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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


FORM 10-Q




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(Mark One)

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

For the quarterly period ended September 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



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APPLIED MICROSYSTEMS CORPORATION

(Exact name of registrant as specified in its charter)




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|                                    |  |                                                   
|----------------------------------- |  | --------------------------------------------------
|Washington
(State of incorporation) |  | 91-1074996
(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)



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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: 7,597,303 shares outstanding as of November 4,
2002.



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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                           
|                               | Item 4. Controls and Procedures                                                              
|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                    
|Section 302(a) Certifications 
|EXHIBIT 99.1                  
|EXHIBIT 99.2                  



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##### Table of Contents



APPLIED MICROSYSTEMS CORPORATION

FORM 10-Q

QUARTER ENDED SEPTEMBER 30, 2002

INDEX

|         |  |                                                                                                                          |  |     
|-------- |  | ------------------------------------------------------------------------------------------------------------------------ |  | ----
|         |  |                                                                                                                          |  | Page
|         |  |                                                                                                                          |  |     
|PART I:  |  | FINANCIAL INFORMATION                                                                                                    |  |     
|Item 1.  |  | Financial Statements:                                                                                                    |  |     
|         |  | Consolidated Balance Sheets as of September 30, 2002 (unaudited)
and December 31, 2001                                   |  | 3   
|         |  | Consolidated Statements of Operations for the three months and
nine months ended September 30, 2002 and 2001 (unaudited) |  | 4   
|         |  | Consolidated Statements of Cash Flows for the nine months ended
September 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                                    |  | 11  
|Item 3.  |  | Quantitative and Qualitative Disclosures About Market Risk                                                               |  | 26  
|Item 4.  |  | Controls and Procedures                                                                                                  |  | 26  
|PART II: |  | OTHER INFORMATION                                                                                                        |  |     
|Item 4.  |  | Submission of Matters to a Vote of Security Holders                                                                      |  | 26  
|Item 6.  |  | Exhibits and Reports on Form 8-K                                                                                         |  | 27  
|         |  | Signatures                                                                                                               |  | 27  
|         |  | Certifications                                                                                                           |  | 28  

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##### Table of Contents






PART I  FINANCIAL INFORMATION




Item 1. Financial Statements




APPLIED MICROSYSTEMS CORPORATION

CONSOLIDATED BALANCE SHEETS

|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |         |        | 
|---------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | -------------- | ----- | ------------ | ----- | ------- | ------ | 
|                                               |                                                                                                                                                                              |                                            |       | September 30,  |       | December 31,
|                                               |                                                                                                                                                                              |                                            |       | 2002           |       | 2001        
|                                               |                                                                                                                                                                              |                                            |       |                |       |             
|                                               |                                                                                                                                                                              |                                            |       | (unaudited)    |       |              |       |        
|                                               |                                                                                                                                                                              |                                            |       | (in thousands)
|ASSETS                                        
|Current assets:                                |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|                                               | Cash and cash equivalents                                                                                                                                                    |                                            | $     | 2,239          |       |              | $     | 2,971   |       
|                                               | Securities available-for-sale                                                                                                                                                |                                            |       | 298            |       |              |       | 3,997   |       
|                                               | Restricted investment                                                                                                                                                        |                                            |       |               |       |              |       | 400     |       
|                                               | Accounts receivable, net                                                                                                                                                     |                                            |       | 1,940          |       |              |       | 3,594   |       
|                                               | Inventories                                                                                                                                                                  |                                            |       | 1,614          |       |              |       | 1,959   |       
|                                               | Prepaid and other current assets                                                                                                                                             |                                            |       | 657            |       |              |       | 429     |       
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|                                               |                                                                                                                                                                              | Total current assets                       |       |                | 6,748 |              |       |         | 13,350 | 
|Property and equipment, net                    |                                                                                                                                                                              |                                            | 1,012 |                |       |              | 1,358 |        
|Other assets                                   |                                                                                                                                                                              |                                            | 537   |                |       |              | 316   |        
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|                                               |                                                                                                                                                                              | Total assets                               |       | $              | 8,297 |              |       | $       | 15,024 | 
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|LIABILITIES AND SHAREHOLDERS EQUITY          
|Current liabilities:                           |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|                                               | Accounts payable                                                                                                                                                             |                                            | $     | 1,419          |       |              | $     | 1,704   |       
|                                               | Accrued payroll                                                                                                                                                              |                                            |       | 827            |       |              |       | 1,178   |       
|                                               | Other accrued expenses                                                                                                                                                       |                                            |       | 1,713          |       |              |       | 1,453   |       
|                                               | Deferred revenue                                                                                                                                                             |                                            |       | 1,812          |       |              |       | 3,253   |       
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|                                               |                                                                                                                                                                              | Total current liabilities                  |       |                | 5,771 |              |       |         | 7,588  | 
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|Capital lease obligation, less current portion |                                                                                                                                                                              |                                            | 139   |                |       |              | 175   |        
|Notes payable                                  |                                                                                                                                                                              |                                            | 178   |                |       |              |      |        
|Accrued cost of business restructuring         |                                                                                                                                                                              |                                            | 917   |                |       |              | 719   |        
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|                                               |                                                                                                                                                                              | Total long-term liabilities                |       |                | 1,234 |              |       |         | 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; 7,597,000 and 7,149,000
shares issued and outstanding at September 30,
2002 and December 31, 2001, respectively |                                            |       | 27,234         |       |              |       | 26,857  |       
|                                               | Accumulated other comprehensive loss                                                                                                                                         |                                            |       | (583           | )     |              |       | (636    | )     
|                                               | Accumulated deficit                                                                                                                                                          |                                            |       | (25,359        | )     |              |       | (19,679 | )     
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|                                               |                                                                                                                                                                              | Total shareholders equity                 |       |                | 1,292 |              |       |         | 6,542  | 
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        
|                                               |                                                                                                                                                                              | Total liabilities and shareholders equity |       | $              | 8,297 |              |       | $       | 15,024 | 
|                                               |                                                                                                                                                                              |                                            |       |                |       |              |       |        

See accompanying notes.

