
intend, anticipate, variations of such
words, and similar expressions identify forward-looking
statements, but their absence does not mean that the statement
is not forward-looking. Actual results may vary significantly
from the results expressed or implied in these statements.
Forward-looking statements reflect managements current
expectations, plans or projections and are inherently uncertain.
These forward-looking statements reflect managements
current expectations and involve risks and uncertainties. Our
actual results could differ materially from results that may be
anticipated by such forward-looking statements. The principal
factors that could cause or contribute to such differences
include, but are not limited to, those discussed in the section
entitled Certain Factors That May Affect Future
Results and those discussed elsewhere in this report.
Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of
this report. We undertake no obligation to revise any
forward-looking statements to reflect events or circumstances
that may subsequently arise. Readers are urged to review and
consider carefully the various disclosures made in this report
and in our other filings made with the SEC that attempt to
advise interested parties of the risks and factors that may
affect our business, prospects and results of operations. The
terms us, we and our refer
to Quinton Cardiology Systems, Inc. and our wholly owned
subsidiaries Quinton Inc. and Burdick, Inc.




Item 1.     Business

Overview

We develop, manufacture, market and service a
family of advanced cardiology products used in the diagnosis,
monitoring and management of patients with heart disease. Our
products include electrocardiographs (ECGs), stress test
systems, Holter monitoring systems, cardiac rehabilitation
telemetry systems, ECG management systems, medical treadmills
and patented electrodes. We also sell a variety of ancillary
cardiology products and consumables related to our principal
products.

Quinton Cardiology Systems, Inc. is a Delaware
corporation formed, initially as a California corporation, in
April 1998 to acquire Quinton Inc., a leading supplier of ECGs,
stress test systems, medical treadmills and other cardiology
products. Quinton Inc. was originally incorporated in 1966 and
was renamed Quinton Cardiology, Inc. in 2003. At
December 31, 2003, our two principal operating subsidiaries
were Quinton Cardiology, Inc. and Burdick, Inc., which we
acquired in January 2003. We are in the process of legally
combining Burdick, Inc. into Quinton Cardiology, Inc., however,
the operational combination was successfully completed in 2003.
We market our products under the Quinton and Burdick brand names.

Industry
Background

The American Heart Association reports there are
over 60 million patients in the U.S. with active or
developing heart disease. Heart disease is the leading cause of
death in the U.S. The American Heart Association also estimates
the direct cost of treating heart disease and stroke at nearly
$200 billion annually, representing 13% of all domestic
healthcare spending. Our products compete in two medical
equipment market sectors: cardiovascular monitoring equipment
and ambulatory telemetry equipment. Based upon reports of Frost
& Sullivan, a leading independent research firm, and
management estimates, we believe that combined 2003 sales in
these market sectors were in excess of $1.0 billion.

Cardiovascular care facilities provide patients
with a variety of diagnostic and treatment techniques ranging
from risk assessment and stress testing to complex surgeries and
rehabilitation services. Diagnostic cardiology systems are
crucial to cardiovascular care. The core of diagnostic
cardiology is the electrocardiogram, or ECG waveform, a
representation of the electrical activity of the heart.
Clinicians use ECG waveform recordings and analyses to assess
the presence and severity of cardiac disease, and to monitor the
efficacy of treatments such as drugs, interventions, operations,
and device implants. Effective use of the ECG waveform in
patient management and the delivery of cardiovascular care
requires that the entire process of recording, storing,
analyzing, retrieving and distributing ECG waveform data be as
rapid and cost effective as possible.

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Despite the technological and clinical advances
in cardiology, healthcare providers face significant challenges
in delivering consistent and high quality cardiovascular care.
Healthcare reform continues to place increasing pressure on
providers of cardiovascular care to see and treat more patients
faster. In addition, the need to control costs, increase
efficiencies and manage data has introduced new layers into the
decision making process for technology utilization. This
changing healthcare environment has resulted in the following
critical needs:



| |   |                                                                                                                                                                                                                   
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | systems and services tailored to the workflow
    needs of clinicians, to improve efficiencies and reduce training
    times;                                                                                     
|
| |  | technologies that can effectively manage data
    from a variety of sources and be scaled from single offices to
    wide area networks;                                                                          
|
| |  | products that are implemented using standards
    such as DICOM and HL-7 for connectivity, to minimize the effort
    and expense required to integrate data across multiple sources;                             
|
| |  | tools to improve the management of resources by
    tracking and trending cost efficiencies in healthcare delivery
    systems, thus providing data to payors which differentiate among
    competitive providers;
|
| |  | methods for preserving and propagating healthcare
    data from legacy systems; and                                                                                                                               
|
| |  | progressive migration to network and Internet
    technologies within a security structure that meets HIPAA
    requirements.                                                                                     

Diagnostic cardiology systems that meet these
needs and challenges will have a significant opportunity and
advantage in the marketplace.

Quinton
Solution

We provide and service a family of advanced
cardiology products that deliver reliable, cost effective
solutions for cardiologists and other healthcare providers. Our
products are easy to use, with simple, intuitive user
interfaces. Many of our cardiology products are based on a
Microsoft Windows-based software architecture designed to
integrate critical data capture, provide enterprise level access
to data, and scale to meet the requirements of a variety of
cardiovascular care facility environments. We believe our
cardiology products provide our customers solutions for
overcoming many of the challenges they face, including the
following key benefits:

Ease of use.Our
products feature intuitive user interfaces that are designed
with significant input from clinicians and technologists to
address the needs of providers and patients. Many of our
products automate many of the data collection functions by
uploading patient information to a database for easy retrieval.
Many of our products use standard computer components and
require minimal configuration. Our user interface has been
designed to conform to the particular clinical procedure rather
than adapting the procedure to the device. Additionally, users
can customize the interface to meet their unique requirements.
We believe this functionality enhances clinical success by
allowing the user to concentrate on the patient and procedure.
Conversely, some products offered by our competitors require
significantly more interaction with the device. In addition, we
believe the ease of use features of our products enable our
customers to use our systems with significantly lower training
requirements and higher productivity than competing products
that do not offer customizable user interfaces.

Network compatibility.Many of our products are designed to
support a clinical network environment, enabling cardiologists
to assimilate, collate and interpret data and disseminate
results to facilitate diagnosis, monitoring and patient
management. These products collect data that may be stored in a
local or network server database. Many of our products connect
to larger enterprise networks that allow data to be shared with
other users, both within the facility and remotely via secure
networks. To facilitate these connections, we have chosen to
implement commonly used formats and protocols. These formats,
such as portable document format and extensible markup language,
facilitate the storage and dissemination of clinical
information. In contrast, some of our competitors use
proprietary formats to store and disseminate clinical
information. We believe that standardized and efficient data
handling are key to addressing the user requirements.

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Effective data capture.Many of our products automate and
assist in the collection, interpretation and retrieval of data
and can effectively display, for side-by-side comparison, the
results of tests performed over an extended period. These
products improve clinical productivity and throughput, which is
the number of reimbursable procedures completed per hour of
system use. For our customers, greater throughput translates
into greater return on investment from our products. Unlike many
competing products, which require more intensive manual work,
our products automate the capture of clinical data and provide
computer assisted interpretation where appropriate.

Improved diagnostic speed and accuracy.As a result of easy to use controls,
effective data capture, and computer assisted diagnosis, we
believe our products allow for improved diagnostic accuracy. The
availability of historical results for comparison allows for a
greater understanding of changes in the patients physical
condition. In addition, by enabling the review and assessment of
test results remotely our systems can greatly speed the time of
diagnosis, which allows more rapid institution of appropriate
therapy for the patient.

Open technology architecture.Our Microsoft Windows-based technology
adheres to established standards for image, waveform, data and
report generation and dissemination, enabling healthcare
providers to share data across a private network or via the
Internet. This Windows-based technology platform was designed to
support data integration activities with other third-party
clinical systems. Unlike certain competitors that utilize
proprietary architecture or protocols, we believe this
technology will permit our customers to easily integrate our
products and systems with their existing infrastructure, and
scale to meet the needs of larger healthcare organizations.

Our
Advantages

We believe our business has several advantages:

Industry leading brands.Quintons founder, Wayne Quinton,
developed the first treadmill designed for cardiac stress
testing in 1953. Since 1966, Quinton has manufactured and sold
high quality, reliable advanced cardiology products. Burdick has
been an innovator in medical devices since 1913 and in
cardiology since 1949. We believe Quinton and Burdick are among
the most respected names in the field of cardiology. We believe
we have enjoyed recognition in ECG, stress test systems, Holter
monitors, rehabilitation telemetry systems and ECG management
systems and are known for a high level of service, which drives
customer loyalty and strong relationships with healthcare
providers.

Large installed base.We believe we have the leading U.S.
installed base of stress test systems and rehabilitation
telemetry systems. In addition, we have a large installed base
of Holter monitors, electrocardiographs and ECG management
systems. Our installed base presents a substantial target market
for future sales of products, systems, and software upgrades, as
well as related service and consumables.

National sales and service organizations.Our national sales organization,
consisting of both a direct sales force and an independent
distributor network, supported by a team of internal sales
representatives, possesses extensive experience and expertise in
advanced cardiology products. In addition, we have a national
service organization whose work enhances customer satisfaction
and retention and supports our sales force with cross-selling
capabilities. We believe we can rely on our national sales and
service organizations to support the sale of our products,
whether developed internally or acquired.

Commitment to research and development.We have invested on average 10.7% of
our revenues over the last three years in product development
efforts. Our research and development efforts contributed to the
release of new versions of products in most of our major product
categories in 2001, 2002 and 2003.

Growth
Strategy

Our growth strategy is to expand our domestic
installed base through sales of new versions of our products,
increase our penetration of international markets through
partnerships and acquisitions, develop industry-leading
connectivity solutions for cardiology products, and acquire
businesses, assets, product lines or technologies that
complement our business or offer other strategic advantages.

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Domestic sales.We
target our installed base for future sales of products, systems
and software upgrades, as well as service and consumables to
support new and existing products. We utilize our direct sales
force to focus principally on the acute care market, principally
selling Quinton branded products. We complement this sales
effort through our well established distributor network, which
is focused on the primary care physician market and principally
sells Burdick branded products. We plan to expand domestic sales
by offering products and service that continue to address
customer needs, from office practices through larger hospitals.
We believe these customer segments will be increasingly
receptive to our new technologies.

International sales.We have generated approximately 7% of
our revenues from international sales over the last three years.
We believe that international markets, particularly in Europe
and Asia, represent a significant opportunity to increase our
sales. We have developed products and systems to be compatible
with regulatory and compliance standards in international
markets. We plan to address this opportunity further through
partnerships with, and acquisitions of, providers of cardiology
related products and service. For example, we have a well
established strategic alliance with one of the leading providers
of cardiology products in Japan to distribute our Q-Stress
system in that country.

Connectivity.We
offer and continue to develop systems that enable customers to
extract electrocardiographic and other data from stand-alone
devices, link together disparate diagnostic and monitoring
devices, and automate the storage, retrieval and processing of
electrocardiographic data. These connectivity features address
significant unmet needs in the diagnostic cardiology systems
market, which should increase demand for, and lead to
incremental sales of our other products and services.

Acquisitions.We
plan to pursue acquisitions of businesses, product lines,
assets, or technologies that are complementary to our business
or offer us other strategic benefits, such as enhanced clinical
or technological value, expanded geographical reach, and
additional sales or research and development capabilities. The
fragmentation of the cardiology industry offers us a unique
opportunity for growth and consolidation through selective
acquisitions. We believe our brand and history in the cardiology
industry, and the acquisition and integration experience of our
management team, puts us in a position to take advantage of this
opportunity. Funding for potential acquisitions could be in the
form of our stock or, alternatively, from outside financing
sources. Because of the uncertainties related to either of these
funding alternatives, there can be no assurance that we will be
successful in making future acquisitions.

Our
Products

Revenues from sales of our systems and related
consumable products were $33.8 million, $37.4 million
and $71.6 million for each of the fiscal years ended
December 31, 2001, 2002 and 2003, respectively. Revenues
from sales of systems and related consumable products for 2001
and 2002 do not include historical revenues of Burdick, which
was acquired in January 2003. A description of the various
systems and consumable products we currently offer include:

Electrocardiography systems.We offer a variety of
electrocardiography systems at various price points and in
various configurations. These products cover the spectrum of
market needs, ranging from low-cost units targeted for
physicians offices to fully featured units that are
designed for the most rigorous clinical and hospital settings.

Cardiac stress testing systems.Our integrated stress testing systems
allow cardiologists and other healthcare providers to monitor
and analyze the performance of the heart under stress. Our
stress systems record a patients heart rate, heart rhythm,
blood pressure, and other vital signs during induced stress.
Quinton treadmills, specifically designed for cardiac monitoring
procedures, provide precise and replicable levels of exertion.
Our systems provide real time analysis, charting, and reporting,
enabling cardiologists and other healthcare providers to
diagnose patients heart disease more accurately and
efficiently.

Holter monitoring systems.Our integrated Holter monitoring
products and systems record and assess the performance of a
patients heart during various activities over extended
periods of time. The Holter recorder, which is typically worn
for a period of 24 hours, records the patients heart rate,
heart rhythm, and

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ECG waveform data. Our Holter offering includes
both 3 lead and true 12 lead ECG waveform diagnostic
capabilities.


Cardiac rehabilitation telemetry systems.Our integrated Q-Tel telemetry
devices, database products and treadmills monitor the
patients heart rate, heart rhythm, and ECG waveform data
during rehabilitation exercises. Our Outcomes rehabilitation
database provides real time clinical data and trend analysis to
enable cardiologists and other healthcare providers to track and
assess improvements in cardiovascular function.

ECG data management systems.We provide an ECG data management
system that automates the processing, storage, retrieval and
editing of electrocardiographic data. Our Pyramis system
extracts the ECG waveforms and arrhythmia data from ECGs via
diskette, direct serial interface, telephone modem, or network
connections.

Other systems and supplies.Diagnostic cardiology products often
require lead wires and electrodes to be attached to the patient
to retrieve and process cardiac electrical activity and chart
paper to generate reports. We sell all of these items, including
our patented Quik-Prep electrodes. We also provide an array of
other complementary cardiology related products, such as blood
pressure monitors, spirometers and defibrillators, among other
things.

In 2003, we introduced new versions of or
enhancements to products in most of our product lines, and we
are currently developing additional new versions of or
enhancements to products in each of these product lines.

We previously manufactured and marketed a line of
monitors and systems (Q-Cath) which allow cardiologists and
other healthcare providers to monitor and analyze cardiovascular
performance, vital signs, and coronary artery blockage during
cardiac catheterization procedures. During 2003, we divested
this product line and established an ongoing joint marketing
alliance with the purchaser for cross referrals of one
anothers products.

Product
Support and Maintenance Services

Revenues from our support and maintenance
services were $9.0 million, $9.1 million and
$12.8 million for each of the fiscal years ended
December 31, 2001, 2002 and 2003, respectively. Revenues
from support and maintenance services for 2001 and 2002 do not
include historical revenues of Burdick, which was acquired in
January 2003. Our product support and maintenance organization
supports our installed base. We provide product installation,
repair and scheduled maintenance services, as well as software
and hardware upgrades.

Sales and
Marketing

Within the U.S. we market and sell our products,
systems and services to hospitals and cardiology clinics, which
we refer to as the acute care market, through a
dedicated national sales force that has broad experience in
selling advanced cardiology products. Each of our sales
representatives sells our entire product line and is responsible
for a region and a personal sales quota.

Within the U.S. we sell our products to
primary care physicians through a well established
independent distributor network, supported by a team of internal
sales representatives.

To complement our domestic sales force and
increase our sales to existing customers, we encourage our
service personnel to actively seek cross-selling opportunities.

Outside the U.S. we rely on indirect sales
channels, using distributors to offer our products. Our
arrangements with distributors are typically territory specific
and cover several of our products. We provide our distributors
with discounts based on a variety of factors including the
annual volume of its orders. Our international distributor
network is managed by a team of employees or agents living
abroad, under the overall direction of a U.S. based
international sales director.

Our sales efforts in the acute care market
increasingly target system sales opportunities. Our sales
efforts historically promoted stand alone product sales and were
most successful in small and midsize hospitals,

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rehabilitation clinics and group cardiology
practices. We believe improvements in our technology and changes
in customer needs make our products attractive to larger
hospitals and physician practices, as well. Our new
system-oriented sales approach enables us to adjust to the
selling environment of larger facilities, which has grown more
complex due to the growing connectivity of devices and systems
within healthcare organizations and has increased the technical
knowledge required of our sales representatives. In addition,
while previous sales efforts have focused on the individual
clinician as the customer, our selling process increasingly
involves multiple customer representatives with differing
expectations, including personnel responsible for information
technology and administration.


Our marketing activity consists primarily of
product marketing through product demonstrations, major
cardiology meetings, publications in professional journals,
telemarketing and website marketing. In addition, we support the
sales efforts of the distributors in the primary care market by
providing funding and other support for certain promotional
activities. Our marketing efforts emphasize our products
ease of use, connectivity, quality, and reliability.

We do not generally have significant sales order
backlog. At both December 31, 2002 and 2003, our total sales
order backlog represented less than 30 days of anticipated
sales volume.

Customer
Service and Support

We believe that a broad range of support services
is essential to the successful installation and utilization of
our advanced cardiology products. We offer a combination of
online, telephone and on-site technical assistance services,
including the ability to have assistance 24 hours a day, seven
days a week. We also provide professional services for network
analysis, design and implementation, and training and education.
Our multiple support programs include basic and extended systems
maintenance and parts replacement.

At December 31, 2003, Quintons
domestic service organization included 68 employees, of which 32
were in domestic field service locations and the remainder were
in call-center operations and factory-based repair. Our large
installed base facilitates the sale of service contracts and
warranties and presents a cross-selling opportunity for products
that are complementary to our customers existing
installations. In international markets our distributors provide
support and other services.

Research and
Development

We believe that strong product development
capabilities are essential to our strategy of enhancing,
developing and incorporating improved functionality, and
maintaining the competitiveness of our products in our core
markets. We have assembled a team of engineers with experience
in user interface design, SQL database management, COM and C++
tools, network computing, clinical algorithms, electrical
engineering, and product verification and validation in clinical
settings. Our research and development process is dependent on
assessment of customer needs, identification and evaluation of
new technologies, and monitoring market acceptance and demand.
We have a structured process for undertaking product development
projects that involves all functional groups at all levels
within our company. This process is designed to provide a
framework for defining and addressing the steps, tasks, and
activities required to bring product concepts and development
projects to market.

Our research and development expenses were
$5.5 million in 2001, $5.1 million in 2002 and
$8.1 million, exclusive of a 2003 acquired research and
development charge, in 2003. This represents approximately 10.7%
of our revenues over that three-year period. Research and
development expenses in total dollars and as a percentage of
revenues for 2001 and 2002 do not reflect research and
development expenses nor revenues of Burdick. During 2001 to
2003, our research and development efforts focused on enhancing
and expanding the proven capabilities of our existing product
lines, introducing new versions of our products and reducing
costs relating to our existing products.

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Technology

We use object-oriented design based on Microsoft
technologies to create the software for many of our systems. We
develop our systems user interfaces for many of our
products using Microsoft Visual Basic and C++ tools. In
addition, in many cases, the data storage layer has been
developed on Microsoft SQL Server. Many of our systems have been
designed for network operation and deployment using industry
standard TCP/ IP network protocol. Many of our software modules
have been developed as objects that can be reused in our other
products as needed.

We are designing many of our systems to meet
emerging industry standards for data sharing. Final clinical
reports from certain of our products can now be rendered in
Adobe PDF format for easy transmission and viewing in standard
browsers. Extensible markup language, or XML, is also used in
certain of our products to communicate complex information with
third-party systems, and the HL7 messaging standard will be
supported to enable communications with leading hospital
information systems. ECG waveform data can be transmitted in
medical industry standard Serial Communication Protocol format
through many of our products.

Most of our systems include hardware components
that connect to the patient and digitize ECG waveform signals,
blood pressure, and other vital signs. These hardware components
connect to the computer operating system via special software
drivers. The digitized patient information is a continuous
stream of data that is analyzed in real-time and communicated to
the user interface components for display. Real-time analysis is
a critical function that typically runs at a high priority
within Microsoft Windows. Applications that require the storage
of all real-time patient data collect this information as a part
of the processing subsystem. Patient data and clinical results
are stored and managed via Microsofts SQL Server.

Manufacturing
and Supply

Our manufacturing process consists primarily of
assembly and testing of ECG cardiographs, stress test systems,
Holter monitoring systems, rehabilitation telemetry systems,
medical treadmills, electrodes and various other products.
During 2003, we performed these manufacturing activities at our
Bothell, Washington facility, our Deerfield, Wisconsin facility
and, to a limited extent, at the facilities of our majority
owned joint venture operation in Shanghai, China. During the
latter part of 2003, we consolidated our Bothell and Deerfield
manufacturing activities into our Deerfield location. We
incurred certain non-recurring charges relating to severance,
moving costs and other consolidation related activities during
2003, aggregating $1.4 million. As the consolidation was
complete by December 31, 2003, we do not expect these
charges to recur in the future.

We also rely upon other third-party suppliers to
provide us with various materials used in the production and
assembly of our devices and systems. We have long-standing
supply relationships for essentially all our outsourced product
components. We maintain a comprehensive quality assurance and
quality control program that includes documentation of all
material specifications, operating procedures, equipment
maintenance and quality control methods. Our quality systems are
based on and in compliance with the requirements of ISO 9001/ EN
46001 and the applicable regulations imposed by the FDA on
medical device manufacturers.

Targeted
Acquisition Opportunities

We plan to pursue acquisition of businesses,
product lines, assets or technologies that are complementary to
our business or offer us other strategic benefits. Many
single-product diagnostic cardiology companies either address
markets that are too small to justify national sales and service
organizations or lack the capital to build such a distribution
and service network. Without a strong distribution channel,
industry-leading products can fail to successfully penetrate
existing markets. We plan to expand our product lines, leverage
the capabilities of our existing sales force and increase sales
of our existing and new product lines by selectively acquiring
those companies, or assets of companies, with strong
differentiated technologies or product lines that complement
ours. We believe that our distribution capabilities, our large
installed customer base, our technology and experienced
management provide us with a suitable platform for acquisitions.
Funding for potential acquisitions could be in the form of our
stock or, alternatively, from outside financing sources. Because
of the

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uncertainties related to either of these funding
alternatives, there can be no assurance that we will be
successful in making future acquisitions.


Our
Competition

The following chart indicates the most
significant competitors for each of our major product lines:

|                                         |  |                                            
|---------------------------------------- |  | -------------------------------------------
|Product                                  |  | Competitors                                
|                                         |  |                                            
|Electrocardiography systems              |  | General Electric, Philips, Welch Allyn     
|Cardiac stress testing systems           |  | General Electric, Philips                  
|Holter monitoring systems                |  | Del Mar Reynolds, General Electric, Philips
|Cardiac rehabilitation telemetry systems |  | Life Sensing Instruments, Scott Care       
|ECG data management systems              |  | General Electric, Philips                  

We believe that cardiologists and other
healthcare providers consider the following factors in
determining which products to purchase:



| |   |                                           
| | - | ------------------------------------------
| |  | quality, accuracy, and reliability;       
|
| |  | reputation of the provider;               
|
| |  | relative ease of use;                     
|
| |  | depth and breadth of features;            
|
| |  | quality of customer support;              
|
| |  | frequency of updates;                     
|
| |  | availability of third-party reimbursement;
|
| |  | conformity to standards of care; and      
|
| |  | price.                                    

We believe our products compete favorably on
these factors. However, products offered by some of our
competitors offer features that may compete favorably on these
factors as well. The market for diagnostic cardiology systems is
highly competitive and we expect competition to intensify. Many
of our competitors enjoy substantial advantages, including
greater resources that can be devoted to the development,
promotion and sale of their products. In addition, many of our
competitors may have more established sales channels, greater
product development experience or greater name recognition.

Third-Party
Reimbursement

In the U.S., as well as in foreign countries,
government-funded or private insurance programs, commonly known
as third-party payors, pay a significant portion of the cost of
a patients medical expenses. A uniform policy of
reimbursement does not exist among all these payors. We believe
that reimbursement is an important factor in the success of any
medical device.

All U.S. and foreign third-party reimbursement
programs, whether government funded or commercially insured, are
developing increasingly sophisticated methods of controlling
healthcare costs through prospective reimbursement and
capitation programs, group purchasing, redesign of benefits,
second opinions required prior to major surgery, careful review
of bills, encouraging healthier lifestyles and exploring more
cost-effective methods of delivering healthcare. These types of
programs can potentially limit the amount which healthcare
providers may be willing to pay for medical devices.

The federal Centers for Medicare & Medicaid
Services issued a Final Rule on its Prospective Payment System
For Outpatient Services on April 7, 2000. This rule
provides for a new system to reimburse Medicare outpatient
surgical services provided in a hospital, and currently
authorizes reimbursement for procedures performed using our
current products.

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Government
Regulation

Our products are medical devices subject to
extensive regulation by the U.S. Food and Drug Administration,
or FDA, and other regulatory agencies. FDA regulations govern,
among other things, the following activities that we perform and
will continue to perform in connection with medical devices:



| |   |                                             
| | - | --------------------------------------------
| |  | product design and development;             
|
| |  | product testing;                            
|
| |  | product manufacturing;                      
|
| |  | product labeling and packaging;             
|
| |  | product handling, storage, and installation;
|
| |  | premarket clearance or approval;            
|
| |  | advertising and promotion; and              
|
| |  | product sales, distribution, and servicing. 

FDAs premarket clearance and approval
requirements.Unless an exemption
applies, each medical device we wish to commercially distribute
in the U.S. must first receive 510(k) clearance or premarket
approval from the FDA. The FDA classifies all medical devices
into one of three classes. Devices deemed to pose lower risk are
placed in either class I or II, which requires the
manufacturer to submit to the FDA a 510(k) premarket
notification, requesting clearance of the device for commercial
distribution in the U.S. Some low risk devices are exempted from
this requirement. Devices deemed by the FDA to pose the greatest
risk, such as life sustaining, life-supporting or implantable
devices, or devices deemed not substantially equivalent to a
previously 510(k) cleared device are placed in class III
requiring premarket approval.

510(k) clearance process.The 510(k) clearance process is the
process applicable to our current products. To obtain 510(k)
clearance, we must submit a premarket notification to the FDA
demonstrating that the proposed device is substantially
equivalent to a previously cleared 510(k) device, a device that
was in commercial distribution before May 28, 1976 for
which the FDA has not yet called for the submission of premarket
approval applications, or is a device that has been reclassified
from class III to either class II or I. The FDAs 510(k)
clearance process usually takes three months from the date the
application is submitted and filed by the FDA, but it can take
significantly longer.

After a device receives 510(k) clearance, any
modification that could significantly affect its safety or
effectiveness, or that would constitute a major change in its
intended use, will require a new 510(k) clearance or could
require premarket approval. The FDA requires each manufacturer
to make this determination initially, but the FDA can review any
such decision and can disagree with a manufacturers
determination. If the FDA disagrees with a manufacturers
determination, the FDA can require the manufacturer to cease
marketing and/or recall the modified device until 510(k)
clearance or premarket approval is obtained. We have modified
aspects of some of our devices since receiving regulatory
clearance. Some of those modifications we believe are not
significant, and therefore, new 510(k) clearances or premarket
approvals are not required. Other modifications we believe are
significant and we have obtained new 510(k) clearances from the
FDA for these modifications. In the future, we may make
additional modifications to our products after they have
received FDA clearance or approval, and in appropriate
circumstances, determine that new clearance or approval is
unnecessary. However, the FDA may disagree with our
determination and if the FDA requires us to seek 510(k)
clearance or premarket approval for any modifications to a
previously cleared product, we may be required to cease
marketing or recall the modified device until we obtain the
required clearance or approval. Under these circumstances, we
may also be subject to significant regulatory fines or other
penalties.

Premarket approval process.A premarket approval application must
be submitted if the medical device is in class III (although the
FDA has the discretion to continue to allow certain
pre-amendment class III devices to use the 510(k) process) or
cannot be cleared through the 510(k) process. A premarket
approval application must be supported by, among other things,
extensive technical, preclinical, clinical trials,

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manufacturing and labeling data to demonstrate to
the FDAs satisfaction the safety and effectiveness of the
device.


After a premarket approval application is
submitted and filed, the FDA begins an in-depth review of the
submitted information, which typically takes between one and
three years, but may take significantly longer. During this
review period, the FDA may request additional information or
clarification of information already provided. Also during the
review period, an advisory panel of experts from outside the FDA
will be convened to review and evaluate the application and
provide recommendations to the FDA as to the approvability of
the device. In addition, the FDA will conduct a preapproval
inspection of the manufacturing facility to ensure compliance
with Quality System regulations. New premarket approval
applications or premarket approval application supplements are
required for significant modifications to the manufacturing
process, labeling and design of a device that is approved
through the premarket approval process. Premarket approval
supplements often require submission of the same type of
information as a premarket approval application, except that the
supplement is limited to information needed to support any
changes from the device covered by the original premarket
approval application, and may not require as extensive clinical
data or the convening of an advisory panel.

Certain of our devices have been classified as
class III pre-amendment devices. Although we currently have
510(k) clearance for these devices, the FDA has the discretion
at any time to request premarket approval applications from us
and all manufacturers of similar devices. If the FDA calls for
premarket approval applications, we will be required to submit
and obtain approvals for such devices within a specified period
of time. If we fail to do so, we will not be allowed to continue
marketing these products.

Clinical trials.A
clinical trial is almost always required to support a premarket
approval application and is sometimes required for a 510(k)
premarket notification. Clinical trials generally require
submission of an application for an investigational device
exemption to the FDA. The investigational device exemption
application must be supported by appropriate data, such as
animal and laboratory testing results, showing that it is safe
to test the device in humans and that the investigational
protocol is scientifically sound. The investigational device
exemption application must be approved in advance by the FDA for
a specified number of patients, unless the product is deemed a
non-significant risk device and eligible for more abbreviated
investigational device exemption requirements. Clinical trials
for a significant risk device may begin once the investigational
device exemption application is approved by the FDA as well as
the appropriate institutional review boards at the clinical
trial sites, and the informed consent of the patients
participating in the clinical trial is obtained.

