**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**





**FORM
      10-K / A**





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


For
                the fiscal year ended December 31,
                2005




OR




**o**
            **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 0-23081




**FARO
      TECHNOLOGIES, INC.**


(Exact
      name of Registrant as specified in its charter)





**Florida**
              *(State
                or other jurisdiction*
              *of
                incorporation or organization)*
            **59-3157093**
              *(I.R.S.
                Employer Identification
                Number)*





**125
                Technology Park, Lake Mary, FL**
              *(Address
                of principal executive offices)*
            **32746**
              *(Zip
                code)*





**(Registrant’s
      telephone number, including area code): (407) 333-9911**





**Securities
      registered pursuant to Section 12(b) of the Act:** None




**Securities
      registered pursuant to Section 12(g) of the Act:** Common
      Stock, par value $.001





Indicate
      by check mark if the registrant is a well-known seasoned issuer, as defined
      in
      Rule 405 of the Securities Act. Yes þ No o





Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or Section 15(d) of the Exchange Act. Yes o No þ





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 þ No o





Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the best
      of registrant’s knowledge, in definite proxy or information statements
      incorporated by reference in Part III of this Form 10-K or any amendment to
      this
      Form 10-K. Yes þ No o





Indicate
      by check mark whether the registrant is large accelerated filer, an accelerated
      filer, or a non-accelerated filer. See definition of “accelerated filer” and
“large accelerated filer” in Rule 12b-2 of the Exchange Act.




Large
                  accelerated filer o
              Accelerated
                  filerþ
              Non-accelerated
                  filero




As
      of
      June 19, 2006, there were outstanding 14,349,726 shares of common stock. The
      aggregate market value of the voting stock held by non-affiliates of the
      Registrant as of June 19, 2006 was $168 million based on the last sale on such
      date on the NASDAQ National Market.





**DOCUMENTS
      INCORPORATED BY REFERENCE**




None.





**TABLE
      OF CONTENTS**




**Page**PART
                I
            
            
            
            1Item
                1.
            
            Business.
            
            3Item
                1A.
            
            Risk
                Factors.
            
            10Item
                1B.
            
            Unresolved
                Staff Comments.
            
            18Item
                2.
            
            Properties.
            
            18Item
                3.
            
            Legal
                Proceedings.
            
            18Item
                4.
            
            Submission
                of Matters to a Vote of Security Holders.
            
            22PART
                II
            
            
            
            23Item
                5.
            
            Market
                For Registrant’s Common Equity and Related Stockholder
                Matters.
            
            24Item
                6.
            
            Selected
                Financial Data.
            
            24Item
                7.
            
            Management’s
                Discussion and Analysis of Financial Condition and Results
                ofOperations.
            
            37Item
                7A.
            
            Quantitative
                and Qualitative Disclosures About Market Risk.
            
            38Item
                8.
            
            Financial
                Statements and Supplementary Data.
            
            67Item
                9.
            
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosure.
            
            67Item
                9A.
            
            Controls
                and Procedures.
            
            67Item
                9B.
            
            Other
                Information.
            
            71PART
                III
            
            
            
            72Item
                10.
            
            Directors
                and Executive Officers of the Registrant.
            
            72Item
                11.
            
            Executive
                Compensation.
            
            77Item
                12.
            
            Security
                Ownership of Certain Beneficial Owners and Management.
            
            81Item
                13.
            
            Certain
                Relationships and Related Transactions.
            
            83Item
                14.
            
            Principal
                Accountant Fees and Services.
            
            83PART
                IV
            
            
            
            85Item
                15.
            
            Exhibits
                and Financial Statement Schedules.
            
            85




i




**EXPLANATORY
      NOTE**




This
      Form
      10-K/A (the “Amended Report”) is being filed to include the conformed signatures
      in Exhibits 31-A, 31-B, 31-C, 32-A, 32-B, and 32-C in accordance with Item
      302
      of Regulation S-T, which typed signature next to the /S/ was omitted in the
      original Form 10-K filed on June 29, 2006.




This
      Amended Report also contains a revised “Report of Independent Registered Public
      Accounting Firm” as a result of the omission of the last two paragraphs of the
      report during the Edgarization process of the original filing.




Except
      for the aforementioned changes, this Amended Report does not modify or update
      other disclosures in the original Form 10-K filed on June 29, 2006.