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APPLIED MICROSYSTEMS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)

|                                     |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |        | 
|------------------------------------ | ----------------------------------- | - | ---------------------------------------- | ----- | ----------------- | - | ------ | ----- | ---- | - | ------ | ----- |  | - | ------ | ------ | 
|                                     |                                     |   | Three Months ended                       |       | Nine Months ended
|                                     |                                     |   | September 30,                            |       | September 30,    
|                                     |                                     |   |                                          |       |                  
|                                     |                                     |   | 2002                                     |       | 2001              |   | 2002   |       | 2001
|                                     |                                     |   |                                          |       |                   |   |        |       |     
|                                     |                                     |   | (in thousands, except per-share amounts)
|Net sales                            |                                     | $ | 2,781                                    |       |                   | $ | 4,605  |       |      | $ | 10,917 |       |  | $ | 23,559 |       
|Cost of sales                        |                                     |   | 908                                      |       |                   |   | 1,181  |       |      |   | 3,644  |       |  |   | 6,504  |       
|                                     |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |       
|Gross profit                         |                                     |   | 1,873                                    |       |                   |   | 3,424  |       |      |   | 7,273  |       |  |   | 17,055 |       
|Operating expenses:                  |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |       
|                                     | Sales, general and administrative   |   |                                          | 1,657 |                   |   |        | 2,971 |      |   |        | 6,729 |  |   |        | 10,859 | 
|                                     | Research and development            |   |                                          | 1,249 |                   |   |        | 2,182 |      |   |        | 4,488 |  |   |        | 8,741  | 
|                                     | In-process research and
development |   |                                          |      |                   |   |        |      |      |   |        | 621   |  |   |        |       | 
|                                     | Business restructuring              |   |                                          |      |                   |   |        | 2,289 |      |   |        | 1,149 |  |   |        | 2,289  | 
|                                     |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |       
|Total operating expenses             |                                     |   | 2,906                                    |       |                   |   | 7,442  |       |      |   | 12,987 |       |  |   | 21,889 |       
|                                     |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |       
|Loss from operations                 |                                     |   | (1,033                                   | )     |                   |   | (4,018 | )     |      |   | (5,714 | )     |  |   | (4,834 | )     
|Interest income and other, net       |                                     |   | (12                                      | )     |                   |   | 50     |       |      |   | 34     |       |  |   | 234    |       
|                                     |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |       
|Net loss                             |                                     | $ | (1,045                                   | )     |                   | $ | (3,968 | )     |      | $ | (5,680 | )     |  | $ | (4,600 | )     
|                                     |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |       
|Per-share amounts:                   |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |       
|Basic and diluted net loss per share |                                     | $ | (0.14                                    | )     |                   | $ | (0.56  | )     |      | $ | (0.77  | )     |  | $ | (0.65  | )     
|                                     |                                     |   |                                          |       |                   |   |        |       |      |   |        |       |  |   |        |       
|Shares used in per-share calculation |                                     |   | 7,553                                    |       |                   |   | 7,113  |       |      |   | 7,355  |       |  |   | 7,053  |       

See accompanying notes.

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APPLIED MICROSYSTEMS CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

|                                                                            |                                             |                                                                        |                                                     |        |                                 |        |        |        |       |        |  
|--------------------------------------------------------------------------- | ------------------------------------------- | ---------------------------------------------------------------------- | --------------------------------------------------- | ------ | ------------------------------- | ------ | ------ | ------ | ----- | ------ | -
|                                                                            |                                             |                                                                        |                                                     |        | Nine Months Ended September 30,
|                                                                            |                                             |                                                                        |                                                     |        |                                
|                                                                            |                                             |                                                                        |                                                     |        | 2002                            |        | 2001  
|                                                                            |                                             |                                                                        |                                                     |        |                                 |        |       
|                                                                            |                                             |                                                                        |                                                     |        | (in thousands)                 
|Operating activities                                                        |                                             |                                                                        |                                                     |        |                                 |        |        |       
|Net loss                                                                    |                                             | $                                                                      | (5,680                                              | )      |                                 | $      | (4,600 | )     
|Adjustments to reconcile net loss to net cash used in
operating activities: |                                             |                                                                        |                                                     |        |                                 |        |        |       
|                                                                            | Depreciation and amortization               |                                                                        |                                                     | 579    |                                 |        |        | 774    |      
|                                                                            | In-process research and development         |                                                                        |                                                     | 621    |                                 |        |        |       |      
|                                                                            | Loss on write off and/or disposal of assets |                                                                        |                                                     | 72     |                                 |        |        | 148    |      
|                                                                            | Net change in operating accounts:           |                                                                        |                                                     |        |                                 |        |        |        |      
|                                                                            |                                             | Accounts receivable                                                    |                                                     |        | 1,738                           |        |        |        | 1,935 |       
|                                                                            |                                             | Inventories                                                            |                                                     |        | 381                             |        |        |        | 49    |       
|                                                                            |                                             | Prepaid and other assets                                               |                                                     |        | (220                            | )      |        |        | (76   | )     
|                                                                            |                                             | Accounts payable, accrued expenses, and accrued business restructuring |                                                     |        | (466                            | )      |        |        | (637  | )     
|                                                                            |                                             | Deferred revenue                                                       |                                                     |        | (1,385                          | )      |        |        | (963  | )     
|                                                                            |                                             |                                                                        |                                                     |        |                                 |        |        |       
|                                                                            |                                             |                                                                        | Net cash used in operating activities               |        |                                 | (4,360 | )      |        |       | (3,370 | )
|Investing activities                                                        |                                             |                                                                        |                                                     |        |                                 |        |        |       
|                                                                            | Purchases of securities available-for-sale  |                                                                        |                                                     | (2,275 | )                               |        |        | (6,026 | )    
|                                                                            | Maturities of securities available-for-sale |                                                                        |                                                     | 5,974  |                                 |        |        | 4,447  |      
|                                                                            | Additions to property and equipment         |                                                                        |                                                     | (118   | )                               |        |        | (180   | )    
|                                                                            |                                             |                                                                        |                                                     |        |                                 |        |        |       
|                                                                            |                                             |                                                                        | Net cash provided by (used in) investing activities |        |                                 | 3,581  |        |        |       | (1,759 | )
|Financing activities                                                        |                                             |                                                                        |                                                     |        |                                 |        |        |       
|                                                                            | Sale of common stock to employees           |                                                                        |                                                     | 57     |                                 |        |        | 287    |      
|                                                                            | Stock options exercised                     |                                                                        |                                                     | 2      |                                 |        |        | 209    |      
|                                                                            | Payments on capital lease obligation        |                                                                        |                                                     | (33    | )                               |        |        | (20    | )    
|                                                                            |                                             |                                                                        |                                                     |        |                                 |        |        |       
|                                                                            |                                             |                                                                        | Net cash provided by financing activities           |        |                                 | 26     |        |        |       | 476    |  
|Effects of foreign exchange rate changes on cash                            |                                             |                                                                        | 21                                                  |        |                                 |        | 305    |       
|                                                                            |                                             |                                                                        |                                                     |        |                                 |        |        |       
|Net decrease in cash and cash equivalents                                   |                                             |                                                                        | (732                                                | )      |                                 |        | (4,348 | )     
|Cash and cash equivalents at beginning of period                            |                                             |                                                                        | 2,971                                               |        |                                 |        | 7,956  |       
|                                                                            |                                             |                                                                        |                                                     |        |                                 |        |        |       
|Cash and cash equivalents at end of period                                  |                                             | $                                                                      | 2,239                                               |        |                                 | $      | 3,608  |       
|                                                                            |                                             |                                                                        |                                                     |        |                                 |        |        |       

Supplemental disclosure of non-cash activities:

During the first quarter of 2001, the Company obtained equipment under a five-year capital lease
obligation of $250,000.

See accompanying notes.

