##### Table of Contents



---

---

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q




---



(Mark One)



|[ X ] | Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|----- | ---------------------------------------------------------------------------------------

For the quarterly period ended June 30, 2002
 
or



|[     ] | Transition report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934
|------- | ----------------------------------------------------------------------------------------

For the transition period from ________ to ________

Commission File Number 0-26778



---



APPLIED MICROSYSTEMS CORPORATION

(Exact name of registrant as specified in its charter)




---



|                         |  |                                        
|------------------------ |  | ---------------------------------------
|Washington               |  | 91-1074996                             
|(State of incorporation) |  | (I.R.S. Employer Identification Number)

5020 148th Avenue N.E., Redmond, Washington 98052-5172
(425) 882-2000
(Address of principal executive offices, including zip code; registrants telephone number, including area code)



---



Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X]  No [   ]

Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date.

Common stock, $.01 par value: 7,559,905 shares outstanding as of July 31, 2002.



---

---



---

TABLE OF CONTENTS



|                               |                                                                                               |                                            |  |  |  |  |  | 
|------------------------------ | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I  FINANCIAL INFORMATION
|                               | Item 1. Financial Statements                                                                 
|                               |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                               |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                               |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                               |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                               | Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
|                               | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|PART II  OTHER INFORMATION   
|                               | Item 4. Submission of matters to a vote of security holders                                  
|                               | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURES                    
|EXHIBIT 99.1                  
|EXHIBIT 99.2                  



---



##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION
 FORM 10-Q
 QUARTER ENDED JUNE 30, 2002
 INDEX

|         |  |                                                                                       |  |                                                                                                                    |    |      |    | 
|-------- |  | ------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------ | -- | ---- | -- | 
|         |  |                                                                                       |  |                                                                                                                    |    | Page
|         |  |                                                                                       |  |                                                                                                                    |    |     
|PART I:  |  | FINANCIAL INFORMATION                                                                 |  |                                                                                                                    |    |     
|        
|Item 1.  |  | Financial Statements:                                                                 |  |                                                                                                                    |    |     
|        
|         |  |                                                                                       |  | Consolidated Balance Sheets as of June 30, 2002 (unaudited) and December 31, 2001                                  |    |      | 3  | 
|        
|         |  |                                                                                       |  | Consolidated Statements of Operations for the three months and
six months ended June 30, 2002 and 2001 (unaudited) |    |      | 4  | 
|        
|         |  |                                                                                       |  | Consolidated Statements of Cash Flows for the six months ended
June 30, 2002 and 2001 (unaudited)                  |    |      | 5  | 
|        
|         |  |                                                                                       |  | Notes to Consolidated Financial Statements (unaudited)                                                             |    |      | 6  | 
|        
|Item 2.  |  | Managements Discussion and Analysis of Financial Condition and Results of
Operations |  |                                                                                                                    | 10 |     
|        
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                            |  |                                                                                                                    | 20 |     
|        
|PART II: |  | OTHER INFORMATION                                                                     |  |                                                                                                                    |    |     
|        
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                   |  |                                                                                                                    | 20 |     
|        
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                      |  |                                                                                                                    | 21 |     
|        
|         |  |                                                                                       |  | Signatures                                                                                                         |    |      | 21 | 



- 2 -



---



##### Table of Contents






PART I  FINANCIAL INFORMATION




Item 1. Financial Statements




APPLIED MICROSYSTEMS CORPORATION
 
CONSOLIDATED BALANCE SHEETS

|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |         |        | 
|---------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | -------------- | ------ | ------------ | ----- | ------- | ------ | 
|                                               |                                                                                                                                                                         |                                            |       | June 30,       |        | December 31,
|                                               |                                                                                                                                                                         |                                            |       | 2002           |        | 2001        
|                                               |                                                                                                                                                                         |                                            |       |                |        |             
|                                               |                                                                                                                                                                         |                                            |       | (unaudited)    |        |              |       |        
|                                               |                                                                                                                                                                         |                                            |       | (in thousands)
|ASSETS                                         |                                                                                                                                                                        
|Current assets:                                |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               | Cash and cash equivalents                                                                                                                                               |                                            | $     | 2,018          |        |              | $     | 2,971   |       
|                                               | Securities available-for-sale                                                                                                                                           |                                            |       | 2,789          |        |              |       | 3,997   |       
|                                               | Restricted investment                                                                                                                                                   |                                            |       |               |        |              |       | 400     |       
|                                               | Accounts receivable, net                                                                                                                                                |                                            |       | 1,737          |        |              |       | 3,594   |       
|                                               | Inventories                                                                                                                                                             |                                            |       | 1,517          |        |              |       | 1,959   |       
|                                               | Prepaid and other current assets                                                                                                                                        |                                            |       | 451            |        |              |       | 429     |       
|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               |                                                                                                                                                                         | Total current assets                       |       |                | 8,512  |              |       |         | 13,350 | 
|Property and equipment, net                    |                                                                                                                                                                         |                                            | 1,108 |                |        |              | 1,358 |        
|Other assets                                   |                                                                                                                                                                         |                                            | 581   |                |        |              | 316   |        
|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               |                                                                                                                                                                         | Total assets                               |       | $              | 10,201 |              |       | $       | 15,024 | 
|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|LIABILITIES AND SHAREHOLDERS EQUITY           |                                                                                                                                                                        
|Current liabilities:                           |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               | Accounts payable                                                                                                                                                        |                                            | $     | 1,395          |        |              | $     | 1,704   |       
|                                               | Accrued payroll                                                                                                                                                         |                                            |       | 1,518          |        |              |       | 1,178   |       
|                                               | Other accrued expenses                                                                                                                                                  |                                            |       | 1,616          |        |              |       | 1,453   |       
|                                               | Deferred revenue                                                                                                                                                        |                                            |       | 1,985          |        |              |       | 3,253   |       
|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               |                                                                                                                                                                         | Total current liabilities                  |       |                | 6,514  |              |       |         | 7,588  | 
|Capital lease obligation, less current portion |                                                                                                                                                                         |                                            | 151   |                |        |              | 175   |        
|Notes payable                                  |                                                                                                                                                                         |                                            | 178   |                |        |              |      |        
|Accrued cost of business restructuring         |                                                                                                                                                                         |                                            | 1,015 |                |        |              | 719   |        
|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               |                                                                                                                                                                         | Total long-term liabilities                |       |                | 1,344  |              |       |         | 894    | 
|Shareholders equity:                          |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               | Preferred stock, $0.01 par value; 5,000,000
shares authorized; none issued and outstanding                                                                              |                                            |       |               |        |              |       |        |       
|                                               | Common stock, $0.01 par value; 25,000,000
shares authorized; 7,538,000 and 7,149,000
shares issued and outstanding at June 30, 2002
and December 31, 2001, respectively |                                            |       | 27,223         |        |              |       | 26,857  |       
|                                               | Accumulated other comprehensive loss                                                                                                                                    |                                            |       | (566           | )      |              |       | (636    | )     
|                                               | Accumulated deficit                                                                                                                                                     |                                            |       | (24,314        | )      |              |       | (19,679 | )     
|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               |                                                                                                                                                                         | Total shareholders equity                 |       |                | 2,343  |              |       |         | 6,542  | 
|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |        
|                                               |                                                                                                                                                                         | Total liabilities and shareholders equity |       | $              | 10,201 |              |       | $       | 15,024 | 
|                                               |                                                                                                                                                                         |                                            |       |                |        |              |       |        

See accompanying notes.