**PART
      I**




**CAUTIONARY
      STATEMENTS FOR FORWARD-LOOKING INFORMATION**




FARO
      Technologies, Inc. (“FARO”, the “Company”, “us”, “we”, or “our”) has made
“forward-looking statements” in this report (within the meaning of the Private
      Securities Litigation Reform Act of 1995). Statements that are not historical
      facts or that describe our plans, beliefs, goals, intentions, objectives,
      projections, expectations, assumptions, strategies, or future events are
      forward-looking statements. In addition, words such as “may,” “will,” “believe,”
“plan,” “should,” “could,” “seek,” “expect,” “anticipate,” “intend,” “estimate,”
“goal,” “objective,” “project,” “forecast,” “target, “ “goal” and similar words,
      or discussions of our strategy or other intentions identify forward-looking
      statements. Other written or oral statements that constitute forward-looking
      statements also may be made by the Company from time to time.




Forward-looking
      statements are not guarantees of future performance and are subject to a number
      of known and unknown risks, uncertainties, and other factors that could cause
      actual results to differ materially from those expressed or implied by such
      forward-looking statements. Consequently, undue reliance should not be placed
      on
      these forward-looking statements. We do not intend to update any forward-looking
      statements, whether as a result of new information, future events, or otherwise,
      unless otherwise required by law. Important factors that could cause a material
      difference in the actual results from those contemplated in such forward-looking
      statements include among others those under “Cautionary Statements” and
      elsewhere in this report and the following:




·
            our
                inability to further penetrate our customer base;




·
            development
                by others of new or improved products, processes or technologies
                that make
                our products obsolete or less
                competitive;




·
            our
                inability to maintain our technological advantage by developing new
                products and enhancing our existing
                products;




·
            our
                ability to successfully identify and acquire target companies or
                achieve
                expected benefits from acquisitions that are
                consumated;




·
            the
                cyclical nature of the industries of our customers and the financial
                condition of our customers;




1





·
            the
                fact that the market potential for the CAM2 market and the potential
                adoption rate for our products are difficult to quantify and
                predict;




·
            the
                inability to protect our patents and other proprietary rights in
                the
                United States and foreign countries and the assertion and ultimate
                outcome
                of infringement claims against us, including the pending suit by
                Hexagon’s
                Cimcore-Romer subsidiary against
                us;




·
            fluctuations
                in our annual and quarterly operating results and the inability to
                achieve
                our financial operating targets as a result of a number of factors
                including, without limitation (i) litigation and regulatory action
                brought
                against us, (ii) quality issues with our products, (iii) excess or
                obsolete inventory, (iv) raw material price fluctuations, (v) expansion
                of
                our manufacturing capability and other inflationary pressures, (vi)
                the
                size and timing of customer orders, (vii) the amount of time that
                it takes
                to fulfill orders and ship our products, (viii) the length of our
                sales
                cycle to new customers and the time and expense incurred in further
                penetrating our existing customer base, (ix) costs associated with
                new
                product introductions, such as product development, marketing, assembly
                line start-up costs and low introductory period production volumes,
                (x)
                the timing and market acceptance of new products and product enhancements,
                (xi) customer order deferrals in anticipation of new products and
                product
                enhancements, (xii) our success in expanding our sales and marketing
                programs, (xiii) costs associated with opening new sales offices
                outside
                of the United States, (xiv) fluctuations in revenue without proportionate
                adjustments in fixed costs, (xv) the efficiencies achieved in managing
                inventories and fixed assets, (xvi) investments in potential acquisitions
                or strategic sales, product or other initiatives, (xvii) shrinkage
                or
                other inventory losses due to product obsolescence, scrap or material
                price changes, (xviii) adverse changes in the manufacturing industry
                and
                general economic conditions, and (xiv) other factors including the
                cost of
                investigation and ongoing litigation expenses noted herein;




·
            the
                outcome of the purported class action
                lawsuit;




·
            our
                inability to successfully implement the requirements of Restriction
                of use
                of Hazardous Substances (RoHS) and Waste Electrical and Electronic
                Equipment (WEEE) compliance into our
                products;




·
            the
                inability of our products to displace traditional measurement devices
                and
                attain broad market acceptance;




·
            the
                impact of competitive products and pricing in the CAM2 market and
                the
                broader market for measurement and inspection devices;




·
            the
                effects of increased competition as a result of recent consolidation
                in
                the CAM2 market;