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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 nine-month periods ended September 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
September 30, 2002 and September 30, 2001, options to purchase 1,237,000 and
1,214,000 shares of common stock, respectively, were outstanding; however, all
stock options were excluded from the calculation of loss per share in the three
and nine-month periods ended September 30, 2002 and 2001, 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
third quarter of 2002, comprehensive loss amounted to $1.0 million compared to
comprehensive loss of $4.0 million for the third quarter of 2001. For the nine
months ended September 30, 2002, comprehensive loss amounted to $5.6 million,
compared to comprehensive loss of $4.5 million for the nine months ended
September 30, 2001.

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4. Inventories

Inventories consist of the following:

|                |  |                |       |              |  |   |       | 
|--------------- |  | -------------- | ----- | ------------ |  | - | ----- | 
|                |  | September 30,  |       | December 31,
|                |  | 2002           |       | 2001        
|                |  |                |       |             
|                |  | (in thousands)
|Finished goods  |  | $              | 1,008 |              |  | $ | 999   | 
|Work in process |  |                | 32    |              |  |   | 55    | 
|Purchased parts |  |                | 574   |              |  |   | 905   | 
|                |  |                |       |              |  |   |       | 
|                |  | $              | 1,614 |              |  | $ | 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.

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

|                               |  |                |       |            |  |            |       |              |  |               |     |  |  |            |     |         |  |   |       | 
|------------------------------ |  | -------------- | ----- | ---------- |  | ---------- | ----- | ------------ |  | ------------- | --- |  |  | ---------- | --- | ------- |  | - | ----- | 
|                               |  | Accrued        |       |            |  |            |       |              |  |               |     |  |  |            |     | Accrued
|                               |  | Balance at     |       |            |  |            |       | Amounts Paid |  |               |     |  |  | Balance at
|                               |  | December 31,   |       | Additional |  | or Charged |       | Amounts      |  | September 30,
|                               |  | 2001           |       | Charges    |  | Off        |       | Reclassified |  | 2002         
|                               |  |                |       |            |  |            |       |              |  |              
|                               |  | (in thousands)
|Severance and
related expenses |  | $              | 64    |            |  | $          | 602   |              |  | $             | 617 |  |  | $          | 30  |         |  | $ | 79    | 
|Asset write-offs               |  |                |      |            |  |            | 67    |              |  |               | 67  |  |  |            |    |         |  |   |      | 
|Abandoned facilities           |  |                | 1,094 |            |  |            | 480   |              |  |               | 241 |  |  |            | (30 | )       |  |   | 1,303 | 
|                               |  |                |       |            |  |            |       |              |  |               |     |  |  |            |     |         |  |   |       | 
|                               |  | $              | 1,158 |            |  | $          | 1,149 |              |  | $             | 925 |  |  | $          |    |         |  | $ | 1,382 | 
|                               |  |                |       |            |  |            |       |              |  |               |     |  |  |            |     |         |  |   |       | 

A portion of the accrued restructuring liabilities in the amount of
$917,000 as of September 30, 2002 is classified as long term on the Companys
balance sheet, compared to $719,000 classified as long term as of December 31,
2001. The remaining $465,000 in accrued restructuring liabilities as of
September 30, 2002 is classified within current liabilities, and consists of
accrued payroll of $79,000, and accrued expenses of $386,000. 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.

As a result of terminating its headquarters lease obligation (see
Termination of Headquarters Lease) the Companys restructuring liabilities
relating to abandoned facilities is expected to be eliminated, with no
remaining obligation expected as of December 31, 2002.

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
service 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.

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7. Asset Sale Transaction

On September 3, 2002, Applied announced that it had entered into an
agreement to sell its embedded systems development tools business and assets to
Metrowerks Corporation, a wholly owned subsidiary of Motorola, Inc. Applieds
shareholders approved the transaction at a special shareholder meeting held on
October 29, 2002, and Applied and Metrowerks subsequently satisfied the
remaining closing requirements. The purchase price was $3.9 million, which
included payment for certain inventories and tangible assets, as well as all
intellectual property related to Applieds embedded systems development tools
business. In addition, Metrowerks assumed certain customer warranty and
support obligations, and offered employment to 26 Applied personnel. Applied
received $3.4 million at closing, with the remaining $500,000 held back for one
year to secure certain indemnification obligations.

As of September 30, 2002, the Company had deferred approximately $270,000
in transaction-related expenses and included such amounts within prepaid and
other current assets. The Company will account for the sale transaction during
the fourth quarter of 2002 and expects to recognize a net gain on the
transaction. During the fourth quarter of 2002, the Company also plans to
assess asset carrying values and required reserve balances, in light of the
transaction.

As part of the sale transaction, the Company requested that certain
customers and licensors of third-party technology assign contractual rights to
Metrowerks. Applied maintained a contractual relationship with Microsoft
whereby Applied provided development tools for Microsofts Xbox video gaming
system. Microsoft elected to exercise their contractual rights under the
agreement with Applied to withdraw certain technology held in escrow in the
event that Applied sold a significant portion of its business. Microsoft also
accelerated certain purchase requirements for development tools, and Applied
delivered such development tools in October 2002, prior to closing the asset
sale transaction. Because the order was accelerated to occur prior to closing
the transaction, Applied and Metrowerks agreed to share the gross margin
realized under the sale of those specific development tools, and Applied
expects to pay Metrowerks approximately $350,000 during the fourth quarter of
2002 as a one-time payment.

With the sale of the historical revenue-generating assets now completed,
the Company plans to pursue the development of hardware and software products
aimed at end-user markets  specifically, corporate data centers  through
Applieds Libra Networks division. Libra Networks was formed as a result of
the Companys acquisition of REBA Technologies in May 2002.

8. Termination of Headquarters Lease

On October 15, 2002, Applied entered into a Lease Termination Agreement
(the Termination Agreement), by and between Applied and Teachers Insurance &
Annuity Association of America (TIAA), the landlord under the Companys
current headquarters facilities lease. Pursuant to the Termination Agreement,
Applied paid an early termination fee of approximately $1 million to TIAA in
exchange for the termination of any further obligations of Applied under the
lease. As of the date of the Termination Agreement, Applieds remaining lease
obligation extended through 2007 and was in excess of $6 million. The
Termination Agreement requires that Applied vacate the leased premises no later
than December 31, 2002. Applied plans to relocate its offices to a smaller
facility in the same geographic region.

In order to secure favorable lease terms, the Company had agreed to
maintain an irrevocable

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letter of credit in favor of TIAA during the lease term. The letter of credit
was initially established at $325,000; to secure the letter of credit, the
Company had pledged a $400,000 certificate of deposit with a bank, which amount
was subject to withdrawal restrictions. The certificate of deposit is
classified within other long-term assets as a restricted investment on the
balance sheet at September 30, 2002, and was classified as a current restricted
investment as of December 31, 2001. These funds will become available to the
Company in the fourth quarter of 2002 as a result of the Termination Agreement,
cancellation of the letter of credit requirement, and elimination of withdrawal
restrictions on the certificate of deposit.