- 3 -



---



##### Table of Contents






APPLIED MICROSYSTEMS CORPORATION
 CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

|                                     |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |       | 
|------------------------------------ | ----------------------------------- | - | ---------------------------------------- | ----- | ---------------- | - | ----- | ----- | ---- | - | ------ | ----- |  | - | ------ | ----- | 
|                                     |                                     |   | Three Months ended                       |       | Six Months ended
|                                     |                                     |   | June 30,                                 |       | June 30,        
|                                     |                                     |   |                                          |       |                 
|                                     |                                     |   | 2002                                     |       | 2001             |   | 2002  |       | 2001
|                                     |                                     |   |                                          |       |                  |   |       |       |     
|                                     |                                     |   | (in thousands, except per-share amounts)
|Net sales                            |                                     | $ | 3,271                                    |       |                  | $ | 8,840 |       |      | $ | 8,136  |       |  | $ | 18,954 |      
|Cost of sales                        |                                     |   | 941                                      |       |                  |   | 2,516 |       |      |   | 2,736  |       |  |   | 5,323  |      
|                                     |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |      
|Gross profit                         |                                     |   | 2,330                                    |       |                  |   | 6,324 |       |      |   | 5,400  |       |  |   | 13,631 |      
|Operating expenses:                  |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |      
|                                     | Sales, general and administrative   |   |                                          | 2,417 |                  |   |       | 4,004 |      |   |        | 5,072 |  |   |        | 7,888 | 
|                                     | Research and development            |   |                                          | 1,583 |                  |   |       | 3,295 |      |   |        | 3,239 |  |   |        | 6,559 | 
|                                     | In-process research and
development |   |                                          | 621   |                  |   |       |      |      |   |        | 621   |  |   |        |      | 
|                                     | Business restructuring              |   |                                          | 1,149 |                  |   |       |      |      |   |        | 1,149 |  |   |        |      | 
|                                     |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |      
|Total operating expenses             |                                     |   | 5,770                                    |       |                  |   | 7,299 |       |      |   | 10,081 |       |  |   | 14,447 |      
|                                     |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |      
|Loss from operations                 |                                     |   | (3,440                                   | )     |                  |   | (975  | )     |      |   | (4,681 | )     |  |   | (816   | )    
|Interest income and other, net       |                                     |   | 17                                       |       |                  |   | 83    |       |      |   | 46     |       |  |   | 184    |      
|                                     |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |      
|Net loss                             |                                     | $ | (3,423                                   | )     |                  | $ | (892  | )     |      | $ | (4,635 | )     |  | $ | (632   | )    
|                                     |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |      
|Per-share amounts:                   |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |      
|Basic and diluted net loss per share |                                     | $ | (0.47                                    | )     |                  | $ | (0.13 | )     |      | $ | (0.64  | )     |  | $ | (0.09  | )    
|                                     |                                     |   |                                          |       |                  |   |       |       |      |   |        |       |  |   |        |      
|Shares used in per-share calculation |                                     |   | 7,338                                    |       |                  |   | 7,055 |       |      |   | 7,255  |       |  |   | 7,023  |      

See accompanying notes.



- 4 -



---



##### Table of Contents






APPLIED MICROSYSTEMS CORPORATION
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

|                                                                            |                                             |                                                                        |                                                     |        |                           |        |        |        |        |        |  
|--------------------------------------------------------------------------- | ------------------------------------------- | ---------------------------------------------------------------------- | --------------------------------------------------- | ------ | ------------------------- | ------ | ------ | ------ | ------ | ------ | -
|                                                                            |                                             |                                                                        |                                                     |        | Six Months Ended June 30,
|                                                                            |                                             |                                                                        |                                                     |        |                          
|                                                                            |                                             |                                                                        |                                                     |        | 2002                      |        | 2001  
|                                                                            |                                             |                                                                        |                                                     |        |                           |        |       
|                                                                            |                                             |                                                                        |                                                     |        | (in thousands)           
|Operating activities                                                        |                                             |                                                                        |                                                     |        |                           |        |        |       
|Net loss                                                                    |                                             | $                                                                      | (4,635                                              | )      |                           | $      | (632   | )     
|Adjustments to reconcile net loss to net cash used in
operating activities: |                                             |                                                                        |                                                     |        |                           |        |        |       
|                                                                            | Depreciation and amortization               |                                                                        |                                                     | 394    |                           |        |        | 540    |       
|                                                                            | In-process research and development         |                                                                        |                                                     | 621    |                           |        |        |       |       
|                                                                            | Loss on write off and/or disposal of assets |                                                                        |                                                     | 72     |                           |        |        |       |       
|                                                                            | Net change in operating accounts:           |                                                                        |                                                     |        |                           |        |        |        |       
|                                                                            |                                             | Accounts receivable                                                    |                                                     |        | 1,945                     |        |        |        | (162   | )     
|                                                                            |                                             | Inventories                                                            |                                                     |        | 475                       |        |        |        | 397    |       
|                                                                            |                                             | Prepaid and other assets                                               |                                                     |        | (14                       | )      |        |        | (75    | )     
|                                                                            |                                             | Accounts payable, accrued expenses, and accrued
business restructuring |                                                     |        | 174                       |        |        |        | (576   | )     
|                                                                            |                                             | Deferred revenue                                                       |                                                     |        | (1,216                    | )      |        |        | (1,010 | )     
|                                                                            |                                             |                                                                        |                                                     |        |                           |        |        |       
|                                                                            |                                             |                                                                        | Net cash used in operating activities               |        |                           | (2,184 | )      |        |        | (1,518 | )
|Investing activities                                                        |                                             |                                                                        |                                                     |        |                           |        |        |       
|                                                                            | Purchases of securities available-for-sale  |                                                                        |                                                     | (2,275 | )                         |        |        | (4,522 | )     
|                                                                            | Maturities of securities available-for-sale |                                                                        |                                                     | 3,483  |                           |        |        | 1,969  |       
|                                                                            | Additions to property and equipment         |                                                                        |                                                     | (72    | )                         |        |        | (119   | )     
|                                                                            |                                             |                                                                        |                                                     |        |                           |        |        |       
|                                                                            |                                             |                                                                        | Net cash provided by (used in) investing activities |        |                           | 1,136  |        |        |        | (2,672 | )
|Financing activities                                                        |                                             |                                                                        |                                                     |        |                           |        |        |       
|                                                                            | Sale of common stock to employees           |                                                                        |                                                     | 47     |                           |        |        | 151    |       
|                                                                            | Stock options exercised                     |                                                                        |                                                     | 1      |                           |        |        | 197    |       
|                                                                            | Payments on capital lease obligation        |                                                                        |                                                     | (22    | )                         |        |        | (10    | )     
|                                                                            |                                             |                                                                        |                                                     |        |                           |        |        |       
|                                                                            |                                             |                                                                        | Net cash provided by financing activities           |        |                           | 26     |        |        |        | 338    |  
|Effects of foreign exchange rate changes on cash                            |                                             |                                                                        | 69                                                  |        |                           |        | (102   | )     
|                                                                            |                                             |                                                                        |                                                     |        |                           |        |        |       
|Net decrease in cash and cash equivalents                                   |                                             |                                                                        | (953                                                | )      |                           |        | (3,954 | )     
|Cash and cash equivalents at beginning of period                            |                                             |                                                                        | 2,971                                               |        |                           |        | 7,956  |       
|                                                                            |                                             |                                                                        |                                                     |        |                           |        |        |       
|Cash and cash equivalents at end of period                                  |                                             | $                                                                      | 2,018                                               |        |                           | $      | 4,002  |       
|                                                                            |                                             |                                                                        |                                                     |        |                           |        |        |       

Supplemental disclosure of non-cash activities:

During the six months ended June 30, 2001, the Company obtained equipment under a five-year capital
lease obligation of $250,000.