Pervasive and continuing FDA regulation.After a medical device is placed on
the market, numerous FDA regulatory requirements apply,
including, but not limited to the following:



| |   |                                                                                                                                                                                                                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Quality System regulation, which requires
    manufacturers to follow design, testing, control, documentation
    and other quality assurance procedures during the manufacturing
    process;                                                                                                        
|
| |  | Establishment Registration, which requires
    establishments involved in the production and distribution of
    medical devices, intended for commercial distribution in the
    U.S. to register with the FDA;                                                                                      
|
| |  | Medical Device Listing, which requires
    manufacturers to list the devices they have in commercial
    distribution with the FDA;                                                                                                                                                                   
|
| |  | Labeling regulations, which prohibit
    misbranded devices from entering the market, as well
    as prohibit the promotion of products for unapproved or
    off-label uses and impose other restrictions on
    labeling; and                                                                   
|
| |  | Medical Device Reporting regulations, which
    require that manufacturers report to the FDA if their device may
    have caused or contributed to a death or serious injury or
    malfunctioned in a way that would likely cause or contribute to
    a death or serious injury if it were to recur.

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Failure to comply with applicable regulatory
requirements can result in enforcement action by the FDA, which
may include one or more of the following sanctions:



| |   |                                                                                             
| | - | --------------------------------------------------------------------------------------------
| |  | fines, injunctions, and civil penalties;                                                    
|
| |  | mandatory recall or seizure of our products;                                                
|
| |  | administrative detention or banning of our
    products;                                    
|
| |  | operating restrictions, partial suspension or
    total shutdown of production;             
|
| |  | refusing our request for 510(k) clearance or
    premarket approval of new product versions;
|
| |  | revocation of 510(k) clearance or premarket
    approvals previously granted; and           
|
| |  | criminal penalties.                                                                         

International Regulation.International sales of medical devices
are subject to foreign government regulations, which vary
substantially from country to country. The time required to
obtain approval by a foreign country may be longer or shorter
than that required for FDA approval, and the requirements may
differ significantly.

The European Union (currently consisting of the
following 15 countries or member states: Austria, Belgium,
Denmark, Finland, France, Germany, Greece, Italy, Ireland,
Luxembourg, the Netherlands, Portugal, Spain, Sweden, the United
Kingdom) has adopted legislation, in the form of directives to
be implemented in each member state, concerning the regulation
of medical devices within the European Union. The directives
include, among others, the Medical Device Directive that
establishes standards for regulating the design, manufacture,
clinical trials, labeling, and vigilance reporting for medical
devices. Under the European Union Medical Device Directive,
medical devices are classified into four classes, I, IIa, IIb,
and III, with class I being the lowest risk and class III being
the highest risk. Under the Medical Device Directive, a
competent authority is nominated by the government of each
member state to monitor and ensure compliance with the
Directive. The competent authority of each member state then
designates a notified body to oversee the conformity assessment
procedures set forth in the Directive, whereby manufacturers
demonstrate that their devices comply with the requirements of
the Directive and are entitled to bear the CE marking. CE is an
abbreviation for Conformité Européene (or European
Conformity) and the CE marking, when placed on a product,
indicates compliance with the requirements of the applicable
directive. Medical devices properly bearing the CE marking may
be commercially distributed throughout the European Union. We
have received CE certification from the British Standards
Institution for conformity with ISO 9001 allowing us to CE mark
our product lines. The ISO quality system has been developed by
the International Organization for Standardization to ensure
that companies are aware of the standards of quality to which
their products will be held worldwide. While no additional
premarket approvals in individual European Union countries are
required prior to marketing of a device bearing the CE marking,
practical complications with respect to marketing introduction
may occur. For example, differences among countries have arisen
with regard to labeling requirements. Failure to maintain the CE
marking will preclude us from selling our products in the
European Union. We may not be successful in maintaining
certification requirements necessary for distribution of our
products in the European Union.

Under the Medical Devices Regulations of Canada,
all medical devices are classified into four classes, class I
being the lowest risk class and class IV being the highest risk.
Class I devices include among others, devices that make
only non-invasive contact with the patient. Classes II, III
and IV include devices of increasingly higher risk as determined
by such factors as degree of invasiveness and the potential
consequences to the patient if the device fails or malfunctions.
Our current products sold in Canada generally fall into
classes II and III. All class II, III and IV medical
devices must have a valid Medical Device License issued by the
Therapeutic Products Directorate of Health Canada before they
may be sold in Canada (class I devices do not require such a
license). We have obtained applicable Medical Device Licenses
for many of our products. Failure to maintain required Medical
Device Licenses in Canada or to meet other requirements of the
Canadian Medical Devices Regulations (such as quality system
standards and labeling requirements) for our

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products will preclude us from selling our
products in Canada. We may not be successful in continuing to
meet the medical device licensing requirements necessary for
distribution of our products in Canada.


Intellectual
Property

The success of our products depends in part on
our internally developed intellectual property and other
proprietary rights. We rely on a combination of patent,
copyright, trademark and trade secret laws, confidentiality
procedures and contractual provisions to protect our
intellectual property and other proprietary rights. We also
generally enter into confidentiality agreements with our
employees and technical consultants.

As of December 31, 2003, Quinton holds
various U.S. and foreign patents, which expire at various times
between 2004 and 2018. Quinton also has certain patent
applications pending before foreign governmental bodies. Our
patents and patent applications protect various aspects of our
business including: filters for filtering ECG signals,
monitoring electrodes and methods of interfacing the monitoring
electrodes to a patient, and devices and methods for obtaining,
analyzing, and presenting physiological data, such as various
cardiology information. We also have perpetual rights to certain
patented technology relating to Quintons medical
treadmills. In addition, we have registered or applied to
register certain trademarks with domestic and certain foreign
trademark authorities.

Our business also depends in part on licenses to
use third parties software in our product offerings. We
believe that the agreements we have in place with these third
parties generally provide for such software at fair market value
and that, if any such agreements expire or terminate, we would
be able to obtain alternative software at comparable prices.

Employees

As of December 31, 2003, we had 365 full
time employees, including 71 in research and development, 97 in
sales and marketing, 68 in technical support services, 79 in
manufacturing and supplies operations, 6 in regulatory affairs
and 44 in finance and administration. These employee totals
include 22 employees in our majority owned Shanghai Joint
Venture. In addition, at December 31, 2003, we had 24
temporary employees, many of whom have subsequently become full
time employees in our manufacturing and supplies operations.
None of our employees are represented by a labor union, except
in China, where substantially all employees are represented by a
labor union. We have not experienced any work stoppages and
consider our relations with our employees to be good.

Foreign
Operations

Sales to customers located outside the United
States were approximately $3.3 million, $2.8 million
and $6.5 million for the years ended December 31,
2001, 2002 and 2003, respectively. The sales amounts for 2001
and 2002 do not include historical international sales of
Burdick. Additional information is provided in Note 2 to
the Consolidated Financial Statements Summary of
Significant Accounting Policies  Segment
Reporting.

Certain
Factors That May Affect Future Results

In addition to the other information contained
in this report, the following risk factors could affect our
actual results and could cause our actual results to differ
materially from those achieved in the past or expressed in our
forward-looking statements. Additional risks and uncertainties
not presently known to us or that we currently deem immaterial
also may impair our business operations.

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The unpredictability of our quarterly revenues
and operating results may cause the trading price of our stock
to decrease.

Our quarterly revenues and operating results have
varied in the past and may continue to vary in the future due to
a number of factors, many of which are outside of our control.
Factors contributing to these fluctuations include:



| |   |                                                                                                                                                                                                                               
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the impact of acquisitions, divestitures and
    other significant corporate events;                                                                                                                                          
|
| |  | changes in our ability to obtain products and
    product components that are manufactured for us by third
    parties, such as Holter monitors, as well as variations in
    prices of these products and product components;
|
| |  | delays in the development or commercial
    introduction of new versions of products and systems;                                                                                                                             
|
| |  | our ability to attain and maintain production
    volumes and quality levels for our products and product
    components;                                                                                                     
|
| |  | effects of domestic and foreign economic
    conditions on our industry and/or customers;                                                                                                                                     
|
| |  | adoption of our system-oriented sales approach;                                                                                                                                                                               
|
| |  | changes in the demand for our products and
    systems;                                                                                                                                                                       
|
| |  | varying sales cycles that can take up to a year
    or more;                                                                                                                                                                  
|
| |  | changes in the mix of products and systems we
    sell;                                                                                                                                                                       
|
| |  | unpredictable budgeting cycles of our customers;                                                                                                                                                                              
|
| |  | delays in obtaining regulatory clearance for new
    versions of our products and systems;                                                                                                                                    
|
| |  | increased product and price competition;                                                                                                                                                                                      
|
| |  | the impact of regulatory changes on the
    availability of third-party reimbursement to customers of our
    products and systems;                                                                                           
|
| |  | the loss of key sales personnel or distributors;
    and                                                                                                                                                                      
|
| |  | seasonality in the sales of our products and
    systems.                                                                                                                                                                     

Due to the factors summarized above, we believe
that period-to-period comparisons of our operating results are
not a good indication of our future performance and should not
be relied on to predict future operating results. Also, it is
possible that, in future periods, our operating results will not
meet the expectations of public market analysts or investors. In
that event, the price of our common stock may decrease.

Failure to keep pace with changes in the
marketplace may cause us to lose market share and our revenues
may decrease.

The marketplace for diagnostic cardiology systems
is characterized by rapid change and technological innovation,
requiring suppliers in the market to regularly update product
features and incorporate new technologies in order to remain
competitive. In developing and enhancing our products we have
made, and will continue to make, assumptions about which
features, technology standards and performance criteria will be
attractive to, or demanded by, our customers. If we implement
features, standards and performance criteria that are different
from those required by our customers or if our competitors
introduce products and systems that better address these needs,
market acceptance of our offerings may suffer or may become
obsolete. In that event, our market share and revenues would
likely decrease.

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Failure to develop and commercialize new
versions of our products would cause our operating results to
suffer, both domestically and internationally.

To be successful, we must develop and
commercialize new versions of our products for both domestic and
international markets. Our products are technologically complex
and must keep pace with rapid and significant technological
change, comply with rapidly evolving industry standards and
government regulations, and compete effectively with new product
introductions of our competitors. Accordingly, many of our
products require significant planning, design, development and
testing at the technological, product and manufacturing process
levels. Our success in developing and commercializing new
versions of our products is affected by our ability to:



| |   |                                                                                                                       
| | - | ----------------------------------------------------------------------------------------------------------------------
| |  | accurately assess customer needs;                                                                                     
|
| |  | develop products that are easy to use;                                                                                
|
| |  | minimize the time required to obtain, as well as
    the costs of, required regulatory clearance or approval;         
|
| |  | price competitively;                                                                                                  
|
| |  | manufacture and deliver on time;                                                                                      
|
| |  | accurately predict and control costs associated
    with manufacturing, installation, warranty and maintenance;       
|
| |  | manage customer acceptance and payment;                                                                               
|
| |  | limit demands by our customers for retrofits,                                                                         
|
| |  | anticipate and meet demands of our international
    customers for products featuring local language capabilities; and
|
| |  | anticipate and compete effectively with our
    competitors efforts.                                                 

The rate of market acceptance of our current or
future products and systems may impact our operating results. In
addition, we may experience design, manufacturing, marketing or
other difficulties that could delay or prevent our development,
introduction or marketing of new versions of our products. Such
difficulties and delays could cause our development expenses to
increase and harm our operating results.

If market conditions cause us to reduce the
selling price of our products and systems, or our market share
is negatively affected by the activities of our competitors, our
margins and operating results will decrease.

The selling price of our products and systems and
the extent of our market share are subject to market conditions.
Market conditions that could impact these aspects of our
operations include:



| |   |                                                                                
| | - | -------------------------------------------------------------------------------
| |  | delays in product launches;                                                    
|
| |  | lengthening of buying or selling cycles;                                       
|
| |  | the introduction of competing products;                                        
|
| |  | price reductions by our competitors;                                           
|
| |  | development of more effective products by our
    competitors;                 
|
| |  | hospital budgetary constraints; and                                            
|
| |  | changes in the reimbursement policies of
    government and third-party payers.

If such conditions force us to sell our products
and systems at lower prices, or if we are unable to effectively
develop and market competitive products, our market share,
margins and operating results will likely decrease.

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If we fail to successfully integrate acquired
businesses, product lines, assets or technologies, our operating
results may suffer.

As part of our growth strategy, we intend to
selectively acquire other businesses, product lines, assets, or
technologies. Successful execution of our acquisition strategy
depends upon our ability to identify, negotiate, complete and
integrate suitable acquisitions and, if necessary, to obtain
satisfactory debt or equity financing. If we acquire
complementary businesses or assets but fail to successfully
integrate them, our financial condition or results of operations
may suffer.

Our future financial results could be
adversely impacted by asset impairments or other
charges.

We have adopted Statement of Financial Accounting
Standards No. 142, Goodwill and Other Intangible
Assets. As a result, we are required to test both acquired
goodwill and other indefinite-lived intangible assets,
consisting of a trade name for impairment on an annual basis
based upon a fair value approach, rather than amortizing them
over time. We are also required to test goodwill for impairment
between annual tests if an event occurs or circumstances change
that would more likely than not reduce the fair value of our
reporting units below their book value. These events or
circumstances could include a significant change in the business
climate, legal factors, operating performance indicators,
competition, sale or disposition of a significant portion of the
business, or other factors such as a decline in our market value
below our book value for an extended period of time.
Additionally, our other indefinite-lived intangible assets must
be tested between annual tests if events or changes in
circumstances indicate that the assets might be impaired. We
evaluate the estimated lives of all intangible assets on an
annual basis, including those with indefinite lives, to
determine if events and circumstances warrant a revision in the
remaining period of amortization. In the case of intangible
assets with indefinite lives, we evaluate whether events or
circumstances continue to support an indefinite useful life. The
amount of any such annual or interim impairment charge could be
significant, and could have a material adverse effect on our
reported financial results for the period in which the charge is
taken.

If we fail to maintain our distributor
relationships our sales and operating results may
suffer.

We sell our products to the domestic primary care
market and to substantially all international markets
principally through third party distributors. While we have well
established relationships with these distributors, the
underlying agreements are generally for periods of one year or
less. If these agreements are cancelled or if we are unable to
renew them as they expire, our sales and operating results may
suffer materially. Our largest customer, Physicians Sales and
Service, Inc., accounted for 14% of our revenues in 2003. There
were no customers that accounted for over 10% of our revenues in
2001 or 2002.

We may need additional capital to continue our
acquisition growth strategy.

Successful continued execution of our acquisition
strategy depends upon our ability to identify, negotiate,
complete and integrate suitable acquisitions and, if necessary,
to obtain satisfactory debt or equity financing. We are likely
to require additional debt or equity financing to make any
further significant acquisitions. Such financing may not be
available on terms that are acceptable to us or at all. If we
are required to incur additional indebtedness to fund
acquisitions in the future, our cash flow may be negatively
affected by additional debt servicing requirements and the terms
of such indebtedness may impose covenants and restrictions that
provide us less flexibility in how we operate our business.
Fluctuations in our stock price may make it difficult to make
acquisitions using our stock as consideration. Moreover, use of
our stock to fund acquisitions may have a significant dilutive
effect on existing shareholders.

Our lack of customer purchase contracts and
our limited order backlog make it difficult to predict sales and
plan manufacturing requirements, which can lead to lower
revenues, higher expenses and reduced margins.

We do not generally have long-term purchase
contracts with customers who order products on a purchase order
basis. In limited circumstances, customer orders may be
cancelled, changed or delayed on short notice.

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Lack of significant order backlog makes it
difficult for us to forecast future sales with certainty. Long
and varying sales cycles with our customers make it difficult to
accurately forecast component and product requirements. These
factors expose us to a number of risks:




| |   |                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | if we overestimate our requirements we may be
    obligated to purchase more components or third-party products
    than is required;                                                                                                                               
|
| |  | if we underestimate our requirements, our
    third-party manufacturers and suppliers may have an inadequate
    product or product component inventory, which could interrupt
    manufacturing of our products and result in delays in shipments
    and revenues;
|
| |  | we may also experience shortages of product
    components from time to time, which also could delay the
    manufacturing of our products; and                                                                                                                     
|
| |  | over or under production can lead to higher
    expense, lower than anticipated revenues, and reduced margins.                                                                                                                                                      

If suppliers discontinue production of
purchased components of our products and we are unable to secure
alternative sources for these components on a timely basis, our
ability to ship products to our customers may be adversely
affected, our revenues may decline and our costs may increase as
a result.

For a variety of reasons, including but not
limited to relatively low volumes, our supplies may discontinue
production of component parts for our products. Alternative
sources of these components may result in higher costs. In
addition, if we are unable to secure alternative sources for
these components, significant delays in product shipments may
result while we re-engineer our products to utilize available
components. This could result in reduced revenues, higher costs
or both.

If we do not develop or maintain successful
relationships with international distributors, our growth may be
limited, sales of our products and systems may decrease and our
operating results may suffer.

During 2001, 2002, and 2003, we generated, on
average, approximately 7% of our revenues from international
sales and our growth strategy contemplates expanded efforts to
increase international sales. All of our international sales in
recent periods were attributable to third-party distributors,
and our success in expanding international sales in the future
will depend on our ability to develop and manage a network of
international distributors and the performance of our
distributors. Because we do not generally have long-term
contracts with our distributors, our distribution relationships
may be terminated on little or no notice. If we lose any
significant international distributors, or if any of our
distributors devote more effort to selling competing products
and systems, our international sales and operating results may
suffer and our growth may be limited. Consequently, our success
in expanding international sales may be limited if our
distributors lack, or are unable to develop, relationships with
important target customers in international markets.

Undetected product errors or defects could
result in increased warranty costs, loss of revenues, product
recalls, delayed market acceptance and claims against
us.

Any errors or defects in our products discovered
after commercial release could result in:



| |   |                                              
| | - | ---------------------------------------------
| |  | failure to achieve market acceptance;        
|
| |  | loss of customers, revenues and market share;
|
| |  | diversion of development resources;          
|
| |  | increased service and warranty costs;        

16



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##### Table of Contents





| |   |                                    
| | - | -----------------------------------
| |  | legal actions by our customers; and
|
| |  | increased insurance costs.         

Inadequate levels of reimbursement from
governmental or other third-party payers for procedures using
our products and systems may cause our revenues to
decrease.

Significant changes in the healthcare systems in
the U.S. or elsewhere could have a significant impact on
the demand for our products and services as well as the way we
conduct business. Federal, state and local governments have
adopted a number of healthcare policies intended to curb rising
healthcare costs. In the U.S., healthcare providers that
purchase our products and systems generally rely on governmental
and other third-party payers, such as federal Medicare, state
Medicaid, and private health insurance plans, to pay for all or
a portion of the cost of heart-monitoring procedures and
consumable products utilized in those procedures. The
availability of such reimbursement affects our customers
decisions to purchase capital equipment. Denial of coverage or
reductions in levels of reimbursement for procedures performed
using our products and systems by governmental or other
third-party payers would cause our revenues to decrease. We are
unable to predict whether federal, state or local healthcare
reform legislation or regulation affecting our business may be
proposed or enacted in the future, or what effect any such
legislation or regulation would have on our business.

If we fail to obtain or maintain applicable
regulatory clearances or approvals for our products, or if
clearances or approvals are delayed, we will be unable to
commercially distribute and market our products in the U.S. and
other jurisdictions.

Our products are medical devices that are subject
to significant regulation in the U.S. and in foreign countries
where we do business. The processes for obtaining regulatory
approval can be lengthy and expensive, and the results are
unpredictable. If we are unable to obtain clearances or
approvals needed to market existing or new products, or obtain
such clearances or approvals in a timely fashion, it could
adversely affect our revenues and profitability.

Available
Information

We maintain an Internet site at
http://www.quinton.com. We make available free of charge on or
through our Internet site, our annual report on Form 10-K,
quarterly reports on Form 10-Q, current reports on
Form 8-K and amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Exchange Act as
soon as reasonably practicable after we electronically file such
material with, or furnish it to, the SEC. We will voluntarily
provide electronic or paper copies of our filings free of charge
upon request.






|        |           
|------- | ----------
|Item 2. | Properties

We have a facility in Bothell, Washington, which
houses our corporate offices and certain of our research and
development and customer support services operations, as well as
the marketing, finance and administration departments. We occupy
approximately 34,000 square feet in this complex. Our lease
of the Bothell facility was renewed in 2003 and expires in
December 2013 with an early termination option in January 2009.

We also have a facility in Deerfield, Wisconsin,
which houses our manufacturing operations and certain of our
research and development, customer support services, marketing,
finance and administrative functions. This is a
100,000 square foot leased facility. The lease expires in
2008 with two five-year renewal options.






|        |                  
|------- | -----------------
|Item 3. | Legal Proceedings

We are not currently a party to any material
legal proceedings.






|        |                                                    
|------- | ---------------------------------------------------
|Item 4. | Submission of Matters to a Vote of
    Shareholders

No matters were submitted to a vote of the
shareholders during the fourth quarter of the fiscal year ended
December 31, 2003.

17



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##### Table of Contents






PART II






|        |                                                                      
|------- | ---------------------------------------------------------------------
|Item 5. | Market for Companys Common Stock and
    Related Shareholder Matters

Our Common Stock is traded on the Nasdaq National
Market (symbol QUIN). The number of shareholders of
record of our Common Stock at March 1, 2004, was 133.

High and low bid quotations for our Common Stock
as quoted on the Nasdaq National Market for the periods
indicated, since May 6, 2002, the date our common stock
began trading, are as follows.

|            |                                   |             |   |      |  |  |   |      | 
|----------- | --------------------------------- | ----------- | - | ---- |  |  | - | ---- | 
|            |                                   |            
|            |                                   | Stock Price
|            |                                   |            
|            |                                   | High        |   | Low 
|            |                                   |             |   |     
|Fiscal 2002 |                                   |             |   |      |  |  |   |     
|            | Second Quarter (from May 6, 2002) |             | $ | 9.06 |  |  | $ | 7.19 | 
|            | Third Quarter                     |             |   | 8.85 |  |  |   | 5.41 | 
|            | Fourth Quarter                    |             |   | 7.90 |  |  |   | 4.54 | 
|Fiscal 2003 |                                   |             |   |      |  |  |   |     
|            | First Quarter                     |             | $ | 7.77 |  |  | $ | 5.25 | 
|            | Second Quarter                    |             |   | 8.13 |  |  |   | 5.14 | 
|            | Third Quarter                     |             |   | 8.85 |  |  |   | 7.20 | 
|            | Fourth Quarter                    |             |   | 8.49 |  |  |   | 7.20 | 

We have never declared or paid any cash dividends
on our Common Stock. We currently anticipate that we will retain
any future earnings for use in the expansion and operations of
our business and do not anticipate paying cash dividends in the
foreseeable future.






|        |                        
|------- | -----------------------
|Item 6. | Selected Financial Data

The following selected consolidated financial
data should be read in conjunction with the consolidated
financial statements and the notes thereto and the information
contained herein in Item 7, Managements
Discussion and Analysis of Financial Condition and Results of
Operations. The following selected consolidated financial
data is derived from our audited consolidated financial
statements included elsewhere in this annual report on form
10-K. Historical results are not necessarily indicative of
future results.

|                                               |                                                            |                                       |        |       |        |      |        |       |        |      |        |       |        |   |        |       |        |   |        |       |        | 
|---------------------------------------------- | ---------------------------------------------------------- | ------------------------------------- | ------ | ----- | ------ | ---- | ------ | ----- | ------ | ---- | ------ | ----- | ------ | - | ------ | ----- | ------ | - | ------ | ----- | ------ | 
|                                               |                                                            |                                      
|                                               |                                                            | Fiscal Year Ending December 31,      
|                                               |                                                            |                                      
|                                               |                                                            | 1999                                  |        | 2000  |        | 2001 |        | 2002  |        | 2003
|                                               |                                                            |                                       |        |       |        |      |        |       |        |     
|                                               |                                                            |                                      
|                                               |                                                            | (In thousands, except for share data)
|Consolidated Statement of Operations
    Data: |                                                            |                                       |        |       |        |      |        |       |        |      |        |       |        |   |        |       |        |   |        |      
|Revenues                                       |                                                            | $                                     | 69,918 |       |        | $    | 50,734 |       |        | $    | 42,874 |       |        | $ | 46,496 |       |        | $ | 84,396 |      
|Cost of revenues                               |                                                            |                                       | 42,438 |       |        |      | 33,719 |       |        |      | 26,020 |       |        |   | 27,883 |       |        |   | 51,131 |      
|                                               |                                                            |                                       |        |       |        |      |        |       |        |      |        |       |        |   |        |       |        |   |        |      
|                                               |                                                            | Gross profit                          |        |       | 27,480 |      |        |       | 17,015 |      |        |       | 16,854 |   |        |       | 18,613 |   |        |       | 33,265 | 
|                                               |                                                            |                                       |        |       |        |      |        |       |        |      |        |       |        |   |        |       |        |   |        |      
|Operating Expenses:                            |                                                            |                                       |        |       |        |      |        |       |        |      |        |       |        |   |        |       |        |   |        |      
|                                               | Research and development                                   |                                       |        | 7,078 |        |      |        | 7,479 |        |      |        | 5,459 |        |   |        | 5,126 |        |   |        | 8,086 |       
|                                               | Write off acquired in-process research and
    development |                                       |        |      |        |      |        |      |        |      |        |      |        |   |        |      |        |   |        | 1,290 |       

18



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|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |         |        |        |  
|-------------------------------------------------------------------------------------------- | ------------------------------------------------------------------- | ------------------------------------- | ---------------------------- | ------- | ------ | ------ | ------- | ------ | ------ | ------ | ------- | ------ | ------ | ------ | --------- | ------ | ------ | ------ | ---------- | ------- | ------ | ------ | -
|                                                                                             |                                                                     |                                      
|                                                                                             |                                                                     | Fiscal Year Ending December 31,      
|                                                                                             |                                                                     |                                      
|                                                                                             |                                                                     | 1999                                  |                              | 2000    |        | 2001   |         | 2002   |        | 2003  
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |       
|                                                                                             |                                                                     |                                      
|                                                                                             |                                                                     | (In thousands, except for share data)
|                                                                                             | Sales and marketing                                                 |                                       |                              | 15,872  |        |        |         | 13,306 |        |        |         | 9,210  |        |        |           | 9,974  |        |        |            | 17,669  |       
|                                                                                             | General and administrative (excluding stock-based
    compensation) |                                       |                              | 5,179   |        |        |         | 4,525  |        |        |         | 4,913  |        |        |           | 5,273  |        |        |            | 7,669   |       
|                                                                                             | Restructuring costs                                                 |                                       |                              |        |        |        |         | 645    |        |        |         |       |        |        |           |       |        |        |            |        |       
|                                                                                             | Stock-based compensation (1)                                        |                                       |                              | 67      |        |        |         | 215    |        |        |         | 2,664  |        |        |           | 111    |        |        |            | 74      |       
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             |                                                                     | Total operating expenses              |                              |         | 28,196 |        |         |        | 26,170 |        |         |        | 22,246 |        |           |        | 20,484 |        |            |         | 34,788 |       
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             |                                                                     |                                       | Operating loss               |         |        | (716   | )       |        |        | (9,155 | )       |        |        | (5,392 | )         |        |        | (1,871 | )          |         |        | (1,523 | )
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|Other Income (Expense):                                                                      |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             | Interest income (expense), net                                      |                                       |                              | (1,517  | )      |        |         | (302   | )      |        |         | (939   | )      |        |           | 330    |        |        |            | (212    | )     
|                                                                                             | Write-off note receivable and accrued interest                      |                                       |                              |        |        |        |         |       |        |        |         | (1,106 | )      |        |           |       |        |        |            |        |       
|                                                                                             | Other income (expense), net                                         |                                       |                              | 182     |        |        |         | 369    |        |        |         | 74     |        |        |           | (6     | )      |        |            | (11     | )     
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             |                                                                     |                                       | Total other income (expense) |         |        | (1,335 | )       |        |        | 67     |         |        |        | (1,971 | )         |        |        | 324    |            |         |        | (223   | )
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|Loss from continuing operations before income
    taxes                                      |                                                                     |                                       | (2,051                       | )       |        |        | (9,088  | )      |        |        | (7,363  | )      |        |        | (1,547    | )      |        |        | (1,746     | )      
|                                                                                             | Income tax benefit (provision)                                      |                                       |                              | (27     | )      |        |         | 2,088  |        |        |         | 205    |        |        |           | 192    |        |        |            | (62     | )     
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|Loss from continuing operations before minority
    interest in loss of consolidated entity  |                                                                     |                                       | (2,078                       | )       |        |        | (7,000  | )      |        |        | (7,158  | )      |        |        | (1,355    | )      |        |        | (1,808     | )      
|                                                                                             | Minority interest in loss of consolidated entity                    |                                       |                              |        |        |        |         |       |        |        |         |       |        |        |           |       |        |        |            | 25      |       
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|Loss from continuing operations                                                              |                                                                     |                                       | (2,078                       | )       |        |        | (7,000  | )      |        |        | (7,158  | )      |        |        | (1,355    | )      |        |        | (1,783     | )      
|Discontinued operations:                                                                     |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             | Income from operations, net                                         |                                       |                              | 448     |        |        |         |       |        |        |         |       |        |        |           |       |        |        |            |        |       
|                                                                                             | Gain (loss) on sale, net                                            |                                       |                              | 4,732   |        |        |         |       |        |        |         | (831   | )      |        |           |       |        |        |            |        |       
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             | Net income (loss)                                                   |                                       | $                            | 3,102   |        |        | $       | (7,000 | )      |        | $       | (7,989 | )      |        | $         | (1,355 | )      |        | $          | (1,783  | )     
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|Basic and diluted loss from continuing operations
    per share (2)                          |                                                                     | $                                     | (7.16                        | )       |        | $      | (13.94  | )      |        | $      | (11.37  | )      |        | $      | (0.17     | )      |        | $      | (0.15      | )      
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|Shares used in computing basic and diluted loss
    from continuing operations per share (2) |                                                                     |                                       | 290,264                      |         |        |        | 502,065 |        |        |        | 629,647 |        |        |        | 7,887,659 |        |        |        | 12,147,720 |        
|Consolidated Statement of Cash Flows
    Data:                                               |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             | Cash flows from operations                                          |                                       | $                            | (1,738  | )      |        | $       | (2,115 | )      |        | $       | 719    |        |        | $         | (1,369 | )      |        | $          | 173     |       
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             | Cash flows from investing activities                                |                                       | $                            | 13,722  |        |        | $       | (672   | )      |        | $       | (280   | )      |        | $         | (3,369 | )      |        | $          | (19,597 | )     
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        
|                                                                                             | Cash flows from financing activities                                |                                       | $                            | (13,123 | )      |        | $       | 2,409  |        |        | $       | (644   | )      |        | $         | 23,902 |        |        | $          | 227     |       
|                                                                                             |                                                                     |                                       |                              |         |        |        |         |        |        |        |         |        |        |        |           |        |        |        |            |        

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|                                 |                            |                |   |        |  |      |   |        |  |      |   |        |  |  |   |        |  |  |   |        | 
|-------------------------------- | -------------------------- | -------------- | - | ------ |  | ---- | - | ------ |  | ---- | - | ------ |  |  | - | ------ |  |  | - | ------ | 
|                                 |                            |               
|                                 |                            | December 31,  
|                                 |                            |               
|                                 |                            | 1999           |   | 2000   |  | 2001 |   | 2002   |  | 2003
|                                 |                            |                |   |        |  |      |   |        |  |     
|                                 |                            |               
|                                 |                            | (In thousands)
|Consolidated Balance Sheet Data: |                            |                |   |        |  |      |   |        |  |      |   |        |  |  |   |        |  |  |   |       
|                                 | Cash and cash equivalents  |                | $ | 801    |  |      | $ | 423    |  |      | $ | 218    |  |  | $ | 19,382 |  |  | $ | 185    | 
|                                 | Total assets               |                |   | 32,682 |  |      |   | 23,654 |  |      |   | 17,466 |  |  |   | 42,050 |  |  |   | 48,317 | 
|                                 | Current liabilities        |                |   | 21,530 |  |      |   | 18,183 |  |      |   | 16,578 |  |  |   | 14,378 |  |  |   | 20,807 | 
|                                 | Long-term liabilities      |                |   |       |  |      |   |       |  |      |   | 831    |  |  |   | 363    |  |  |   | 1,180  | 
|                                 | Total shareholders equity |                | $ | 11,152 |  |      | $ | 5,471  |  |      | $ | 57     |  |  | $ | 27,309 |  |  | $ | 26,132 | 



---



|    |                                                                                                                                                                                                                
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Stock-based compensation charges, though reported
    separately in the statement of operations, are attributed to
    general and administrative expenses.                                                    
|   
|(2) | See Note 2 to the consolidated financial
    statements for a reconciliation of the denominators used in
    computing basic and diluted loss per share from continuing
    operations for 2001, 2002 and 2003.






|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

You should read the following discussion and
analysis in conjunction with our consolidated financial
statements and related notes included elsewhere in this report.
Except for historical information, the following discussion
contains forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. All statements
other than statements of historical fact, including future
results of operations or financial position, made in this Annual
Report on Form 10-K are forward looking. The words
believe, expect, intend,
anticipate, variations of such words, and similar
expressions identify forward-looking statements, but their
absence does not mean that the statement is not forward-looking.
These forward-looking statements reflect managements
current expectations and involve risks and uncertainties. Our
actual results could differ materially from results that may be
anticipated by such forward-looking statements. The principal
factors that could cause or contribute to such differences
include, but are not limited to, those discussed in the section
entitled Certain Factors That May Affect Future
Results and those discussed elsewhere in this report..
Readers are cautioned not to place undue reliance on these
forward-looking statements, which speak only as of the date of
this report. We undertake no obligation to revise any
forward-looking statements to reflect events or circumstances
that may subsequently arise. Readers are urged to review and
consider carefully the various disclosures made in this report
and in our other filings made with the SEC that attempt to
advise interested parties of the risks and factors that may
affect our business, prospects and results of
operations.