9. Recent Accounting Pronouncements

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.

In June 2002, the FASB issued SFAS 146, Accounting for Exit or Disposal
Activities. SFAS 146 addresses issues regarding the recognition, measurement,
and reporting of costs that are associated with exit and disposal activities,
including restructuring activities. SFAS 146 is effective for exit or disposal
activities that are initiated after December 31, 2002, and early application is
encouraged. The Company is currently assessing the impact of SFAS 146 on its
financial statements.

10. Reclassifications

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

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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 intent to pursue new market and product opportunities
through our Libra Networks division, 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 and expectations regarding quotation of
our common stock on the Nasdaq SmallCap Market and the impact of potential
delisting, our beliefs regarding period-to-period results of operations, our
expectations regarding future financial performance, 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, those identified in the section entitled
Risks Related to Applieds Continuing Business Operations in the Proxy
Statement mailed to shareholders on our about September 26, 2002, 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 has historically created solutions to
expedite the development, test and deployment of business and safety-critical
embedded systems. We developed, marketed and supported a comprehensive suite
of software and hardware-enhanced development, test, and verification tools for
the development of complex embedded microprocessor-based applications. Using
these 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.

On September 3, 2002, we announced that we had entered into an agreement
to sell our embedded systems development tools business and assets to
Metrowerks Corporation, a wholly owned subsidiary of Motorola, Inc. Applieds
shareholders approved the transaction at a special shareholder meeting held on
October 29, 2002, and Applied and Metrowerks subsequently satisfied the
remaining closing requirements. The purchase price was $3.9 million, which
included payment for certain inventories and tangible assets, as well as all
intellectual property related to Applieds embedded systems

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development tools business. In addition, Metrowerks assumed certain
customer warranty and support obligations, and offered employment to 26 Applied
personnel. We received $3.4 million at closing, with the remaining $500,000
held back for one year to secure certain indemnification obligations.

With the sale of the historical revenue-generating assets now completed,
we plan to pursue the development of hardware and software products aimed at
end-user markets  specifically, corporate data centers  through our Libra
Networks division. Libra Networks was formed as a result of the Companys
acquisition of REBA Technologies in May 2002. The Company is also evaluating
whether the value deliverable to shareholders might be optimized by liquidating
the Company rather than continuing to pursue the Libra Networks opportunity.
Liquidation of a corporation is not a simple process, and would require a
shareholder vote and present other complexities, with significant uncertainties
surrounding the timing and amount of any distribution to shareholders. In view
of our ongoing consumption of cash during every month that we search for
venture funding to finance our Libra Networks business, our board of directors
has determined that we should accelerate our search for funding, and continue
to carefully manage our cash consumption, until such time as we have a fixed
determination as to which of these two alternatives better optimizes
shareholder value.

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 May 2002 REBA acquisition,
accounting for dispositions such as the sale of our embedded systems
development tools assets and business, 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. Our critical accounting policies are expected to change in the
near future as a result of the sale of our embedded systems development tools
business and assets.

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 have historically earned 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

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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, though our near-term Libra Networks
operations are not expected to immediately generate revenues.

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  including the impact of
the recently completed asset sale  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 allocation of the purchase price in light of the circumstances and
determined that the entire purchase consideration be allocated to in-process
research and 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.

Dispositions. As noted previously, subsequent to September 30, 2002, we
completed the sale of our embedded systems development tools business. We will
account for the sale transaction during the fourth quarter of 2002 and expect
to recognize a net gain on the transaction. During the fourth quarter of 2002,
we also plan to assess asset carrying values and required reserve balances, in
light of the transaction.

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. In October 2002 we
signed a lease termination agreement (the Termination Agreement) with the
landlord of our headquarters facility whereby we paid an early termination fee
of approximately $1 million to the landlord in exchange for the termination of
any further obligations under the lease. As of the date of the Termination
Agreement, Applieds remaining obligation extended through 2007 and was in
excess of $6 million. We will assess the impact of changes in the underlying
assumptions for any remaining required restructuring liabilities in light of
the Termination Agreement.

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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 September 30, |       | Nine Months Ended September 30,
|                                  |  |                                  |       |                                
|(dollars in thousands)            |  | 2002                             |       | Change                          |  | 2001 |        | 2002 |  | Change |       | 2001
|                                  |  |                                  |       |                                 |  |      |        |      |  |        |       |     
|Hardware-enhanced
debugging tools |  | $                                | 1,454 |                                 |  | $    | (908   | )    |  | $      | 2,362 |      |  | $ | 4,577  |  |  | $ | (4,375  | )  |  | $ | 8,952  | 
|Software analysis
tools           |  |                                  | 873   |                                 |  |      | (1,364 | )    |  |        | 2,237 |      |  |   | 3,936  |  |  |   | (2,434  | )  |  |   | 6,370  | 
|Game development
systems          |  |                                  | 454   |                                 |  |      | 448    |      |  |        | 6     |      |  |   | 2,404  |  |  |   | (5,833  | )  |  |   | 8,237  | 
|                                  |  |                                  |       |                                 |  |      |        |      |  |        |       |      |  |   |        |  |  |   |         |    |  |   |        | 
|Total net sales                   |  | $                                | 2,781 |                                 |  | $    | (1,824 | )    |  | $      | 4,605 |      |  | $ | 10,917 |  |  | $ | (12,642 | )  |  | $ | 23,559 | 
|                                  |  |                                  |       |                                 |  |      |        |      |  |        |       |      |  |   |        |  |  |   |         |    |  |   |        | 
|                                  |  |                                  |       |                                 |  |      | (40    | %)   |  |        |       |      |  |   |        |  |  |   | (54     | %) |  |   |        | 

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

The overall decline in hardware-enhanced debugging, or run control,
tools and software analysis tools revenues in the three and nine-month periods
ended September 30, 2002, in comparison to the same periods in 2001, were
attributable primarily to continued lower demand from telecommunications
customers; lower volume of software licenses sold through third-party
developers of integrated development environments; a continued low level of
technology spending in the major geographies in which we do business; the
effect of our cost-control measures that forced us to choose development
projects among each of our product categories, thereby eliminating some
potential revenue-generating opportunities; and our announced asset sale in
early September that caused customer uncertainty in the last month of our
quarter (historically, a high percentage of our quarterly revenues occurs in
the third month of each quarter). Some software analysis tools customers also
delayed purchasing products in the third quarter of 2002 due to expected new
product releases in the fourth quarter of 2002.

The Companys game development tools relate to 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;
however, quarterly game development system revenues have fluctuated
significantly depending on order cycles from Microsoft and Nintendo.

Our net sales also include product support revenues, which are included
within the aforementioned major categories of our products. These support
revenues totaled $530,000 in the third quarter of 2002, compared to $760,000 in
the third quarter of 2001. Support revenues were $1.7 million in the nine
months ended September 30, 2002, compared to $2.5 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.