·
            risks
                associated with expanding international operations, such as fluctuations
                in currency exchange rates, difficulties in staffing and managing
                foreign
                operations, political and economic instability, and the burdens and
                potential exposure of complying with a wide variety of U.S. and foreign
                laws and labor practices;




·
            our
                inability to maintain our level of sales or grow sales in China as
                a
                result of, among other things, the impact of our investigation of
                potential violations of the Foreign Corrupt Practices Act and
                modifications to our business practices in
                China;




·
            higher
                than expected increases in expenses relating to our Asia Pacific
                expansion
                or our Swiss manufacturing
                facility;




·
            our
                inability to find less expensive alternatives to stock options to
                attract
                and retain employees;




·
            difficulties
                in recruiting research and development engineers, and application
                engineers;




·
            the
                failure to effectively manage our
                growth;




2





·
            variations
                in the effective income tax rate and the difficulty in predicting
                the tax
                rate on a quarterly and annual basis;




·
            the
                loss of key suppliers and the inability to find sufficient alternative
                suppliers in a reasonable period or on commercially reasonable terms;
                and




·
            the
                matters set forth under “Cautionary Statements” in “Management’s
                Discussion and Analysis of Financial Condition and Results of Operations”
                below.





**ITEM
                  1.**
            **BUSINESS.**




The
      Company designs, develops, manufactures, markets and supports portable, software
      driven, 3-D measurement systems that are used in a broad range of manufacturing,
      industrial, building construction and forensic applications. The Company’s Faro
      Arm, Faro Scan Arm and Faro Gage articulated measuring devices, the Faro Laser
      Tracker, and their companion CAM2 software, provide for Computer-Aided Design
      (CAD)-based inspection and/or factory-level statistical process control.
      Together, these products integrate the measurement, quality inspection, and
      reverse engineering functions with CAD software to improve productivity, enhance
      product quality and decrease rework and scrap in the manufacturing process.
      The
      Company uses the acronym “CAM2” for this process, which stands for
      computer-aided manufacturing measurement. The Company’s Digital Template
      articulated measuring device and its related software are used to measure the
      shape of existing counter tops and other structures in residential or commercial
      buildings to provide the data required to manufacture replacement countertops
      or
      other structures. The Digital Template reduces the time required to measure
      these existing products and to provide the data to manufacturing machines to
      create the replacement structures, compared to traditional techniques. In March
      2005 the Company acquired iQvolution AG, a German designer, developer and
      manufacturer of a portable laser-based device for measuring the detailed
      composition of factories, oil refineries and other structures. This device
      and
      its related software, which the Company sells under the product name Laser
      Scanner LS also has forensic applications such as capturing detailed 3-D crime
      scene information. As of June 2006, the Company’s products have been purchased
      by approximately 4,900 customers worldwide, ranging from small machine shops
      to
      such large manufacturing and industrial companies as Audi, Bell Helicopter,
      Boeing, British Aerospace, Caterpillar, Daimler Chrysler, General Electric,
      General Motors, Honda, Johnson Controls, Komatsu Dresser, Lockheed Martin,
      Nissan, Siemens and Volkswagen, among many others.




We
      were
      founded in 1982 and we re-incorporated in Florida in 1992. Our worldwide
      headquarters are located at 125 Technology Park, Lake Mary, Florida 32746,
      and
      our telephone number is (407) 333-9911.




**Industry
      Background**




The
      Company believes that there are three principal forces driving the need for
      its
      products and services: 1) the widespread use by manufacturers of CAD in product
      development which shortens product cycles; 2) the adoption by manufacturers of
      quality standards such as Six Sigma and ISO-9000 (and its offshoot QS-9000),
      which stress the measurement of every step in a manufacturing process to reduce
      or eliminate defects, and 3) the inability of traditional measurement devices
      to
      address many manufacturing problems, especially those related to large
      components for products such as automobiles, aircraft, heavy duty construction
      equipment, factory retrofits and countertops.




***CAD
      changes the manufacturing process.*** The
      creation of physical products involves the processes of design, engineering,
      production and measurement and quality inspection. These basic processes have
      been profoundly affected by the computer hardware and software revolution that
      began in the 1980s. CAD software was developed to automate the design process,
      providing manufacturers with computerized 3-D design capability. Today, most
      manufacturers use some form of CAD software to create designs and engineering
      specifications for new products and to quantify and modify designs and
      specifications for existing products. The use of CAD can shorten the time
      between design changes. While
      manufacturers previously designed their products to be in production for longer
      periods of time, current manufacturing practices must accommodate more frequent
      product introductions and modifications, while satisfying more stringent quality
      and safety standards. Assembly
      fixtures and measurement tools must be figuratively linked to the CAD design
      to
      enable production to keep up with the rate of design change.