Overview

We develop, manufacture, market and service a
family of advanced cardiology products used in the diagnosis,
monitoring and management of patients with heart disease. Our
products include electrocardiographs (ECGs), stress test
systems, Holter monitoring systems, cardiac rehabilitation
telemetry systems, ECG management systems, medical treadmills
and patented electrodes. We also sell a variety of ancillary
cardiology products and consumables related to our principal
products. We sell our products under the Quinton and Burdick
brand names.

On January 2, 2003, we concluded the
purchase of 100% of the stock of Spacelabs Burdick, Inc.,
which we refer to as Burdick. Based in Deerfield, Wisconsin,
Burdick had approximately 150 employees. Burdicks
historical strength in ECG cardiographs, Holter monitors and
cardiology information systems, combined with its distribution
network focused on U.S. physicians offices,
complements Quintons strength in cardiac stress testing
and cardiac rehabilitation monitoring and its hospital focused
direct sales force.

We categorize our revenues as either systems
revenue, which includes capital equipment and related items, or
service revenue, which includes service contracts, equipment
repair and replacement part sales. We derive our revenues
primarily from the sale of our cardiology products and related
consumables, and to a lesser extent, from services.

20



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Our operating results have depended, and will
continue to depend, upon the continued adoption of our products
by cardiologists and other healthcare providers. The rate of
adoption is influenced significantly over the longer term by
government laws and mandates, physician group guidelines,
performance and pricing of our products, relationships with key
physicians and hospitals and other factors.

Our quarterly revenues also may be impacted by
other factors including the length of our sales cycle, the
timing of sales orders, budget cycles of our customers,
competition, the timing and introduction of new versions of our
products, the loss of, or difficulties affecting, key personnel
and distributors, the timing of the implementation of screening
mandates, changes in market dynamics, the timing of product
developments or market introductions and acquisitions or
divestitures. These factors have impacted our historical results
to a greater extent than has seasonality. Combinations of these
factors have historically influenced our growth rate and
profitability significantly in one period compared to another,
and may continue to influence future periods and compromise our
ability to make accurate forecasts.

We derive a portion of our service revenue from
sales of separate extended maintenance arrangements. We defer
these revenues based on the time period of the maintenance
arrangements and recognize these revenues over the applicable
maintenance period.

Domestic sales accounted for an average of
approximately 93% of our revenues during each of the last three
years.

Cost of revenues consists primarily of the costs
associated with manufacturing, assembling and testing our
products, related overhead costs, and compensation and other
costs related to manufacturing support and logistics. We rely on
third parties to manufacture certain of our product components.
Accordingly, a significant portion of our cost of revenues
consists of payments to these manufacturers. Cost of service
revenue consists of customer support costs, training and
professional service expenses, parts and compensation. In
addition, our hardware products carry a warranty period that
includes factory repair services or replacement parts as needed.
We accrue estimated expenses for warranty obligations at the
time products are shipped.

Our gross profit has been and will continue to be
affected by a variety of factors, including competition, the mix
and average selling prices of products, maintenance and
services, new versions of products, the cost of components and
manufacturing labor, fluctuations in manufacturing volumes,
component shortages, and the mix of distribution channels
through which our products are sold. Our gross profit will be
adversely affected by price declines if we are unable to reduce
costs on existing products or to introduce new versions of
products with higher margins.

Research and development expenses consist
primarily of salaries and related expenses for development and
engineering personnel, fees paid to consultants, and prototype
costs related to the design, development, testing and
enhancement of our diagnostic cardiology systems. We expense our
research and development costs as they are incurred. As our
products become more dependent on software, we may be required
to capitalize certain software development costs in the future.
Several components of our research and development effort
require significant funding, the timing of which can cause
significant quarterly variability in our expenses. We are
devoting substantial resources to the continued development of
new versions of products to meet the changing requirements of
our customers. As a result, our research and development
expenses may increase in the future.

Sales and marketing expenses consist primarily of
salaries, commissions and related expenses for personnel engaged
in sales, marketing and sales support functions as well as costs
associated with promotional and other marketing activities. We
intend to expand our sales and marketing operations
substantially, both domestically and internationally, in order
to increase sales of our products. In addition, we believe part
of our future success will be dependent upon establishing
successful relationships with a variety of additional resellers
in other countries. We expect that sales and marketing expenses
will increase in absolute dollars as we expand our sales efforts
in both domestic and international locations, hire additional
sales and marketing personnel and initiate additional marketing
programs.

General and administrative expenses consist
primarily of salaries and related expenses for executive,
finance, accounting, legal and human resources personnel,
professional fees and corporate expenses. We

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expect general and administrative expenses to
increase in absolute dollars as we employ additional personnel
and incur additional costs related to the growth of our business
and our operation as a public company. Expenses we incurred in
connection with litigation against a former supplier, which went
to trial in January 2003, caused general and administrative
expenses to grow in 2001 and 2002. We did not incur any further
significant expenses in connection with this litigation in 2003.


Stock-based compensation charges are recorded
when the exercise price of an option or the sales price of
restricted stock is less than the fair value of the underlying
common stock for awards to employees. We also record stock-based
compensation charges when options are granted to non-employees.
Compensation charges for non-employees are based on estimates of
the underlying stock fair values and are determined using option
pricing models. Although stock-based compensation is a general
and administrative expense, we present stock-based compensation
separately from general and administrative expenses.

Critical Accounting Estimates and
Policies

To prepare financial statements that conform with
accounting principles generally accepted in the United States of
America, we must select and apply accounting policies and make
estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related
disclosure of contingent assets and liabilities. We base our
accounting estimates on historical experience and on various
other assumptions that we believe to be reasonable under the
circumstances, the results of which form our basis for making
judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or
conditions.

Critical
Accounting Estimates

There are certain critical accounting estimates
that we believe require significant judgment in the preparation
of our consolidated financial statements. We consider an
accounting estimate to be critical if:



| |   |                                                                                                                                                                                                
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | it requires us to make assumptions because
    information was not available at the time or it included matters
    that were highly uncertain at the time we were making the
    estimate, and
|
| |  | changes in the estimate or different estimates
    that we reasonably could have selected would have had a material
    impact on our financial condition or results of operations.            

Our critical accounting estimates include those
affecting revenues, the allowance for doubtful accounts, the
salability and recoverability of inventory, warranty
liabilities, the carrying value of our investment in
ScImage, Inc., the useful lives and fair value of
intangible assets, income taxes, purchase price allocations,
accounting for stock-based compensation, and contingencies.

Revenues.We
recognize revenue from sales of our systems generally when title
transfers to the customer, typically upon shipment. We recognize
revenue on sales of systems made to distributors when the
product is shipped to our distributors and all of our
significant obligations have been met. When we sell a system and
installation is a component of the sale, the timing of our
recognition of revenues from that sale depends on whether the
installation services we need to perform are inconsequential or
perfunctory. In cases where our remaining installation or
integration obligations are determined to be inconsequential or
perfunctory, we defer revenue associated with the fair value of
the installation or integration obligations until these services
have been completed. The factors we consider in determining
whether an installation obligation is significant include the
amount of time and cost we estimate it will take to perform the
installation. The timing of our revenue recognition could be
materially affected if we made different judgments regarding our
installation obligations.

When a product upgrade for a system is due to be
released in the near future, we occasionally sell purchasers of
the system the right to upgrade to the new version when it is
released. The timing of our recognition of revenues from system
sales that include upgrade rights depends on our judgment about
whether there is sufficient objective evidence regarding the
fair value of the upgrade right. If there is sufficient
objective evidence of the fair value of the upgrade right, we
recognize revenues from the sale of the system, net of the fair
value of the upgrade right, at the time of shipment and we defer
recognition of the revenue related to the

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fair value of the upgrade rights until the
upgrade is shipped. If there is not sufficient evidence of the
fair value of the upgrade right, we defer all revenues from the
sale of the system, including the upgrade right, until the
upgrade is shipped. The factors we consider in determining if
there is adequate evidence of fair value include whether the
undelivered upgrade right is sold separately at prices that, in
our judgment, are within a narrow range or, if the upgrade right
has not been sold separately, whether we have established list
prices which, in our judgment, will be the probable price of the
upgrade when it is introduced into the market. The timing of our
revenue recognition could be materially affected if we made
different judgments regarding the sufficiency of the evidence
regarding the fair value of these upgrade rights.


Accounts Receivable.Accounts receivable represent a significant portion of our
assets. We must make estimates of the collectability of accounts
receivable. We analyze historical write-offs, changes in our
internal credit policies and customer concentrations when
evaluating the adequacy of our allowance for doubtful accounts.
Different estimates regarding the collectability of accounts
receivable may have a material impact on the timing and amount
of reported bad debt expense and on the carrying value of
accounts receivable.

Inventories.Inventories represent a significant portion of our assets. We
value inventories at the lower of cost, on an average cost
basis, or market. We regularly perform a detailed analysis of
our inventories to determine whether adjustments are necessary
to reduce inventory values to estimated realizable value. We
consider various factors in making this determination, including
the salability of individual items or classes of items, recent
sales history and predicted trends, industry market conditions
and general economic conditions. Different estimates regarding
the realizable value of inventories could have a material impact
on our reported net inventory and cost of sales, and thus could
have a material impact on the financial statements as a whole.

Purchase Price
Allocations.In connection with our
acquisitions of the medical treadmill manufacturing line and
Spacelabs Burdick, Inc., we have allocated the respective
purchase prices plus transaction costs to the estimated fair
values of assets acquired and liabilities assumed. These
purchase price allocation estimates were made based on our
estimates of fair values. Had these estimates been different,
reported amounts allocated to assets and liabilities and results
of operations subsequent to the acquisitions could be materially
impacted.

Goodwill.Goodwill
represents the excess of cost over the estimated fair value of
net assets acquired in connection with our acquisitions of the
medical treadmill manufacturing line and Spacelabs
Burdick, Inc. noted above. We test goodwill for impairment
on an annual basis, and between annual tests in certain
circumstances, for each reporting unit identified for purposes
of accounting for goodwill. A reporting unit represents a
portion of our business for which we regularly review certain
discrete financial information and operational results. We have
determined that we have two reporting units, consisting of our
general cardiology products and service business and the
Shanghai-Burdick joint venture, both of which operate in the
cardiology market and have similar economic and operating
characteristics.

Application of the goodwill impairment test
requires judgment, including the identification of reporting
units, assigning assets and liabilities to reporting units,
assigning goodwill to reporting units, and determining the fair
value of each reporting unit. Significant judgments required to
estimate the fair value of reporting units include estimating
future cash flows, determining appropriate discount rates and
other assumptions. Changes in these estimates and assumptions
could materially affect the determination of fair value for each
reporting unit, and potentially result in recognition of an
impairment of goodwill, which would be reflected as a loss on
our statement of operations and as a reduction in the carrying
value of goodwill.

Intangible Assets.Our intangible assets are comprised primarily of a trade name,
developed technology and customer relationships, all of which
were acquired in our acquisition of Burdick. We use our judgment
to estimate the fair value of each of these intangible assets.
Our judgment about fair value is based on our expectation of
future cash flows and an appropriate discount rate. We also use
our judgment to estimate the useful lives of each intangible
asset.

We believe the Burdick trade name has an
indefinite life and, accordingly, we do not amortize the trade
name. We evaluate this conclusion annually and make a judgment
about whether there are factors that would limit our ability to
benefit from the trade name in the future. If there were such
factors, we would start amortizing the trade name over the
expected remaining period in which we believed it would continue
to be

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provide benefit. We also test the trade name
asset for impairment annually, or more frequently if events and
circumstances indicate that the asset might be impaired.


With respect to our developed technology and
customer relationship intangible assets, we also evaluate the
remaining useful lives annually. We also evaluate whether our
intangible assets are impaired. For our trade name, this
evaluation is performed annually, or more frequently if events
occur that suggest there may be an impairment loss, and involves
comparing the carrying amount to our estimate of fair value. For
our developed technology and customer relationship intangible
assets, this evaluation would be performed if events occur that
suggest there may be an impairment loss. If we conclude that any
of our intangible assets is impaired, we would record this as a
loss on our statement of operations and as a reduction to the
intangible asset.

Warranty.We provide
warranty service covering the systems we sell. We estimate and
accrue for future costs of providing warranty service, which
relate principally to the hardware components of the systems,
when the systems are sold. Our estimates are based in part on
our warranty claims history and our cost to perform warranty
service. Differences could result in the amount of the recorded
warranty liability and cost of sales if we made different
judgments or use different estimates.

Investment in Unconsolidated
Entity.We assess the fair value of
our investment in ScImage, Inc. in each period to determine
whether the fair value of the investment has declined below its
carrying amount and whether any such decline is other than
temporary. Any excess of the carrying amount over the estimated
fair value would be treated as an unrealized loss and charged to
operations. The carrying value of this investment would be
reduced by the amount of the unrealized loss and the resulting
amount would be considered the new carrying value of the
investment. The information to evaluate the fair value of the
investment in ScImage is limited since ScImage is a privately
held company. We believe that the carrying amount of the
investment is appropriate, though our belief is necessarily
based on limited information and subjective judgments that could
change in the future.

Income Taxes.As
part of the process of preparing our consolidated financial
statements, we are required to determine our income taxes. This
process involves calculating our current tax obligation or
refund and assessing the nature and measurements of temporary
differences resulting from differing treatment of items for tax
and accounting purposes. These differences result in deferred
tax assets and liabilities. In each period, we assess the
likelihood that our deferred tax assets will be recovered from
existing deferred tax liabilities or future taxable income. To
the extent we believe that we do not meet the test that recovery
is more likely than not, we establish a valuation
allowance. To the extent that we establish a valuation allowance
or change this allowance in a period, we adjust our tax
provision or tax benefit in the statement of operations. We use
our judgment to determine our provision or benefit for income
taxes, and any valuation allowance recorded against our net
deferred tax assets. Based on a number of factors including our
history of operating losses, we have not determined that it is
more likely than not that we will realize the future benefits of
a significant portion of our net deferred tax assets.
Accordingly, we have provided a valuation allowance against our
deferred tax assets except to the extent of existing deferred
tax liabilities that we expect to reverse over time, and
expected refunds. Various factors, such as our operating
results, may cause our conclusions to change in the near term,
which may result in recognition of an income tax benefit.

Critical
Accounting Policies

Our critical accounting policies are those that
involve the most complex or subjective decisions or assessments.
Our most critical accounting policies are those related to
revenue recognition, accounting for stock-based compensation,
and segment reporting.

Revenue Recognition:Revenue from sales of systems is generally recognized when title
transfers to the customer, typically upon shipment. We recognize
revenue on sales of systems made to our distributors when the
product is shipped to our distributors and all of our
significant obligations have been satisfied. Our distributors do
not have price protection and generally do not have product
return rights, except in limited cases upon termination of our
distributor agreement.

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We offer optional extended service contracts to
our customers. Service revenues are recognized over the term of
the extended service contracts, which generally begin after the
expiration of the original warranty period. For service
performed, other than pursuant to warranty and extended service
contract obligations, we recognize revenue when the service is
performed and collection of the resulting receivable is probable.

Accounting for Stock-Based
Compensation.We have elected to
measure our stock-based compensation expense relating to grants
to employees under our stock option plans using the intrinsic
value method. Under this method, we record no compensation
expense when we grant stock options to employees if the exercise
price for a fixed stock option award to an employee is equal to
the fair value of the underlying common stock at the date we
grant the stock option.

A different method for accounting for employee
stock option grants is the fair value method. Under the fair
value method, a company is required to determine the fair value
of options granted to employees based on an option pricing model
which incorporates such factors as the current stock price,
exercise prices of the options, expected volatility of future
movements in the price of the underlying stock, risk-free
interest rates, the term of the options and any dividends
expected to be paid. The fair value determined under this method
is then amortized over the vesting period of the related
options. Had we chosen to account for employee stock options
using the fair value method, we would have recorded additional
stock based compensation expense of approximately
$0.1 million, $0.4 million and $1.0 million for
the years ended December 31, 2001, 2002 and 2003,
respectively.

Segment Reporting.Accounting standards require companies to disclose certain
information about each of their reportable segments. Based on
the similar economic and operating characteristics of the
components of our business, we have determined that we currently
have only one reportable segment, diagnostic cardiology systems
and related services.

Results of Operations

The following discussion of our results of
operations should be read in conjunction with Selected
Financial Data, the consolidated financial statements and
accompanying notes and other financial data included elsewhere
in this report. Our fiscal year ends on December 31.

|                              |              |                     |       |      |   |      |       |      |   |  |       |      |  
|----------------------------- | ------------ | ------------------- | ----- | ---- | - | ---- | ----- | ---- | - |  | ----- | ---- | -
|                              |              |                    
|                              |              | Fiscal Year        
|                              |              |                    
|                              |              | 2001                |       | 2002 |   | 2003
|                              |              |                     |       |      |   |     
|                              |              |                    
|                              |              | (as a percentage of
|                              |              | revenues)          
|Statement of Operations Data: |              |                     |       |      |   |      |       |      |   |  |       |     
|Revenues:                     |              |                     |       |      |   |      |       |      |   |  |       |     
|                              | Systems      |                     |       | 78.9 | % |      |       | 80.4 | % |  |       | 84.8 | %
|                              | Service      |                     |       | 21.1 |   |      |       | 19.6 |   |  |       | 15.2 |  
|                              |              |                     |       |      |   |      |       |      |   |  |       |     
|Total revenues                |              |                     | 100.0 |      |   |      | 100.0 |      |   |  | 100.0 |     
|                              |              |                     |       |      |   |      |       |      |   |  |       |     
|Cost of Revenues:             |              |                     |       |      |   |      |       |      |   |  |       |     
|                              | Systems      |                     |       | 49.4 |   |      |       | 50.0 |   |  |       | 52.1 |  
|                              | Service      |                     |       | 11.3 |   |      |       | 10.0 |   |  |       | 8.5  |  
|                              |              |                     |       |      |   |      |       |      |   |  |       |     
|Total cost of revenues        |              |                     | 60.7  |      |   |      | 60.0  |      |   |  | 60.6  |     
|                              |              |                     |       |      |   |      |       |      |   |  |       |     
|                              | Gross margin |                     |       | 39.3 |   |      |       | 40.0 |   |  |       | 39.4 |  
|                              |              |                     |       |      |   |      |       |      |   |  |       |     

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|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |      |      | 
|----------------------------------------------------------------------------------- | -------------------------------------------------------------------------- | ------------------------ | ----- | ---- | ---- | ---- | ---- | ---- | ---- |  | ---- | ---- | ---- | 
|                                                                                    |                                                                            |                         
|                                                                                    |                                                                            | Fiscal Year             
|                                                                                    |                                                                            |                         
|                                                                                    |                                                                            | 2001                     |       | 2002 |      | 2003
|                                                                                    |                                                                            |                          |       |      |      |     
|                                                                                    |                                                                            |                         
|                                                                                    |                                                                            | (as a percentage of     
|                                                                                    |                                                                            | revenues)               
|Operating Expenses:                                                                 |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|                                                                                    | Research and development                                                   |                          |       | 12.7 |      |      |      | 11.0 |      |  |      | 9.6  |     
|                                                                                    | Write off acquired in-process research and
    development                 |                          |       | 0.0  |      |      |      | 0.0  |      |  |      | 1.5  |     
|                                                                                    | Sales and marketing                                                        |                          |       | 21.5 |      |      |      | 21.5 |      |  |      | 20.9 |     
|                                                                                    | General and administrative, excluding stock-based
    compensation expense |                          |       | 11.5 |      |      |      | 11.3 |      |  |      | 9.1  |     
|                                                                                    | Stock-based compensation                                                   |                          |       | 6.2  |      |      |      | 0.2  |      |  |      | 0.1  |     
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|                                                                                    |                                                                            | Total operating expenses |       |      | 51.9 |      |      |      | 44.0 |  |      |      | 41.2 | 
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|Operating loss                                                                      |                                                                            |                          | (12.6 | )    |      |      | (4.0 | )    |      |  | (1.8 | )   
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|Other Income (Expense):                                                             |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|                                                                                    | Interest income (expense), net                                             |                          |       | (0.8 | )    |      |      | 0.2  |      |  |      | (0.2 | )   
|                                                                                    | Write-off note receivable and accrued interest                             |                          |       | (2.6 | )    |      |      | 0.0  |      |  |      | 0.0  |     
|                                                                                    | Interest income (expense), putable warrants                                |                          |       | (1.4 | )    |      |      | 0.5  |      |  |      | 0.0  |     
|                                                                                    | Other income, net                                                          |                          |       | 0.2  |      |      |      | 0.0  |      |  |      | 0.0  |     
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|                                                                                    | Total other income (expense)                                               |                          |       | (4.6 | )    |      |      | 0.7  |      |  |      | (0.2 | )   
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|Loss from continuing operations before income
    taxes                             |                                                                            |                          | (17.2 | )    |      |      | (3.3 | )    |      |  | (2.0 | )   
|                                                                                    | Income tax benefit (provision)                                             |                          |       | 0.5  |      |      |      | 0.4  |      |  |      | (0.1 | )   
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|Loss from continuing operations before minority
    interest in consolidated entity |                                                                            |                          | (16.7 | )    |      |      | (2.9 | )    |      |  | (2.1 | )   
|                                                                                    | Minority interest in loss of consolidated entity                           |                          |       | 0.0  |      |      |      | 0.0  |      |  |      | 0.0  |     
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|Loss from continuing operations                                                     |                                                                            |                          | (16.7 | )    |      |      | (2.9 | )    |      |  | (2.1 | )   
|Discontinued Operations:                                                            |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|                                                                                    | Loss on sale, net                                                          |                          |       | (1.9 | )    |      |      | 0.0  |      |  |      | 0.0  |     
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     
|Net loss                                                                            |                                                                            |                          | (18.6 | )%   |      |      | (2.9 | )%   |      |  | (2.1 | )%  
|                                                                                    |                                                                            |                          |       |      |      |      |      |      |      |  |      |     

Comparison of Years Ended December 31,
2003 and December 31, 2002

Consolidated operating results for the year ended
December 31, 2003 include the operating results of Burdick,
which we acquired on January 2, 2003.

Revenues

Revenues increased by $37.9 million, or
81.5%, to $84.4 million in 2003 from $46.5 million in
2002. This increase was principally due to the addition of
revenues from the Burdick business, which we acquired in January
2003.

As set forth in the pro forma financial
information included in our Current Report on Form 8-K/ A
filed with the SEC on March 18, 2003, pro forma combined
revenues of Quinton and Burdick for the year ended
December 31, 2002, had the acquisition been completed as of
January 1, 2002, were $85.5 million. Because of
significant uncertainty in Burdicks distributor channels
resulting from the pending sale of Burdick during the second
half of 2002 and the earlier sale of Burdicks parent on
July 2, 2002, Burdicks revenues were declining at the
time of our acquisition, especially in the international
markets. We believe that the former Burdick business has now
been successfully combined with Quinton and that uncertainties
relating to the distribution channels for the Burdick products
have been satisfactorily resolved. Management further believes
that

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revenues from substantially all of Quintons
major product categories were stable or increasing at year end,
except for revenues associated with our hemodynamic monitoring
line, as discussed below.


Systems revenues increased by $34.2 million,
or 91.4%, to $71.6 million in 2003 from $37.4 million
in 2002. This increase was primarily due to the addition of
Burdicks systems revenues. Pro forma combined systems
revenues of Quinton and Burdick for the year ended
December 31, 2002, had the acquisition been completed as of
January 1, 2002, would have been $74.6 million. The
decline in systems revenues in 2003 of $3.0 million, as
compared to the pro forma combined Quinton and Burdick systems
revenues in 2002, was principally due to the decline relating to
Burdicks revenues, combined with various fluctuations in
revenues from Quintons other product lines, none of which
were individually material.

Service revenues increased by $3.7 million,
or 41.0%, to $12.8 million in 2003 from $9.1 million
in 2002. Pro forma combined service revenues of Quinton and
Burdick for the year ended December 31, 2002, had the
acquisition been completed as of January 1, 2002, would
have been $10.9 million. The increase in service revenues
in 2003 of $1.9 million, as compared to the pro forma
combined Quinton and Burdick service revenues in 2002, was due
principally to an improvement in focus and execution in
providing service to the Burdick customers and to the overall
growth of our installed customer base.

On October 21, 2003, we announced the sale
of our hemodynamic monitoring product line. In connection with
this transaction, we discontinued substantially all sales of
hemodynamic monitoring systems. Quinton will continue to provide
service, on a gradually declining basis, to the customers with
installed Quinton systems until April, 2004, at which time the
buyer of this line will assume all remaining service
responsibility. Systems and service revenue relating to the
hemodynamic monitoring product line accounted for revenues in
2003 of approximately $1.9 million and $1.0 million,
respectively.

Gross
Profit

Gross profit increased by $14.7 million, or
78.7%, to $33.3 million in 2003 from $18.6 million in
2002. This increase was primarily due to the addition of gross
profit from the Burdick business. Gross margin decreased to
39.4% in 2003 from 40.0% in 2002. Pro forma combined gross
margin for Quinton and Burdick, as if they had been combined on
January 1, 2002, would have been 35.7%. During the year
ended December 31, 2003, we recognized an
acquisition-related charge to cost of revenues of
$0.3 million, reflecting an upward adjustment to
Burdicks inventory valuation from Burdicks
historical cost at the acquisition date that was expensed in the
quarter ended March 31, 2003. In addition, for the year
ended December 31, 2003, we recognized a charge to cost of
revenues of $1.4 million, reflecting charges related to the
consolidation of our manufacturing operations. These charges to
cost of revenues represented an adverse impact to gross profit
of approximately 2.0 percentage points. Charges relating to
the Burdick acquisition are not expected to recur. Charges
relating to the consolidation of our manufacturing operations
are not expected to recur beyond 2003, as the consolidation was
completed prior to year end. We expect to realize cost savings
from the consolidation of our manufacturing operations of
between $1.5 million and $2.0 million annually
thereafter. These cost savings relate principally to reductions
in staffing and facilities costs. Substantially all of the cost
savings will be to cost of revenues.