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International sales were 39% of net sales in the third quarter of 2002,
compared to 45% in the third quarter of 2001. International sales represented
31% of net sales in the nine months ended September 30, 2002, compared to 27%
in the same period in 2001. In dollars, international revenues declined 48% in
the third quarter of 2002, and declined 46% in the nine months ended September
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 nine
months 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.

|                       |                |      |                    |      |                   |      |       |      |   |   |       |    |   |   |        |    |  
|---------------------- | -------------- | ---- | ------------------ | ---- | ----------------- | ---- | ----- | ---- | - | - | ----- | -- | - | - | ------ | -- | -
|                       |                |      | Three Months Ended |      | Nine Months Ended
|                       |                |      | September 30,      |      | September 30,    
|                       |                |      |                    |      |                  
|(dollars in thousands) |                | 2002 |                    | 2001 |                   | 2002 |       | 2001
|                       |                |      |                    |      |                   |      |       |     
|Cost of Sales          |                | $    | 908                |      |                   | $    | 1,181 |      |   | $ | 3,644 |    |   | $ | 6,504  |   
|                       | % of net sales |      |                    | 33   | %                 |      |       | 26   | % |   |       | 33 | % |   |        | 28 | %
|Gross profit           |                | $    | 1,873              |      |                   | $    | 3,424 |      |   | $ | 7,273 |    |   | $ | 17,055 |   
|                       | % of net sales |      |                    | 67   | %                 |      |       | 74   | % |   |       | 67 | % |   |        | 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.

The gross profit percentages in the three and nine-month periods ended
September 30, 2002 were lower than in the comparable periods in 2001 due
primarily to lower production volumes and differences in the overall sales mix
between the two periods.

|                                           |  |                                  |       |                                 |  |      |        |      |  |        |       |      |  |   |       |  |  |   |        |    |  |   |        | 
|------------------------------------------ |  | -------------------------------- | ----- | ------------------------------- |  | ---- | ------ | ---- |  | ------ | ----- | ---- |  | - | ----- |  |  | - | ------ | -- |  | - | ------ | 
|                                           |  | Three Months Ended September 30, |       | Nine Months Ended September 30,
|                                           |  |                                  |       |                                
|(dollars in thousands)                     |  | 2002                             |       | Change                          |  | 2001 |        | 2002 |  | Change |       | 2001
|                                           |  |                                  |       |                                 |  |      |        |      |  |        |       |     
|Sales, general and
administrative
expenses |  | $                                | 1,657 |                                 |  | $    | (1,314 | )    |  | $      | 2,971 |      |  | $ | 6,729 |  |  | $ | (4,130 | )  |  | $ | 10,859 | 
|                                           |  |                                  |       |                                 |  |      | (44    | %)   |  |        |       |      |  |   |       |  |  |   | (38    | %) |  |   |        | 

The decreases in sales, general and administrative expenses in the third
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.

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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 fluctuations, we may choose to
hedge a portion of our foreign exchange risk. No such hedging activities were
in effect during the first nine 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 September 30, |       | Nine Months Ended September 30,
|                                  |  |                                  |       |                                
|(dollars in thousands)            |  | 2002                             |       | Change                          |  | 2001 |      | 2002 |  | Change |       | 2001
|                                  |  |                                  |       |                                 |  |      |      |      |  |        |       |     
|Research and
development expenses |  | $                                | 1,249 |                                 |  | $    | (933 | )    |  | $      | 2,182 |      |  | $ | 4,488 |  |  | $ | (4,253 | )  |  | $ | 8,741 | 
|                                  |  |                                  |       |                                 |  |      | (43  | %)   |  |        |       |      |  |   |       |  |  |   | (49    | %) |  |   |       | 

The decreases in research and development expenses in the three and
nine-month periods ended September 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.

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

In May 2002, we announced that we had completed the acquisition of REBA
Technologies, Inc., and formed Libra Networks, a division of Applied
Microsystems, to pursue development of the acquired technology. This
patent-pending technology is focused on enhancing the operation of server farms
for enterprises, application service 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 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.

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|                       |  |                                  |   |                                 |  |      |        |      |  |        |       |      |  |   |       |  |  |   |        |    |  |   |       | 
|---------------------- |  | -------------------------------- | - | ------------------------------- |  | ---- | ------ | ---- |  | ------ | ----- | ---- |  | - | ----- |  |  | - | ------ | -- |  | - | ----- | 
|                       |  | Three Months Ended September 30, |   | Nine Months Ended September 30,
|                       |  |                                  |   |                                
|(dollars in thousands) |  | 2002                             |   | Change                          |  | 2001 |        | 2002 |  | Change |       | 2001
|                       |  |                                  |   |                                 |  |      |        |      |  |        |       |     
|Business restructuring |  | $                                |  |                                 |  | $    | (2,289 | )    |  | $      | 2,289 |      |  | $ | 1,149 |  |  | $ | (1,140 | )  |  | $ | 2,289 | 
|                       |  |                                  |   |                                 |  |      | (100   | %)   |  |        |       |      |  |   |       |  |  |   | (50    | %) |  |   |       | 

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 September 30, |     | Nine Months Ended September 30,
|                               |  |                                  |     |                                
|(dollars in thousands)         |  | 2002                             |     | Change                          |  | 2001 |      | 2002 |  | Change |    | 2001
|                               |  |                                  |     |                                 |  |      |      |      |  |        |    |     
|Interest income and
other, net |  | $                                | (12 | )                               |  | $    | (62  | )    |  | $      | 50 |      |  | $ | 34 |  |  | $ | (200 | )  |  | $ | 234 | 
|                               |  |                                  |     |                                 |  |      | (124 | %)   |  |        |    |      |  |   |    |  |  |   | (86  | %) |  |   |     | 

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 nine-month periods ended September 30, 2002
and 2001.

Liquidity and Capital Resources

As of September 30, 2002, we had $2.5 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 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 September 30,

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2002, but will be available to Applied in the fourth quarter of 2002 as a
result of our terminating our headquarters facilities lease and the
corresponding cancellation of the letter of credit. As a result of the sale of
our embedded systems development tools assets, we received $3.4 million in
November 2002 (the remaining $500,000 of the agreed-upon purchase price is held
back for one year to secure certain indemnification obligations). After
closing the asset sale transaction, we paid a $1 million lease termination fee
to the landlord of our headquarters facility, and have transaction and other
liabilities from the embedded systems development tools business that will need
to be satisfied. These obligations are expected to be offset somewhat by the
collection of accounts receivable and the sale of excess assets not needed for
the Libra Networks business.

The Libra Networks business initially requires capital primarily for the
financing of product development activities, capital equipment purchases, and
to fund required corporate infrastructure. We have historically required
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 $4.4 million for
operating activities in the first nine months of 2002, compared to using $3.4
million for operating activities in the first nine months of the prior year.
We used cash to purchase $118,000 in property and equipment in the first nine
months of 2002, compared to purchasing $180,000 in the first nine months of
2001 (excluding an equipment purchase of $250,000 in 2001, financed under a
long-term capital lease). As of September 30, 2002, we had no significant
commitments with regard to new capital purchases. As a result of terminating
our headquarters facility lease, we have no significant remaining long-term
operating lease commitments. We have commitments under a capital lease
obligation of up to $62,000 per year through 2006.