3


***Quality
      standards dictate measurement to reduce defects.*** QS-9000
      is the name given to the Quality System Requirements of the automotive industry
      that were developed by Chrysler, Ford, General Motors and major truck
      manufacturers and issued in late 1994. Companies that become registered under
      QS-9000 are considered to have higher standards and better quality products.
      Six
      Sigma embodies the principles of total quality management that focus on
      measuring results and reducing product or service failure rates to 3.4 per
      million. All aspects of a Six Sigma company’s infrastructure must be analyzed,
      and if necessary, restructured to increase revenues and raise customer
      satisfaction levels. The all-encompassing nature of these and other quality
      standards has resulted in manufacturers measuring every aspect of their process,
      including stages of product assembly that may have never been measured before,
      in part because of the lack of suitable measurement equipment.




***Traditional
      products don’t measure up*** .
      A
      significant aspect of the manufacturing process, which traditionally has not
      benefited from computer-aided technology, is measurement and quality inspection.
      Historically, manufacturers have measured and inspected products using
      hand-measurement tools such as scales, calipers, micrometers and plumb lines
      for
      simple measuring tasks, test (or check) fixtures for certain large manufactured
      products and traditional coordinate measurement machines (CMM) for objects
      that
      require higher precision measurement. However, the broader utility of each
      of
      these measurement methods is limited.




Although
      hand-measurement tools are often appropriate for simple geometric measurements,
      including hole diameters or length and width of a rectangular component, their
      use for complex part measurements, such as the fender of a car, is limited.
      Also
      these devices do not allow for the measurements to be directly compared to
      the
      CAD model of the part. Test fixtures (customized fixed tools used to make
      comparative measurements of complex production parts to “master parts”) are
      relatively expensive and must be reworked or discarded each time a dimensional
      change is made in the part being measured. In addition, these manual measuring
      devices do not permit the manufacturer to compare the dimensions of an object
      with its CAD model. Traditional templates made of wood or Styrofoam for
      countertop design are prone to breakage and dimensional errors. The template
      making process is time consuming as well.




Conventional
      CMMs are generally large, fixed-base machines that provide very high levels
      of
      precision and provide a link to the CAD model of the object being measured.
      However, fixed-base CMMs require the object being measured be brought to the
      CMM
      and the object fit within the CMMs measurement grid. As manufactured
      subassemblies increase in size and become integrated into even larger
      assemblies, they become less transportable, thus diminishing the utility of
      a
      conventional CMM. Consequently, manufacturers must continue to use
      hand-measuring tools, or expensive customized test fixtures, in order to measure
      large or unconventionally shaped objects. Some parts or assemblies are not
      easily accessible and cannot be measured at all using traditional
      devices.




Escalating
      global competition has created a demand for higher quality products with shorter
      life cycles. Manufacturers require more rapid design, greater control of the
      manufacturing process, tools to compare components to their CAD specifications
      and the ability to precisely measure components that cannot be measured or
      inspected by conventional devices. Moreover, they increasingly require
      measurement capabilities to be integrated into the manufacturing process and
      to
      be available on the factory floor.




4


**FARO
      Products**




**The
      Faro Arm** ***.*** The
      Faro
      Arm is a combination of a portable, six or seven-axis, instrumented articulated
      measurement arm, a computer, and software programs under the acronym CAM2.


·
            ***Articulated
                Arm***-
                Each articulated arm is comprised of three major joints, each of
                which may
                consist of one, two or three axes of motion. The articulated arm
                is
                available in a variety of sizes, configurations and precision levels
                that
                are suitable for a broad range of applications. To take a measurement,
                the
                operator simply touches the object to be measured with a probe at
                the end
                of the arm and presses a button. Data can be captured at either individual
                points or a series of points. Digital rotational transducers located
                at
                each of the joints of the arm measure the angles at those joints.
                This
                rotational measurement data is transmitted to an on-board controller
                that
                converts the arm angles to precise locations in 3-D space using “xyz”
                position coordinates and “ijk” orientation
                coordinates. 
 ·
            ***Computer***-
                The Company pre-installs its CAM2 software on either a notebook or
                desktop
                style computer, depending on the customer’s need, and the measuring
                device, computer and installed software are sold as a system. The
                computers are not manufactured by the Company, but are purchased
                from
                various suppliers.