Gross profit from systems increased by
$13.5 million, or 95.2%, to $27.6 million in 2003 from
$14.1 million in 2002. This increase was primarily due to
the addition of gross profit from the Burdick business. Gross
margin increased to 38.6% in 2003 from 37.8% in 2002. Pro forma
combined gross margin from systems for Quinton and Burdick, as
if they had been combined on January 1, 2002, would have
been 35.0%. The increase in gross margin was primarily due to
the results of product cost reduction initiatives, including
design cost reductions and other reductions in purchased
components of our products. For the year ended December 31,
2003, we recognized an acquisition related charge to systems
cost of revenues of $0.3 million, which was discussed
above. In addition, for the year ended December 31, 2003,
we recognized a charge to cost of revenues related to the
consolidation of our manufacturing operations of
$1.3 million which was discussed above. These charges to
cost of revenues represented an adverse impact to gross margin
from systems revenues of approximately 2.2 percentage
points.

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Gross profit from service increased by
$1.2 million, or 26.7%, to $5.7 million in 2003 from
$4.5 million in 2002. This increase was primarily due to
the addition of service revenues from the Burdick business plus
organic growth in service revenues, without a proportionate
increase in related costs. Service gross margin decreased to
44.1% in 2003 from 49.1% in 2002. This decrease in gross margin
was primarily due to the impact of Burdicks lower gross
margin on service revenues. Pro forma combined gross margin from
service for Quinton and Burdick, as if they had been combined on
January 1, 2002, would have been 40.1%. For the year ended
December 31, 2003, we recognized a charge to cost of
revenues related to the consolidation of our manufacturing
operations of $0.1, which was discussed above. This charge to
cost of revenues represented an adverse impact to gross margin
from service revenues of approximately 0.8 percentage point.

Operating
Expenses

Research and development expenses increased by
$3.0 million, or 57.7%, to $8.1 million in 2003 from
$5.1 million in 2002. This increase was primarily due to
the impact of additional research and development expenses
relating to the acquired Burdick business. As a percentage of
revenues, research and development expenses decreased to 9.6%
for the year ended December 31, 2003 from 11.0% for the
comparable period in 2002. This decrease principally reflects
lower proportionate spending on research and development in the
Burdick business and cost efficiencies of operating the Quinton
and Burdick businesses on a combined basis.

During the year ended December 31, 2003, we
recorded a charge of $1,290,000 to write off in-process research
and development acquired in the Burdick acquisition. See
Note 3 to the Consolidated Financial Statements. In future
periods, we do not expect to incur additional in-process
research and development write-offs relating to the Burdick
acquisition.

Sales and marketing expenses increased by
$7.7 million, or 77.2%, to $17.7 million in 2003 from
$10.0 million in 2002. This increase was primarily due to
the impact of additional sales and marketing expenses relating
to the acquired Burdick business. As a percentage of revenues,
sales and marketing expenses decreased to 20.9% for the year
ended December 31, 2003 from 21.5% for the comparable
period in 2002. This decrease primarily reflects lower
proportionate spending on sales and marketing in the Burdick
business and cost efficiencies of operating the Quinton and
Burdick businesses on a combined basis.

General and administrative expenses, excluding
stock-based compensation, increased by $2.4 million, or
45.4%, to $7.7 million in 2003 from $5.3 million in
2002. This increase was primarily due to the impact of
additional general and administrative expenses relating to the
acquired Burdick business. As a percentage of revenues, general
and administrative expenses, excluding stock-based compensation,
decreased to 9.1% for the year ended December 31, 2003 from
11.3% for the comparable period in 2002. This decrease primarily
reflects lower proportionate spending in general and
administrative areas in the Burdick business and cost
efficiencies of operating the Quinton and Burdick businesses on
a combined basis.

Stock-based compensation expense decreased by
$37,000 to $74,000 in 2003 from $111,000 in 2002. Stock-based
compensation expense for both periods relates to the intrinsic
value of stock options granted in 2001.

Other Income
(Expense)

Total other expense was $223,000 in 2003, as
compared to total other income of $324,000 in 2002. Interest
income decreased by $212,000 to $13,000 in 2003 from $225,000 in
2002 primarily due to a decline in interest-earning assets over
the comparable period in 2002. Interest expense increased by
$143,000 to $257,000 in 2003 from $114,000 in 2002. In
connection with the acquisition of Burdick, we used
substantially all of our cash, plus borrowings under our line of
credit, to fund the purchase price. As a result, our average
borrowings on our bank line of credit over the year ended
December 31, 2003 increased over our average borrowings
over the comparable period in 2002. In addition, interest income
related to putable warrants decreased by $187,000 to $32,000 in
2003 from $219,000 in 2002. These warrants, held by a former
lender, were adjusted to their fair market value at the end of
each accounting period. Gains and losses reflected in the income
statement represent the adjustment of the warrants to their fair
market value during the related period.

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All remaining warrants were redeemed for cash in
2003 and there were no warrants outstanding as of
December 31, 2003.


Income Tax
Benefit (Provision)

In 2003, we recorded a federal income tax
provision of $21,000 and a state income tax provision of $3,000
due to a deferred tax liability relating to goodwill on our
treadmill line acquisition. In addition, we recorded state
income tax provisions of $38,000.

In 2002, we recognized a tax benefit of $192,000
related principally to a refund of alternative minimum taxes
paid in prior periods. We received the refund in 2003.

Our gross deferred tax assets of approximately
$12.7 million have been adjusted by a valuation allowance
for the net balance due to the uncertainty regarding
realization. At the end of 2003 we had approximately
$11.6 million and $18.9 million of net operating loss
carryforwards for federal and state income tax purposes,
respectively, that expire between 2018 and 2023.

Comparison of Years Ended December 31,
2002 and December 31, 2001

Revenues

Revenues increased by $3.6 million, or 8.4%,
to $46.5 million in 2002 from $42.9 million in 2001.
Systems revenue increased by $3.6 million, or 10.5%, to
$37.4 million in 2002 from $33.8 million in 2001.
Stress system revenues increased by $1.5 million in 2002 as
compared to 2001, due primarily to continued market acceptance
of our new stress product following its introduction in April
2001. In addition, we introduced the Q-Tel RMS system in May
2002, which resulted in an increase in our rehabilitation
telemetry revenues of $3.8 million in 2002 as compared to
2001. The increase in stress and rehabilitation telemetry
revenues was offset partially by decreases in sales of our
cardiac catheterization management systems and Holter monitoring
systems of $1.4 million and $0.5 million,
respectively. We believe the decrease in cardiac catheterization
management systems sales was principally due to the anticipated
release of our next generation cardiac catheterization
management product, which was scheduled for release in early
2003. Our Holter systems sales decrease was caused by an
interruption in Holter component supplies when we transitioned
to a new supplier in mid-2001. Service revenues increased by
$0.1 million, or 0.7%, to $9.1 million in 2002 from
$9.0 million in 2001.

Systems revenues as a percentage of total
revenues increased to 80.4% in 2002 from 78.9% in 2001. This
increase was primarily attributable to a larger percentage
increase in our systems revenues than in our services revenues.
Because we derive service revenues from our installed base,
service revenue increases did not directly correlate to system
revenue increases. System revenues as a percentage of total
revenues increased in 2002 primarily due to the introduction of
new versions of products into the market in 2002.

Gross
Profit

Gross profit increased by $1.7 million, or
10.4%, to $18.6 million in 2002 from $16.9 million in
2001. Overall gross margin percentage increased to 40.0% in 2002
from 39.3% in 2001. Gross profit from systems increased by
$1.5 million or 11.7%, to $14.1 million in 2002 from
$12.7 million in 2001. Systems gross margin improved to
37.8% in 2002 compared to 37.4% in 2001. Gross profit from
service increased by $0.3 million, or 6.7%, to
$4.5 million in 2002 from $4.2 million in 2001.
Service gross margin improved to 49.1% in 2002 compared to 46.4%
in 2001. Our overall improvement in gross margin was driven
primarily by our continued emphasis on cost reductions.

Operating
Expenses

Research and development expenses decreased by
$0.3 million, or 6.1%, to $5.1 million in 2002 from
$5.5 million in 2001. As a percentage of revenues, research
and development expenses decreased to 11.0% in 2002 from 12.7%
in 2001. The decrease resulted primarily from reductions in
staffing and outside engineering services.

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Sales and marketing expenses increased by
$0.8 million, or 8.3%, to $10.0 million in 2002 from
$9.2 million in 2001. Sales and marketing expenses were
approximately 21.5% of revenues for both 2002 and 2001. The
increase, in terms of dollars, was caused partially by a
$0.4 million increase in our marketing staffing in 2002,
and a $0.4 million increase in commission expenses
resulting from higher revenues. The increases in staffing were
related to our introduction of new products into the market
during 2002.

General and administrative expenses, excluding
stock-based compensation, increased by $0.4 million, or
7.3%, to $5.3 million in 2002 from $4.9 million in
2001. As a percentage of revenues, general and administrative
expenses, excluding stock-based compensation, decreased to 11.3%
in 2002 from 11.5% in 2001. The increase in general and
administrative expenses, excluding stock-based compensation, in
terms of dollars, was caused primarily by increased professional
fees, insurance and other costs relating to our public company
status. Expenses associated with litigation against a former
supplier were approximately $0.8 million in each of 2002
and 2001. The decrease in general and administrative expenses,
excluding stock-based compensation, as a percentage of revenues
was attributable to higher revenues in 2002 compared to 2001.

Stock-based compensation expense decreased by
$2.6 million to $0.1 million in 2002 from
$2.7 million in 2001. Stock-based compensation expense in
2002 related to the intrinsic value of stock options granted in
2001. The expense in 2001 related primarily to compensation
expense recorded for stock options issued to an officer of the
Company who was not an employee prior to December 31, 2001.

Other Income
(Expense)

Other income was $0.3 million in 2002, as
compared to other expense of $2.0 million in 2001. This
change was partially due to $0.2 million reduction of
interest expense on outstanding borrowings under our bank line
of credit that we repaid in May 2002 and interest income of
$0.2 million in 2002 on our short-term investments. The
increase in other income was also partially the result of
recording interest income on putable warrants of
$0.2 million in 2002 as compared to recording interest
expense on putable warrants of $0.6 million in 2001. In
addition, a write-off of a note receivable and related accrued
interest created a non-cash expense of $1.1 million in
2001. This note receivable was partial consideration for the
sale of our fitness business net assets in 1999. The company
that purchased our fitness business filed for bankruptcy in
August 2001. In February 2002, the assets of this bankrupt
company were sold through an auction, and the proceeds were
insufficient to repay the amount owed to us.

Income Tax
Benefit

In 2002, we recognized a tax benefit of
$0.2 million related principally to a refund of alternative
minimum taxes paid in prior periods that we received in 2003.
During 2001, we recognized a tax benefit of $0.2 million
related to a carry back of tax losses to prior years.

Our gross deferred tax assets of approximately
$8.9 million were adjusted by a valuation allowance for the
net balance due to the uncertainty regarding realization. At the
end of 2002 we had approximately $8.5 million of net
operating loss carryforwards for federal income tax purposes
that expire in 2022.

Liquidity and Capital Resources

Net cash generated from operating activities was
$0.2 million for the year ended December 31, 2003,
compared to net cash used for operating activities of
$1.4 million for the comparable period in 2002. Net cash
generated from operating activities increased primarily as the
result of a $2.0 million increase in our net income,
excluding non-cash income and expenses.

During 2003, we incurred $8.1 million of
research and development expenses. We expect to continue
incurring research and development expenses. We prioritize our
research and development spending to continue development of new
product versions and to meet the changing requirements of our
customers. As a result, our research and development expenses
will continue in the future.

Net cash used in investing activities was
$19.6 million for the year ended December 31, 2003,
compared to net cash used in investing activities of $3.4
million for the comparable period in 2002. Net cash used in

30



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investing activities increased primarily due to
our investment in Burdick of $19.4 million, net of cash
acquired, payments of acquisition costs and a refund from the
reduction in the purchase price. For the year ended
December 31, 2003, capital equipment expenditures were
approximately $1.3 million, an increase of
$0.3 million over the comparable period in 2002. This
increase was primarily due to the purchase and conversion of an
enterprise resource planning system and the purchase of a
telephone system. We received cash of $1.0 million from the
sale of our hemodynamic monitoring product line in 2003 and
recorded a note receivable of $0.7 million, which is due in
October of 2004.


Net cash from financing activities was
$0.2 million for the year ended December 31, 2003,
which resulted primarily from net borrowings on our credit line
of $0.4 million , proceeds from exercises of stock options
of $0.1 million and proceeds from issuance of common stock
in accordance with our employee stock purchase plan of
$0.4 million, partially offset by debt payments of $0.4
million related to the note payable issued in the treadmill
manufacturing business acquisition and a payment for the
redemption of putable warrants of $0.3 million. Net
borrowings on our credit line for the year ended December 31,
2003 were partially used to fund part of the purchase price of
acquiring Burdick and partially for working capital
requirements. Net cash from financing activities of
$23.9 million for the year ended December 31, 2002 was
primarily the result of proceeds from our initial public
offering, including the over-allotment shares, of approximately
$28.2 million, net of underwriting discounts and offering
expenses and proceeds from the issuance of common stock in
accordance with our employee stock purchase plan of
$0.3 million, offset by net repayments on our bank line of
credit of $4.5 million and a payment of $0.2 million for
the redemption of putable warrants.

Cash and cash equivalents declined from
$19.4 million at December 31, 2002 to
$0.2 million at December 31, 2003, due primarily to
the use of cash to fund the Burdick acquisition. Accounts
receivable and inventories at December 31, 2003 increased
$5.1 million and $5.2 million, respectively, from
balances at December 31, 2002 due primarily to the
acquisition of Burdick. Prepaid expenses and other current
assets at December 31, 2003 increased $0.9 million
from balances at December 31, 2002 due primarily to
recording a note receivable of $0.7 million, which relates
to the sale of the hemodynamic monitoring product line. Accounts
payable and warranty liability at December 31, 2003
increased $1.4 million and $1.0 million, respectively,
from balances at December 31, 2002 due primarily to the
acquisition of Burdick. Accrued liabilities at December 31,
2003 increased $3.9 million from the balances at
December 31, 2002 due to recording $1.5 million in
deferred consideration on the sale of the hemodynamic monitoring
product line, and the remainder due primarily to the acquisition
of Burdick.

In December 2002, in order to provide additional
funding for the acquisition of Burdick, we established a
$12.0 million revolving credit facility with Silicon Valley
Bank subject to certain accounts receivable and inventory
provisions relating to both Quinton and Burdick. This facility
has a term of two years. All borrowings under this facility will
be classified as current liabilities. As of December 31,
2003, the balance on this credit facility was $0.4 million.
Outstanding balances under this facility bear interest at the
greater of (i) a variable rate ranging from a minimum of
the banks prime lending rate plus 0.5% to a maximum of the
prime lending rate plus 1.5%, based on a ratio of funded debt to
earnings before interest, taxes, depreciation and amortization
(EBITDA), which at December 31, 2003 was 5.75%
or (ii) $9,000 per month. In addition, unused balances under
this facility bear monthly fees equal to 0.50% per annum on the
difference between the maximum credit limit and the average
daily principal balance during the month. At December 31,
2003, we had borrowings under this line of credit of
$0.4 million. As of December 31, 2003, we had capacity
to borrow an additional $9.0 million based on eligible
accounts receivable and eligible inventory. The current line of
credit expires on December 30, 2004. We have maintained the
same commercial banking relationship since June 1998.

The credit facility contains standard negative
covenants and restrictions on actions by us, including but not
limited to, activity related to our common stock repurchases,
liens, investments, capital expenditures, indebtedness,
restricted payments including cash payments of dividends, and
fundamental changes in, or disposition of our assets. Certain of
these actions may be taken by us with the consent of the lender.
In addition, the credit agreement requires that we meet certain
financial covenants, namely a minimum tangible net worth
measure. As of December 31, 2003, we were in compliance
with all covenants under the credit facility.

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The tables below summarize our contractual
obligations and other commercial commitments as of
December 31, 2003:

|                        |                                    |       |       |           |  |       |       |        |  |         |       |       |  |   |       |       |  |   |     |     | 
|----------------------- | ---------------------------------- | ----- | ----- | --------- |  | ----- | ----- | ------ |  | ------- | ----- | ----- |  | - | ----- | ----- |  | - | --- | --- | 
|                        |                                    |       |       | Less than |  | 1  3 |       | 3  5  |  | After  
|                        |                                    | Total |       | 1 year    |  | years |       | years  |  | 5 years
|                        |                                    |       |       |           |  |       |       |        |  |        
|Contractual Obligations |                                    |       |       |           |  |       |       |        |  |         |       |       |  |   |       |       |  |   |     |    
|Long-term debt          |                                    | $     | 363   |           |  | $     | 363   |        |  | $       |      |       |  | $ |      |       |  | $ |    |    
|Operating leases        |                                    |       | 5,327 |           |  |       | 1,090 |        |  |         | 2,055 |       |  |   | 1,942 |       |  |   | 240 |    
|Purchase obligations*   |                                    |       | 9,641 |           |  |       | 9,641 |        |  |         |      |       |  |   |      |       |  |   |    |    
|                        |                                    |       |       |           |  |       |       |        |  |         |       |       |  |   |       |       |  |   |     |    
|                        | Total contractual cash obligations |       | $     | 15,331    |  |       | $     | 11,094 |  |         | $     | 2,055 |  |   | $     | 1,942 |  |   | $   | 240 | 
|                        |                                    |       |       |           |  |       |       |        |  |         |       |       |  |   |       |       |  |   |     |    



---



|  |                                                                                                                             
|- | ----------------------------------------------------------------------------------------------------------------------------
|* | Purchase obligations primarily consist of
    outstanding purchase orders issued in the ordinary course of our
    business.

|                             |                              |       |     |           |  |       |     |       |  |         |   |   |  |   |   |   |  |   |   |   | 
|---------------------------- | ---------------------------- | ----- | --- | --------- |  | ----- | --- | ----- |  | ------- | - | - |  | - | - | - |  | - | - | - | 
|                             |                              |       |     | Less than |  | 1  3 |     | 3  5 |  | After  
|                             |                              | Total |     | 1 year    |  | years |     | Years |  | 5 years
|                             |                              |       |     |           |  |       |     |       |  |        
|Other Commercial Commitments |                              |       |     |           |  |       |     |       |  |         |   |   |  |   |   |   |  |   |   |  
|Line of credit**             |                              | $     | 534 |           |  | $     | 534 |       |  | $       |  |   |  | $ |  |   |  | $ |  |  
|Guarantees                   |                              |       |    |           |  |       |    |       |  |         |  |   |  |   |  |   |  |   |  |  
|                             |                              |       |     |           |  |       |     |       |  |         |   |   |  |   |   |   |  |   |   |  
|                             | Total commercial commitments |       | $   |          |  |       | $   |      |  |         | $ |  |  |   | $ |  |  |   | $ |  | 
|                             |                              |       |     |           |  |       |     |       |  |         |   |   |  |   |   |   |  |   |   |  



---



|   |                                                                                                                  
|-- | -----------------------------------------------------------------------------------------------------------------
|** | Line of credit includes borrowings, minimum
    maintenance fees, and unused fees related to our credit facility.

We anticipate that, for 2004, our future expected
operating cash flow and borrowings available to us under our
credit facility will be sufficient to meet operating expenses,
working capital requirements, capital expenditures and other
obligations for at least 12 months. Our ability to repay
borrowings under the bank line of credit and to satisfy other
liabilities may depend on future operating performance. We may
be affected by economic, financial, competitive, legislative,
regulatory, business and other factors beyond our control. In
addition, we are continually considering intellectual property
and other acquisitions that complement or expand our existing
business or that may enable it to expand into new markets.
Future acquisitions may require additional debt, equity
financing or both. We may not be able to obtain any additional
financing, or may not be able to obtain additional financing on
acceptable terms.

Initial
Public Offering

In May 2002, we consummated an initial public
offering of our common stock. In the offering, we sold 4,000,000
shares of our common stock at a price of $7.00 per share. In
addition, in June 2002, the underwriters of the offering
exercised their over-allotment option to purchase an additional
600,000 shares at $7.00 per share.

Proceeds from the offering, including the
over-allotment shares, were approximately $28.2 million,
net of underwriting discounts and offering expenses. The
principal purposes of the offering were to obtain additional
working capital and to establish a public market for our common
stock. In May 2002, we used approximately $4.5 million of
the offering proceeds to repay the outstanding balance under our
line of credit. In October 2002, we used $1.0 million of the
offering proceeds to pay part of the purchase price for the
treadmill business acquisition described below. During the
months of December 2002 and January 2003, we used
$20.2 million of the offering proceeds to pay part of the
purchase price to acquire 100% of the stock of Spacelabs
Burdick, Inc.

Medical
Treadmill Manufacturing Line Acquisition

On October 1, 2002, we acquired the medical
treadmill manufacturing line and related assets and technology
rights from our previous supplier of these treadmills.
Consideration for the purchase included $1,000,000 in cash and
approximately $900,000 in notes payable over two years. Medical
treadmills are an integral component of cardiac stress testing
systems and cardiac rehabilitation systems. This acquisition has

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permitted us to continue to develop the
underlying technology of the treadmills in concert with advances
in its cardiac monitoring systems. We have also begun to pursue
design changes that will provide updated features, drive a
reduction in per-unit costs and possibly result in an array of
medical treadmills at different price points. In connection with
the transaction, we contracted to manufacture certain treadmills
under an OEM contract for two years from the date of the
transaction. Total revenues relating to this contract were
$0.2 million in 2002 and $1.4 million in 2003. We
expect revenue from the OEM contract sales of these treadmills
to be approximately $0.9 million in 2004.


Spacelabs
Burdick, Inc. Acquisition

On January 2, 2003, we purchased 100% of the
stock of Spacelabs Burdick, Inc. (Burdick).
Burdicks historical strength in ECG cardiographs, Holter
monitors and cardiology information systems, combined with its
distribution network focused on U.S. physicians offices,
complements Quintons strength in cardiac stress testing
and cardiac rehabilitation monitoring and its hospital focused
direct sales force. The consolidated financial statements
include Burdicks results since January 2, 2003.

The original purchase price of $24.0 million
was funded with approximately $20.2 million in cash, a
holdback of $1.3 million for working capital adjustments
plus a partial draw down on our revolving bank credit facility.
Transaction related costs were approximately $700,000.

On April 21, 2003, an agreement was reached
with the seller to adjust the purchase price to
$20.4 million, based principally on the amount of
Burdicks net working capital at the date of acquisition.
In accordance with this agreement, we kept the $1.3 million
that was held back at closing and received a $2.3 million
refund from the seller subsequent to the April 21, 2003
agreement. The refund was used to reduce borrowings against our
line of credit.

Sale of
Hemodynamic Monitoring Product Line

On October 21, 2003, we announced the sale
of our hemodynamic monitoring product line. As consideration, we
received $1.0 million in cash on October 21, 2003 and a
note receivable of $0.7 million, due October 21, 2004.
The buyer may pay additional contingent consideration of up to
$1.5 million based on future sales of the buyers
products to our previous hemodynamic products customers.
Contingent consideration received during the period in which we
are filling our post-closing transition obligations will be
deferred until these obligations are fulfilled. Contingent
consideration received after this period will be recognized as
income in the period in which it is received. We expect to
recognize a gain in the second quarter of 2004 of between
$0.6 million and $0.7 million on the transaction,
excluding the effect of any contingent consideration.

The hemodynamic monitoring product line
represented approximately $3.0 million of the Companys
revenues for the year ended December 31, 2003. During 2004,
however, the Company expects to make cost adjustments,
principally in the form of staffing reductions, and accordingly,
management does not expect the loss of these revenues to have a
materially adverse impact on operating income in 2004 and beyond.






|         |                                                               
|-------- | --------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk

We develop products in the U.S. and sell them
worldwide. As a result, our financial results could be affected
by factors such as changes in foreign currency exchange rates or
weak economic conditions in foreign markets. Since our revenues
are currently priced in U.S. dollars and are translated to local
currency amounts, a strengthening of the dollar could make our
products less competitive in foreign markets. Interest income
and expense is sensitive to changes in the general level of U.S.
interest rates, particularly since our investments are in
short-term investments calculated at variable rates.

We own preferred equity securities of a privately
held company, ScImage, Inc., which we account for using the cost
method. The fair value of our investment is not readily
determinable from published market data, so we use our judgment
to estimate the fair value. If the estimated fair value of this
investment were to decline to an amount below its carrying
amount, and we considered the decline other than temporary, we
would record a loss. We believe that our $1 million
carrying amount of this investment is appropriate, though our
belief is necessarily based on our estimate of fair value.

33



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|        |                                                
|------- | -----------------------------------------------
|Item 8. | Financial Statements and Supplementary
    Data

The consolidated financial statements and
supplementary data are included beginning on page F-1 of
this Report.

Quarterly
Financial Results

The following table sets forth selected unaudited
quarterly financial information and operating data for the last
eight quarters. This information has been prepared on the same
basis as our audited consolidated financial statements and
includes, in the opinion of management, all normal and recurring
adjustments that management considers necessary for a fair
statement of the quarterly results for the periods. The
operating results and data for any quarter are not necessarily
indicative of the results for future periods.

|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |       |  
|---------------------------------------------------------------------------------- | ---------------------------- | ------------------------------------- | ------ | -------- | - | ------------- | ------ | ------------ | - | --------- | ------ | -------- | - | ------------- | ------ | ------------ | - | - | ------ | ------ | - | - | ------ | ----- | - | - | ------ | ----- | - | - | ------ | ----- | -
|                                                                                   |                              | March 31,                             |        | June 30, |   | September 30, |        | December 31, |   | March 31, |        | June 30, |   | September 30, |        | December 31,
|                                                                                   |                              | 2002                                  |        | 2002     |   | 2002          |        | 2002         |   | 2003      |        | 2003     |   | 2003          |        | 2003        
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |             
|                                                                                   |                              |                                      
|                                                                                   |                              | (In thousands, except for share data)
|Consolidated Statement of
    Operations Data:                                     |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|Revenues                                                                           |                              | $                                     | 10,389 |          |   | $             | 11,259 |              |   | $         | 11,655 |          |   | $             | 13,193 |              |   | $ | 20,283 |        |   | $ | 20,706 |       |   | $ | 21,034 |       |   | $ | 22,373 |      
|Cost of revenues                                                                   |                              |                                       | 6,236  |          |   |               | 6,882  |              |   |           | 7,068  |          |   |               | 7,697  |              |   |   | 12,439 |        |   |   | 12,264 |       |   |   | 12,455 |       |   |   | 13,973 |      
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|                                                                                   | Gross profit                 |                                       |        | 4,153    |   |               |        | 4,377        |   |           |        | 4,587    |   |               |        | 5,496        |   |   |        | 7,844  |   |   |        | 8,442 |   |   |        | 8,579 |   |   |        | 8,400 |  
|Operating Expenses:                                                                |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|Research and development                                                           |                              |                                       | 1,353  |          |   |               | 1,334  |              |   |           | 1,205  |          |   |               | 1,234  |              |   |   | 2,087  |        |   |   | 1,989  |       |   |   | 1,969  |       |   |   | 2,041  |      
|Write off acquired in-process research and
    development                         |                              |                                       |       |          |   |               |       |              |   |           |       |          |   |               |       |              |   |   | 1,290  |        |   |   |       |       |   |   |       |       |   |   |       |      
|Sales and marketing                                                                |                              |                                       | 2,453  |          |   |               | 2,466  |              |   |           | 2,460  |          |   |               | 2,595  |              |   |   | 4,326  |        |   |   | 4,491  |       |   |   | 4,519  |       |   |   | 4,333  |      
|General and administrative (excluding stock-based
    compensation)                |                              |                                       | 1,483  |          |   |               | 1,106  |              |   |           | 1,434  |          |   |               | 1,250  |              |   |   | 2,027  |        |   |   | 1,942  |       |   |   | 1,829  |       |   |   | 1,871  |      
|Stock-based compensation                                                           |                              |                                       | 35     |          |   |               | 35     |              |   |           | 23     |          |   |               | 18     |              |   |   | 18     |        |   |   | 18     |       |   |   | 18     |       |   |   | 20     |      
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|                                                                                   | Total operating expenses     |                                       |        | 5,324    |   |               |        | 4,941        |   |           |        | 5,122    |   |               |        | 5,097        |   |   |        | 9,748  |   |   |        | 8,440 |   |   |        | 8,335 |   |   |        | 8,265 |  
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|                                                                                   | Operating income (loss)      |                                       |        | (1,171   | ) |               |        | (564         | ) |           |        | (535     | ) |               |        | 399          |   |   |        | (1,904 | ) |   |        | 2     |   |   |        | 244   |   |   |        | 135   |  
|Other Income (Expense):                                                            |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|Interest income (expense), net                                                     |                              |                                       | (73    | )        |   |               | 17     |              |   |           | 97     |          |   |               | 70     |              |   |   | (75    | )      |   |   | (73    | )     |   |   | (63    | )     |   |   | (33    | )    
|Non-cash interest income (expense), putable
    warrants                           |                              |                                       |       |          |   |               | 133    |              |   |           | 161    |          |   |               | (75    | )            |   |   | 95     |        |   |   | (63    | )     |   |   |       |       |   |   |       |      
|Other income (expense), net                                                        |                              |                                       | 3      |          |   |               |       |              |   |           | (2     | )        |   |               | (7     | )            |   |   | 4      |        |   |   | (13    | )     |   |   | 2      |       |   |   | (4     | )    
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|                                                                                   | Total other income (expense) |                                       |        | (70      | ) |               |        | 150          |   |           |        | 256      |   |               |        | (12          | ) |   |        | 24     |   |   |        | (149  | ) |   |        | (61   | ) |   |        | (37   | )
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|Income (loss) before income taxes and
    minority interest in consolidated entity |                              |                                       | (1,241 | )        |   |               | (414   | )            |   |           | (279   | )        |   |               | 387    |              |   |   | (1,880 | )      |   |   | (147   | )     |   |   | 183    |       |   |   | 98     |      
|Income tax benefit (provision)                                                     |                              |                                       | (10    | )        |   |               | (4     | )            |   |           | (2     | )        |   |               | 208    |              |   |   |       |        |   |   | (9     | )     |   |   | (4     | )     |   |   | (49    | )    
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|Income (loss) before minority interest in
    loss (income) of consolidated entity |                              |                                       | (1,251 | )        |   |               | (418   | )            |   |           | (281   | )        |   |               | 595    |              |   |   | (1,880 | )      |   |   | (156   | )     |   |   | 179    |       |   |   | 49     |      
|Minority interest in loss (income) of
    consolidated entity                      |                              |                                       |       |          |   |               |       |              |   |           |       |          |   |               |       |              |   |   | 21     |        |   |   | (1     | )     |   |   | 4      |       |   |   | 1      |      
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|Net income (loss)                                                                  |                              | $                                     | (1,251 | )        |   | $             | (418   | )            |   | $         | (281   | )        |   | $             | 595    |              |   | $ | (1,859 | )      |   | $ | (157   | )     |   | $ | 183    |       |   | $ | 50     |      
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|Net income (loss) per share  basic                                                |                              | $                                     | (1.91  | )        |   | $             | (0.06  | )            |   | $         | (0.02  | )        |   | $             | 0.05   |              |   | $ | (0.15  | )      |   | $ | (0.01  | )     |   | $ | 0.02   |       |   | $ | 0.00   |      
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      
|Net income (loss) per share 
    diluted                                          |                              | $                                     | (1.91  | )        |   | $             | (0.06  | )            |   | $         | (0.02  | )        |   | $             | 0.05   |              |   | $ | (0.15  | )      |   | $ | (0.01  | )     |   | $ | 0.01   |       |   | $ | 0.00   |      
|                                                                                   |                              |                                       |        |          |   |               |        |              |   |           |        |          |   |               |        |              |   |   |        |        |   |   |        |       |   |   |        |       |   |   |        |      

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|        |                                                                                         
|------- | ----------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements with
    Accountants on Accounting and Financial Disclosure

As of May 10, 2002, we dismissed Arthur
Andersen LLP (Arthur Andersen) as our independent
accountant. Arthur Andersen had served as our independent
accountant since May 1999. The decision to change our
independent accountant was recommended by our Audit Committee
and approved by our Board of Directors. Arthur Andersens
report on the financial statements for the year ending
December 31, 2001 did not contain an adverse opinion or
disclaimer of opinion, nor was it qualified or modified as to
uncertainty, audit scope, or accounting principles. We have had
no disagreements with Arthur Andersen on any matter of
accounting principles or practices, financial statement
disclosure, or auditing scope or procedures, which, if not
resolved to the satisfaction of Arthur Andersen, would have
caused it to make a reference to the subject matter of the
disagreement in connection with its reports.