See accompanying notes.



- 5 -



---



##### Table of Contents






APPLIED MICROSYSTEMS CORPORATION
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. Basis of Presentation

The accompanying unaudited consolidated financial statements have been
prepared by Applied Microsystems Corporation (Applied or the Company) in
accordance with accounting principles generally accepted in the United States
of America for interim financial information and according to the rules and
regulations of the Securities and Exchange Commission. Accordingly, they do
not include all of the information and footnotes required by accounting
principles generally accepted in the United States of America for complete
financial statements. In the opinion of management, all adjustments (which
include only normal recurring adjustments) considered necessary for a fair
presentation have been included. The balance sheet at December 31, 2001 has
been derived from the audited financial statements included in the Companys
Form 10-K for the year then ended. The results of operations for the
three-month and six-month periods ended June 30, 2002, are not necessarily
indicative of results to be expected for the entire year ending December 31,
2002 or for any other fiscal period. For further information, refer to the
consolidated financial statements and footnotes thereto included in the
Companys Form 10-K for the year ended December 31, 2001.

2. Computation of Loss Per Share

Basic loss per share is computed using the weighted-average number of
common shares outstanding during the period. Diluted loss per share is
computed using the weighted-average number of common shares and dilutive common
stock equivalent shares outstanding during the period. Common stock equivalent
shares are excluded from the computation of diluted loss per share if their
effect is antidilutive; therefore, due to the Companys net losses, basic and
diluted loss per share are determined excluding common stock equivalents. At
June 30, 2002 and December 31, 2001, options to purchase 1,377,000 and
1,491,000 shares of common stock, respectively, were excluded from the
calculation of loss per share because their effect was antidilutive.

3. Comprehensive Loss

As defined by applicable accounting and reporting standards, Applieds
comprehensive loss is comprised of net loss and the effects of current-period
translation adjustments, which are recorded directly to equity. During the
second quarter of 2002, comprehensive loss amounted to $3.4 million compared to
comprehensive loss of $409,000 for the second quarter of 2001. For the six
months ended June 30, 2002, comprehensive loss amounted to $4.6 million,
compared to comprehensive loss of $566,000 for the six months ended June 30,
2001.



- 6 -



---



##### Table of Contents



4. Inventories

Inventories consist of the following:

|                |  |                |       |              |  |   |       | 
|--------------- |  | -------------- | ----- | ------------ |  | - | ----- | 
|                |  | June 30,       |       | December 31,
|                |  | 2002           |       | 2001        
|                |  |                |       |             
|                |  | (in thousands)
|Finished goods  |  | $              | 855   |              |  | $ | 999   | 
|Work in process |  |                | 52    |              |  |   | 55    | 
|Purchased parts |  |                | 610   |              |  |   | 905   | 
|                |  |                |       |              |  |   |       | 
|                |  | $              | 1,517 |              |  | $ | 1,959 | 
|                |  |                |       |              |  |   |       | 

5. Business Restructuring Activities

In August 2001, in response to economic uncertainty and reduced revenue
streams, Applied implemented a restructuring plan designed to reduce operating
costs. The restructuring plan included a reduction of approximately 90
full-time employees worldwide across the Companys functional organizations;
discontinuance or reallocation of selected projects and activities the Company
believed were not essential to its long-term goals; abandonment of excess space
at the Companys headquarters; as well as other cost reduction and control
measures. As a result of adopting the restructuring plan, Applied recorded a
restructuring charge of $2.3 million in the third quarter of 2001.

The charge for abandoned facilities relates to amounts accrued for
estimated losses on lease commitments for facilities that Applied has abandoned
in connection with the restructuring; the corresponding accrued liability will
be reduced as the Company pays its lease commitments. During the second
quarter of 2002, the Company reassessed the potential exposure for losses for
the abandoned space identified in the August 2001 restructuring in light of
revised estimates of the timeframe and terms under which a sublease could be
negotiated. As a result, the Company recognized an additional charge of
$480,000 in the three months ended June 30, 2002.

In May 2002, the Company announced further plans to reduce expenses
through a reduction in personnel and realignment of business objectives. The
cost reductions consisted primarily of a reduction of approximately 45
full-time employees worldwide across the Companys functional organizations, as
well as a write-off of certain assets for which the book value was deemed in
excess of net realizable value under accounting rules. As a result, the
Company recognized a charge of $602,000 for severance and related expenses and
$67,000 for asset write-offs in the three months ended June 30, 2002.



- 7 -



---



##### Table of Contents



Restructuring charge activity during the six-month period ended June 30,
2002 was as follows:

|                               |  |                    |       |            |  |            |       |              |  |              |     |  |  |   |     |            |  |         |       | 
|------------------------------ |  | ------------------ | ----- | ---------- |  | ---------- | ----- | ------------ |  | ------------ | --- |  |  | - | --- | ---------- |  | ------- | ----- | 
|                               |  |                    |       |            |  |            |       |              |  |              |     |  |  |   |     |            |  | Accrued
|                               |  |                    |       |            |  |            |       |              |  | Amounts Paid |     |  |  |   |     | Balance at
|                               |  | Accrued Balance at |       | Additional |  | or Charged |       | Amounts      |  | June 30,    
|                               |  | December 31, 2001  |       | Charge     |  | Off        |       | Reclassified |  | 2002        
|                               |  |                    |       |            |  |            |       |              |  |             
|                               |  | (in thousands)    
|Severance and
related expenses |  | $                  | 64    |            |  | $          | 602   |              |  | $            | 320 |  |  | $ | 30  |            |  | $       | 376   | 
|Asset write-offs               |  |                    |      |            |  |            | 67    |              |  |              | 67  |  |  |   |    |            |  |         |      | 
|Abandoned facilities           |  |                    | 1,094 |            |  |            | 480   |              |  |              | 159 |  |  |   | (30 | )          |  |         | 1,385 | 
|                               |  |                    |       |            |  |            |       |              |  |              |     |  |  |   |     |            |  |         |       | 
|                               |  | $                  | 1,158 |            |  | $          | 1,149 |              |  | $            | 546 |  |  | $ |    |            |  | $       | 1,761 | 
|                               |  |                    |       |            |  |            |       |              |  |              |     |  |  |   |     |            |  |         |       | 

A portion of the accrued restructuring liabilities in the amount of
$1,015,000 as of June 30, 2002 is classified as long term on the Companys
balance sheet since it represents lease commitments that will not be settled in
the next 12 months, compared to $719,000 classified as long term as of December
31, 2001. The remaining $746,000 accrued restructuring liabilities as of June
30, 2002 are classified as current liabilities and consist of accounts payable
of $41,000, accrued payroll of $335,000, and accrued expenses of $370,000. As
of December 31, 2001, current business restructuring liabilities consisted of
accounts payable of $3,000, accrued payroll of $12,000, and other accrued
expenses of $424,000.

6. Acquisition of REBA Technologies, Inc.

In May 2002, the Company announced that it had completed the acquisition
of REBA Technologies, Inc. (REBA). REBAs patent-pending technology is
focused on enhancing the operation of server farms for enterprises, application
server providers and network service providers. The acquisition consideration
consisted of an aggregate of approximately 350,000 shares of the Companys
common stock plus an aggregate principal amount of $178,000 of promissory
notes, due May 2004, and bearing interest at the rate of 6% annually. The
Company did not acquire any personnel, tangible assets or known liabilities in
the transaction. As a result of the acquisition, the Company recognized
in-process research and development expenses of $621,000 in the second quarter
of 2002, representing the entire purchase price (including transaction-related
expenses).