·
            ***CAM2
                Software***-
                See separate section on CAM2 Software
                below.




**The
      Digital Template.** A lower
      accuracy articulated arm device targeted at the home remodeling market. This
      device is designed to replace traditional physical templates used in countertop,
      cabinet and other home remodeling applications.




**The
      Faro Scan Arm.** The Faro
      Scan Arm is a Faro Arm equipped with a combination of a hard probe (like that
      in
      the Faro Arm) *and* a
      non-contact line laser probe. This product provides our customers the ability
      to
      measure their products without touching them.




**The
      Faro Gage.** Sold
      as a
      combination of an articulated arm device with a computer and software, the
      Faro
      Gage is a smaller, higher accuracy version of the Faro Arm product. What
      distinguishes the Faro Gage from the Faro Arm are the special mounting features
      and the basic software which are unique to the Faro Gage. The Faro Gage is
      targeted at machine tools, and bench tops around machine tools, where basic
      measurements of smaller machined parts must be measured. As such, the CAM2
      software developed for this device features basic 2-D and 3-D measurements
      common to these applications. (See also “Faro Gage Software”
below.)




**The
      Faro Laser Tracker.** A
      combination of a portable, large-volume laser measurement tool, a computer,
      and
      CAM2 software programs.


·
            ***Laser
                Tracker***-
                The Faro Laser Tracker utilizes an ultra-precise laser beam to measure
                objects of up to 230 feet. It enables manufacturing, engineering,
                and
                quality control professionals to measure and inspect large parts,
                machine
                tools and other large objects on-site and/or in-process. With its
                greater
                angular resolution, repeatability, and accuracy, the Faro Laser Tracker
                advances already-proven tracker technology. Among its many enhanced
                features is SuperADM, which improves upon existing Absolute Distance
                Measurement technology by providing the time-saving ability to reacquire
                the laser beam without the need to return to a known reference point
                or
                the need to hold the target
                stationary.




5


·
            ***Computer***-
                See description under Faro Arm
                above.


·
            ***CAM2
                Software***--
                See separate section on CAM2 software below.




**The
      Faro Laser Scanner LS.** The
      FARO
      Laser Scanner LS utilizes laser technology to measure and collect a cloud of
      data points, allowing for the detailed and precise three-dimensional rendering
      of an object or an area as large as a factory. This technology is currently
      used
      for factory planning, facility life-cycle management, quality control, forensic
      analysis and in general, capturing large volumes of three-dimensional data.
      Laser scanning technology simplifies modeling, reduces project time and
      maintains or increases the accuracy of the image. The resulting data is used
      with major CAD systems or FARO’s own proprietary software for the applications
      listed above.




**CAM2
      Software.** ****** CAM2
      is
      the Company’s family of proprietary CAD-based measurement and statistical
      process control software. The CAM2 product line includes the following software
      programs, many of which are translated into multiple languages:


·
            **CAM2
                Measure X******allows
                users to compare measurements of manufactured components or assemblies
                with the corresponding CAD data for the components or assemblies.CAM2Measure X is offered with the Faro Arm and the Faro Laser Tracker.


·
            **CAM2
                SPC Process**allowsfor
                the collection, organization, and presentation of measurement data
                factory-wide. Not limited to measurements from the Faro Arm or Faro
                Laser
                Tracker,CAM2SPC Process accepts data from CMM and other computer-based measurement
                devices from many different measurement applications along the production
                line. 
 ·
            **Soft
                Check Tool******is
                a custom software program designed to lead an operator through a
                measurement process on the Faro Arm or Faro Laser Tracker with minimal
                training. These programs are created by the Company from specifications
                provided by the customer. 
 ·
            **Faro
                Gage Software**includes
                a dedicated graphical interface designed for the ease of use of the
                operator. Capable of producing graphical and tabular reports, the
                software
                runs a library of gauging and Soft Check
                tools. 
 **Laser
                Scanner LS Software.********The
                Company has a number of programs available for its Laser Scanner
                LS
                product, as follows:  ·
            **Faro
                Scout**is
                a powerful software tool for displaying 3-D measurements and navigation
                in
                huge pointclouds. 
 ·
            **Faro
                Scene**is
                software for displaying, analyzing, administration and editing of
                3-D
                measurements in huge pointclouds including registration of multiple
                pointclouds. 
 ·
            **Farocloud
                for AutoCAD**supports the visualization and analysis of millions of 3-D points
                in the
                well known AutoCAD software environment. As-built documentation of
                industrial structures, historic buildings or many more applications
                are
                possible. 
 ·
            **Faroworks**is
                a web-based tool for the administration of complex projects and navigation
                from floorplan to scan with links to
                measurements.