During the period that Arthur Andersen served as
our independent accountant and through May 10, 2002, there
have been no reportable events as defined in
Item 304(a)(1)(v) of Regulation S-K.

On May 10, 2002, we engaged KPMG LLP
(KPMG) as our independent accountant to audit our
financial statements for the fiscal year ending
December 31, 2002. The decision to engage KPMG was
recommended by our Audit Committee and approved by our Board of
Directors.

Since May 1999 and through May 10, 2002, we
had not consulted with KPMG regarding (i) the application
of accounting principles to a specified transaction, either
completed or proposed, that was an important factor we
considered in reaching a decision on an accounting, auditing, or
financial reporting issue, or the type of audit opinion that
might be rendered on our financial statements, or (ii) any
matter that was the subject of either a disagreement or a
reportable event.






|         |                        
|-------- | -----------------------
|Item 9A. | Controls and Procedures

We maintain disclosure controls and procedures
designed to ensure that information required to be disclosed in
our filings under the Securities Exchange Act of 1934 is
recorded, processed, summarized and reported within the time
periods specified in the Securities and Exchange
Commissions rules and forms. Our chief executive officer
and chief financial officer have evaluated our disclosure
controls and procedures as of the end of the period covered by
this annual report of Form 10-K and have determined that
such disclosure controls and procedures are effective.

There has been no change in our internal control
over financial reporting in connection with this evaluation that
has materially affected, or is reasonably likely to materially
affect, our internal control over financial reporting.




PART III






|         |                                                    
|-------- | ---------------------------------------------------
|Item 10. | Executive Officers and Directors of the
    Company

Information called for by Part III, Item 10,
is included in our Proxy Statement relating to our annual
meeting of shareholders to be held on May 14, 2004, and is
incorporated herein by reference. Such Proxy Statement will be
filed within 120 days of December 31, 2003, our fiscal
year end.






|         |                       
|-------- | ----------------------
|Item 11. | Executive Compensation

Information called for by Part III, Item 11,
is included in our Proxy Statement relating to our annual
meeting of shareholders to be held on May 14, 2004, and is
incorporated herein by reference.






|         |                                                                   
|-------- | ------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management

Information called for by Part III, Item 12,
is included in our Proxy Statement relating to our annual
meeting of shareholders to be held on May 14, 2004 and is
incorporated herein by reference.

35



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##### Table of Contents



Equity
Compensation Plan Information

The following table provides information as of
December 31, 2003 about Quintons common stock that
may be issued upon the exercise of outstanding stock options and
other rights granted to employees, consultants or directors
under our currently existing equity compensation plans.

|                                                               |       |                         |           |                      |  |                             |      |      |  |  |         |         | 
|-------------------------------------------------------------- | ----- | ----------------------- | --------- | -------------------- |  | --------------------------- | ---- | ---- |  |  | ------- | ------- | 
|                                                               |       |                         |           |                      |  | Number of securities       
|                                                               |       |                         |           |                      |  | remaining available for    
|                                                               |       | Number of               |           |                      |  | future issuance under      
|                                                               |       | securities to be issued |           | Weighted-average     |  | equity compensation        
|                                                               |       | upon exercise of        |           | exercise price of    |  | plans (excluding           
|                                                               |       | outstanding options,    |           | outstanding options, |  | securities reflected in the
|Plan category                                                  |       | warrants and rights     |           | warrants and rights  |  | first column)(1)(2)(3)     
|                                                               |       |                         |           |                      |  |                            
|Equity compensation plans approved by security
    holders     |       |                         | 1,700,067 |                      |  | $                           | 4.01 |      |  |  | 442,825 |        
|Equity compensation plans not approved by
    security holders |       |                         | 135,000   |                      |  |                             | 8.16 |      |  |  |        |        
|                                                               |       |                         |           |                      |  |                             |      |      |  |  |         |        
|                                                               | Total |                         |           | 1,835,067            |  |                             | $    | 4.32 |  |  |         | 442,825 | 
|                                                               |       |                         |           |                      |  |                             |      |      |  |  |         |        



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Includes 329,335 shares remaining available for
    purchase under Quintons 2002 Employee Stock Purchase Plan.
    The 2002 Employee Stock Purchase Plan includes an evergreen
    formula pursuant to which the number of shares authorized for
    grant will be increased annually by the least of (1) 227,272
    shares, (2) an amount equal to 2 percent of the
    outstanding shares of the common stock of the Company as of the
    end of the immediately preceding fiscal year on a fully diluted
    basis, and (3) a lesser amount determined by our Board of
    Directors. Excludes 227,272 additional shares of common stock
    that became available for purchase under the 2002 Employee Stock
    Purchase Plan on January 1, 2004 pursuant to the evergreen
    formula.                                                                                                                                                                                                                                                                                                                                  
|   
|(2) | Includes 113,490 shares remaining available for
    issuance under Quintons 2002 Stock Incentive Plan. The
    2002 Stock Incentive Plan includes an evergreen formula pursuant
    to which the number of shares authorized for grant will be
    increased annually by the least of (1) 681,818 shares, (2)
    an amount equal to 3 percent of the number of shares of
    common stock outstanding on a fully diluted basis as of the end
    of our immediately preceding fiscal year, and (3) a lesser
    amount determined by our Board of Directors. Excludes 421,499
    additional shares of common stock that became available for
    issuance under the 2002 Stock Incentive Plan on January 1,
    2004 pursuant to the evergreen formula. Also excludes shares
    that will become issuable under the 2002 Stock Incentive Plan if
    and when they cease to be subject to outstanding awards (other
    than by reason of exercise or settlement of the awards) under
    our 1998 Amended and Restated Equity Incentive Plan (which was
    suspended on the effective date of our initial public offering).
|   
|(3) | Our stock option grant program for nonemployee
    directors is administered under the 2002 Stock Incentive Plan
    and provides for the following automatic grants of stock to each
    of our nonemployee directors: (1) an initial grant to
    purchase 10,000 shares of our Common Stock as of the date of the
    directors initial election or appointment to the Board and
    (2) an annual grant to purchase 5,000 shares of our common
    stock immediately following each years annual shareholders
    meeting, except that any nonemployee director who received an
    initial grant within three months before an annual meeting of
    shareholders will not receive an annual grant until immediately
    following the second annual meeting after the date of the
    initial grant. Stock options granted under this program will
    vest and become exercisable in equal monthly installments over
    the 12-month period following the grant date (assuming continued
    Board service).                                                                                                           



| |                                                                           
| | --------------------------------------------------------------------------
| | Description of Equity Compensation Awards
    Not Approved By Shareholders

During 2003 our Board of Directors granted two
nonqualified stock options outside of the 2002 Stock Incentive
Plan but governed by the terms and conditions of the 2002 Stock
Incentive Plan as inducement awards for newly hired employees.
Atul Jhalani, our Vice President of Marketing, was granted a
nonqualified stock option on October 22, 2003 to purchase
75,000 shares of our common stock at an exercise price of $8.04

36



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##### Table of Contents



per share. The other nonqualified stock option
was granted on July 23, 2003 to an employee to purchase
60,000 shares of our common stock at an exercise price of $8.32
per share.


Administration.Both
of these options may be administered by our Board of Directors
or any committee appointed by the Board to administer the 2002
Stock Incentive Plan (the plan administrator). The
plan administrators decisions, determinations and
interpretations are binding on the holders of these options.

Vesting and Exercise.The exercise price for shares
purchased under these options must be paid in a form acceptable
to the plan administrator, which forms may include cash, a
check, shares of already owned common stock, a broker-assisted
cashless exercise or such other consideration as the plan
administrator may permit. Each of these options will vest and
become exercisable by the holder based on a vesting schedule as
follows: 25% [after the first year][after six months] and 1/36th
of the remaining shares subject to the option each month
thereafter. Unless the plan administrator determines otherwise,
options vested as of the date of termination of each
optionees employment or service relationship with Quinton
by reason of death or disability generally will be exercisable
for one year after the date of termination unless the option
term expires as of an earlier date. In the event of termination
for a reason other than death or disability, these options will
be exercisable for a period of time determined by the plan
administrator, generally three months after the date of
termination, and in no event may these options be exercisable
after the expiration of their respective terms. A transfer of
employment or service relationship between us, our subsidiaries
and any parent of Quinton will not be deemed a termination for
purposes of these options.

Transferability.Unless otherwise determined by the
plan administrator, these options may not be transferred or
assigned except by will or the laws of descent and distribution,
and may not be exercised by anyone other than the holder during
the holders lifetime.

Adjustment of Shares.In the event of stock splits, stock
dividends, reclassification or similar changes in our capital
structure, the Board of Directors, in its sole discretion, will
make equitable adjustments in (a) the number of shares
covered by each of these options and (b) the purchase price
of the common stock underlying each option.

Company Transaction.In the event of merger or
consolidation of Quinton with or into any other company or a
sale, lease, exchange or other transfer of all or substantially
all our then outstanding securities or all or substantially all
our assets, these options will be assumed or substituted for
successor company. If the successor company refuses to assume or
substitute for these options, these options will become
immediately vested and exercisable immediately prior to the
effective date of the transaction and will then be terminated.

Termination and Amendment.The Board of Directors may at any time
amend these options. No amendment of these options may impair
the rights of the holder of the amended option without that
holders written consent. These options will expire on the
tenth anniversary of the grant date, unless earlier terminated
by their terms.

Federal Income Tax Consequences.The following is a summary of the
material United States federal income tax consequences to us and
to the holders of these options. The summary is based on the
Code and the United States Treasury regulations promulgated
thereunder in effect as of the date of this report, all of which
may change with retroactive effect. The summary is not intended
to be a complete analysis or discussion of all potential tax
consequences that may be important to the holders of these
options.

Generally, the grant of a nonqualified stock
option will not result in any federal income tax consequences to
the participant or to us. Upon exercise of a nonqualified stock
option, the participant generally will recognize ordinary income
equal to the excess of the fair market value of the stock on the
date of exercise over the amount paid for the stock upon
exercise of the option. Subject to certain limitations, we
generally will be entitled to a corresponding business expense
deduction equal to the ordinary income recognized by the
participant. Upon disposition of the stock, the participant will
recognize capital gain or loss equal to the difference between
the amount realized on the disposition of such stock over the
sum of the amount paid for such stock plus any amount recognized
as ordinary income upon exercise of the option. Such capital
gain or loss will be characterized as short-term or long-term,
depending on how long the stock was held. Slightly different
rules may apply to optionees who are subject to
Section 16(b) of the Exchange Act. Stock Awards.

37



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##### Table of Contents



Upon the receipt of shares of our common stock
pursuant to a stock award that is subject to repurchase rights,
the holder will generally recognize ordinary compensation income
(subject to FICA and income tax withholding) when the shares
vest in an amount equal to the fair market value of the shares
that vest on each vesting date. If the stock award is not
subject to restrictions other than restrictions on transfer, or
the holder files an election pursuant to Section 83(b) of
the Code, the holder will generally recognize ordinary
compensation income (subject to FICA and income tax withholding)
in an amount equal to the fair market value of the shares on the
date of receipt.







|         |                                                   
|-------- | --------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions

Information called for by Part III, Item 13,
is included in our Proxy Statement relating to our annual
meeting of shareholders to be held on May 14, 2004, and is
incorporated herein by reference.




Item 14.     Principal Accountant Fees and Services.

Information called for by Part III, Item 14,
is included in our Proxy Statement relating to our annual
meeting of shareholders to be held on May 14, 2004, and is
incorporated herein by reference.

38



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##### Table of Contents






PART IV






|         |                                                                      
|-------- | ---------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statements, Schedules
    and Reports on Form 8-K

(a) Documents filed as part of this Report:

(1) Index to Financial Statements:

|                                                               |  |  |     | 
|-------------------------------------------------------------- |  |  | --- | 
|Reports of Independent Auditors                                |  |  | F-2 | 
|Consolidated Balance Sheets                                    |  |  | F-4 | 
|Consolidated Statements of Operations                          |  |  | F-5 | 
|Consolidated Statements of Changes in
    Shareholders Equity |  |  | F-6 | 
|Consolidated Statements of Cash Flows                          |  |  | F-7 | 
|Notes to Consolidated Financial Statements                     |  |  | F-8 | 

(2) Index to Financial Statement
Schedules:



| |                                                                                                                                                                             
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | All schedules are omitted because they are
    inapplicable or the requested information is shown in the
    consolidated financial statements or the related notes thereto.

(3) Index to Exhibits:

The Exhibit Index is included on
pages 40 to 41.

(b) Reports on Form 8-K:

On October 23, 2003, we furnished a current
report on Form 8-K issuing a press release announcing
results for the fiscal quarter ended September 30, 2003.

39



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##### Table of Contents



EXHIBIT INDEX

|        |    |             |  |                                                                                                                                                                                     
|------- | -- | ----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 2  | .1          |  | Stock Purchase Agreement dated December 23,
    2002 by and among Spacelabs Medical, Inc., Spacelabs Burdick,
    Inc., Quinton Cardiology Systems, Inc. and Datex-Ohmeda, Inc. (1) 
|        | 2  | .2          |  | ABPM Private Label Distribution Agreement by and
    between Spacelabs Medical, Inc. and Spacelabs Burdick, Inc. (1)                                                                
|        | 3  | .1          |  | Restated Certificate of Incorporation of the
    registrant. (2)                                                                                                                    
|        | 3  | .2          |  | Bylaws of the registrant. (2)                                                                                                                                                       
|        | 4  | .1          |  | Specimen Company Stock Certificate. (3)                                                                                                                                             
|        | 4  | .2          |  | Investors Rights Agreement. (3)                                                                                                                                                    
|        | 10 | .1*         |  | 1998 Amended and Restated Equity Incentive Plan.
    (3)                                                                                                                            
|        | 10 | .2*         |  | 2002 Stock Incentive Plan. (3)                                                                                                                                                      
|        | 10 | .3*         |  | 2002 Employee Stock Purchase Plan. (3)                                                                                                                                              
|        | 10 | .4*         |  | Stock Option Grant Program for Nonemployee
    Directors. (3)                                                                                                                       
|        | 10 | .5*         |  | 2003 Management Incentive Plan.                                                                                                                                                     
|        | 10 | .6*         |  | Form of Indemnification Agreement.                                                                                                                                                  
|        | 10 | .7*         |  | Lease Agreement between Quinton Inc. and AHP
    Subsidiary Holding Corporation regarding premises at Bothell,
    Washington, dated August 31, 1998. (3)                           
|        | 10 | .8          |  | First Amendment to Lease between Quinton Inc. and
    AHP Subsidiary Holding Corporation, dated August 31, 1998.
    (3)                                                            
|        | 10 | .9          |  | OEM Agreement between Quinton Inc. and Mortara
    Instrument, Inc. dated August 1, 2000. (3)                                                                                       
|        | 10 | .10         |  | OEM Agreement between Quinton Inc. and Mortara
    Instrument, Inc. dated October 17, 2000. (3)                                                                                     
|        | 10 | .11         |  | OEM Agreement between Quinton Inc. and Mortara
    Instrument, Inc. dated October 1, 2001. (3)                                                                                      
|        | 10 | .12         |  | Addendum No. 1 to the OEM Agreement between
    Mortara Instrument, Inc. and Quinton Inc. dated August 1,
    2001. (3)                                                             
|        | 10 | .13         |  | Loan and Security Agreement between Quinton
    Cardiology Systems, Inc. and Quinton Inc. and Silicon Valley
    Bank dated December 30, 2002. (4)                                  
|        | 10 | .14         |  | Amendment to Loan Documents between Quinton
    Cardiology Systems, Inc., Quinton Inc. and Burdick, Inc. and
    Silicon Valley Bank dated January 9, 2003. (4)                     
|        | 10 | .15         |  | Streamline Facility Agreement between Quinton
    Cardiology Systems, Inc. and Quinton Inc. and Silicon Valley
    Bank dated as of December 30, 2002. (4)                          
|        | 10 | .16         |  | Cross-Corporate Continuing Guaranty between
    Quinton Cardiology Systems, Inc. and Quinton Inc. and Silicon
    Valley Bank dated December 30, 2002. (4)                          
|        | 10 | .17         |  | Intellectual Property Security Agreement between
    Quinton Cardiology Systems, Inc. and Quinton Inc. and Silicon
    Valley Bank dated December 30, 2002. (4)                     
|        | 10 | .18         |  | Assumption Agreement between Quinton Cardiology
    Systems, Inc., Quinton Inc. and Burdick, Inc. and Silicon Valley
    Bank dated January 9, 2003. (4)                            
|        | 10 | .19         |  | Cross-Corporate Continuing Guaranty between
    Burdick Inc. and Silicon Valley Bank dated January 9, 2003.
    (4)                                                                 
|        | 10 | .20         |  | Intellectual Property Security Agreement between
    Burdick, Inc. and Silicon Valley Bank dated January 9,
    2003. (4)                                                           
|        | 10 | .21         |  | Lease Agreement between Carl Ruedebusch LLC and
    Burdick, Inc. regarding premises at Deerfield Industrial Park in
    Deerfield, Wisconsin dated as of April 6, 1998. (4)        
|        | 10 | .22         |  | Form of Indemnification Agreement between Quinton
    Cardiology Systems, Inc. and each of its directors and executive
    officers. (5)                                            
|        | 10 | .23         |  | Lease Agreement between Quinton Cardiology
    Systems, Inc. and Hibbs/ Woodinville Associates, L.L.C.
    regarding premises at Bothell, Washington, dated August 29,
    2003. (5)
|        | 10 | .24*        |  | Letter Agreement between Quinton Cardiology
    Systems, Inc. and Darryl Lustig dated October 9, 2003.                                                                              

40



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##### Table of Contents



|        |    |             |  |                                                                                                                                                                                                                                                                                                                                                                                                                                
|------- | -- | ----------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 10 | .25*        |  | Letter Agreement between Quinton Cardiology
    Systems, Inc. and Darryl Lustig dated March 21, 2003.                                                                                                                                                                                                                                                                                                                          
|        | 10 | .26*        |  | Form of Quinton Cardiology Systems, Inc. Stock
    Option Grant Notice and Stock Option Agreement (This exhibit
    represents other substantially identical documents that have
    been omitted because they are substantially identical to this
    document in all material respects and an Appendix attached to
    this exhibit sets forth material details by which the omitted
    documents differ from this exhibit).
|        | 10 | .27*        |  | Quinton Cardiology Systems, Inc. Stock Option
    Grant Notice and Stock Option Agreement between Quinton
    Cardiology Systems, Inc. and Atul Jhalani, dated as of
    October 23, 2003.                                                                                                                                                                                                                                     
|        | 21 | .1          |  | Subsidiaries. (4)                                                                                                                                                                                                                                                                                                                                                                                                              
|        | 23 | .1          |  | Independent Auditors Consent.                                                                                                                                                                                                                                                                                                                                                                                                 
|        | 23 | .2          |  | Notice Regarding Lack of Consent of Arthur
    Andersen LLP.                                                                                                                                                                                                                                                                                                                                                                   
|        | 31 | .1          |  | Certification of Chief Executive Officer pursuant
    to Section 302(a) of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                     
|        | 31 | .2          |  | Certification of Chief Financial Officer pursuant
    to Section 302(a) of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                     
|        | 32 | .1          |  | Certification of Chief Executive Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                     
|        | 32 | .2          |  | Certification of Chief Financial Officer pursuant
    to 18 U.S.C. Section 1350, as adopted pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                     



---



|  |                                                                       
|- | ----------------------------------------------------------------------
|* | Indicates management contract or compensatory
    plan or arrangement.



|    |                                                                                                                                                   
|--- | --------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Incorporated by reference to the
    Registrants Current Report on Form 8-K (File
    No. 000-49755) filed on January 17, 2003.                  
|   
|(2) | Incorporated by reference to the
    Registrants Current Report on Form 8-K (File
    No. 000-49755) filed on May 21, 2003.                      
|   
|(3) | Incorporated by reference to the
    Registrants Registration Statement on Form S-1 (File
    No. 333-83272).                                    
|   
|(4) | Incorporated by reference to the
    Registrants Annual Report on Form 10-K for the year
    ended December 31, 2002 (File No. 000-49755).       
|   
|(5) | Incorporated by reference to the
    Registrants Quarterly Report on Form 10-Q for the quarter
    ended September 30, 2003 (File No. 000-49755).

41



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##### Table of Contents






SIGNATURES

Pursuant to the requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934, the registrant
has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.



| |                                 
| | --------------------------------
| | QUINTON CARDIOLOGY SYSTEMS, INC.



| |     |                       
| | --- | ----------------------
| | By: | /s/ MICHAEL K. MATYSIK

| |                        
| | -----------------------
| |                        
| | Michael K. Matysik     
| | Chief Financial Officer

Date: March 12, 2004

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed below by the
following persons on behalf of the registrant and in the
capacities indicated and on the dates indicated.

|                                                     |  |                                                                                                    |  |                |  | 
|---------------------------------------------------- |  | -------------------------------------------------------------------------------------------------- |  | -------------- |  | 
|                                                     |  |                                                                                                    |  |               
|Signature                                            |  | Title                                                                                              |  | Date          
|                                                     |  |                                                                                                    |  |               
|/s/ JOHN R. HINSONJohn R. Hinson                     |  | President, Chief Executive Officer and Director
    (Principal Executive Officer)                  |  | March 12, 2004
|                                                    
|/s/ MICHAEL K. MATYSIKMichael K. Matysik             |  | Senior Vice President and Chief Financial Officer
    (Principal Financial and Accounting Officer) |  | March 12, 2004
|                                                    
|/s/ RUEDIGER NAUMANN-ETIENNERuediger Naumann-Etienne |  | Chairman of the Board                                                                              |  | March 12, 2004
|                                                    
|/s/ W. ROBERT BERGW. Robert Berg                     |  | Director                                                                                           |  | March 12, 2004
|                                                    
|/s/ JUE-HSIEN CHERNJue-Hsien Chern                   |  | Director                                                                                           |  | March 12, 2004
|                                                    
|/s/ HARVEY N. GILLISHarvey N. Gillis                 |  | Director                                                                                           |  | March 12, 2004

42



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC.

AND SUBSIDIARIES


INDEX TO CONSOLIDATED FINANCIAL
STATEMENTS

|                                                               |  |  |     | 
|-------------------------------------------------------------- |  |  | --- | 
|Reports of Independent Auditors                                |  |  | F-2 | 
|Consolidated Balance Sheets                                    |  |  | F-4 | 
|Consolidated Statements of Operations                          |  |  | F-5 | 
|Consolidated Statements of Changes in
    Shareholders Equity |  |  | F-6 | 
|Consolidated Statements of Cash Flows                          |  |  | F-7 | 
|Notes to Consolidated Financial Statements                     |  |  | F-8 | 

F-1



---



##### Table of Contents



INDEPENDENT AUDITORS REPORT

The Board of Directors and Shareholders

Quinton Cardiology Systems, Inc.:

We have audited the accompanying consolidated
balance sheets of Quinton Cardiology Systems, Inc. and
subsidiaries as of December 31, 2003 and 2002, and the
related consolidated statements of operations,
shareholders equity and cash flows for the years then
ended. 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. The
consolidated financial statements of Quinton Cardiology Systems,
Inc. and subsidiaries for the year ended December 31, 2001,
were audited by other auditors who have ceased operations. Those
auditors expressed an unqualified opinion on those financial
statements in their report dated February 8, 2002, except
for the matter discussed in Note 20 to the financial statements,
for which their report date was March 29, 2002.

We conducted our audits in accordance with
auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the
audit to obtain reasonable assurance about 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. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the financial statements referred
to above present fairly, in all material respects, the financial
position of Quinton Cardiology Systems, Inc. and subsidiaries as
of December 31, 2003 and 2002, and the results of their
operations and their cash flows for the years then ended in
conformity with accounting principles generally accepted in the
United States of America.



| |             
| | ------------
| | /s/ KPMG LLP

Seattle, Washington

February 6, 2004


F-2



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##### Table of Contents



REPORT OF INDEPENDENT PUBLIC
ACCOUNTANTS

To the Board of Directors and Shareholders of QIC
Holding Corp.:

We have audited the accompanying consolidated
balance sheets of QIC Holding Corp. (a California corporation,
since renamed as Quinton Cardiology Systems, Inc.) and
subsidiaries as of December 31, 2001 and 2000, and the
related consolidated statements of operations,
shareholders equity and cash flows for each of the three
years in the period ended December 31, 2001. 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
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about 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. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the financial statements referred
to above present fairly, in all material respects, the financial
position of QIC Holding Corp. and subsidiaries as of
December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the three years in
the period ended December 31, 2001 in conformity with
accounting principles generally accepted in the United States.



| |                        
| | -----------------------
| | /s/ ARTHUR ANDERSEN LLP
| |                        

Seattle, Washington

February 8, 2002, (except for Note 17,


for which the date is March 29, 2002)


This audit report of Arthur Andersen LLP, our
former independent public accountants, is a copy of the original
report dated February 8, 2002 rendered by Arthur Andersen
LLP on our consolidated financial statements included in our
Form S-1 (Registration No. 333-83272) filed on
February 22, 2002, as amended. This audit report has not
been reissued by Arthur Andersen LLP since February 22, 2002 nor
has Arthur Andersen LLP provided a consent to the inclusion of
its report in this Form 10-K. We are including this copy of
the Arthur Andersen LLP audit report pursuant to
Rule 2-02(e) of Regulation S-X under the Securities
Act of 1933. For further discussion, see Exhibit 23.2 to
the Form 10-K for the fiscal year ended December 31,
2003, of which this report forms a part.