We received funds totaling $59,000 in the first nine months 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 $496,000
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 we will need to supplement our existing cash and cash
equivalents through the infusion of additional capital by the first half of
2003 to meet our anticipated cash needs. 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, and have now sold our embedded systems
development tools business and assets. 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. We are actively
seeking new sources of financing. Our future capital requirements will depend
on a number of factors, including the costs of fully meeting our remaining
obligations from the embedded systems development tools business, any
indemnification claims that might be made under the terms of the asset sale
agreement, our success in developing and marketing Libra Networks products, and
the potential use of funds for strategic purposes. In seeking additional
funds, we may sell additional equity, debt, or convertible securities, attempt
to obtain credit facilities, or seek to derive cash from the licensing or sale
of remaining assets; 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 SmallCap Market and our
ability to obtain financing may suffer as a result. In addition, if we are
unable to raise sufficient additional capital by the first half of 2003, we
could be required to sell or discontinue our business operations.

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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.

Our embedded systems development tools business has accounted for all of our
revenues to date; we do not have any immediate source of revenue, and we expect
to incur significant losses for an indefinite period of time.

The embedded systems development tools business we sold has historically
accounted for all of our revenue. Our Libra Networks business involves the
development of a new and as yet unreleased product line with no market
penetration in a highly competitive market sector typified by rapid changes in
technology and competitive products. We do not expect our Libra Networks
business to produce any revenues in the near term, and we plan to operate at a
loss until at least 2004. We can provide no assurance regarding when or to
what extent Libra Networks will begin to produce revenues, or whether we will
ever reach profitability. If we are unable to achieve significant levels of
recurring revenue from our Libra Networks business, our losses will likely
continue indefinitely. If this occurs, the market price of our common stock
could suffer as well as our viability as a going concern.

In addition, we have certain remaining obligations in connection with our
embedded systems development tools business that are not needed for our Libra
Networks business. These obligations were not transferred in the asset sale,
and we will continue to bear the costs of these commitments even though the
development of the Libra Networks business will not benefit from such
commitments. We also have certain foreign subsidiaries that are unnecessary in
the operation of the Libra Networks business. We anticipate incurring costs in
connection with winding down these subsidiaries, including but not limited to
severance obligations and lease terminations. We also have remaining certain
severance expenses related to U.S. personnel who were not employed by
Metrowerks and were not required for the Libra business.

We do not currently have sufficient working capital to fund our Libra Networks
business, and we may be unable to obtain additional capital. If we raise
additional financing, you may suffer significant dilution.

We anticipate that we will need a third-party investment in the first half
of 2003 to provide additional working capital for our Libra Networks business.
We cannot be certain that financing from third parties will be available on
acceptable terms to us or at all. The extent and timing of our future capital
requirements will depend upon several factors, including the rate of market
acceptance of our products, the degree of competition for our products, our
ability to build and expand an efficient indirect distribution system, and our
level of expenditures for product development, sales, and marketing activities.
If our capital requirements vary materially from those currently planned, we
may require financing sooner than anticipated. The level of funding of
pre-revenue-stage companies generally by both venture funds and strategic
investors has fallen dramatically in the past two years, and this is equally
true in the interconnect and networking technologies space. If we cannot raise
funds on acceptable terms, we may not be able to develop our products and
services, take advantage of future opportunities, or respond to competitive
pressures or unanticipated requirements, any of which could have a material
adverse effect on our ability to grow our business. In addition, we may be
required to sell or discontinue

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operations of our business. Further, if we issue equity securities, you may
experience severe dilution of your ownership percentage, and the new equity
securities may have rights, preferences or privileges senior to those of our
common stock. If our common stock is listed on The Nasdaq SmallCap Market at
the time of a proposed equity financing resulting in the sale and issuance of
twenty percent or more of the outstanding shares of our capital stock, we will
be required to obtain shareholder approval of such issuance. There can be no
assurance that we will be able to obtain any necessary shareholder approval,
and the failure to obtain such approval could limit our ability to obtain
needed capital.

We are dependent on a single line of business that currently has no products or
revenues. We cannot predict our future results because our Libra Networks
business has no operating history.

Our only line of business is the development of the Libra Networks
products and technology. We have not yet developed any products based on this
technology, and consequently there are currently no revenues from this line of
business. Furthermore, we cannot provide assurance that any products will be
developed on this technology or the timing of such developments if a product is
created. Given the lack of operating history in the Libra Networks business,
it is difficult to predict our future results. The Libra Networks business is
characterized by rapid technological change, new product development, a new and
unproven business model, and evolving industry standards. You should consider
the risks and uncertainties that we may encounter as a pre-revenue-stage
company in a new and rapidly evolving market. These uncertainties include:



| |  |  | our ability to design and engineer products having the
technological features planned for the Libra Networks product line;   
| | - |  | -----------------------------------------------------------------------------------------------------------------------------
|
| |  |  | customer demand for, and acceptance of, the Libra Networks business
products;                                                
|
| |  |  | our ability to establish relationships with OEMs, VARs, system
integrators, and other channel partners needed to drive sales;
|
| |  |  | our ability to demonstrate the benefits of our products and
services to end-user data center managers;                       
|
| |  |  | our unproven and evolving business model;                                                                                    
|
| |  |  | unfavorable economic conditions in the technology industry;                                                                  
|
| |  |  | decreased spending on technology due to adverse economic conditions; and                                                     
|
| |  |  | global economic conditions.                                                                                                  

We may be required to pay up to $3.3 million to Metrowerks for breaches of our
representations in the asset sale agreement.

We have an obligation to indemnify Metrowerks for any losses from breaches
of our representations or warranties in the asset sale agreement that occur
within 12 months after the closing date of the asset sale or within the
applicable statute of limitations period for claims relating to our ownership
of our assets, payment of our taxes, and our compliance with applicable laws,
if longer. Our indemnification obligations are limited by an overall cap of
$3.3 million on the amount of the indemnification. Although we know of no
breaches of our representations or warranties, the payment of any such
indemnification obligations would adversely impact our cash resources and our
ability to pursue our Libra Networks business, or the timing and amount of any
distribution to shareholders in the event of liquidation of the Company.

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Following the asset sale, our cash resources are limited and could be
diminished due to our inability to collect on our accounts receivable and
utilize or liquidate inventory not sold to Metrowerks.

The proceeds from the asset sale along with our current working capital
are not sufficient to fund our continuing business. After closing the asset
sale, we have limited cash resources, which we will need to manage carefully
until we are able to raise additional capital. After the asset sale, we expect
to collect cash from certain accounts receivable that we retained. If we are
unable to collect upon these accounts, our cash resources will be less than we
anticipate. Our debtors may not pay us due to their insolvency, bankruptcy,
lack of funds, or refusal to pay. As a result of the asset sale, our business
relationship with many of our debtors has been terminated, and some of our
debtors may be more likely to delay payments or attempt to renegotiate amounts
owing. There can be no assurance that Metrowerks will cooperate with us to
collect these accounts. Furthermore, the transition from our historical
business of developing tools for embedded software systems to our Libra
Networks business may prevent us from utilizing certain inventories that could
otherwise have been revenue-producing, and we may be unable to sell such
inventories to third parties, or such sales may be at distressed prices.