6


·
            **Walkinside**is
                a high performance 3-D viewer with full room measurement and other
                features.




**Customers**




As
      of
      June 2006, the
      Company’s products have been purchased by approximately 4,900 customers
      worldwide, including small machine shops, large manufacturing and industrial
      companies, home improvement shops, universities and law enforcement agencies.
      The Company’s ten largest customers by revenue represented an aggregate of 8.9%
      of the Company’s total revenues in 2005. No customer represented more than 2.5%
      of the Company’s sales in 2005.




**Sales
      and Marketing**




The
      Company directs its sales and marketing efforts on a decentralized basis in
      three main regions around the world: Americas, Europe/Africa and Asia/Pacific.
      The regional headquarters for the Americas is in the Company’s headquarters in
      Lake Mary, Florida and the Europe/Africa regional headquarters is in Stuttgart,
      Germany. The Company opened a regional headquarters for the Asia/Pacific region
      in Singapore in 2005. At December 31, 2005 the Company employed 86, 113, and
      83
      sales and marketing specialists in the Americas, Europe/Africa, and Asia/Pacific
      regions, respectively. The Company has direct sales representation in the United
      States, Canada, Brazil, Germany, United Kingdom, France, Spain, Italy, Poland,
      Netherlands, India, South Korea, China, Singapore, Malaysia, Vietnam, and Japan.
      See Footnote 20 to the Notes to Consolidated Financial Statements, incorporated
      herein by reference to Item 8 hereof, for financial information about the
      Company’s foreign and domestic operations and export sales required by this
      Item.




The
      Company uses a process of integrated lead qualification and sales demonstration.
      Once a customer opportunity is identified, the Company employs a team-based
      sales approach involving inside and outside sales personnel who are supported
      by
      application engineers. With the exception of the digital template product which
      is sold by Faro Arm sales people, each product has a separate sales force,
      reporting to regional sales managers for all products. The Company employs
      a
      variety of marketing techniques to promote brand awareness and customer
      identification.




**Research
      and Development**




The
      Company believes that its future success depends on its ability to maintain
      technological leadership, which will require ongoing enhancements of its
      products and the development of new applications and products that provide
      3-D
      measurement solutions. Accordingly, the Company intends to continue to make
      substantial investments in the development of new technologies, the
      commercialization of new products that build on the Company’s existing
      technological base, and the enhancement and development of additional
      applications for its products.




The
      Company’s research and development efforts are directed primarily at enhancing
      the functional adaptability of its current products and developing new and
      innovative products that respond to specific requirements of the emerging market
      for 3-D measurement systems. The Company’s research and development efforts have
      been devoted primarily to mechanical hardware, electronics and software. The
      Company’s engineering development efforts will continue to focus on enhancing
      our existing products and developing new products for the CAM2
      market.




At
      December 31, 2005, the Company employed 55  scientists
      and technicians in its research and development efforts. Research and
      development expenses were approximately $6.4 million in 2005 as compared to
      $5.4
      million in 2004 and $4.5 million in 2003. We believe that the continual
      development or acquisition of innovative new products is critical to our future
      success. The field of CAM2 and more broadly, 3-D measurement, continues to
      expand and new technologies and applications will be essential to competing
      in
      this market . Research
      and development activities, especially with respect to new products and
      technologies, are subject to significant risks, and there can be no assurance
      that any of the Company’s research and development activities will be completed
      successfully or on schedule, or, if so completed, will be commercially
      accepted.




7


**Intellectual
      Property**




The
      Company holds or has pending 68 patents in the United States and related patents
      worldwide. The Company also has 23 registered or pending trademarks in the
      United States and worldwide.




The
      Company relies on a combination of contractual provisions and trade secret
      laws
      to protect its proprietary information. There can be no assurance that the
      steps
      taken by the Company to protect its trade secrets and proprietary information
      will be sufficient to prevent misappropriation of its proprietary information
      or
      preclude third-party development of similar intellectual property.