Because Lary L. Evans is a director of the Company and was the holder of
approximately 86% of REBAs outstanding shares, the negotiation of the terms of
the acquisition was handled by an independent committee of the Companys Board
of Directors composed of disinterested directors. This committee engaged an
independent valuation firm to provide a basis for negotiations, and ultimately
recommended that the transaction be approved by the Companys entire Board of
Directors.

At closing of the transaction, 50% of the merger consideration was placed
into an escrow for the purpose of securing the indemnification obligations of
the REBA shareholders under the merger agreement. Those shares and notes will
remain in escrow for a period of three years from the closing date and until
all pending claims for indemnification, if any, have been resolved.



- 8 -



---



##### Table of Contents



7. Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (the FASB) issued
Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other
Intangible Assets. SFAS 142 requires that goodwill and intangible assets with
indefinite useful lives no longer be amortized, but instead be tested for
impairment at least annually in accordance with the provisions of SFAS 142.
SFAS 142 is effective for the Companys year ending December 31, 2002, and is
not expected to affect the Companys financial statements unless the Company
enters into transactions that result in recognizing goodwill.

In August 2001, the FASB issued SFAS 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS 144 clarifies the model to be used for
long-lived assets to be disposed of, thus providing for greater consistency
among companies, and also clarifies other implementation issues related to the
impairment and disposal of long-lived assets. SFAS 144 is effective for the
Companys year ending December 31, 2002, and is not expected to materially
affect the Companys financial statements.

8. Reclassifications

Certain prior-period amounts have been reclassified to conform to the
current-period presentation.



- 9 -



---



##### Table of Contents








|Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------

This quarterly report on Form 10-Q contains forward-looking statements
within the meaning of the federal securities laws. These forward-looking
statements include, without limitation, statements regarding our expectations
and beliefs about our cost-reduction plans, our intent to pursue new market and
product opportunities through the acquisition of REBA Technologies, our beliefs
and expectations regarding future operating trends, our expectations and
beliefs about the market and industry, our goals, plans, and expectations
regarding our products and services and product development, our intent to
continue to invest resources in research and development, our beliefs regarding
the impact of our restructuring plans, our beliefs and expectations regarding
quotation of our common stock on the NASDAQ National Market and the impact of
potential delisting, our beliefs regarding period-to-period results of
operations, our expectations regarding future financial performance, our
expectations regarding international sales, our expectations and beliefs
regarding revenue and revenue trends, our beliefs and expectations regarding
fluctuations in revenues and operating results, our expectations regarding
development costs, our beliefs and expectations regarding our results of
operation and financial position, our beliefs and expectations regarding
liquidity and capital resources, and our expectations regarding the impact of
recent accounting pronouncements and revenue recognition matters. These
statements are subject to risks and uncertainties that could cause actual
results and events to differ materially from those anticipated. These risks
and uncertainties include, without limitation, those identified in the section
of this quarterly report on Form 10-Q entitled Certain Factors That May Affect
Future Results of Operations below and the section of our annual report on
Form 10-K for the fiscal year ended December 31, 2001 entitled Risk Factors
That May Affect Future Results. Applied undertakes no obligation to update
forward-looking statements to reflect events or circumstances occurring after
the date of this quarterly report on Form 10-Q.

The following managements discussion and analysis of financial conditions
should be read in conjunction with managements discussion and analysis of
financial condition and results of operations included in our Form 10-K for the
year ended December 31, 2001.

As used in this quarterly report on Form 10-Q, unless the context
otherwise requires, the terms we, us, the Company, and Applied refer to
Applied Microsystems Corporation, a Washington corporation, and its
subsidiaries.

Overview

Applied Microsystems Corporation creates solutions to expedite the
development, test and deployment of business and safety-critical embedded
systems. We develop, market and support a comprehensive suite of software and
hardware-enhanced development, test, and verification tools for the development
of complex embedded microprocessor-based applications. Since our incorporation
in 1979, we have developed significant expertise in high-end microprocessors,
real-time systems, and software analysis technology  three key competencies
that position us to meet the needs of software developers. Using our tools,
engineers develop, test, debug, emulate and verify embedded software found in a
wide variety of products, including voice and data communications networks,
console games, avionics systems, automotive systems, medical devices, and
consumer electronics.

Increasingly, embedded systems technology is at the core of new
capabilities in the commercial communications and computing markets  in
applications such as storage area networks, networking appliances,
communications and networking equipment. While Applied has historically been a
developer of tools for use by embedded systems developers, our newly formed
Libra Networks division represents



- 10 -



---



##### Table of Contents



an expansion into development of hardware and software products aimed at
end-user markets  specifically, corporate data centers.

Critical Accounting Policies and Estimates

This discussion and analysis of financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States. The preparation of these financial statements requires us
to make estimates and judgments that affect the reported amounts of assets,
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities. On an on-going basis, we evaluate our critical accounting
policies and estimates, including those related to revenue recognition,
inventories, accounting for acquisitions such as the recently completed REBA
acquisition, and restructuring costs. We base our estimates and our future
expectations on historical experience and on various other assumptions that we
believe to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions.

We believe the following accounting policies are the most critical to aid
in fully understanding and evaluating our more significant judgments and
estimates used in the preparation of our consolidated financial statements.

Revenue recognition. We earn revenue on the sale of hardware and software
products. We also earn revenue on the sale of services, including hardware and
software support, installation, training, and professional engineering
services. Revenue from the sale or licensing of products is recognized when
persuasive evidence of an arrangement exists, delivery of the product has
occurred, the fee is fixed or determinable, and collectibility is probable. If
the fee due from a customer is not fixed or determinable, revenue is recognized
as payments become due from a customer. If customers have inspection or
acceptance rights beyond standard warranty provisions, revenue is recognized
when formal notification of inspection or acceptance has been received from the
customer. Due to business customs in Japan and our interpretation of Japanese
law, product sales in Japan are recognized when the customer notifies us that
it has inspected and accepted the product. In the absence of receiving written
notification of inspection and acceptance, we recognize revenue in Japan on
receipt of payment by the customer as an indication of acceptance. When
products are sold with significant installation services, all revenue is
deferred until installation is completed. Revenue from training and contract
engineering services is generally recognized as the services are performed.
Revenue from longer-term agreements to perform development services is
recognized under the percentage-of-completion method, measured based on labor
effort or cost incurred to total estimated labor effort or cost (assuming other
revenue recognition criteria are met). Revenue results are difficult to
predict, and any shortfall in revenue or delay in recognizing revenue could
cause our operating results to vary significantly from quarter to quarter, and
could result in future operating losses,

Inventories. We write down our inventories for estimated obsolescence or
unmarketable inventories equal to the difference between cost and the estimated
net realizable value based on assumptions about future demand and market
conditions. Changes in those underlying assumptions could result in additional
write-downs of inventories.

Acquisitions.In May 2002, we announced our acquisition of REBA
Technologies, Inc. Applied does not have a history of acquiring companies;
therefore, the accounting policies relating to acquisitions depend on the facts
and circumstances of the specific transaction. In this case, we assessed the
proper



- 11 -



---



##### Table of Contents



allocation of the purchase price in light of the circumstances and
determined that the entire purchase consideration be allocated to in-process
research in development, based primarily on the fact that we acquired
patent-pending technology (and we acquired no other significant tangible or
intangible assets). Future acquisitions, if any, could result in different
accounting treatment depending on the relevant facts and circumstances.