Our Libra Networks technology and products are not fully developed, are
untested, and remain subject to significant uncertainty. Rapid technological
change could render our products and services obsolete.

Our Libra Networks technology and products are in the development stage
and have not been completed or proven. The market for products related to data
management is characterized by rapid technological innovation, sudden changes
in user and customer requirements and preferences, frequent new product and
service introductions, and the emergence of new industry standards and
practices. Each of these characteristics could render our Libra Networks
products, intellectual property and systems obsolete. The rapid evolution of
our market requires that we improve continually the performance, features and
reliability of our products and services, particularly in response to
competitive offerings. The successful development of our products is subject
to the risks that:



| |  |  | any or all of our proposed products are found to be
ineffective for their intended purposes;                            
| | - |  | ------------------------------------------------------------------------------------------------------------------------
|
| |  |  | the proposed products or procedures are uneconomical to
manufacture or market or do not achieve broad market acceptance;
|
| |  |  | third parties hold proprietary rights that preclude us from marketing them; or                                          
|
| |  |  | third parties market a superior or equivalent product.                                                                  

Significant undetected errors or delays in new products or releases may
affect market acceptance of our products. There can be no assurance that,
despite our testing, errors will not be found in new products or releases after
commencement of commercial shipments, resulting in loss of customers or failure
to achieve market acceptance.

In addition, our Libra Networks technology and products will need to be
compatible with a broad array of disparate technologies in order to be
interoperable with other products routinely used in corporate data centers such
as routers, switches, operating systems and systems management software. This
interoperability may depend on partnerships with third parties such as Cisco,
Dell, IBM, Sun, BEA, BMC, and Microsoft. We currently do not have any
partnerships with such third parties. Without such partnerships, we may not
achieve market acceptance or demand for our products within our target base of
customers, because our products will not operate with many of the applications
they currently use.

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If we are unable to secure funding for Libra Networks, or the outlook for
funding represents unacceptable risks, we may choose to liquidate the Company,
and any distribution to shareholders is subject to significant uncertainty.

The Company is focusing effort on raising funds for Libra Networks;
however, the Company is also considering whether the value deliverable to
shareholders might be optimized by liquidating the company rather than
continuing to pursue the Libra Networks opportunity. Liquidation of a
corporation is not a simple process, and would require a shareholder vote.
Even after shareholder approval, liquidation distributions to shareholders
might have to be delayed for a lengthy period of time, so that assets remaining
after the asset sale can be sold, so that known and contingent creditors can be
satisfied, and so that the indemnification obligations in favor of Metrowerks
can expire or be otherwise provided for. A liquidation of Applied would also
involve numerous other complexities, including tax consequences to shareholders
and potential severance obligations to certain company executives and to other
Applied personnel. The process of liquidation, including the satisfaction or
settlement of our contingent liabilities and indemnification obligations,
presents significant uncertainties surrounding the timing and amount of any
distribution to shareholders. In the event of liquidation, there can be no
assurance that any assets will be available for distribution to shareholders.

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
September 30, 2002, and we incurred corresponding operating losses in each of
these periods. In addition, we have now sold the assets that provided our
historical revenue base. 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. In May
2002, we announced that we had acquired REBA Technologies, Inc., and formed
Libra Networks, a division of Applied Microsystems. 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:



| |  |  | our ability to manage our limited cash resources long enough for us
to improve our financial performance;                                                 
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | our ability to integrate REBA into our Libra Networks business and
to expand into development of hardware and software products aimed at
end-user markets;
|
| |  |  | the introduction of our Libra Networks products or our competitors products;                                                                             
|
| |  |  | the mix of our Libra Networks 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.                                                                                                                               

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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 could
decline.

If we are unable to meet the listing requirements for the Nasdaq SmallCap
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 SmallCap
Market (the SmallCap Market). However, in order to continue to be included
in the SmallCap Market, a company must maintain, among other things, a minimum
closing bid price of $1.00 per share and a $1,000,000 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 $0.16 per share on November 4, 2002, with
a corresponding total market value on that date of $1.2 million. In order to
maintain compliance with the SmallCap 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 SmallCap Market
maintenance criteria in the future may result in the delisting of the Companys
common stock from the SmallCap 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.

The emergence of InfiniBand, the Switch Fabric communication technology that
will be incorporated in our initial Libra Networks product release, as a
worldwide standard is uncertain.

Our initial Libra Networks products are being developed using InfiniBand
architecture. InfiniBand is currently the only new Switch Fabric technology
available for widespread usage. Libra Networks is an active member of the
InfiniBand Trade Association (IBTA)  an organization founded by major
technology companies such as Compaq Computer Corp., Dell Computer Corp.,
Hewlett-Packard Co., IBM Corp., Intel Corp., Microsoft Corp., and Sun
Microsystems Inc., to jointly develop InfiniBand specifications and to promote
its adoption as a worldwide standard for server-to-server, and
network-to-server interconnect solutions.

In the second quarter of 2002, Microsoft and Intel each announced that
they will limit further investments in InfiniBand-based products.
Specifically, Intel announced that it will stop developing host channel adapter
chips for InfiniBand; and Microsoft stated that it no longer plans to
incorporate InfiniBand into its next-generation server operating system, the
Windows.Net Server, although it will continue to assist companies offering
InfiniBand products that plug into Microsoft products. These announcements
have created doubt regarding the feasibility and likelihood of InfiniBands
acceptance as the worldwide standard for server-to-server, and
network-to-server interconnect solutions. It is unclear whether these
announcements reflect a loss of confidence in the InfiniBand technology as a
potential worldwide interconnect standard, or are merely financial decisions
based upon uncertainties as to how quickly the market for InfiniBand products
will materialize or based upon other internal resource-allocation
considerations. If InfiniBand is not accepted as a standard in the
marketplace, our products will have to be redesigned to operate under a
different architecture. While we plan to incorporate other emerging switch
fabric technologies in future releases of our Libra Networks products, delays
in product releases and slower revenue growth would be likely since no other
switch fabric alternatives are expected

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to be available in the same time frame as InfiniBand.

We will rely on third parties to provide certain components and software for
our Libra Networks products. If our vendors fail to deliver their products in
a reliable, timely and cost-efficient manner, our business will suffer.

We expect to depend on relationships with third parties such as Intel,
Mellanox, and others who may be sole source providers of key, leading-edge
hardware and software components critical for some of the products we are
developing in our Libra Networks business. If these providers of exclusive
proprietary technology do not produce these components or software modules on a
timely basis, or if the components or software modules do not meet our
specifications or are otherwise flawed, we may have to delay product delivery,
recall, or replace unacceptable products. As a result, we could lose existing
and potential customers and any revenues that we may have at that time may
decline dramatically.