F-3



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |         |        | 
|---------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | ------- | ------ |  | ----- | ------- | ------ | 
|                                                                                                                 |                                                                                                                                                                            |                                           
|                                                                                                                 |                                                                                                                                                                            | December 31,                              
|                                                                                                                 |                                                                                                                                                                            |                                           
|                                                                                                                 |                                                                                                                                                                            | 2002                                       |       | 2003   
|                                                                                                                 |                                                                                                                                                                            |                                            |       |        
|                                                                                                                 |                                                                                                                                                                            |                                           
|                                                                                                                 |                                                                                                                                                                            | (in thousands, except                     
|                                                                                                                 |                                                                                                                                                                            | share amounts)                            
|ASSETS                                                                                                          
|Current Assets:                                                                                                  |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 | Cash and cash equivalents                                                                                                                                                  |                                            | $     | 19,382  |        |  | $     | 185     |       
|                                                                                                                 | Accounts receivable, net of allowance for
    doubtful accounts of $398 and $663, respectively                                                                             |                                            |       | 7,384   |        |  |       | 12,480  |       
|                                                                                                                 | Inventories                                                                                                                                                                |                                            |       | 7,462   |        |  |       | 12,690  |       
|                                                                                                                 | Prepaid expenses and other current assets                                                                                                                                  |                                            |       | 528     |        |  |       | 1,419   |       
|                                                                                                                 | Income taxes receivable                                                                                                                                                    |                                            |       | 206     |        |  |       |        |       
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 |                                                                                                                                                                            | Total current assets                       |       |         | 34,962 |  |       |         | 26,774 | 
|Machinery and equipment, net of accumulated
    depreciation and amortization of $4,382 and $5,076, respectively |                                                                                                                                                                            |                                            | 3,510 |         |        |  | 4,918 |        
|Intangible assets, net of accumulated
    amortization of $567 and $948, respectively                            |                                                                                                                                                                            |                                            | 393   |         |        |  | 5,672 |        
|Restricted cash deposit                                                                                          |                                                                                                                                                                            |                                            | 1,325 |         |        |  |      |        
|Investment in unconsolidated entity                                                                              |                                                                                                                                                                            |                                            | 1,000 |         |        |  | 1,000 |        
|Goodwill                                                                                                         |                                                                                                                                                                            |                                            | 860   |         |        |  | 9,953 |        
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 |                                                                                                                                                                            | Total assets                               |       | $       | 42,050 |  |       | $       | 48,317 | 
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|LIABILITIES AND SHAREHOLDERS
    EQUITY                                                                        
|Current Liabilities:                                                                                             |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 | Line of credit                                                                                                                                                             |                                            | $     |        |        |  | $     | 354     |       
|                                                                                                                 | Current portion of long term debt                                                                                                                                          |                                            |       | 363     |        |  |       | 363     |       
|                                                                                                                 | Accounts payable                                                                                                                                                           |                                            |       | 4,776   |        |  |       | 6,183   |       
|                                                                                                                 | Accrued liabilities                                                                                                                                                        |                                            |       | 3,415   |        |  |       | 7,349   |       
|                                                                                                                 | Warranty liability                                                                                                                                                         |                                            |       | 1,089   |        |  |       | 2,059   |       
|                                                                                                                 | Deferred revenue                                                                                                                                                           |                                            |       | 4,407   |        |  |       | 4,499   |       
|                                                                                                                 | Putable warrants                                                                                                                                                           |                                            |       | 328     |        |  |       |        |       
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 |                                                                                                                                                                            | Total current liabilities                  |       |         | 14,378 |  |       |         | 20,807 | 
|Long term debt, net of current portion                                                                           |                                                                                                                                                                            |                                            | 363   |         |        |  |      |        
|Deferred tax liability                                                                                           |                                                                                                                                                                            |                                            |      |         |        |  | 1,180 |        
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 |                                                                                                                                                                            | Total liabilities                          |       |         | 14,741 |  |       |         | 21,987 | 
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|Minority interest in consolidated entity                                                                         |                                                                                                                                                                            |                                            |      |         |        |  | 198   |        
|Shareholders Equity:                                                                                            |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 | Preferred stock (10,000,000 shares authorized),
    $0.001 par value, no shares outstanding as of December 31,
    2002 and 2003                                           |                                            |       |        |        |  |       |        |       
|                                                                                                                 | Common stock (65,000,000 shares authorized),
    $0.001 par value, 12,049,136 and 12,214,905 shares issued and
    outstanding at December 31, 2002 and 2003, respectively |                                            |       | 45,085  |        |  |       | 45,617  |       
|                                                                                                                 | Deferred stock-based compensation                                                                                                                                          |                                            |       | (180    | )      |  |       | (106    | )     
|                                                                                                                 | Accumulated deficit                                                                                                                                                        |                                            |       | (17,596 | )      |  |       | (19,379 | )     
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 |                                                                                                                                                                            | Total shareholders equity                 |       |         | 27,309 |  |       |         | 26,132 | 
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        
|                                                                                                                 |                                                                                                                                                                            | Total liabilities and shareholders equity |       | $       | 42,050 |  |       | $       | 48,317 | 
|                                                                                                                 |                                                                                                                                                                            |                                            |       |         |        |  |       |        

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

F-4



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES

CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |        |        |  
|------------------------------------------------------------------------------------------------------------ | --------------------------------------------------------------------------------------------------------- | ---------------------------- | ------- | ------ | ------ | ---- | --------- | ------ | ------ | - | ---------- | ------ | ------ | -
|                                                                                                             |                                                                                                           |                             
|                                                                                                             |                                                                                                           | Year Ended December 31,     
|                                                                                                             |                                                                                                           |                             
|                                                                                                             |                                                                                                           | 2001                         |         | 2002   |        | 2003
|                                                                                                             |                                                                                                           |                              |         |        |        |     
|                                                                                                             |                                                                                                           |                             
|                                                                                                             |                                                                                                           | (in thousands, except share 
|                                                                                                             |                                                                                                           | and per share amounts)      
|Revenues:                                                                                                    |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Systems                                                                                                   |                              | $       | 33,833 |        |      | $         | 37,389 |        |   | $          | 71,557 |       
|                                                                                                             | Service                                                                                                   |                              |         | 9,041  |        |      |           | 9,107  |        |   |            | 12,839 |       
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             |                                                                                                           | Total revenues               |         |        | 42,874 |      |           |        | 46,496 |   |            |        | 84,396 |  
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|Cost of Revenues:                                                                                            |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Systems                                                                                                   |                              |         | 21,170 |        |      |           | 23,247 |        |   |            | 43,955 |       
|                                                                                                             | Service                                                                                                   |                              |         | 4,850  |        |      |           | 4,636  |        |   |            | 7,176  |       
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             |                                                                                                           | Total cost of revenues       |         |        | 26,020 |      |           |        | 27,883 |   |            |        | 51,131 |  
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             |                                                                                                           | Gross profit                 |         |        | 16,854 |      |           |        | 18,613 |   |            |        | 33,265 |  
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|Operating Expenses:                                                                                          |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Research and development                                                                                  |                              |         | 5,459  |        |      |           | 5,126  |        |   |            | 8,086  |       
|                                                                                                             | Write off acquired in-process research and
    development                                                |                              |         |       |        |      |           |       |        |   |            | 1,290  |       
|                                                                                                             | Sales and marketing                                                                                       |                              |         | 9,210  |        |      |           | 9,974  |        |   |            | 17,669 |       
|                                                                                                             | General and administrative (excluding $2,664,
    $111 and $74 of stock-based compensation, respectively) |                              |         | 4,913  |        |      |           | 5,273  |        |   |            | 7,669  |       
|                                                                                                             | Stock-based compensation                                                                                  |                              |         | 2,664  |        |      |           | 111    |        |   |            | 74     |       
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             |                                                                                                           | Total operating expenses     |         |        | 22,246 |      |           |        | 20,484 |   |            |        | 34,788 |  
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             |                                                                                                           | Operating loss               |         |        | (5,392 | )    |           |        | (1,871 | ) |            |        | (1,523 | )
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|Other Income (Expense):                                                                                      |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Interest income                                                                                           |                              |         |       |        |      |           | 225    |        |   |            | 13     |       
|                                                                                                             | Interest expense                                                                                          |                              |         | (358   | )      |      |           | (114   | )      |   |            | (257   | )     
|                                                                                                             | Interest income (expense), putable warrants                                                               |                              |         | (581   | )      |      |           | 219    |        |   |            | 32     |       
|                                                                                                             | Write-off of note receivable and accrued interest                                                         |                              |         | (1,106 | )      |      |           |       |        |   |            |       |       
|                                                                                                             | Other income (expense), net                                                                               |                              |         | 74     |        |      |           | (6     | )      |   |            | (11    | )     
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             |                                                                                                           | Total other income (expense) |         |        | (1,971 | )    |           |        | 324    |   |            |        | (223   | )
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|Loss from continuing operations before income
    taxes and minority interest in loss of consolidated entity |                                                                                                           |                              | (7,363  | )      |        |      | (1,547    | )      |        |   | (1,746     | )     
|                                                                                                             | Income tax benefit (provision)                                                                            |                              |         | 205    |        |      |           | 192    |        |   |            | (62    | )     
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|Loss from continuing operations before minority
    interest in loss of consolidated entity                  |                                                                                                           |                              | (7,158  | )      |        |      | (1,355    | )      |        |   | (1,808     | )     
|                                                                                                             | Minority interest in loss of consolidated entity                                                          |                              |         |       |        |      |           |       |        |   |            | 25     |       
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|Loss from continuing operations                                                                              |                                                                                                           |                              | (7,158  | )      |        |      | (1,355    | )      |        |   | (1,783     | )     
|Discontinued operations:                                                                                     |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Loss on sale of discontinued segment, net of
    applicable income taxes of $0                            |                              |         | (831   | )      |      |           |       |        |   |            |       |       
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Net loss                                                                                                  |                              | $       | (7,989 | )      |      | $         | (1,355 | )      |   | $          | (1,783 | )     
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|Basic and diluted net loss per share:                                                                        |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Continuing operations                                                                                     |                              | $       | (11.37 | )      |      | $         | (0.17  | )      |   | $          | (0.15  | )     
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Discontinued operations                                                                                   |                              | $       | (1.32  | )      |      | $         |       |        |   | $          |       |       
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|                                                                                                             | Net loss                                                                                                  |                              | $       | (12.69 | )      |      | $         | (0.17  | )      |   | $          | (0.15  | )     
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       
|Weighted average shares used to compute basic and
    diluted net loss per share                             |                                                                                                           |                              | 629,647 |        |        |      | 7,887,659 |        |        |   | 12,147,720 |       
|                                                                                                             |                                                                                                           |                              |         |        |        |      |           |        |        |   |            |       

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

F-5



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES



CONSOLIDATED STATEMENTS OF SHAREHOLDERS
EQUITY


|                            |                                                                        |                                              |        |                 |   |              |            |             |   |             |     |        |   |              |         |          |   |       |        |        |   |  |            |           |   |   |      |        |   |   |         |        |   |   |        |        |  
|--------------------------- | ---------------------------------------------------------------------- | -------------------------------------------- | ------ | --------------- | - | ------------ | ---------- | ----------- | - | ----------- | --- | ------ | - | ------------ | ------- | -------- | - | ----- | ------ | ------ | - |  | ---------- | --------- | - | - | ---- | ------ | - | - | ------- | ------ | - | - | ------ | ------ | -
|                            |                                                                        |                                              |        |                 |   |              |            |             |   |             |     |        |   |             
|                            |                                                                        | Series A                                     |        | Series B        |   |              |            |             |   |             |     |       
|                            |                                                                        | Preferred Stock                              |        | Preferred Stock |   | Common Stock |            | Deferred    |   |             |     |       
|                            |                                                                        |                                              |        |                 |   |              |            | Stock-based |   | Accumulated |     |       
|                            |                                                                        | Amount                                       |        | Shares          |   | Amount       |            | Shares      |   | Amount      |     | Shares |   | Compensation |         | Deficit  |   | Total
|                            |                                                                        |                                              |        |                 |   |              |            |             |   |             |     |        |   |              |         |          |   |      
|                            |                                                                        |                                             
|                            |                                                                        | (dollars in thousands, except share amounts)
|Balance, December 31, 2000. |                                                                        | $                                            | 12,230 |                 |   |              | 12,230,000 |             |   | $           | 865 |        |   |              | 865,000 |          |   | $     | 1,006  |        |   |  | 1,093,072  |           |   | $ | (378 | )      |   | $ | (8,252  | )      |   | $ | 5,471  |       
|                            | Issuance of common stock upon exercise of stock
    options            |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | 5      |   |  |            | 10,403    |   |   |      |       |   |   |         |       |   |   |        | 5      |  
|                            | Repurchase of shares in connection with
    termination                |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | (94    | ) |  |            | (426,200  | ) |   |      |       |   |   |         |       |   |   |        | (94    | )
|                            | Deferred stock compensation                                            |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | 2,573  |   |  |            |          |   |   |      | (2,573 | ) |   |         |       |   |   |        |       |  
|                            | Amortization of deferred stock compensation                            |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        |       |   |  |            |          |   |   |      | 2,664  |   |   |         |       |   |   |        | 2,664  |  
|                            | Net loss                                                               |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        |       |   |  |            |          |   |   |      |       |   |   |         | (7,989 | ) |   |        | (7,989 | )
|                            |                                                                        |                                              |        |                 |   |              |            |             |   |             |     |        |   |              |         |          |   |       |        |        |   |  |            |           |   |   |      |        |   |   |         |        |   |   |        |       
|Balance, December 31, 2001. |                                                                        |                                              | 12,230 |                 |   |              | 12,230,000 |             |   |             | 865 |        |   |              | 865,000 |          |   |       | 3,490  |        |   |  | 677,275    |           |   |   | (287 | )      |   |   | (16,241 | )      |   |   | 57     |       
|                            | Issuance of common stock upon exercise of stock
    options            |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | 60     |   |  |            | 91,191    |   |   |      |       |   |   |         |       |   |   |        | 60     |  
|                            | Deferred stock compensation                                            |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | 4      |   |  |            |          |   |   |      | (4     | ) |   |         |       |   |   |        |       |  
|                            | Amortization of deferred stock compensation                            |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        |       |   |  |            |          |   |   |      | 111    |   |   |         |       |   |   |        | 111    |  
|                            | Proceeds from issuance of common stock, net of
    issuance costs      |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | 28,184 |   |  |            | 4,600,000 |   |   |      |       |   |   |         |       |   |   |        | 28,184 |  
|                            | Conversion of preferred stock to common stock                          |                                              |        | (12,230         | ) |              |            | (12,230,000 | ) |             |     | (865   | ) |              |         | (865,000 | ) |       |        | 13,095 |   |  |            | 6,639,347 |   |   |      |       |   |   |         |       |   |   |        |       |  
|                            | Proceeds from issuance of stock under employee
    stock purchase plan |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | 252    |   |  |            | 41,323    |   |   |      |       |   |   |         |       |   |   |        | 252    |  
|                            | Net loss                                                               |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        |       |   |  |            |          |   |   |      |       |   |   |         | (1,355 | ) |   |        | (1,355 | )
|                            |                                                                        |                                              |        |                 |   |              |            |             |   |             |     |        |   |              |         |          |   |       |        |        |   |  |            |           |   |   |      |        |   |   |         |        |   |   |        |       
|Balance, December 31, 2002. |                                                                        |                                              |       |                 |   |              |           |             |   |             |    |        |   |              |        |          |   |       | 45,085 |        |   |  | 12,049,136 |           |   |   | (180 | )      |   |   | (17,596 | )      |   |   | 27,309 |       
|                            | Issuance of common stock upon exercise of stock
    options            |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | 81     |   |  |            | 81,883    |   |   |      |       |   |   |         |       |   |   |        | 81     |  
|                            | Amortization of deferred stock compensation                            |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        |       |   |  |            |          |   |   |      | 74     |   |   |         |       |   |   |        | 74     |  
|                            | Proceeds from issuance of stock under employee
    stock purchase plan |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        | 451    |   |  |            | 83,886    |   |   |      |       |   |   |         |       |   |   |        | 451    |  
|                            | Net loss                                                               |                                              |        |                |   |              |            |            |   |             |     |       |   |              |         |         |   |       |        |       |   |  |            |          |   |   |      |       |   |   |         | (1,783 | ) |   |        | (1,783 | )
|                            |                                                                        |                                              |        |                 |   |              |            |             |   |             |     |        |   |              |         |          |   |       |        |        |   |  |            |           |   |   |      |        |   |   |         |        |   |   |        |       
|Balance, December 31, 2003. |                                                                        | $                                            |       |                 |   |              |           |             |   | $           |    |        |   |              |        |          |   | $     | 45,617 |        |   |  | 12,214,905 |           |   | $ | (106 | )      |   | $ | (19,379 | )      |   | $ | 26,132 |       
|                            |                                                                        |                                              |        |                 |   |              |            |             |   |             |     |        |   |              |         |          |   |       |        |        |   |  |            |           |   |   |      |        |   |   |         |        |   |   |        |       

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

F-6



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |         |       |        |         |  
|--------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------ | -------------------------------------------------------------------------- | ----------------------------------- | ---------------------------------------- | ----- | ------ | ------ | ------ | ----- | ------ | ------- | ------- | ----- | ------ | ------- | -
|                                                                            |                                                                                                  |                                                                           
|                                                                            |                                                                                                  | Year Ended December 31,                                                   
|                                                                            |                                                                                                  |                                                                           
|                                                                            |                                                                                                  | 2001                                                                       |                                     | 2002                                     |       | 2003  
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |       
|                                                                            |                                                                                                  |                                                                           
|                                                                            |                                                                                                  | (in thousands)                                                            
|Operating Activities:                                                       |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|                                                                            | Net loss                                                                                         |                                                                            | $                                   | (7,989                                   | )     |        | $      | (1,355 | )     |        | $       | (1,783  | )    
|                                                                            | Adjustments to reconcile net loss to net cash
    from operating activities                     |                                                                            |                                     |                                          |       |        |        |        |       |        |         |         |      
|                                                                            |                                                                                                  | Depreciation and amortization                                              |                                     |                                          | 1,148 |        |        |        | 1,197 |        |         |         | 1,858 |       
|                                                                            |                                                                                                  | Loss on disposal of machinery and equipment                                |                                     |                                          | 58    |        |        |        | 21    |        |         |         | 365   |       
|                                                                            |                                                                                                  | Amortization of deferred stock-based compensation                          |                                     |                                          | 2,664 |        |        |        | 111   |        |         |         | 74    |       
|                                                                            |                                                                                                  | Write off of purchased in-process research and
    development             |                                     |                                          |      |        |        |        |      |        |         |         | 1,290 |       
|                                                                            |                                                                                                  | Minority interest in loss of consolidated entity                           |                                     |                                          |      |        |        |        |      |        |         |         | (25   | )     
|                                                                            |                                                                                                  | Deferred taxes                                                             |                                     |                                          |      |        |        |        |      |        |         |         | 24    |       
|                                                                            |                                                                                                  | Interest expense (income), putable warrants                                |                                     |                                          | 581   |        |        |        | (219  | )      |         |         | (32   | )     
|                                                                            |                                                                                                  | Write-off of note receivable and accrued interest                          |                                     |                                          | 1,106 |        |        |        |      |        |         |         |      |       
|                                                                            |                                                                                                  | Loss on sale of discontinued segment                                       |                                     |                                          | 831   |        |        |        |      |        |         |         |      |       
|                                                                            |                                                                                                  | Changes in operating assets and liabilities, net
    of business acquired: |                                     |                                          |       |        |        |        |       |        |         |         |       |       
|                                                                            |                                                                                                  |                                                                            | Accounts receivable                 |                                          |       | 2,055  |        |        |       | (1,261 | )       |         |       | (1,298 | )      
|                                                                            |                                                                                                  |                                                                            | Inventories                         |                                          |       | 270    |        |        |       | (876   | )       |         |       | 1,543  |        
|                                                                            |                                                                                                  |                                                                            | Prepaid expenses and other assets   |                                          |       | 18     |        |        |       | 55     |         |         |       | 227    |        
|                                                                            |                                                                                                  |                                                                            | Income taxes receivable and payable |                                          |       | 1,209  |        |        |       | (206   | )       |         |       |       |        
|                                                                            |                                                                                                  |                                                                            | Accounts payable                    |                                          |       | 340    |        |        |       | 712    |         |         |       | (1,318 | )      
|                                                                            |                                                                                                  |                                                                            | Accrued liabilities                 |                                          |       | (1,042 | )      |        |       | (164   | )       |         |       | (504   | )      
|                                                                            |                                                                                                  |                                                                            | Warranty liability                  |                                          |       | (531   | )      |        |       | (235   | )       |         |       | (46    | )      
|                                                                            |                                                                                                  |                                                                            | Deferred revenue                    |                                          |       | 1      |        |        |       | 851    |         |         |       | (202   | )      
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|                                                                            |                                                                                                  |                                                                            |                                     | Net cash flows from operating activities |       |        | 719    |        |       |        | (1,369  | )       |       |        | 173     |  
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|Investing Activities:                                                       |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|                                                                            | Purchase of Burdick, Inc., net of cash acquired                                                  |                                                                            |                                     |                                         |       |        |        |       |       |        |         | (19,385 | )    
|                                                                            | Proceeds from sale of hemodynamic monitoring
    product line                                    |                                                                            |                                     |                                         |       |        |        |       |       |        |         | 1,000   |      
|                                                                            | Restricted cash deposit for acquisition                                                          |                                                                            |                                     |                                         |       |        |        | (1,325 | )     |        |         |        |      
|                                                                            | Acquisition of treadmill manufacturing business                                                  |                                                                            |                                     |                                         |       |        |        | (1,000 | )     |        |         |        |      
|                                                                            | Proceeds from sales of machinery and equipment                                                   |                                                                            |                                     |                                         |       |        |        |       |       |        |         | 133     |      
|                                                                            | Purchases of machinery and equipment                                                             |                                                                            |                                     | (280                                     | )     |        |        | (1,044 | )     |        |         | (1,345  | )    
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|                                                                            |                                                                                                  |                                                                            |                                     | Net cash flows from investing activities |       |        | (280   | )      |       |        | (3,369  | )       |       |        | (19,597 | )
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|Financing Activities:                                                       |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|                                                                            | Borrowings (repayments) on bank line of
    credit, net                                          |                                                                            |                                     | (555                                     | )     |        |        | (4,471 | )     |        |         | 354     |      
|                                                                            | Proceeds from issuance of common stock, net of
    issuance costs of $3,981 and $0, respectively |                                                                            |                                     |                                         |       |        |        | 28,471 |       |        |         | 451     |      
|                                                                            | Payments of long term debt                                                                       |                                                                            |                                     |                                         |       |        |        |       |       |        |         | (363    | )    
|                                                                            | Redemption of putable warrants                                                                   |                                                                            |                                     |                                         |       |        |        | (158   | )     |        |         | (296    | )    
|                                                                            | Proceeds from exercise of stock options                                                          |                                                                            |                                     | 5                                        |       |        |        | 60     |       |        |         | 81      |      
|                                                                            | Repurchase of shares in connection with
    termination                                          |                                                                            |                                     | (94                                      | )     |        |        |       |       |        |         |        |      
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|                                                                            |                                                                                                  |                                                                            |                                     | Net cash flows from financing activities |       |        | (644   | )      |       |        | 23,902  |         |       |        | 227     |  
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|Net change in cash and cash equivalents                                     |                                                                                                  |                                                                            | (205                                | )                                        |       |        | 19,164 |        |       |        | (19,197 | )      
|Cash and cash equivalents, beginning of year                                |                                                                                                  |                                                                            | 423                                 |                                          |       |        | 218    |        |       |        | 19,382  |        
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|Cash and cash equivalents, end of year                                      |                                                                                                  | $                                                                          | 218                                 |                                          |       | $      | 19,382 |        |       | $      | 185     |        
|                                                                            |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|Supplemental disclosures of cash flow information:                          |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|                                                                            | Cash refunds received (paid) for income taxes                                                    |                                                                            | $                                   | (1,410                                   | )     |        | $      |       |       |        | $       | 206     |      
|                                                                            | Cash paid for interest                                                                           |                                                                            |                                     | 389                                      |       |        |        | 131    |       |        |         | 264     |      
|Supplemental disclosures of noncash investing and
    financing activities: |                                                                                                  |                                                                            |                                     |                                          |       |        |        |        |       |        |         |        
|                                                                            | Note issued in connection with acquisition of
    treadmill manufacturing business               |                                                                            | $                                   |                                         |       |        | $      | 925    |       |        | $       |        |      
|                                                                            | Note receivable recorded in connection with the
    sale of hemodynamic monitoring product line  |                                                                            |                                     |                                         |       |        |        |       |       |        |         | 728     |      

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

F-7



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS

1.     Organization
and Description of Business

Quinton Cardiology Systems, Inc.
(Quinton), a Delaware corporation, which
reincorporated from California in May 2003, changed its name
from QIC Holding Corp. in February 2002. Quinton and its
subsidiaries are referred to herein as the Company. The Company
develops, manufactures, markets and services a family of
advanced cardiology products used in the diagnosis, monitoring,
and management of patients with heart disease.

On June 5, 1998, an investor group led by WR
Hambrecht+Co acquired the Company from American Home Products in
a leveraged buyout (the Acquisition). The results of
operations and the purchased costs of the acquired assets and
liabilities are included in the Companys consolidated
financial statements since the Acquisition.

Certain
Significant Risks and Uncertainties

The Company is subject to a number of risks and
can be affected by a variety of factors. For example, management
of the Company believes that any of the following factors could
have a significant negative effect on the Companys future
financial position, results of operations and cash flows:
failure to keep pace with changes in the marketplace; failure to
develop and commercialize new versions of products or product
lines; reduced demand or lack of growth in demand or future
acceptance for the Companys products and services; risks
associated with product liability and product defects or errors;
competition with other companies with greater financial,
technical and marketing resources; inadequate levels of
reimbursement from governmental or other third-party payors for
procedures using the Companys products and systems;
failure of the Company or its suppliers to obtain or maintain
necessary FDA clearances or approvals for products;
discontinuance or interruption of the availability of purchased
components of the Companys products; inability to secure
additional adequate financing; failure to attract and retain key
personnel; failure to protect intellectual property; risks
associated with maintaining the Companys domestic and
international distributor relationships; risks associated with
expanding international operations; failure to successfully
integrate other businesses, products lines, assets or
technologies acquired by the Company; inability to manage
growth; and litigation or other claims against the Company.
Further, the Company may require additional funds that may not
be readily available or on terms that are acceptable to the
Company.

2.     Summary of
Significant Accounting Policies



| |                      
| | ---------------------
| | Basis of Presentation

The accompanying consolidated financial
statements include the accounts of Quinton Cardiology Systems,
Inc., its wholly owned subsidiaries and its majority owned
Shanghai-Burdick joint venture. All significant intercompany
accounts and transactions have been eliminated.

Use of
Estimates

The preparation of the financial statements and
related disclosures in conformity with accounting principles
generally accepted in the United States of America requires
management to make estimates and assumptions that affect the
reported amounts of assets and liabilities, the disclosure of
contingent assets and liabilities at the date of the financial
statements and revenues and expenses during the period reported.
These estimates include the collectability of accounts
receivable, the saleability and recoverability of inventory, the
adequacy of warranty liabilities, the realizability of
investments, the realizability of deferred tax assets and useful
lives of tangible and intangible assets, among others. The
market for the Companys products is characterized by
intense competition, rapid technological development and
frequent new product introductions, all of which could affect
the future realizability of the Companys assets. Estimates
and assumptions are

F-8



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

reviewed periodically, and the effects of
revisions are reflected in the consolidated financial statements
in the period they are determined to be necessary. Actual
results could differ from these estimates.

Cash and Cash
Equivalents

For purposes of the statement of cash flows,
highly liquid investments with a maturity at the date of
purchase of three months or less are considered cash equivalents.

Accounts
Receivable

Accounts receivable are recorded at invoiced
amount and do not bear interest. The Company performs initial
and ongoing evaluations of its customers financial
position, and generally extends credit on open account. The
Company maintains an allowance for doubtful accounts which is
reflective of managements best estimate of probable
accounts receivable losses. Management determines the allowance
based on known troubled accounts, historical experience, and
other currently available evidence. Trade receivable balances
are charged against the allowance at the time management
determines such balances to be uncollectible.

Inventories

Inventories are stated at the lower of cost,
determined on a weighted-average basis, or market. Costs include
materials, labor and overhead. The Company records inventory
write-downs based on its estimate of excess and/or obsolete
inventory.

Machinery and
Equipment

Machinery and equipment are stated at cost.
Machinery and equipment is depreciated using the straight-line
method over the estimated useful lives of the assets of two to
14 years. Leasehold improvements are amortized over the
shorter of the estimated useful lives or the remaining lease
term. The costs for improvements are capitalized. Expenditures
for maintenance and repairs are expensed as incurred. Upon
retirement or disposal, the cost and accumulated depreciation of
machinery and equipment are reduced and any gain or loss is
recorded.

Intangible
Assets

The Companys intangible assets are
comprised primarily of a trade name, developed technology and
customer relationships, all of which were acquired in our
acquisition of Burdick. Company management uses judgment to
estimate the fair value of each of these intangible assets. The
judgment about fair value is based on expectations of future
cash flows and an appropriate discount rate. Company management
also uses judgment to estimate the useful lives of each
intangible asset. The Company believes the Burdick trade name
has an indefinite life, and accordingly does not amortize the
trade name. The Company evaluates this conclusion annually and
makes a judgment about whether there are factors that would
limit the ability to benefit from the trade name in the future.
If there were such factors, the Company would start amortizing
the trade name. The Company also tests the indefinite life trade
name intangible asset for impairment on an annual basis or more
frequently if events or changes in circumstances indicate that
the asset might be impaired. With respect to developed
technology and customer relationship intangible assets, the
Company also evaluates the remaining useful lives annually to
evaluate whether the intangible assets are impaired. For the
trade name, this evaluation is performed annually or if events
occur that suggest there may be an impairment loss, and involves
comparing the carrying amount to the Companys estimate of
fair value. For developed technology and customer relationship
intangible assets, this evaluation would be performed if events
occur that suggest there may be an impairment loss. If we
conclude that any of our intangible assets are impaired, we
would record this as a loss on our statement of operations and
as a reduction to the intangible asset. The

F-9



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Company recorded amortization expense for
identifiable intangibles of $122,000, $130,000, and $381,000 for
the years ended December 31, 2001, 2002 and 2003,
respectively.

Goodwill

Goodwill represents the excess of costs over the
estimated fair values of net assets acquired in connection with
our acquisitions of the medical treadmill manufacturing line in
2002 and Spacelabs Burdick, Inc. in 2003, which, in accordance
with SFAS No. 142, Goodwill and Other Intangible
Assets, are not being amortized. Also in accordance with
SFAS No. 142, the Company tests goodwill for impairment at
the reporting unit level on an annual basis and between annual
tests in certain circumstances. On the date of the Spacelabs
Burdick acquisition, the Company determined that it had three
reporting units, consisting of the Burdick line of products, the
Quinton line of products and the Shanghai-Burdick joint venture,
all of which operate in the diagnostic cardiology market and
have similar operating and economic characteristics. As of the
beginning of the fourth quarter of 2003, the Company decided to
reorganize its reporting units and consolidate the Quinton and
Burdick reporting units into one reporting unit. This was driven
by the Companys decision to consolidate its manufacturing
operations into one facility in Deerfield, Wisconsin. After the
consolidation of the manufacturing operations, the Company will
manufacture its products under both the Quinton and the Burdick
brands in one facility. The Shanghai-Burdick joint venture will
remain as a separate reporting unit.

SFAS No. 142 requires a two-step goodwill
impairment test whereby the first step, used to identify
potential impairment, compares the fair value of a reporting
unit with its carrying amount including goodwill. If the fair
value of a reporting unit exceeds its carrying amount, goodwill
of the reporting unit is considered not impaired, thus the
second step of the goodwill impairment test used to quantify
impairment is unnecessary. Management has estimated that the
fair values of the Companys reporting units to which
goodwill has been allocated exceed their carrying amounts, and
as a result, the second step of the impairment test, which would
compare the implied fair value of the reporting unit goodwill
with the carrying amount of that goodwill, was unnecessary for
the periods presented.