Restructuring costs. In the third quarter of 2001, we implemented a
restructuring plan designed to reduce operating costs. Again in the second
quarter of 2002, we implemented further cost reductions. These restructuring
plans included reductions in full-time employees worldwide across our
functional organizations; discontinuance or reallocation of selected projects
and activities not essential to our long-term goals; abandonment of excess
space at our headquarters; as well as other cost reduction and control
measures. We used estimates to establish accruals in connection with the
restructuring plans, particularly with regard to our contractual lease
obligations for abandoned facilities, and the timing and market rates that may
be available if we successfully sublease the excess space. Actual costs may
differ from these estimates, depending significantly on our success in
subleasing excess space under reasonable terms.

Results of Operations

Our revenues can be classified into three broad categories:
hardware-enhanced debugging tools, software analysis tools, and game
development systems. The following table provides revenue information for each
of these categories.

|                                  |  |                             |       |                           |  |      |        |      |  |        |       |      |  |   |       |  |  |   |         |    |  |   |        | 
|--------------------------------- |  | --------------------------- | ----- | ------------------------- |  | ---- | ------ | ---- |  | ------ | ----- | ---- |  | - | ----- |  |  | - | ------- | -- |  | - | ------ | 
|                                  |  | Three Months Ended June 30, |       | Six Months Ended June 30,
|                                  |  |                             |       |                          
|(dollars in thousands)            |  | 2002                        |       | Change                    |  | 2001 |        | 2002 |  | Change |       | 2001
|                                  |  |                             |       |                           |  |      |        |      |  |        |       |     
|Hardware-enhanced
debugging tools |  | $                           | 1,494 |                           |  | $    | (1,485 | )    |  | $      | 2,979 |      |  | $ | 3,123 |  |  | $ | (3,467  | )  |  | $ | 6,590  | 
|Software analysis
tools           |  |                             | 1,450 |                           |  |      | (727   | )    |  |        | 2,177 |      |  |   | 3,063 |  |  |   | (1,070  | )  |  |   | 4,133  | 
|Game development
systems          |  |                             | 327   |                           |  |      | (3,357 | )    |  |        | 3,684 |      |  |   | 1,950 |  |  |   | (6,281  | )  |  |   | 8,231  | 
|                                  |  |                             |       |                           |  |      |        |      |  |        |       |      |  |   |       |  |  |   |         |    |  |   |        | 
|Total net sales                   |  | $                           | 3,271 |                           |  | $    | (5,569 | )    |  | $      | 8,840 |      |  | $ | 8,136 |  |  | $ | (10,818 | )  |  | $ | 18,954 | 
|                                  |  |                             |       |                           |  |      |        |      |  |        |       |      |  |   |       |  |  |   |         |    |  |   |        | 
|                                  |  |                             |       |                           |  |      | (63    | %)   |  |        |       |      |  |   |       |  |  |   | (57     | %) |  |   |        | 

We earn revenue on the sale of hardware and software products. We also
earn revenue on the sale of services, including hardware and software support,
installation, training, and professional engineering services.

The overall decrease in net sales in the three and six-month periods ended
June 30, 2002, as compared to the same periods in 2001, was attributable
primarily to lower game development systems revenues. The Company maintains
agreements with Nintendo and Microsoft to provide game development tools for
Nintendos GameCube and Microsofts Xbox video gaming systems. Game
development systems revenues were particularly strong in the first half of 2001
due primarily to shipments to Microsoft in anticipation of the November 2001
retail launch of the Xbox. Future game development revenues are expected to
vary from period to period, and the overall success of our game development
solutions depends significantly on the timing of product launches for new video
game consoles as well as the retail success of the video gaming systems that we
currently support. Quarterly game development tools revenues also fluctuate
depending on order cycles from Microsoft and Nintendo.



- 12 -



---



##### Table of Contents



Hardware-enhanced debug, test, and performance solutions revenues also
decreased in the quarter and year-to-date periods ended June 30, 2002, as
compared to the prior-year periods. The decrease in these run control
products was due primarily to decreased demand from telecommunications
customers, continued slower-than-anticipated unit volumes through distribution
channels, and a general decline in technology spending in the various
geographies in which we do business, particularly in Japan. The decrease in
run control product revenues was also attributable to our focus on developing
products and channels for software analysis tools as customers have moved from
hardware development to software development; therefore, the Company has
invested less in developing and supporting run control products than in prior
periods. We have also decreased overall product development spending due to
our adoption of cost-control measures.

Software analysis revenues also declined in the three and six months ended
June 30, 2002, as compared to the same periods ended June 30, 2001. These
decreases were due primarily to decreased demand from telecommunications
customers, lower volume of licenses sold through third-party developers of
integrated development environments, a general decline in technology spending
in the major geographies in which we do business, and the termination of
certain development projects for which we received non-recurring engineering
fees in the first half of 2001. In addition, we have adopted cost-control
measures that have forced us to choose among development projects among each of
our product categories, thereby eliminating some potential revenue-generating
opportunities and leading to overall lower revenues.

Our net sales also include product support revenues, which are included
within the aforementioned major categories of our products. These support
revenues totaled $560,000 in the second quarter of 2002, compared to $855,000
in the second quarter of 2001. Support revenues were $1.2 million in the six
months ended June 30, 2002, compared to $1.8 million in the same period in
2001. These declines were due primarily to lower run control product sales,
for which support contracts are often sold.

International sales were 30% of net sales in the second quarter of 2002,
compared to 18% in the second quarter of 2001. International sales represented
29% of net sales in the six months ended June 30, 2002, compared to 23% in the
same period in 2001. Though international revenues represented a greater
percentage of total revenues in the 2002 periods presented, international
revenues declined 37% in the second quarter of 2002, and declined 46% in the
six months ended June 30, 2002, compared to the same periods in 2001. The
declines in international revenues were due primarily to the previously
mentioned slowdown among telecommunications customers, as well as continued
overall unfavorable economic conditions for the sale of our products in Japan
and Europe.

Our sales through our foreign subsidiaries are generally denominated in
local currencies. As a result, fluctuations in currency exchange rates can
have a significant effect on our reported net sales; however, exchange-rate
fluctuations did not materially impact our operating results in the first half
of 2002. We are unable to predict currency exchange rate fluctuations and
anticipate that such fluctuations may affect our net sales to varying degrees
in the future.



- 13 -



---



##### Table of Contents



|                       |                |      |                             |      |                           |      |       |      |   |   |       |    |   |   |        |    |  
|---------------------- | -------------- | ---- | --------------------------- | ---- | ------------------------- | ---- | ----- | ---- | - | - | ----- | -- | - | - | ------ | -- | -
|                       |                |      | Three Months Ended June 30, |      | Six Months Ended June 30,
|                       |                |      |                             |      |                          
|(dollars in thousands) |                | 2002 |                             | 2001 |                           | 2002 |       | 2001
|                       |                |      |                             |      |                           |      |       |     
|Cost of Sales          |                | $    | 941                         |      |                           | $    | 2,516 |      |   | $ | 2,736 |    |   | $ | 5,323  |   
|                       | % of net sales |      |                             | 29   | %                         |      |       | 28   | % |   |       | 34 | % |   |        | 28 | %
|Gross profit           |                | $    | 2,330                       |      |                           | $    | 6,324 |      |   | $ | 5,400 |    |   | $ | 13,631 |   
|                       | % of net sales |      |                             | 71   | %                         |      |       | 72   | % |   |       | 66 | % |   |        | 72 | %

Cost of sales includes materials, labor and overhead incurred in the
manufacturing of products as well as the cost of providing professional
services, performing non-recurring engineering, and estimated warranty costs.
We perform periodic assessments of required reserves for potential inventory
obsolescence, and corresponding adjustments to such reserves are included
within cost of sales. The dollar amounts of cost of sales and gross profit
fluctuate based on a number of factors, including the volume of corresponding
net sales and vendor pricing pressures.