Despite
      the Company’s efforts to protect its proprietary rights, unauthorized parties
      may attempt to copy aspects of the Company’s products or to obtain and use
      information that the Company regards as proprietary. The Company intends to
      vigorously defend its proprietary rights against infringement by third parties.
      However, policing unauthorized use of the Company’s products is difficult,
      particularly overseas, and the Company is unable to determine the extent to
      which piracy of its software products exists. In addition, the laws of some
      foreign countries do not protect the Company’s proprietary rights to the same
      extent as the laws of the United States.




The
      Company does not believe that any of its products infringe on the proprietary
      rights of third parties. There can be no assurance, however, that third parties
      will not claim infringement by the Company with respect to current or future
      products. Any such claims, with or without merit, could be time-consuming,
      result in costly litigation, cause product shipment delays or require the
      Company to enter into royalty or licensing agreements. Such royalty or licensing
      agreements, if required, may not be available on terms acceptable to the Company
      or at all, which could have a material adverse effect upon the Company’s
      business, operating results and financial condition. The Company has been
      defending itself in a patent infringement suit brought against the Company
      by
      Cimcore-Romer (a subsidiary of Hexagon) on November 25, 2003. (See Item 3 -
      Legal Proceedings)




**Manufacturing
      and Assembly**




The
      Company manufactures its products at its headquarters in Lake Mary, Florida,
      and
      at its plants in Kennett Square, Pennsylvania, Schaffhausen, Switzerland,
      Stuttgart, Germany, and Singapore. Manufacturing consists primarily of
      assembling finished products with components and subassemblies, purchased from
      suppliers, into finished products. The primary components, which include
      machined parts and electronic circuit boards, are produced by subcontractors
      according to the Company’s specifications. All products are assembled,
      calibrated and tested for accuracy and functionality before shipment. In limited
      circumstances, the Company performs in-house circuit board assembly and part
      machining.




The
      Company’s manufacturing, engineering, and design headquarters have been
      registered to the ISO-9001 standard since July 1998. Semi-annual surveillance
      audits have documented continuous improvement to this multinational standard.
      The Company continues to examine its scope of registration as the business
      evolves and has chosen English as the standard business language for its
      operations. This decision is expected to significantly influence the Company’s
      operations and documentation globally. This has been done in concert with the
      ISO Standard Registrar, and is expected to increase customer confidence in
      the
      Company’s products and services worldwide.




8


The
      Company takes a global approach to ISO registration, seeking to have all
      locations registered with identical scope of accreditation and capabilities
      for
      the products generated and serviced. In 2004 FARO took this to the highest
      level
      possible. Our manufacturing sites in Lake Mary, Kennett Square, Stuttgart,
      and
      Schaffhausen are now jointly registered to ISO-9001:2000. In addition, our
      service sites in the United States, Germany, Switzerland, Japan, China, and
      Brazil have been jointly accredited to  ISO-17025
      for Calibration and Certification Laboratories by the Laboratory Accreditation
      Bureau.




**Competition**




Our
      portable measurement systems compete in the broad market for measurement devices
      for manufacturing and industrial applications which, in addition to portable
      articulated arms, laser tracker and laser scanner products, consist of
      fixed-base CMMs, templates and go/no-go gages, check fixtures, and handheld
      measurement tools. The broad market for measurement devices is highly
      competitive. In the Faro Gage product line, we compete with manufacturers of
      handheld measurement tools and fixed-base CMMs, including some large,
      well-established companies. In the Faro Arm, Faro Scan Arm, Faro Laser Tracker,
      and Faro Laser Scanner LS product lines, we compete primarily with Hexagon
      Metrology, a division of Hexagon. We also compete in these product lines with
      a
      number of other smaller competitors.




We
      will
      be required to make continued investments in technology and product development
      to maintain the technological advantage that we believe we currently have over
      our competition. Some of our competitors, including some manufacturers of fixed
      based CMMs and Hexagon, possess substantially greater financial, technical,
      and
      marketing resources than we possess. Moreover, we cannot be certain that our
      technology or our product development efforts will allow us to successfully
      compete as the industry evolves. As the market for our portable measurement
      systems expands, additional competition may emerge and the Company’s existing
      and future competitors may commit more resources to the markets in which the
      Company participates. For example, fixed-base CMM manufacturers are introducing
      CAD-based inspection software in response to the trend toward CAD-based factory
      floor metrology. In addition, some fixed-base CMM manufacturers are
      miniaturizing and increasing the mobility of their conventional CMMs.