Purchase
Accounting

SFAS No. 141, Business
Combinations, requires that the purchase method of
accounting be used for all business combinations and establishes
specific criteria for the recognition of intangible assets
separately from goodwill. In connection with the Companys
acquisitions of the medical treadmill manufacturing line and
Spacelabs Burdick, Inc., the Company allocated the respective
purchase prices plus transaction costs to estimated fair values
of assets acquired and liabilities assumed. These purchase price
allocation estimates were made based on our estimates of fair
values.

Income
Taxes

Income taxes are accounted for under the asset
and liability method. Under this method, deferred tax assets and
liabilities are recognized for the estimated future tax
consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities
and their respective tax bases, as well as net operating loss
and tax credit carryforwards. A valuation allowance is recorded
to reduce the carrying amounts of deferred tax assets if it is
more likely than not that such assets will not be realized.

Revenue
Recognition

The Companys revenue recognition policies
are based on the requirements of SEC Staff Accounting Bulletin
No. 104, Revenue Recognition, and the Emerging
Issues Task Force consensus on Issue No. 00-21,
Revenue arrangements with Multiple Deliverables. In
addition, to the extent revenues are allocated to software
elements, AICPA Statement of Position 97-2, Software
Revenue Recognition as amended by AICPA Statement of
Position 98-9, Software Revenue Recognition with Respect
to Certain Arrangements.

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Revenue from sales of systems is generally
recognized when title transfers to the customer, typically upon
shipment. The Company recognizes revenue on sales of systems
made to distributors when the product is shipped to its
distributors and all significant obligations of the Company have
been satisfied. In making a determination of whether significant
obligations have been met, the Company evaluates any
installation or integration obligations to determine whether
those obligations are inconsequential or perfunctory. In cases
where the remaining installation or integration obligation is
determined to be inconsequential or perfunctory, the Company
defers the portion of revenue associated with the fair value of
the installation and integration obligation until these services
have been completed. Distributors do not have price protection
and generally do not have product return rights, except in
limited cases upon termination of the distributor agreement.
With respect to software revenue, the fair value of undelivered
software is deferred and the residual fair value of delivered
software is recognized. Revenue from software implementation
services is recognized as the services are provided. The Company
occasionally sells software and hardware upgrades. With respect
to software upgrades, the fair value of undelivered software
upgrades is deferred and recognized upon delivery of the
specified upgrades. With respect to hardware upgrades, the
Company recognizes revenue when the hardware is shipped.

The Company offers optional extended service
contracts to customers. Service revenues are recognized on a
straight-line basis over the term of the extended service
contracts, which generally begin after the expiration of the
original warranty period. For services performed, other than
pursuant to warranty and extended service contract obligations,
revenue is recognized when the service is performed and
collection of the resulting receivable is reasonably assured.

Freight charges billed to customers and included
in revenue were $1,236,000, $1,585,000 and $1,473,000 in 2001,
2002 and 2003, respectively. The associated expense is
classified within cost of revenues in the accompanying
consolidated statements of operations.

Software
Development Costs

Under the criteria set forth in SFAS No. 86,
Accounting for the Costs of Computer Software to be Sold,
Leased or Otherwise Marketed, capitalization of software
development costs begins upon the establishment of technological
feasibility of the product, which the Company has defined as the
completion of beta testing of a working product. The
establishment of technological feasibility requires considerable
judgment by management with respect to certain external factors,
including, but not limited to, the estimated economic life of
changes in software and hardware technology. Amounts
capitalizable under this statement, after consideration of the
above factors, were immaterial and, therefore, no software
development costs have been capitalized.

Export
Sales

For the years ended December 31, 2001, 2002
and 2003, export sales were 8%, 6% and 8%, respectively, of
total revenues. Export sales are denominated in U.S. dollars.
Accordingly, the Company did not incur any foreign currency
transaction gains or losses.

Foreign
Currency Translation

The functional currency of our Shanghai-Burdick
joint venture is the Chinese Renminbi. The Company translated
assets and liabilities related to this operation to U.S. dollars
at the exchange rate in effect at the date of the consolidated
balance sheet. The Company converted revenues and expenses into
U.S. dollars using the average monthly exchange rates. The rate
of exchange between the Chinese Renminbi and the U.S. dollar did
not change during 2003. Accordingly, the Company did not incur
any foreign currency translation adjustments in 2003.

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Advertising
Costs

The cost of advertising is expensed as incurred.
During the years ended December 31, 2001, 2002 and 2003,
the Company incurred advertising expenses of $110,000, $114,000
and $199,000, respectively.

Warranty

The Company provides warranty service covering
the systems it sells. Estimated future costs of providing
warranty service, which relate principally to the hardware
components of the systems, are provided when the systems are
sold. Estimated future costs are based in part on warranty
claims history and other relevant information.

Research and
Development Costs

Research and development costs are expensed as
incurred.

Financial
Instruments And Concentrations Of Credit Risk

Financial instruments that potentially subject
the Company to concentrations of credit risk consist of cash and
cash equivalents, accounts receivable, accounts payable, accrued
liabilities and debt. Financial instruments that are short-term
and/or that have little or no market risk are estimated to have
a fair value equal to book value. The assets and liabilities
listed above fall under this category.

The Company owns preferred equity securities of a
privately held company, ScImage, Inc. which is accounted for
using the cost method. The fair value of the investment is not
readily determinable from published market data, so judgment is
used to estimate the fair value. If the estimated fair value of
this investment was to decline to an amount below its carrying
amount, and the decline was considered other than temporary, a
loss would be recorded. The Company believes that the carrying
amount of the investment is appropriate, but is necessarily
based on the Companys estimate of fair value.

Accounting
for Stock-Based Compensation

The Company has elected to apply the
disclosure-only provisions of SFAS No. 123,
Accounting for Stock-Based Compensation. In
accordance with the provisions of SFAS 123, the Company applies
Accounting Principles Board Opinion (APB)
No. 25, Accounting for Stock Issued to
Employees, and related interpretations in accounting for
its stock option plans. The Company accounts for stock options
issued to non-employees in accordance with the provisions of
SFAS 123 and Emerging Issues Task Force consensus on Issue
No. 96-18, Accounting for Equity Instruments That are
Issued to Other Than Employees for Acquiring, or in Conjunction
with Selling, Goods or Services (EITF 96-18).

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Had compensation cost been determined based on
the fair value of all option awards at the grant dates during
2001, 2002 and 2003, consistent with the provisions of SFAS 123,
the Companys reported net loss would have been the pro
forma amounts indicated below (amounts in thousands except per
share amounts):

|                                                                                                                                                    |  |      |        |      |  |      |        |   |  |   |        |  
|--------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                                                                                                                                    |  | 2001 |        | 2002 |  | 2003
|                                                                                                                                                    |  |      |        |      |  |     
|Net loss  as reported                                                                                                                              |  | $    | (7,989 | )    |  | $    | (1,355 | ) |  | $ | (1,783 | )
|Add back: Stock-based employee compensation
    expense included in reported loss, net of related tax effects                                       |  |      | 42     |      |  |      | 111    |   |  |   | 74     |  
|Deduct: Total stock-based employee compensation
    expense determined under fair value based method for all awards,
    net of related tax effects |  |      | (153   | )    |  |      | (476   | ) |  |   | (1,286 | )
|                                                                                                                                                    |  |      |        |      |  |      |        |   |  |   |        |  
|Net loss  pro forma                                                                                                                                |  | $    | (8,100 | )    |  | $    | (1,720 | ) |  | $ | (2,995 | )
|                                                                                                                                                    |  |      |        |      |  |      |        |   |  |   |        |  
|Net loss per share  as reported                                                                                                                    |  | $    | (12.69 | )    |  | $    | (0.17  | ) |  | $ | (0.15  | )
|Net loss per share  pro forma                                                                                                                      |  | $    | (12.86 | )    |  | $    | (0.22  | ) |  | $ | (0.25  | )

The fair value of each employee option grant is
established on the date of grant using the Black-Scholes
option-pricing model with the following assumptions: risk-free
interest rates ranging from 3.5% to 5.0%; volatility of zero,
90% and 85% in 2001, 2002 and 2003, respectively; zero dividend
yield; and five to seven year expected life from grant date. The
weighted-average fair value of options granted in 2001, 2002 and
2003 was $3.30, $5.49 and $5.08, respectively.

The weighted average fair value of each employee
stock purchase right under the Companys 2002 Employee
Stock Purchase Plan was $1.93 in 2003. The following assumptions
were used in The Black-Scholes option-pricing model to perform
the calculation in 2003: risk-free interest rate of 2.0%;
volatility of 85%; zero dividend yield; and 0.75 year expected
life from grant date.

Net Income
(Loss) Per Share

In accordance with SFAS No. 128,
Computation of Earnings Per Share, basic loss per
share is computed by dividing net loss by the weighted average
number of shares of common stock outstanding during the period.
Common stock that the Company has the right to repurchase is not
included in the calculation of outstanding shares. Diluted loss
per share is computed by dividing net loss by the weighted
average number of common and dilutive common equivalent shares
outstanding during the period. Common equivalent shares consist
of the shares of common stock issuable upon the conversion of
the convertible preferred stock (using the if-converted method)
and shares issuable upon the exercise of stock options and
warrants (using the treasury stock method); common equivalent
shares are excluded from the calculation if their effect is
antidilutive.

The following table sets forth the computation of
basic and diluted weighted average common shares outstanding for
the periods ended December 31:

|                                                                      |  |      |         |      |  |      |           |   |  |  |            | 
|--------------------------------------------------------------------- |  | ---- | ------- | ---- |  | ---- | --------- | - |  |  | ---------- | 
|                                                                      |  | 2001 |         | 2002 |  | 2003
|                                                                      |  |      |         |      |  |     
|Weighted average common shares outstanding                            |  |      | 718,817 |      |  |      | 7,895,814 |   |  |  | 12,147,720 | 
|Less: weighted average shares subject to
    repurchase               |  |      | (89,170 | )    |  |      | (8,155    | ) |  |  |           | 
|                                                                      |  |      |         |      |  |      |           |   |  |  |            | 
|Denominator for basic and diluted earnings per
    share calculations |  |      | 629,647 |      |  |      | 7,887,659 |   |  |  | 12,147,720 | 
|                                                                      |  |      |         |      |  |      |           |   |  |  |            | 

For the years ended December 31, 2001, 2002
and 2003, 7,965,245, 1,490,784 and 1,835,067, respectively,
shares of common stock subject to repurchase, stock options,
warrants and common stock issuable upon conversion of
outstanding preferred stock were excluded from the computation
of diluted loss per share, as

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

their impact was antidilutive. If the Company had
reported net income, the calculation of earnings per share would
have included the dilutive effect of these common stock
equivalents using the treasury stock and if converted methods.

Concentrations

The Companys two largest vendors accounted
for 12% and 10% of the Companys purchases for the year
ended December 31, 2003. The Companys largest vendor
accounted for 17% and 17% of the Companys purchases for
the years ended December 31, 2001 and 2002, respectively.
Although products are available from other sources, this
vendors inability or unwillingness to supply products in a
timely manner or on terms acceptable to the Company could
adversely affect the Companys ability to meet
customers demands.

The Companys largest customer accounted for
14% of the Companys revenues for the year ended
December 31, 2003. For the years ended December 31,
2001 and 2002, there were no customers that accounted for
greater than 10% of the Companys revenues.

Segment
Reporting

The Company has adopted SFAS No. 131,
Disclosures About Segments of an Enterprise and Related
Information. SFAS 131 requires companies to disclose
certain information about reportable segments. Based on the
criteria within SFAS 131, the Company has determined that it
currently has one reportable segment, diagnostic cardiology
systems and related services.

The following table summarizes revenues, which
are attributed based on the geographic location of the
customers, for the years ended December 31 (amounts in
thousands),

|                    |  |      |        |      |  |      |        |  |  |   |        | 
|------------------- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ------ | 
|                    |  | 2001 |        | 2002 |  | 2003
|                    |  |      |        |      |  |     
|Domestic            |  | $    | 39,624 |      |  | $    | 43,702 |  |  | $ | 77,909 | 
|Other International |  |      | 3,250  |      |  |      | 2,794  |  |  |   | 6,487  | 
|                    |  |      |        |      |  |      |        |  |  |   |        | 
|Total               |  | $    | 42,874 |      |  | $    | 46,496 |  |  | $ | 84,396 | 
|                    |  |      |        |      |  |      |        |  |  |   |        | 

Recent
Accounting Pronouncements

In November 2002, the Emerging Issues Task Force
(EITF) reached a consensus on EITF 00-21, Revenue
Arrangements with Multiple Deliverables with respect to
determining when and how to allocate revenue from sales with
multiple deliverables. The EITF 00-21 consensus provides a
framework for determining when and how to allocate revenue from
sales with multiple deliverables based on a determination of
whether the multiple deliverables qualify to be accounted for as
separate units of accounting. The consensus is effective
prospectively for arrangements entered into in fiscal periods
beginning after June 15, 2003. The Company adopted this
consensus during the three-month period ended September 30,
2003. The adoption of this consensus resulted in the Company
deferring approximately $116,000 of revenues for the year ending
December 31, 2003, which represented the value of
installation obligations associated with the sales of our
systems.

In May 2003, the Financial Accounting Standards
Board (FASB) issued Statement of Financial
Accounting Standard No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities
and Equity. The Statement establishes standards for how an
issuer classifies and measures certain financial instruments
with characteristics of both liabilities and equity. It requires
that an issuer classify a financial instrument that is within
its scope as a liability (or an asset in some circumstances).
The Company adopted this statement at the beginning of the
three-month period ended September 30, 2003. While the

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QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

adoption of this standard did not have a material
impact on the Companys consolidated financial statements
as a whole, Note 3 contains additional disclosures as required
by the standard.

In December 2003, the FASB revised FASB
Interpretation No. 46 (FIN 46R), Consolidation of
Variable Interest Entities, an interpretation of ARB
No. 51. This interpretation addresses how a business
enterprise should evaluate whether it has a controlling
financial interest in an entity through means other than voting
rights and accordingly should consolidate the entity. FIN 46R
requires that calendar year-end public companies apply the
unmodified or revised provisions of FIN 46 to entities
previously considered special purpose entities in the reporting
period ended December 31, 2003. The interpretation is
applicable to all other entities not previously considered
special purpose entities in the quarter ending March 31,
2004. The adoption of FIN 46R did not have a material effect on
the Companys consolidated financial statements as a whole.
Further, the Company does not anticipate that the adoption in
2004 as it relates to non-special purpose entities will have an
impact on the Companys consolidated financial statements
as a whole.

3.     Acquisition of
Burdick, Inc.

On January 2, 2003, the Company purchased
100% of the stock of Spacelabs Burdick, Inc.
(Burdick). Burdicks historical strength in ECG
cardiographs, Holter monitors and cardiology information
systems, combined with its distribution network focused on U.S.
physicians offices, complements Quintons strength in
cardiac stress testing and cardiac rehabilitation monitoring and
its hospital focused direct sales force. The consolidated
financial statements include Burdicks results since
January 2, 2003.

The original purchase price of $24.0 million
was funded with approximately $20.2 million in cash, a
holdback of $1.3 million for working capital adjustments
plus a partial draw down on our revolving bank credit facility.
Transaction related costs were approximately $700,000.

On April 21, 2003, an agreement was reached
with the seller to adjust the purchase price to
$20.4 million, based principally on the amount of
Burdicks net working capital at the date of acquisition.
In accordance with this agreement, the Company kept the
$1.3 million that was held back at closing and received a
$2.3 million refund from the seller subsequent to the
April 21, 2003 agreement. The refund was used to reduce
borrowings against the Companys line of credit.

The Company has now obtained all of the
information the Company has arranged to obtain in order to
finalize the purchase price allocation. The purchase price,
including incremental costs directly related to the transaction,
was allocated as follows (in thousands):

|                                                                |                       |   |        |        | 
|--------------------------------------------------------------- | --------------------- | - | ------ | ------ | 
|Cash and cash equivalents                                       |                       | $ | 386    |       
|Accounts receivable, net of allowance for
    doubtful accounts |                       |   | 3,798  |       
|Inventories                                                     |                       |   | 6,771  |       
|Prepaid expenses and other current assets                       |                       |   | 184    |       
|Machinery and equipment                                         |                       |   | 2,104  |       
|In-process research and development                             |                       |   | 1,290  |       
|Intangible assets                                               |                       |   | 5,660  |       
|Goodwill                                                        |                       |   | 9,027  |       
|                                                                |                       |   |        |       
|                                                                | Total assets acquired |   |        | 29,220 | 
|Current liabilities                                             |                       |   | (6,961 | )     
|Deferred income taxes                                           |                       |   | (1,156 | )     
|                                                                |                       |   |        |       
|                                                                | Net assets acquired   |   | $      | 21,103 | 
|                                                                |                       |   |        |       

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Inventories included an adjustment to
Burdicks historical cost to increase finished goods to
fair market value less expected disposal costs and selling
margin. This adjustment resulted in a valuation of inventory of
$300,000 in excess of Burdicks historical cost. This
increase in the inventory valuation was charged to cost of
revenues in the three-month period ended March 31, 2003, as
the associated inventories were sold in the normal course of
business.

Acquired in-process research and development
relates to two product development projects underway at the time
of the acquisition. Neither project had received required
regulatory approvals at the acquisition date, and each project
had risks associated with achieving desired functionality and
market acceptance. The value assigned to in-process research and
development was determined using a discounted cash flow method
applied to expected cash flows over a 15 year period
commencing in 2003. In discounting expected future cash flows,
the Company used an annual discount rate of 16%, which
management believes is an appropriate risk adjusted rate given
the nature of the projects, the remaining project risks and the
uncertainty of the future cash flows.

The first of the two projects, representing 87%
of the total value of acquired in-process research and
development, related to a new resting ECG monitor. This project
was approximately 70% complete at the date of acquisition and
was subsequently completed and the related product (the Atria
3000) was released, as expected, at the end of the first quarter
of 2003. Margins on this product are expected to be in line with
the Companys historical margins. Costs to complete this
project were expensed in the three-month period ended
March 31, 2003.

The second of the two projects, representing 13%
of the total value of acquired in-process research and
development related to a product for the detection and
preprocessing of low-level electrical signals generated by the
heart. This project was approximately 50% complete at the date
of acquisition. Management has assigned a low priority to this
project and decided to postpone further development
indefinitely, although the underlying technology may have
application to other projects that the Company may pursue in the
future. In the opinion of management, the indefinite
postponement of further development of this project will not
materially adversely affect the overall return on investment
relating to the Burdick acquisition.

All of the acquired in process research and
development was written off during the first quarter of 2003,
resulting in a charge to operating expenses of $1,290,000.

Intangible assets consist of the trade name of
$3,400,000, developed technology of $860,000 and distributor
relationships of $1,400,000, which were valued based on
discounted cash flow methods applied to the estimated future
cash flows attributable to the respective assets. The trade name
was determined, by management, to have an indefinite useful
life. Developed technology was assigned a seven year useful
life, based on the estimated remaining economic life of the
related products. Distributor relationships relate to
long-standing contractual relationships with an extensive
network of independent distributors, which represents the
exclusive channel through which Burdick sells its products. The
economic life of the distributor relationships has been
determined to be 10 years, based on historical turnover
experience and in consideration of the long standing and stable
nature of these relationships.

Goodwill in the amount of $9,027,000 represents
the excess of the net purchase price over the fair value of the
assets and liabilities acquired. Goodwill recorded in the
Burdick acquisition relates to the long-standing nature of
Burdicks business, its substantial market share, its
complementary fit with Quintons pre-existing business, and
managements expectations relating to future operating
synergies and cost efficiencies that can be realized as a result
of operating the businesses on a combined basis.

A deferred income tax liability was recorded
related to the trade name and other intangible assets, which
have no tax basis. Because of the indefinite life of the trade
name, the associated deferred tax liability has not been used to
reduce the valuation allowance against existing deferred income
tax assets.

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following unaudited pro forma data summarizes
the results of operations for the year ended December 31,
2002 as if the Burdick acquisition had been completed on
January 1, 2002. The pro forma data gives effect to actual
operating results prior to the acquisition, adjusted to include
the pro forma effect of depreciation of machinery and equipment,
amortization of identified intangible assets and interest on
cash balances. (in thousands, except per share amounts)

|                                       |  |                   |        |  
|-------------------------------------- |  | ----------------- | ------ | -
|                                       |  | Year Ended       
|                                       |  | December 31, 2002
|                                       |  |                  
|Revenues                               |  | $                 | 85,492 |  
|Net loss                               |  | $                 | (6,361 | )
|Net loss per share  basic and diluted |  | $                 | (0.81  | )

Minority
Interest

As part of the acquisition of Burdick, the
Company acquired 56% ownership of Shanghai Burdick Medical
Instrument Co., LTD. (Shanghai-Burdick). The
Shanghai-Burdick joint venture has a limited life of thirty
years, terminating in 2030. If the joint venture is terminated,
the Company would be required to liquidate the net assets of the
joint venture and distribute proceeds to the partners. Assuming
the joint venture were to have been terminated effective
December 31, 2003, the Company estimates that such net
proceeds would approximate the carrying value of the minority
interest recorded in the accompanying consolidated balance
sheet, which was $198,000 at December 31, 2003.

4.     Consolidation
of Manufacturing Operations

During the third quarter of 2003, the Company
announced plans to consolidate its Deerfield, Wisconsin and
Bothell, Washington manufacturing and production activities to
its Deerfield location. As a result of the related transition
activities, the Company recognized certain charges relating to
severance and other consolidation related activities of
approximately $1,418,000 during the year ended December 31,
2003. The Company completed this consolidation by the end of
2003.

Changes in the Companys accrued liabilities
for the year ended December 31, 2003 related to the
consolidation of manufacturing operations were as follows
(amounts in thousands):

|                                                                     |                                                                                                              |   |     |        |  
|-------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------ | - | --- | ------ | -
|Manufacturing consolidation liabilities as of
    December 31, 2002. |                                                                                                              | $ |    |       
|                                                                     | Severance, employee transition and other
    consolidation related costs charged to systems cost of revenues |   |     | 1,304  |  
|                                                                     | Severance and other employee transition costs
    charged to service cost of revenues                        |   |     | 114    |  
|                                                                     | Costs paid during the period                                                                                 |   |     | (1,094 | )
|                                                                     |                                                                                                              |   |     |       
|Manufacturing consolidation liabilities as of
    December 31, 2003. |                                                                                                              | $ | 324 |       
|                                                                     |                                                                                                              |   |     |       

5.     Sale of
Hemodynamic Monitoring Product Line

On October 21, 2003, the Company sold its
hemodynamic monitoring product line. As consideration, the
Company received $1,000,000 in cash on October 21, 2003 and
a note receivable for $750,000, due October 21, 2004. The
buyer may pay additional contingent consideration of up to
$1,500,000 based on future sales of the buyers products to
our previous hemodynamic products customers.

Based on the Companys post-closing
transition responsibilities, which extend into the second
quarter of 2004, the Company has deferred the recognition of any
gain on the transaction until its transition responsibilities
are fulfilled. After the Company transfers inventory and other
assets associated with this line, having an aggregate value of
approximately $600,000, to the buyer, and write-off of goodwill
associated with this

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

line of approximately $270,000, the Company
expects to recognize a gain in the second quarter of 2004 of
between $600,000 and $700,000 on the transaction, excluding the
effect of any contingent consideration.

Contingent consideration received during the
period in which the Company is filling its post-closing
transitional obligations will be deferred until these
obligations are fulfilled. Contingent consideration received
after this period will be recognized as income in the period in
which it is earned.

6.     Discontinued
Operations

In December 1999, the Company completed the sale
of the net assets of Quinton Fitness, Inc. (the Fitness
subsidiary) to StairMaster Sports/ Medical Products, Inc.
(StairMaster). The Company received cash proceeds of
approximately $11,287,000, $3,000,000 of equity representing a
10.5% interest in StairMaster, and a $1,000,000 promissory note
(the StairMaster Note). The Company sold its equity
in StairMaster to W.R. Hambrecht/ StairMaster, LLC on
December 17, 1999.

In 2001, in connection with a bankruptcy
declaration by StairMaster, the assets of StairMaster were
acquired by an unrelated third party. As a result of
StairMasters bankruptcy and the subsequent acquisition of
its assets, the Company recognized a loss of $1,106,000 related
to the StairMaster Note and related accrued interest. Also, in
2001 the Company recognized a loss of $831,000 resulting from a
contingency that existed at the date of the sale to StairMaster,
related to a sublease agreement between the Company and
StairMaster. The sublease agreement originally extended through
2003, but was amended to expire at December 31, 2002 as a
result of the bankruptcy proceedings. This amount was recorded
within discontinued operations for the year ended
December 31, 2001.

7.     Inventories

Inventories are comprised of the following as of
December 31 (amounts in thousands):

|                  |  |      |       |      |  |   |        | 
|----------------- |  | ---- | ----- | ---- |  | - | ------ | 
|                  |  | 2002 |       | 2003
|                  |  |      |       |     
|Raw materials     |  | $    | 3,433 |      |  | $ | 9,708  | 
|Work in progress  |  |      | 984   |      |  |   |       | 
|Finished goods    |  |      | 3,045 |      |  |   | 2,982  | 
|                  |  |      |       |      |  |   |        | 
|Total inventories |  | $    | 7,462 |      |  | $ | 12,690 | 
|                  |  |      |       |      |  |   |        | 

8.     Machinery and
Equipment

Machinery and equipment includes the following as
of December 31 (amounts in thousands):

|                                                |          |             |              |      |  |      |        |       |  |   |        |       | 
|----------------------------------------------- | -------- | ----------- | ------------ | ---- |  | ---- | ------ | ----- |  | - | ------ | ----- | 
|                                                |          | Depreciable |              |      |  |     
|                                                |          | Lives       |              | 2002 |  | 2003
|                                                |          |             |              |      |  |     
|Equipment                                       |          |             | (2-14 years) |      |  | $    | 6,475  |       |  | $ | 8,051  |      
|Furniture and fixtures                          |          |             | (3-13 years) |      |  |      | 613    |       |  |   | 988    |      
|Leasehold improvements                          |          |             | (2-6 years)  |      |  |      | 804    |       |  |   | 955    |      
|                                                |          |             |              |      |  |      |        |       |  |   |        |      
|                                                | Subtotal |             |              |      |  |      |        | 7,892 |  |   |        | 9,994 | 
|Less: Accumulated depreciation and amortization |          |             |              |      |  |      | (4,382 | )     |  |   | (5,076 | )    
|                                                |          |             |              |      |  |      |        |       |  |   |        |      
|Net machinery and equipment                     |          |             |              |      |  | $    | 3,510  |       |  | $ | 4,918  |      
|                                                |          |             |              |      |  |      |        |       |  |   |        |      

During the years ended December 31, 2001,
2002 and 2003, the Company recorded depreciation and
amortization expense of $1,026,000, $1,067,000 and $1,477,000,
respectively, relating to machinery and equipment.

F-18



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

9.     Intangible
Assets

The gross carrying amount and accumulated
amortization of the Companys amortized intangible assets
were $3,220,000 and $948,000, respectively, at December 31,
2003 and have a weighted-average amortization period of
7.9 years. The Company recorded amortization expense of
$381,000 for the year ended December 31, 2003 relating to
these intangible assets. The carrying amount of the
Companys intangible asset with an indefinite life was
$3,400,000 at December 31, 2003, and, accordingly, does not
amortize this asset.

At December 31, 2002, the gross carrying
amount and accumulated amortization of the Companys
amortized intangible assets were $960,000 and $567,000,
respectively, and had a weighted-average amortization period of
5.5 years. The Company recorded amortization expense of $130,000
for the year ended December 31, 2003 relating to these
intangible assets.

The Companys estimated amortization expense
for the next five years is summarized as follows (in thousands):

|           |  |   |     | 
|---------- |  | - | --- | 
|2004       |  | $ | 323 | 
|2005       |  | $ | 323 | 
|2006       |  | $ | 323 | 
|2007       |  | $ | 310 | 
|2008       |  | $ | 273 | 
|Thereafter |  | $ | 720 | 

10.     Goodwill

On October 1, 2002, the Company acquired the
medical treadmill manufacturing business and related assets and
technology rights from its previous supplier of these
treadmills. The aggregate purchase price was $1,925,000,
including $1,000,000 in cash and $925,000 in notes payable over
two years. The Company recorded goodwill of $926,000 in
connection with this purchase.

On January 2, 2003, the Company purchased
100% of the stock of Spacelabs Burdick, Inc.
(Burdick). The Company recorded goodwill of
$9,027,000 in connection with this purchase. See Note 3.

11.     Accrued
Liabilities and Warranty

Accrued liabilities are comprised of the
following as of December 31 (amounts in thousands):

|                                                                      |  |      |       |      |  |   |       | 
|--------------------------------------------------------------------- |  | ---- | ----- | ---- |  | - | ----- | 
|                                                                      |  | 2002 |       | 2003
|                                                                      |  |      |       |     
|Accrued compensation and benefits                                     |  | $    | 1,564 |      |  | $ | 3,452 | 
|Accrued sales tax                                                     |  |      | 196   |      |  |   | 358   | 
|Sublease liability                                                    |  |      | 831   |      |  |   |      | 
|Deferred consideration on sale of hemodynamic
    monitoring business |  |      |      |      |  |   | 1,540 | 
|Other accrued liabilities                                             |  |      | 824   |      |  |   | 1,999 | 
|                                                                      |  |      |       |      |  |   |       | 
|Total accrued liabilities                                             |  | $    | 3,415 |      |  | $ | 7,349 | 
|                                                                      |  |      |       |      |  |   |       | 

The Companys warranty liability is
summarized as follows (amounts in thousands):

|                             |  |           |       |             |  |            |       |            |  |        |       |  |  |   |        |   |  |   |       | 
|---------------------------- |  | --------- | ----- | ----------- |  | ---------- | ----- | ---------- |  | ------ | ----- |  |  | - | ------ | - |  | - | ----- | 
|                             |  |           |       | Increase    |  | Charged to |       |            |  |       
|                             |  | Beginning |       | through     |  | cost of    |       | Applied to |  | End of
|                             |  | of Period |       | acquisition |  | revenues   |       | liability  |  | Period
|                             |  |           |       |             |  |            |       |            |  |       
|Year Ended December 31, 2002 |  | $         | 1,269 |             |  | $          |      |            |  | $      | 762   |  |  | $ | (942   | ) |  | $ | 1,089 | 
|Year Ended December 31, 2003 |  |           | 1,089 |             |  |            | 1,016 |            |  |        | 1,384 |  |  |   | (1,430 | ) |  |   | 2,059 | 

F-19



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

12.     Borrowings

In connection with the Acquisition, the Company
borrowed $20,000,000 under a term loan agreement. On
December 22, 1998, the Company converted $11,000,000 of the
term loan to a line of credit. The line of credit and the term
loan (collectively the Loan) were subject to the
terms and conditions of the original loan agreement. The term
loan was repaid in connection with the sale of the discontinued
segment. Borrowings under the line of credit were repaid in May
2002 with proceeds from the initial public offering. The line of
credit expired on June 5, 2002.