Despite the significant difference in product mix, the gross profit
percentage in the second quarter of 2002 was comparable to the same quarter in
2001 due primarily to the increased efficiency of Applieds manufacturing
operations during that quarter resulting from the high volume of game
development tools manufactured in the first half of 2001. Game development
tools generally carry an overall lower gross margin percentage than Applieds
other product categories. The gross profit percentage in the six months ended
June 30, 2002 was lower than in the comparable period in 2001 due primarily to
lower production volumes and differences in the overall sales mix between the
two periods; in particular, first half 2002 game development tools carried a
lower gross margin percentage than in the first half of 2001 due primarily to
changes in the mix of sales and services provided to our game development
customers.

We expect our gross profit percentage to fluctuate based upon our product
and service mix, geographic mix, foreign currency fluctuations, and variances
in volume and related absorption of overhead costs.

|                                           |  |                             |       |                           |  |      |        |      |  |        |       |      |  |   |       |  |  |   |        |    |  |   |       | 
|------------------------------------------ |  | --------------------------- | ----- | ------------------------- |  | ---- | ------ | ---- |  | ------ | ----- | ---- |  | - | ----- |  |  | - | ------ | -- |  | - | ----- | 
|                                           |  | Three Months Ended June 30, |       | Six Months Ended June 30,
|                                           |  |                             |       |                          
|(dollars in thousands)                     |  | 2002                        |       | Change                    |  | 2001 |        | 2002 |  | Change |       | 2001
|                                           |  |                             |       |                           |  |      |        |      |  |        |       |     
|Sales, general and
administrative
expenses |  | $                           | 2,417 |                           |  | $    | (1,587 | )    |  | $      | 4,004 |      |  | $ | 5,072 |  |  | $ | (2,816 | )  |  | $ | 7,888 | 
|                                           |  |                             |       |                           |  |      | (40    | %)   |  |        |       |      |  |   |       |  |  |   | (36    | %) |  |   |       | 

The decreases in sales, general and administrative expenses in the second
quarter and year-to-date 2002 periods, as compared to the same periods in 2001,
were due primarily to our adoption of cost-reduction plans in August 2001 and
May 2002, which resulted in significantly lower personnel-related expenses.
The cost reduction plans, and lower revenue levels, also have resulted in lower
infrastructure and commission expenses.

When incurred, minor foreign exchange gains and losses are included in
sales, general and administrative expenses. In order to mitigate certain
intercompany risks associated with exchange rate



- 14 -



---



##### Table of Contents



fluctuations, we may choose to hedge a portion of our foreign exchange
risk. No such hedging activities were in effect during the first six months of
2002, nor in the prior three years. Although we may engage in exchange-rate
hedging activities with respect to certain exchange-rate risks, there can be no
assurance that we will do so or that any such activities will successfully
protect us against such risks.

|                                  |  |                             |       |                           |  |      |        |      |  |        |       |      |  |   |       |  |  |   |        |    |  |   |       | 
|--------------------------------- |  | --------------------------- | ----- | ------------------------- |  | ---- | ------ | ---- |  | ------ | ----- | ---- |  | - | ----- |  |  | - | ------ | -- |  | - | ----- | 
|                                  |  | Three Months Ended June 30, |       | Six Months Ended June 30,
|                                  |  |                             |       |                          
|(dollars in thousands)            |  | 2002                        |       | Change                    |  | 2001 |        | 2002 |  | Change |       | 2001
|                                  |  |                             |       |                           |  |      |        |      |  |        |       |     
|Research and
development expenses |  | $                           | 1,583 |                           |  | $    | (1,712 | )    |  | $      | 3,295 |      |  | $ | 3,239 |  |  | $ | (3,320 | )  |  | $ | 6,559 | 
|                                  |  |                             |       |                           |  |      | (52    | %)   |  |        |       |      |  |   |       |  |  |   | (51    | %) |  |   |       | 

The decreases in research and development expenses in the three and
six-month periods ended June 30, 2002, as compared to the same periods in 2001,
were primarily due to our adoption of cost-reduction plans in August 2001 and
May 2002. These plans led to reductions in certain development projects and
reductions in development personnel and related expenditures.

We believe that our continued investment in focused research and
development activities is critical to our future success. Despite an overall
reduction in resources available for research and development (as a result of
our cost-control efforts), we intend to continue to invest in product
development, including research and development efforts related to technology
acquired from REBA. Research and development expenses may fluctuate to the
extent that our engineering resources are utilized to fulfill the needs of
customers under contractual development arrangements. In such cases,
engineering costs are charged to costs of goods sold.

|                                    |  |                             |     |                           |  |      |      |      |  |        |   |      |  |   |     |  |  |   |      |   |  |   |   | 
|----------------------------------- |  | --------------------------- | --- | ------------------------- |  | ---- | ---- | ---- |  | ------ | - | ---- |  | - | --- |  |  | - | ---- | - |  | - | - | 
|                                    |  | Three Months Ended June 30, |     | Six Months Ended June 30,
|                                    |  |                             |     |                          
|(dollars in thousands)              |  | 2002                        |     | Change                    |  | 2001 |      | 2002 |  | Change |   | 2001
|                                    |  |                             |     |                           |  |      |      |      |  |        |   |     
|In-process research
and development |  | $                           | 621 |                           |  | $    | (621 | )    |  | $      |  |      |  | $ | 621 |  |  | $ | (621 | ) |  | $ |  | 

In May 2002, we announced that we had completed the REBA acquisition.
REBAs patent-pending technology is focused on enhancing the operation of
server farms for enterprises, application server providers and network service
providers. The acquisition consideration consisted of an aggregate of
approximately 350,000 shares of the Companys common stock plus an aggregate
principal amount of $178,000 of promissory notes, due May 2004, and bearing
interest at the rate of 6% annually. We did not acquire any personnel,
tangible assets or known liabilities in the transaction. As a result of the
acquisition, we recognized in-process research and development expenses of
$621,000 in the second quarter of 2002, representing the entire purchase price
(including transaction-related expenses).

Because Lary L. Evans is a director of the Company and was the holder of
approximately 86% of REBAs outstanding shares, the negotiation of the terms of
the acquisition was handled by an independent committee of our Board of
Directors composed of disinterested directors. This committee engaged an
independent valuation firm to provide a basis for negotiations, and ultimately
recommended that the transaction be approved by our entire Board of Directors.