We may not be able to meet our product development objectives or market
expectations.

Our Libra Networks product development efforts are inherently difficult to
manage and keep on schedule, and there can be no assurance that we will be able
to meet our development objectives or to meet market expectations. In addition
to development delays, we may experience substantial cost overruns in
completing development of our products. The technological feasibility for some
of the products that we envision is not completely established. The products
being developed by us may contain undetected flaws when introduced. There can
be no assurance that, despite testing by us and by potential customers, flaws
will not be found in the products, resulting in loss of or delay in market
acceptance. We may be unable, for technological or other reasons, to develop
and introduce products in a timely manner in response to changing customer
requirements. Further, there can be no assurance that while we are attempting
to finish development of our products, a competitor will not introduce similar
products, thus diminishing our technological advantage, or a superior
alternative to ours, rendering our products and technologies partially or
wholly obsolete, or at least requiring substantial re-engineering in order to
become commercially acceptable. Our failure to maintain our product
development schedules, avoid cost overruns and undetected errors, or introduce
a product that is superior to competing products would have a materially
adverse effect on our business, financial condition, and results of operations.

We are highly dependent on our key personnel to manage our business, and
because of competition for qualified personnel we may not be able to recruit or
retain necessary personnel.

Our continued growth and success depend to a significant degree on the
continued services of our senior management and other key employees and our
ability to attract and retain highly skilled and experienced technical,
managerial, sales, and marketing personnel. We have historically been a
developer of tools for use by embedded software systems developers. Our Libra
Networks business 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 this new line of
business, we also expect to encounter new product development challenges, new
customer requirements, new competitors and other new business challenges, with
which our existing management may be unfamiliar. Our management may lack the
necessary knowledge, strategic and customer contacts, and experience to
effectively meet the demands of the market our Libra Networks business targets,
and competition for such personnel is intense. There can be no assurance that
we will be successful in recruiting new personnel or in retaining existing
personnel. Except for Stephen J. Verleye, our President and Chief Executive
Officer, none of our employees is subject to a long-term employment agreement.
The loss of one or more key employees or our inability to attract additional
qualified employees could

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have a material adverse effect on our business, results of operations and
financial condition. In addition, we may experience increased compensation
costs in order to attract and retain skilled employees.

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

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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 September 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.




Item 4. Controls and Procedures

(a)  Under the supervision and with the participation of our management,
including our principal executive officer and principal financial officer, we
conducted an evaluation of our disclosure controls and procedures, as such term
is defined under Rule 13a-14(c) promulgated under the Securities Exchange Act
of 1934, as amended (the Exchange Act), within 90 days of the filing date of
this report. Based on their evaluation, our principal executive officer and
principal accounting officer concluded that our disclosure controls and
procedures are effective.

(b)  There have been no significant changes (including corrective actions
with regard to significant deficiencies or material weaknesses) in our internal
controls or in other factors that could significantly affect these controls
subsequent to the date of the evaluation referenced in paragraph (a) above.




PART II  OTHER INFORMATION




Item 4. Submission of Matters to a Vote of Security Holders

A Special Meeting of Shareholders was held on October 29, 2002. The
following summarizes the results of matters voted upon at the Annual
Meeting:

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | The shareholders voted 4,529,911 shares in the affirmative, 173,093
shares in the negative, and 10,453 shares abstained relative to
approval of the Asset Purchase Agreement dated as of September 3,
2002, by and between Metrowerks Corporation, a Texas corporation and
wholly owned subsidiary of Motorola, Inc., a Delaware corporation,
and Applied Microsystems Corporation, a Washington corporation, and
to approve the proposed sale of Applieds embedded systems
development tools business and assets to Metrowerks.

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##### 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                                                                                                                                                                                                          
|
| |     |  | We filed a report on Form 8-K dated September 3, 2002, regarding
the execution of an agreement to sell our embedded systems
development tools business to Metrowerks Corporation, a wholly
owned subsidiary of Motorola, Inc.
|
| |     |  | We filed a report on Form 8-K dated September 12, 2002, regarding
our notification that Nasdaq approved our application to transfer
Applieds common stock to the Nasdaq SmallCap Market.                                    
|
| |     |  | We filed a report on Form 8-K dated October 15, 2002, regarding an
agreement to terminate our headquarters facility lease.                                                                                                   
|
| |     |  | We filed a report on Form 8-K dated November 4, 2002, regarding our
closing the sale of our embedded systems development tools business
to Metrowerks.                                                                       




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: November 13, 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)

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##### Table of Contents






Section 302(a) Certifications

I, Robert C. Bateman, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of Applied Microsystems
Corporation;                                                                                                                                                                                                                                       
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;                   
|  
|4. |  | The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:                                                                                                     



| | a) |  | designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        



|5. |  | The registrants other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent functions):
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrants
ability to record, process, summarize and report financial data and
have identified for the registrants auditors any material
weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrants
internal controls; and                                                                                                                                        



|6. |  | The registrants other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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##### Table of Contents



|                                                                                  |  |                   |  | 
|--------------------------------------------------------------------------------- |  | ----------------- |  | 
|Date:                                                                             |  | November 13, 2002 |  | 
|                                                                                  |  |                   |  | 
|                                                                                 
|/s/ Robert C. Bateman                                                             |  |                  
|                                                                                  |  |                  
|Robert C. BatemanVice President, Chief Financial Officer,
Secretary and Treasurer |  |                  

I, Stephen J. Verleye, certify that:



|1. |  | I have reviewed this quarterly report on Form 10-Q of Applied Microsystems
Corporation;                                                                                                                                                                                                                                       
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this quarterly report;
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and cash
flows of the registrant as of, and for, the periods presented in this
quarterly report;                   
|  
|4. |  | The registrants other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we
have:                                                                                                     



| | a) |  | designed such disclosure controls and procedures to ensure
that material information relating to the registrant, including its
consolidated subsidiaries, is made known to us by others within
those entities, particularly during the period in which this
quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants disclosure
controls and procedures as of a date within 90 days prior to the
filing date of this quarterly report (the Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                        



|5. |  | The registrants other certifying officers and I have disclosed, based on
our most recent evaluation, to the registrants auditors and the audit
committee of registrants board of directors (or persons performing the
equivalent functions):
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or operation of
internal controls which could adversely affect the registrants
ability to record, process, summarize and report financial data and
have identified for the registrants auditors any material
weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves management
or other employees who have a significant role in the registrants
internal controls; and                                                                                                                                        

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##### Table of Contents





|6. |  | The registrants other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.
|-- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                        |  |                   |  | 
|------------------------------------------------------- |  | ----------------- |  | 
|Date:                                                   |  | November 13, 2002 |  | 
|                                                        |  |                   |  | 
|                                                       
|/s/ Stephen J. Verleye                                  |  |                  
|                                                        |  |                  
|Stephen J. VerleyePresident and Chief Executive Officer |  |                  

-30-