In connection with the 2003 acquisition of
Spacelabs Burdick, Inc., the Company established a line of
credit on December 30, 2002. Borrowings under the line of
credit are currently limited to the lesser of $12,000,000 or an
amount based on eligible accounts receivable and eligible
inventories. Substantially all of the Companys assets are
pledged as collateral for the line of credit. This line of
credit bears interest at the greater of (i) a variable rate
ranging from the banks prime rate plus a minimum of 0.5%
to a maximum of 1.5% based on a funded debt to Earnings Before
Interest, Taxes, Depreciation, and Amortization
(EBITDA) ratio, which amounted to 5.75% at
December 31, 2003 or (ii) $9,000 per month. In addition,
unused balances under this facility bear monthly fees equal to
0.50% per annum on the difference between the maximum credit
limit and the average daily principal balance during the month.
The current line of credit expires on December 30, 2004. At
December 31, 2003, the Company had borrowings under this
line of credit of $354,000. At December 31, 2002, the
Company had no outstanding borrowings under this line of credit.
As of December 31, 2003, the Company had capacity to borrow
an additional $8,998,000 based on eligible accounts receivable
and eligible inventory.

Putable
Warrants

In connection with the Loan, in 1998 the Company
issued warrants to purchase 123,536 shares of Series A
convertible preferred stock with an exercise price of $0.01 per
share which were immediately exercisable. At the holders
option, the Company is required to make a cash payment to the
holder equal to the fair market value of the shares issuable
upon conversion of the warrants. Pursuant to EITF 00-19,
Accounting for Derivative Financial Instruments Indexed
to, and Potentially Settled in, a Companys Own
Stock, the Company recorded this obligation at its fair
value in the accompanying balance sheet as a liability. The
liability was marked to fair value at each reporting date with
the fair value representing the amount of cash payments the
Company would be required to make to the holder. The change in
fair value is recorded in the consolidated statements of
operations as interest income or expense, putable warrants.
These warrants were redeemed in 2002 and 2003 for $158,000 and
$296,000, respectively. As of December 31, 2003, there were
no remaining warrants outstanding.

13.     Income
Taxes

The Company accounts for income taxes pursuant to
the provisions of SFAS No. 109, Accounting for Income
Taxes. A valuation allowance has been recorded for the net
balance of the deferred tax assets as a result of uncertainties
regarding realization of the asset including the lack of
operating profitability to date and the uncertainty over future
operating profitability. The valuation allowance increased in
2001, 2002 and 2003 by $3,136,000, $1,501,000 and $2,157,000,
respectively.

F-20



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Deferred tax assets (liabilities) are
comprised of the following as of December 31 (amounts in
thousands):

|                           |                                                                       |                                |   |       |        |   |        |        |         |  
|-------------------------- | --------------------------------------------------------------------- | ------------------------------ | - | ----- | ------ | - | ------ | ------ | ------- | -
|                           |                                                                       | 2002                           |   | 2003 
|                           |                                                                       |                                |   |      
|Deferred tax assets:       |                                                                       |                                |   |       |        |   |        |       
|                           | Net operating loss carryforward                                       |                                | $ | 2,891 |        |   | $      | 4,414  |        
|                           | Stock-based compensation                                              |                                |   | 1,040 |        |   |        | 1,190  |        
|                           | Sublease liability                                                    |                                |   | 283   |        |   |        |       |        
|                           | Putable warrants                                                      |                                |   | 111   |        |   |        |       |        
|                           | Research and experimentation credits                                  |                                |   | 1,958 |        |   |        | 2,413  |        
|                           | Inventory basis difference                                            |                                |   | 1,406 |        |   |        | 1,857  |        
|                           | Warranty liability                                                    |                                |   | 370   |        |   |        | 782    |        
|                           | Depreciation                                                          |                                |   | 167   |        |   |        |       |        
|                           | Deferred consideration on sale of hemodynamic
    monitoring business |                                |   |      |        |   |        | 820    |        
|                           | Accrued compensation and severance                                    |                                |   |      |        |   |        | 766    |        
|                           | Other                                                                 |                                |   | 703   |        |   |        | 446    |        
|                           |                                                                       |                                |   |       |        |   |        |       
|                           |                                                                       | Gross deferred tax assets      |   |       | 8,929  |   |        |        | 12,688  |  
|                           |                                                                       | Valuation Allowance            |   |       | (8,929 | ) |        |        | (11,086 | )
|Deferred tax liabilities:  |                                                                       |                                |   |       |        |   |        |       
|                           | Depreciation                                                          |                                |   |      |        |   |        | (843   | )      
|                           | Burdick intangible assets                                             |                                |   |      |        |   |        | (759   | )      
|                           | Burdick trade name intangible asset                                   |                                |   |      |        |   |        | (1,156 | )      
|                           | Goodwill from treadmill line acquisition                              |                                |   |      |        |   |        | (24    | )      
|                           |                                                                       |                                |   |       |        |   |        |       
|                           |                                                                       | Gross deferred tax liabilities |   |       |       |   |        |        | (2,782  | )
|                           |                                                                       |                                |   |       |        |   |        |       
|Net deferred tax liability |                                                                       | $                              |  |       |        | $ | (1,180 | )     
|                           |                                                                       |                                |   |       |        |   |        |       

At December 31, 2003, the Company had net
operating loss carryforwards of approximately $11,615,000 and
$18,900,000 related to U.S. federal and state jurisdictions,
respectively, and credit carryforwards totaling $2,413,000.
These carryforwards expire between 2018 and 2023. Net operating
loss carryforwards include $903,000 which arose from the
exercise of non-qualified stock options. The tax benefit of
which will be reflected as a credit to shareholders equity
when realized. In addition, state net operating loss
carryforwards include approximately $11,000,000 attributable to
the acquisition of Burdick, Inc. The tax benefit of which will
be reflected as a reduction in goodwill when realized.
Sections 382 and 383 of the Internal Revenue Code of 1986,
as amended, provide for limitations on the utilization of net
operating loss and research and experimentation credit
carryforwards if the Company has undergone or were to undergo an
ownership change, as defined in Section 382.

A tax law change effected in 2002 entitled the
Company to a refund of alternative minimum taxes paid in prior
periods. Due to this tax law change, the Company recognized a
tax benefit of $206,000 in 2002. The Company received the refund
in 2003.

F-21



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The benefit from (provision for) income taxes
attributable to continuing operations are as follows (amounts in
thousands):

|         |                                   |                         |   |      |   |      |   |     |   |  |   |     |  
|-------- | --------------------------------- | ----------------------- | - | ---- | - | ---- | - | --- | - |  | - | --- | -
|         |                                   |                        
|         |                                   | Year Ended December 31,
|         |                                   |                        
|         |                                   | 2001                    |   | 2002 |   | 2003
|         |                                   |                         |   |      |   |     
|Current  |                                   |                         |   |      |   |      |   |     |   |  |   |    
|         | Federal                           |                         | $ | 228  |   |      | $ | 206 |   |  | $ |    |  
|         | State                             |                         |   | (23  | ) |      |   | (14 | ) |  |   | (38 | )
|         |                                   |                         |   |      |   |      |   |     |   |  |   |    
|         | Total current benefit (provision) |                         |   | 205  |   |      |   | 192 |   |  |   | (38 | )
|         |                                   |                         |   |      |   |      |   |     |   |  |   |    
|Deferred |                                   |                         |   |      |   |      |   |     |   |  |   |    
|         | Federal                           |                         |   |     |   |      |   |    |   |  |   | (21 | )
|         | State                             |                         |   |     |   |      |   |    |   |  |   | (3  | )
|         |                                   |                         |   |      |   |      |   |     |   |  |   |    
|         | Total deferred provision          |                         |   |     |   |      |   |    |   |  |   | (24 | )
|         |                                   |                         |   |      |   |      |   |     |   |  |   |    
|         | Total benefit (provision)         |                         | $ | 205  |   |      | $ | 192 |   |  | $ | (62 | )
|         |                                   |                         |   |      |   |      |   |     |   |  |   |    

A reconciliation of the United States statutory
rate to the effective tax rates attributable to continuing
operations follows:

|                                                   |  |                         |       |      |  |      |       |   |  |  |       |   
|-------------------------------------------------- |  | ----------------------- | ----- | ---- |  | ---- | ----- | - |  |  | ----- | --
|                                                   |  |                        
|                                                   |  | Year Ended December 31,
|                                                   |  |                        
|                                                   |  | 2001                    |       | 2002 |  | 2003
|                                                   |  |                         |       |      |  |     
|Federal income tax benefit at U.S. statutory rates |  |                         | 34.0  | %    |  |      | 34.0  | % |  |  | 34.0  | % 
|Alternative minimum tax                            |  |                         |      |      |  |      | 13.3  |   |  |  |      |   
|Non-deductible expenses                            |  |                         | 11.6  |      |  |      | (2.5  | ) |  |  | (34.7 | ) 
|State income taxes, net of federal benefit         |  |                         | (0.2  | )    |  |      | (1.1  | ) |  |  | (1.3  | ) 
|Increase in deferred tax valuation allowance       |  |                         | (42.6 | )    |  |      | (31.5 | ) |  |  | (0.5  | ) 
|                                                   |  |                         |       |      |  |      |       |   |  |  |       |   
|Benefit (provision) for income taxes               |  |                         | 2.8   | %    |  |      | 12.2  | % |  |  | (2.5  | )%
|                                                   |  |                         |       |      |  |      |       |   |  |  |       |   

14.     Commitments
and Contingencies



| |                  
| | -----------------
| | Lease Commitments

The Company leases its office facilities in
Bothell, WA under an operating lease. This non-cancelable
facility lease agreement expires on December 31, 2013 with
an option to terminate in January 2009. The Company leases
office, production and warehouse facilities in Deerfield, WI
under an operating lease. This non-cancelable facility lease
agreement expires on November 30, 2008 with two five-year
renewal options. The Company also leases equipment under
non-cancelable operating leases. Future minimum lease payments,
assuming the option in January 2009 to terminate the Bothell
lease is exercised, under non-cancelable leases totaled
$5,327,000 at December 31, 2003, payable as follows
(amounts in thousands):

|           |  |   |       | 
|---------- |  | - | ----- | 
|2004       |  | $ | 1,090 | 
|2005       |  |   | 1,039 | 
|2006       |  |   | 1,016 | 
|2007       |  |   | 992   | 
|2008       |  |   | 950   | 
|Thereafter |  |   | 240   | 

Net rental expense, including common area
maintenance costs, during 2001, 2002 and 2003 was approximately
$1,628,000, $1,643,000 and $2,253,000, respectively. For the
years ended December 31, 2001

F-22



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

and 2002, the Company received rent of
approximately $805,000 and $609,000, respectively, including
common area maintenance costs, from a sublease to StairMaster
(see Note 6). The sublease payments were recorded as reductions
of monthly rent expense.

Other
Commitments

The Company is committed under a licensing
agreement with a vendor to pay a license fee for each copy of
the vendors software incorporated into the Companys
products, and to purchase a minimum number of licenses each
year. The agreement term is five years and expires in June 2006.
Minimum billings are calculated on an annual basis each June and
vary from year to year. At December 31, 2003, the balance of the
annual commitment is $96,000. Certain penalty provisions exist
if the Company chooses to cancel this agreement prematurely.
Early cancellation would require the Company to purchase 140
additional licenses from the vendor at the price of $4,000 each,
payable over 12 months from notice of cancellation. If the
Company cancels the agreement prematurely for the purpose of
exiting participation in Holter monitoring in the U.S.
marketplace, this penalty clause would be reduced to a purchase
of 12 additional months of minimums from that point forward, but
no less than 85 additional licenses, which under this penalty
provision totals $340,000 as of December 31, 2003.

As of December 31, 2003, the Company had
purchase obligations of approximately $9,301,000 consisting of
outstanding purchase orders issued in the normal course of
business.

Legal
Matters

In July 1998, the Company signed an Original
Equipment Manufacturer and Distributor Agreement with Zymed,
Incorporated (Zymed), a related party (see Note 18).
This agreement provided for the purchase of certain Holter
monitoring items, and appointed the Company exclusive
distributor of such products in the United States and Canada for
a period of five years. In the third quarter of 2000 the Company
received a notice of termination of this agreement from Zymed
based on the alleged inability of the parties to agree on
pricing and volume requirements as set forth in the agreement.
This notice of termination provided for a 180 day notice
period that expired in February 2001.

The Company disputed this notice of termination,
and filed suit in the State of Washington principally citing a
claim for breach of contract. The Company was seeking monetary
damages and other remedies available under the law. The products
supplied under this agreement represented a significant portion
of the Companys revenues, approximately 12.0% in 2000 and
3.0% in 2001. The Company made a significant effort to mitigate
the impact of this termination. The Company incurred significant
legal expenses related to the litigation of this dispute. The
case went to trial and concluded in January 2003. The jury found
in favor of the defendant.

The Company is a defendant in various other legal
matters arising in the normal course of business. In the opinion
of management, the ultimate resolution of these other matters is
not expected to have a material effect on the Companys
consolidated financial position, results of operations or cash
flows.

15.     Shareholders
Equity

Convertible
Preferred Stock

The Company had 12,230,000 and 865,000 shares of
preferred stock as Series A convertible preferred stock and
Series B convertible preferred stock, respectively,
outstanding as of December 31, 2001. During 2002, all
preferred stock outstanding was converted according to the
original conversion terms to 6,639,347 shares of common stock.

F-23



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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Company is authorized to issue a total of
10,000,000 shares of preferred stock, which includes the
Series A and B convertible preferred stock that was
converted to common stock during 2002. The Board of Directors is
authorized to determine or alter the rights, preferences,
privileges and restrictions granted to or imposed upon any
wholly unissued series of preferred stock.

Common
Stock

The Company is authorized to issue a total of
65,000,000 shares of common stock.

During 2001, 2002 and 2003, the Company issued
10,403, 91,191 and 81,883 shares of common stock, respectively,
in connection with stock option exercises for total proceeds of
$5,000, $60,000 and $81,000, respectively.

In May 2002, the Company consummated an initial
public offering of its common stock. In the offering, the
Company sold 4,000,000 shares of common stock at a price of
$7.00 per share. In addition, in June 2002, the underwriters of
the offering exercised their over-allotment option to purchase
an additional 600,000 shares at $7.00 per share. Proceeds from
the offering, including the over-allotment shares, were
$28,219,000, net of underwriting discounts and offering expenses
of $3,981,000. All of the outstanding shares of convertible
preferred stock automatically converted into 6,639,347 shares of
common stock upon completion of the offering.

During 2002 and 2003, the Company issued 41,323
and 83,886 shares of common stock, respectively, in connection
with the Employee Stock Purchase Plan for total proceeds of
$252,000 and $451,000, respectively.

In February 2001, the Company exercised its
option to repurchase 426,200 of unvested common shares from its
former President and Chief Executive Officer for $93,764, the
total purchase price paid by the former employee for the
unvested shares.

The following shares of common stock have been
reserved for issuance as of December 31, 2003:

|                                                 |  |  |           | 
|------------------------------------------------ |  |  | --------- | 
|Outstanding stock options                        |  |  | 1,835,067 | 
|Stock options available for future grant         |  |  | 442,825   | 
|Warrants to purchase common stock                |  |  |          | 
|                                                 |  |  |           | 
|Total common shares reserved for future issuance |  |  | 2,277,892 | 
|                                                 |  |  |           | 

16.     Stock Option
Plan

In February 2002, the Companys board of
directors adopted and the Companys shareholders approved
the 2002 Stock Incentive Plan (the 2002 Plan). The
2002 Plan became effective upon completion of the initial public
offering and replaced the 1998 Equity Incentive Plan (the
1998 Plan) for purposes of all future incentive stock
awards. The 2002 Plan allows the Company to issue awards of
incentive or nonqualified stock options, shares of common stock
or units denominated in common stock, all of which may be
subject to restrictions. The Company initially reserved 376,804
shares for issuance under the 2002 Plan, including 263,168
shares which were transferred from the 1998 Plan. In addition,
the 2002 Plan authorizes annual increases in shares for issuance
equal to the lesser of (i) 681,818 shares, (ii) 3% of
the number of shares of common stock outstanding on a fully
diluted basis as of the end of the Companys immediately
preceding fiscal year, (iii) and the lesser amount
established by the Companys board of directors. Any shares
from increases in previous years that are not actually issued
will continue to be included in the aggregate number of shares
available for future issuance.

Options generally vest ratably over a three and
one-half to four year period. The term of the options is for a
period of ten years or less. Options generally expire
90 days after termination of employment. If participants

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

exercise unvested options, the Company has the
right to repurchase the unvested shares at the original option
exercise price in the event of termination of employment. At
December 31, 2002 and 2003, there were no shares of
unvested common stock which were subject to repurchase by the
Company according to these repurchase rights.

The Company has also adopted a stock option grant
program for non-employee directors, administered under the terms
and conditions of the 2002 Plan, which became effective upon
completion of the Companys public stock offering.

In addition, the Company adopted a 2002 Employee
Stock Purchase Plan (ESPP) in February 2002. The
ESPP was implemented upon the effectiveness of the
Companys public stock offering. The ESPP permits eligible
employees to purchase common stock through payroll deductions.
The Company initially reserved 227,272 shares for issuance under
the ESPP Plan. In addition, the ESPP Plan authorizes annual
increases in shares for issuance equal to the lesser of
(i) 227,272 shares, (ii) 2% of the number of shares of
common stock outstanding on a fully diluted basis as of the end
of the Companys immediately preceding fiscal year, and
(iii) and the lesser amount established by the
Companys board of directors. Any shares from increases in
previous years that are not actually issued will continue to be
included in the aggregate number of shares available for future
issuance.

The following table summarizes information about
option transactions:

|                           |           |         |           |           |   |   |      |      | 
|-------------------------- | --------- | ------- | --------- | --------- | - | - | ---- | ---- | 
|                           |           |         |           | Weighted-
|                           |           |         |           | Average  
|                           |           |         |           | Exercise 
|                           |           | Options |           | Price    
|                           |           |         |           |          
|Balance, December 31, 2000 |           |         | 1,170,474 |           |   |   | 1.67 |     
|                           | Granted   |         |           | 121,438   |   |   |      | 2.53 | 
|                           | Exercised |         |           | (10,403   | ) |   |      | 0.53 | 
|                           | Canceled  |         |           | (38,779   | ) |   |      | 1.08 | 
|                           |           |         |           |           |   |   |      |     
|Balance, December 31, 2001 |           |         | 1,242,730 |           |   |   | 1.78 |     
|                           | Granted   |         |           | 336,886   |   |   |      | 8.30 | 
|                           | Exercised |         |           | (91,191   | ) |   |      | 0.67 | 
|                           | Canceled  |         |           | (39,101   | ) |   |      | 1.69 | 
|                           |           |         |           |           |   |   |      |     
|Balance, December 31, 2002 |           |         | 1,449,324 |           |   |   | 3.37 |     
|                           | Granted   |         |           | 517,450   |   |   |      | 6.58 | 
|                           | Exercised |         |           | (81,883   | ) |   |      | 0.98 | 
|                           | Canceled  |         |           | (49,824   | ) |   |      | 5.48 | 
|                           |           |         |           |           |   |   |      |     
|Balance, December 31, 2003 |           |         | 1,835,067 |           |   | $ | 4.32 |     
|                           |           |         |           |           |   |   |      |     

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following information is provided for options
outstanding and exercisable at December 31, 2003:

|                |               |             |  |             |           |             |  |           |      |           |  |  |           |  |  |  |           |  |  |   |      | 
|--------------- | ------------- | ----------- |  | ----------- | --------- | ----------- |  | --------- | ---- | --------- |  |  | --------- |  |  |  | --------- |  |  | - | ---- | 
|                |               |             |  |            
|                |               | Outstanding |  | Exercisable
|                |               |             |  |            
|                |               |             |  | Weighted-   |           |            
|                |               |             |  | Weighted-   |           | Average     |  |           |      | Weighted-
|                |               |             |  | Average     |           | Remaining   |  |           |      | Average  
|Range of        |               | Number of   |  | Exercise    |           | Contractual |  | Number of |      | Exercise 
|Exercise Prices |               | Options     |  | Price       |           | Life        |  | Options   |      | Price    
|                |               |             |  |             |           |             |  |           |      |          
|                | $0.22         |             |  |             | 139,528   |             |  | $         | 0.22 |           |  |  | 4.6 years |  |  |  | 139,528   |  |  | $ | 0.22 | 
|                | $0.88 - $1.87 |             |  |             | 17,041    |             |  | $         | 1.29 |           |  |  | 4.0 years |  |  |  | 17,041    |  |  | $ | 1.29 | 
|                | $2.20         |             |  |             | 838,315   |             |  | $         | 2.20 |           |  |  | 6.6 years |  |  |  | 823,408   |  |  | $ | 2.20 | 
|                | $3.30         |             |  |             | 26,530    |             |  | $         | 3.30 |           |  |  | 7.9 years |  |  |  | 16,520    |  |  | $ | 3.30 | 
|                | $5.40         |             |  |             | 10,000    |             |  | $         | 5.40 |           |  |  | 9.2 years |  |  |  | 7,499     |  |  | $ | 5.40 | 
|                | $6.00 - $6.28 |             |  |             | 336,350   |             |  | $         | 6.01 |           |  |  | 8.8 years |  |  |  | 10,239    |  |  | $ | 6.28 | 
|                | $6.80 - $8.37 |             |  |             | 467,303   |             |  | $         | 8.27 |           |  |  | 8.7 years |  |  |  | 171,680   |  |  | $ | 8.31 | 
|                |               |             |  |             |           |             |  |           |      |           |  |  |           |  |  |  |           |  |  |   |      | 
|                | $0.22 - $8.37 |             |  |             | 1,835,067 |             |  | $         | 4.32 |           |  |  | 7.4 years |  |  |  | 1,185,915 |  |  | $ | 2.91 | 
|                |               |             |  |             |           |             |  |           |      |           |  |  |           |  |  |  |           |  |  |   |      | 

At December 31, 2001 and 2002, the Company
had 943,162 and 1,067,642 options exercisable, respectively,
with a weighted-average exercise price of $1.63 and $2.33,
respectively.

Under APB 25, no compensation expense is
recognized for options awarded to employees if the exercise
price of the option equals the fair market value of the
underlying stock on the grant date. Deferred stock-based
compensation is recorded when the exercise price of an option or
the sales price of the restricted stock is lower than the fair
market value of the underlying common stock on the date of
grant. The Company is amortizing the deferred stock-based
compensation over the vesting period of the underlying options,
which is typically three and a half years. Amortization of
deferred stock-based compensation to employees was approximately
$42,000, $111,000 and $74,000 for the years ended
December 31, 2001, 2002 and 2003, respectively.
Compensation expense is decreased in the period of forfeiture by
any recognized but unvested compensation upon the early
termination of an option holders services.

During the year ended December 31, 2000, the
Company granted 391,363 stock options to the Companys
non-employee Chief Executive Officer. The options were scheduled
to vest over a three and a half year period. The original terms
required that the individual continue his consulting
relationship with the Company in order to continue vesting.
These options were accounted for in accordance with the
provisions of SFAS 123 and EITF 96-18. Accordingly, using the
Black-Scholes option pricing model and assuming a term of
10 years, a risk-free interest rate of 5.2% and expected
volatility of 70.0%, the options were marked to fair value at
each reporting period through charges to stock-based
compensation in the statements of operations. Effective December
31, 2001, the individual became an employee of the Company.
Additionally, on that date the individuals remaining
unvested options were accelerated and became fully vested.
Accordingly, $2,622,000 was recognized in stock-based
compensation expense related to these options for the year ended
December 31, 2001.

17.     Employee
Benefit Plans

The Company is the sponsor of the Quinton Inc
401(k) Plan and Trust (the 401(k) Plan), which was
established in August 1998. The 401(k) Plan covers all employees
of Quinton Inc. who are at least 21 years of age. The
401(k) Plan includes a provision for an employee deferral of up
to 16% of compensation and a discretionary employer match
determined by the Board. The Company made matching contributions
of approximately $288,000, $306,000 and $331,000 for the years
ended December 31, 2001, 2002 and 2003, respectively. At
December 31, 2002 and 2003, the Company had accrued $64,000
and $48,000 for matching plan contributions, respectively.

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

As part of the acquisition of Burdick on
January 2, 2003, the Company became the sponsor of the
Spacelabs Burdick, Inc. Savings Plan (Burdick Plan).
The Burdick Plan covers all employees of Spacelabs Burdick, Inc.
The Burdick Plan includes a provision for an employee deferral
of up to 16% of compensation and a discretionary employer match
determined by the Board. The Company made matching contributions
of approximately $68,000 for the year ended December 31,
2003. At December 31, 2003, the Company did not have an
accrual for matching plan contributions.

18.     Related Party
Transactions

The Companys transactions with related
parties included in the consolidated financial statements are as
follows:

WR
Hambrecht+Co

WR Hambrecht+Co is a member of W.R.
Hambrecht/QIC, LLC, which owned 81% of the Series A
convertible preferred stock prior to conversion to common stock
in 2002. William R. Hambrecht is an executive of WR Hambrecht+Co
and was one of the Companys directors at the time of the
stock conversion in 2002.

WR Hambrecht+Co beneficially held more than five
percent of the outstanding shares of StairMaster. During the
years ended December 31, 2001, 2002, and 2003, the Company
paid StairMaster $2,610,000, $2,338,000, and $0, respectively,
for treadmills and related components that StairMaster supplied
to the Company.

Philips/Agilent/Zymed

Agilent, a former owner of 19.0% of the
Series A convertible preferred stock prior to conversion to
common stock in 2002, sold its shares to Philips Electronics
North America Corporation (Philips) in August 2001.
The Company has a royalty agreement with Agilent. For the years
ended December 31, 2001, 2002 and 2003, the Company paid
approximately $5,000, $5,000 and $3,000, respectively, in
royalties related to this agreement.

During the year ended December 31, 2000,
Agilent acquired Zymed, which was a member of W.R. Hambrecht/
QIC, LLC. The Company has a software development and license
agreement with Zymed. The agreement requires the Company to pay
royalties to Zymed related to a non-exclusive software package
license. For the year ended December 31, 2002 and 2003, the
Company paid royalties of $13,000 and $6,000, respectively,
related to this agreement. The Company had a royalty liability
of $9,000 and $21,000 at December 31, 2002 and 2003,
respectively, related to this agreement.

For the years ended December 31, 2001, 2002
and 2003, the Company purchased approximately $1,079,000,
$94,000 and $128,000, respectively, of inventory from Philips,
Agilent and Zymed, collectively. For the years ended
December 31, 2001, 2002 and 2003, the Company recorded
revenues of approximately $50,000, $69,000 and $63,000,
respectively, from Philips, Agilent, and Zymed, collectively.

ScImage

The Company owns an investment in ScImage,
representing a 3% preferred ownership interest, a privately held
company, which is accounted for using the cost method. The
Company earns commissions from the sale of ScImages
products. For the years ended December 31, 2001, 2002 and
2003, the Company recorded commissions from ScImage of $77,000,
$0 and $0, respectively.

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##### Table of Contents



QUINTON CARDIOLOGY SYSTEMS, INC. AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

19.     Valuation and
Qualifying Accounts

A summary of the activity in the allowance for
doubtful accounts follows (amounts in thousands):

|                             |  |           |     |             |  |             |     |            |  |           |     |  |  |   |     |  |  |   |     | 
|---------------------------- |  | --------- | --- | ----------- |  | ----------- | --- | ---------- |  | --------- | --- |  |  | - | --- |  |  | - | --- | 
|                             |  |           |     |             |  | Expenses    |     |            |  | Balance 
|                             |  | Beginning |     | Burdick     |  | and         |     |            |  | End of   
|                             |  | of Period |     | Acquisition |  | Adjustments |     | Write-offs |  | Period   
|                             |  |           |     |             |  |             |     |            |  |          
|Year Ended December 31, 2001 |  | $         | 674 |             |  | $           |    |            |  | $         | 120 |  |  | $ | 409 |  |  | $ | 385 | 
|Year Ended December 31, 2002 |  | $         | 385 |             |  | $           |    |            |  | $         | 160 |  |  | $ | 147 |  |  | $ | 398 | 
|Year Ended December 31, 2003 |  | $         | 398 |             |  | $           | 234 |            |  | $         | 213 |  |  | $ | 182 |  |  | $ | 663 | 

A summary of the activity in the sublease
liability follows (amounts in thousands):

|                             |  |           |     |             |  |            |     |           |  |   |      |   |  |   |     | 
|---------------------------- |  | --------- | --- | ----------- |  | ---------- | --- | --------- |  | - | ---- | - |  | - | --- | 
|                             |  |           |     | Expenses    |  |            |     | Balance 
|                             |  | Beginning |     | and         |  | Applied to |     | End of   
|                             |  | of Period |     | Adjustments |  | Liability  |     | Period   
|                             |  |           |     |             |  |            |     |          
|Year Ended December 31, 2001 |  | $         |    |             |  | $          | 831 |           |  | $ |     |   |  | $ | 831 | 
|Year Ended December 31, 2002 |  | $         | 831 |             |  | $          |    |           |  | $ |     |   |  | $ | 831 | 
|Year Ended December 31, 2003 |  | $         | 831 |             |  | $          |    |           |  | $ | (831 | ) |  | $ |    | 

20.     Reverse Stock
Split

Effective March 29, 2002, the Companys
Board of Directors approved a 1 to 2.2 reverse stock split of
the Companys common stock. All common shares and per share
amounts in the accompanying consolidated financial statements
have been adjusted to reflect the reverse stock split.

F-28