At closing of the transaction, 50% of the merger consideration was placed
into an escrow for the purpose of securing the indemnification obligations of
the REBA shareholders under the merger



- 15 -



---



##### Table of Contents



agreement. Those shares and notes will remain in escrow for a period of
three years from the closing date and until all pending claims for
indemnification, if any, have been resolved.

|                       |  |                             |       |                           |  |      |        |      |  |        |   |      |  |   |       |  |  |   |        |   |  |   |   | 
|---------------------- |  | --------------------------- | ----- | ------------------------- |  | ---- | ------ | ---- |  | ------ | - | ---- |  | - | ----- |  |  | - | ------ | - |  | - | - | 
|                       |  | Three Months Ended June 30, |       | Six Months Ended June 30,
|                       |  |                             |       |                          
|(dollars in thousands) |  | 2002                        |       | Change                    |  | 2001 |        | 2002 |  | Change |   | 2001
|                       |  |                             |       |                           |  |      |        |      |  |        |   |     
|Business restructuring |  | $                           | 1,149 |                           |  | $    | (1,149 | )    |  | $      |  |      |  | $ | 1,149 |  |  | $ | (1,149 | ) |  | $ |  | 

In August 2001, we implemented a restructuring plan designed to reduce
operating costs. The restructuring plan included an abandonment of excess
space at the Companys headquarters; as well as other cost reduction and
control measures. During the second quarter of 2002, we reassessed the
potential exposure for losses for the abandoned space identified in the August
2001 restructuring in light of revised estimates of the timeframe and terms
under which a sublease could be negotiated. As a result, we recognized an
additional charge of $480,000 in the second quarter of 2002.

In May 2002, we announced further plans to reduce expenses through a
reduction in personnel and realignment of business objectives. The cost
reductions consisted primarily of a reduction of approximately 45 full-time
employees worldwide across the Companys functional organizations, as well as a
write-off of certain assets for which the book value was deemed in excess of
net realizable value under accounting rules. As a result, we recognized
$669,000 in restructuring charges during the second quarter of 2002.

|                               |  |                             |    |                           |  |      |     |      |  |        |    |      |  |   |    |  |  |   |      |    |  |   |     | 
|------------------------------ |  | --------------------------- | -- | ------------------------- |  | ---- | --- | ---- |  | ------ | -- | ---- |  | - | -- |  |  | - | ---- | -- |  | - | --- | 
|                               |  | Three Months Ended June 30, |    | Six Months Ended June 30,
|                               |  |                             |    |                          
|(dollars in thousands)         |  | 2002                        |    | Change                    |  | 2001 |     | 2002 |  | Change |    | 2001
|                               |  |                             |    |                           |  |      |     |      |  |        |    |     
|Interest income and
other, net |  | $                           | 17 |                           |  | $    | (66 | )    |  | $      | 83 |      |  | $ | 46 |  |  | $ | (138 | )  |  | $ | 184 | 
|                               |  |                             |    |                           |  |      | (80 | %)   |  |        |    |      |  |   |    |  |  |   | (75  | %) |  |   |     | 

Our interest income and other, net, decreased from the prior-year periods
due primarily to a decrease in our cash available for short-term investments.

Income Taxes

Applicable accounting standards require that we calculate an estimated
annual effective tax rate and apply such tax rate to the pre-tax operating
results of interim periods. Deferred income taxes reflect the net tax effects
of temporary differences between the tax basis of assets and liabilities and
the corresponding financial statement amounts. Due to the uncertainty of our
ability to utilize our net deferred tax assets, including our net operating
losses and research and development credits, a valuation allowance has been
established for financial reporting purposes equal to the amount of the net
deferred tax assets. Accordingly, no income tax provision or benefit is
recorded for the three-month and six-month periods ended June 30, 2002 and
2001.

Liquidity and Capital Resources

As of June 30, 2002, we had $4.8 million in cash, cash equivalents, and
short-term investments, compared to $7.4 million as of December 31, 2001. The
December 31, 2001 amount includes $400,000



- 16 -



---



##### Table of Contents



subject to withdrawal restrictions to secure a letter of credit relating
primarily to our lease on our headquarters facility; this amount is included in
long-term other assets as of June 30, 2002. As a result of actions taken to
reduce operating expenses during 2001 and further reductions implemented in the
second quarter of 2002, our expenditure levels have been reduced substantially.

We require capital primarily for the financing of inventories and accounts
receivable, sales and marketing efforts, product development activities,
capital equipment purchases, and to fund operating losses. We used cash of
$2.2 million for operating activities in the first six months of 2002, compared
to using $1.5 million for operating activities in the first six months of the
prior year. We used cash to purchase $72,000 in property and equipment in the
first six months of 2002, compared to purchasing $119,000 in the first six
months of 2001 (excluding an equipment purchase of $250,000 in the first half
of 2001, financed under a long-term capital lease). As of June 30, 2002, we
had no significant commitments with regard to new capital purchases. We have
facility and equipment operating lease commitments totaling $1.7 million in
2002 (including amounts already paid in the first half of 2002), $1.5 million
in 2003, $1.5 million in 2004, $1.5 million in 2005, $1.4 million in 2006, and
$0.6 million thereafter. We also have commitments under a capital lease
obligation of up to $62,000 per year through 2006.

We received funds totaling $48,000 in the first half of 2002 from the sale
of our common stock to personnel through an employee stock purchase plan and
the exercise of employee stock options, compared to receiving $348,000 in the
same period of the prior year. Receipt of such funds depends on many factors,
including factors outside our control; therefore, these funding sources may not
provide meaningful cash to us in the future.

We believe that our existing cash and cash equivalents will be sufficient
to meet our anticipated cash needs for working capital and capital expenditures
through December 31, 2002. However, any projections of future cash needs and
cash flows are subject to substantial uncertainty. We have continued to post
operating losses, despite significant cost reductions, due primarily to
declines in revenues. The Companys losses have led to steadily lower
resources available to fund operations, and call into question our ability to
fund operations over the next 12 months. A continuing inability to achieve
improved results of operations would require us to further reduce our
expenditures or seek other sources of financing. Our future capital
requirements will depend on a number of factors, including the duration of
weakness in certain customer sectors and in international sales, costs
associated with sales and marketing programs, product development efforts, and
the use of funds for strategic purposes. To the extent additional funds are
required, we may sell additional equity, debt, or convertible securities,
attempt to obtain credit facilities, o seek to derive cash from the licensing
or sale of one or more assets or product lines; however, there can be no
assurance that we will be able to obtain such funds or on terms that are
acceptable. Our stock is currently trading at prices less than $1 per share.
If our stock continues to trade at this level, our stock could be delisted from
the NASDAQ National Market and our ability to obtain financing may suffer as a
result.

Certain Factors That May Affect Future Results of Operations

Our actual results could differ materially from those anticipated or
stated or implied by forward-looking statements in this report due to a variety
of factors, including those risks and uncertainties associated with our
business which include, but are not limited to, those risk factors disclosed
below, in our most recent filings with the Securities and Exchange Commission
(the SEC), and in our 2001 Annual Report on Form 10-K filed with the SEC on
March 28, 2002.



- 17 -



---



##### Table of Contents



If we are unable to derive revenue from new products or services, our
revenues, operating results, earnings, or future projections may be adversely
affected and our business would be harmed.

Our revenues have declined the past three years and in the quarter ended
June 30, 2002, and we incurred corresponding operating losses in each of these
periods. We believe that our success will depend in large part on our ability
to improve our financial performance and long-term strategic direction,
including the introduction of new products and services. Revenues from certain
traditional products and markets have eroded in recent years, and we expect
that we will need to conceive new sources of revenues in the future. The
decline in revenues from traditional sources, while attributable in part to an
overall decline in worldwide technology spending, may represent a permanent
decline in demand for the type of products offered by us. In May 2002, we
announced that we had acquired REBA Technologies, Inc. We have historically
been a developer of tools for use by embedded systems developers, and the REBA
acquisition represents an expansion into development of hardware and software
products aimed at end-user markets  specifically, corporate data centers, in
which we have limited experience. As we enter new lines of business, we also
expect to encounter new competitors and different business challenges.

Factors that may affect our ability to improve our financial performance
include, but are not limited to:



| |  |  | the degree to which demand for and revenues from our traditional
product lines may increase from their currently depressed levels;         
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our ability to manage our limited cash resources long enough for us
to improve our financial performance;                                  
|
| |  |  | our ability to integrate REBA into our business and to expand into
development of hardware and software products aimed at end-user
markets;
|
| |  |  | the introduction or enhancement of our products or our competitors products;                                                              
|
| |  |  | an increase in our operating costs;                                                                                                        
|
| |  |  | the impact of our restructuring plans;                                                                                                     
|
| |  |  | the mix of our products and services sold;                                                                                                 
|
| |  |  | the mix of our domestic and international sales;                                                                                           
|
| |  |  | unfavorable economic conditions in the technology industry;                                                                                
|
| |  |  | decreased spending on technology due to adverse economic conditions;                                                                       
|
| |  |  | changes in accounting pronouncements applicable to us; and                                                                                 
|
| |  |  | global economic conditions.                                                                                                                

If we are unable to derive revenue from new products or services, our
revenues, operating results, earnings, or future projections may be adversely
affected. In addition, if our operating results are below the levels expected
by investors or securities analysts, the price of our common stock is likely to
decline.

If we are unable to manage our potential growth or our cost-reduction and
restructuring plans, our competitive position, results of operations and
financial condition could suffer.

We seek to grow our business by selectively strengthening our sales and
marketing programs, focusing our product and service offerings, and potentially
providing solutions to new markets. Such growth, if achieved, would place
additional burdens on our management and increase the requirement to recruit
and retain personnel with the right skill sets, as well as require additional
infrastructure expenditures. This growth also would place a significant strain
on our financial, operational,



- 18 -



---



##### Table of Contents



management, marketing, and sales systems and resources, especially after
our implementation of our restructuring plans that included a significant
reduction in personnel. If we are unable to effectively manage such growth,
our business, competitive position, results of operations, and financial
condition could suffer.

In August 2001, we announced and subsequently completed a restructuring
plan, including a reduction in our workforce, which affected all parts of our
organization. In May 2002, we announced further plans to reduce expenses
primarily through a reduction in personnel and a realignment of business
objectives. If we are unable to effectively manage our cost-reduction and
restructuring plans and workforce reductions, our business operations could be
subject to disruption and our business and results of operations could suffer.

If we are unable to meet the listing requirements for the NASDAQ National
Market, we may be delisted, which would likely have a material adverse impact
on our share price and our ability to obtain additional funding.

The Companys common stock is currently quoted on the NASDAQ National
Market (the National Market). However, in order to continue to be included
in the National Market, a company must maintain, among other things, a minimum
closing bid price of $1.00 per share and a $5,000,000 market value of the
total outstanding shares, excluding those held by officers, directors or
beneficial owners of ten percent or more of the outstanding shares. The
closing price of our common stock was $0.48 per share on July 31, 2002, with a
corresponding total market value on that date of $3.6 million. In order to
maintain compliance with the National Market listing requirements, we may be
required to take various measures including, but not limited to, raising
additional capital and implementing a reverse split of the Companys common
stock. Certain of such measures, including any reverse stock split, would
require shareholder approval. Failure to meet any of the National Market
maintenance criteria in the future may result in the delisting of the Companys
common stock from the National Market. The delisting of the Companys common
stock would have an adverse impact on the market price and liquidity of the
Companys securities and may adversely affect the Companys ability to obtain
additional financing. As a result of such delisting, an investor may find it
more difficult to dispose of, or to obtain accurate quotations as to the market
value of, the Companys common stock.



- 19 -



---



##### Table of Contents






Item 3. Quantitative and Qualitative Disclosures About Market Risk

We develop products in the United States and sell primarily in North
America, Asia and Europe. As a result, financial results could be affected by
factors such as changes in foreign currency exchange rates or weak economic
conditions in foreign markets. Since our products are generally initially
priced in U.S. Dollars and translated to local currency amounts, a
strengthening of the dollar could make our products less competitive in foreign
markets.

We are exposed to market risk related to changes in interest rates, which
could adversely affect the value of our short-term investments. We maintain a
short-term investment portfolio consisting of interest bearing securities with
an average maturity of less than one year. These securities are classified as
available-for-sale securities. These interest-bearing securities are subject
to interest rate risk and will fall in value if market interest rates increase.
If market interest rates were to increase immediately and uniformly to 110% of
their levels at June 30, 2002, the fair value of the portfolio would decline by
an immaterial amount. We do not expect our operating results or cash flows to
be affected to any significant degree by a sudden change in market interest
rates.




PART II  OTHER INFORMATION




Item 4. Submission of matters to a vote of security holders

The Companys Annual Meeting of Shareholders was held on May 21,
2002. The following summarizes the results of matters voted upon at the
Annual Meeting.



| | (1) |  | The following persons were elected to serve as directors
until the next Annual Meeting of Shareholders or until their
earlier retirement, resignation or removal:
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     |  |     |           |          |  |  |        | 
|-------------------- |  | --- | --------- | -------- |  |  | ------ | 
|Nominee              |  | For |           | Withheld
|                     |  |     |           |         
|Lary L. Evans        |  |     | 5,725,421 |          |  |  | 24,626 | 
|Charles H. House     |  |     | 5,728,979 |          |  |  | 21,068 | 
|Elwood D. Howse, Jr. |  |     | 5,725,807 |          |  |  | 24,240 | 
|Stephen J. Verleye   |  |     | 5,725,633 |          |  |  | 24,414 | 



| | (2) |  | The shareholders voted 5,717,747 shares in the
affirmative, 29,975 shares in the negative, and 2,325 shares
abstained relative to ratification of the appointment of Ernst
& Young LLP as independent auditors for the Companys fiscal
year ending December 31, 2001.
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



- 20 -



---



##### Table of Contents






Item 6. Exhibits and Reports on Form 8-K



| | (A) |  | The following exhibits are filed as part of this report.                                                                                                                                                                                                                                                        
| | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |     |  | 99.1 Certification of Chief Executive Officer                                                                                                                                                                                                                                                                   
|
| |     |  | 99.2 Certification of Chief Financial Officer                                                                                                                                                                                                                                                                   
|
| | (B) |  | Reports on Form 8-K                                                                                                                                                                                                                                                                                             
|
| |     |  | On April 24, 2002, we filed a report on Form 8-K regarding our
press release which announced that we had entered into a
non-binding letter of intent to acquire REBA Technologies, Inc.                                                                                                                         
|
| |     |  | On May 24, 2002, we filed a report on Form 8-K announcing that
we had completed the acquisition of REBA Technologies, Inc.                                                                                                                                                                                      
|
| |     |  | On June 21, 2002 we filed a report on Form 8-K announcing that on
June 14, 2002, we dismissed Ernst & Young LLP as our independent
accountants. We also disclosed that on June 20, 2002, the Company
engaged Grant Thornton LLP as our new independent accountants for
the fiscal year ending December 31, 2002.




SIGNATURES

Pursuant to the requirements 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.

|                      |                                                                                                                                                                    |                       
|--------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ----------------------
|                      | APPLIED MICROSYSTEMS CORPORATION
(Registrant)                                                                                                                     
|                     
|Date: August 14, 2002 | By:                                                                                                                                                                | /s/  Robert C. Bateman
|                      |                                                                                                                                                                   
|                      | Robert C. BatemanVice President, Chief Financial Officer,
Secretary and Treasurer
(Principal Financial and Accounting Officer
and Duly Authorized Signing Officer)

- 21 -