**Government
      Regulation**




Our
      operations are subject to numerous governmental laws and regulations, including
      those governing antitrust and competition, the environment, securities
      transactions and disclosures, import and export of products, currency
      conversions and repatriation, taxation of foreign earnings and earnings of
      expatriate personnel and use of local employees and suppliers. Our foreign
      operations are subject to the U.S. Foreign Corrupt Practices Act (“FCPA”), which
      makes illegal any payments to foreign officials or employees of foreign
      governments that are intended to induce them to use their influence to assist
      us
      or to gain any improper advantage for us. The Company operates in certain
      regions that are more highly prone to risk under the FCPA.




Manufacturers
      of electrical goods will become subject to the European Union’s Restrictions of
      Hazardous Substances, (“RoHS”) and Waste Electrical and Electronic Equipment
      (“WEEE”) directives, which take effect during 2006. Parallel initiatives are
      being proposed in other jurisdictions, including several states in the United
      States and China. RoHS prohibits the use of lead, mercury and certain other
      specified substances in electronics products, and WEEE makes producers of
      electrical goods financially responsible for specified collection, recycling,
      treatment, and disposal of covered electronic products and components.




9


We
      expect
      that we will have our products in compliance with the RoHS directive in time.
      However, if we are unable to do so, we would be unable to sell our products
      in
      European Union countries, as well as possible several states in the United
      States and China, which would have a material adverse effect on our sales and
      results of operation.




**Backlog**




At
      December 31, 2005,  the
      Company had orders representing approximately  $3.5
      million  in
      product sales outstanding. The majority of these specific orders were shipped
      by
      June 16, 2006, and, as of June 16, 2006, the Company had orders representing
      approximately $7.3 million  in
      product sales outstanding. At December 31, 2004 and 2003, the Company had orders
      representing approximately $5.1 million and $7.5 million in product sales
      outstanding, respectively.




The
      Company’s decreased backlog at December 31, 2005 is the result of improved
      order-to-shipment turnaround times for its laser tracker and articulated arm
      product lines in 2005 to meet customer demand. The Company believes that
      substantially all of the outstanding sales orders as of June 16, 2006 will
      be
      shipped during 2006.




**Employees**




At
      December 31, 2005, the Company had 657 full-time employees, consisting of
      282 sales and marketing professionals, 134 production staff, 55 research and
      development staff, 80 administrative staff, and 106 customer service/application
      engineering specialists. The Company is not a party to any collective bargaining
      agreements and believes its employee relations are good. Management believes
      that its future growth and success will depend in part on its ability to retain
      and continue to attract highly skilled personnel. The Company anticipates that
      it will be able to obtain the additional personnel required to satisfy its
      staffing requirements over the foreseeable future.




**Available
      Information**




We
      maintain a web site with the address www.faro.com. Information contained on
      our
      web site is not a part of, or incorporated by reference into, this Annual Report
      on Form 10-K. We make available free of charge through our web site our
      Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current
      Reports on Form 8-K, proxy statements and amendments to these reports, as
      soon as reasonably practicable after we electronically file these reports with,
      or furnish these reports to, the Securities and Exchange Commission.




We
      were
      organized in 1982 and are incorporated in Florida.


**ITEM
        1A.**  **RISK
        FACTORS.**




We
      discuss expectations regarding our future performance and make other
      forward-looking statements in our annual and quarterly reports, press releases
      and other written and oral statements. These forward-looking statements are
      based on currently available competitive, financial and economic data and our
      operating plans. They are inherently uncertain, and investors must recognize
      that events could turn out to be significantly different from our expectations.
      The following discussion of risks and uncertainties which is not exclusive,
      highlights some important factors to consider when evaluating our trends and
      future results.




10


***Our
      customers’ buying process for our products is highly decentralized, and
      therefore, it typically requires significant time and expense for us to further
      penetrate the potential market of a specific customer, which may delay our
      ability to generate additional revenue.***




Our
      success will depend, in part, on our ability to further penetrate our customer
      base. During 2005, 40.6% of our revenue was attributable to sales to our
      existing customers, compared to 52.7% in 2004. If we are not able to continue
      to
      penetrate our existing customer base, our sales growth will be impaired. Most
      of
      our customers have a decentralized buying process for measurement devices.
      Thus,
      we must spend significant time and resources to increase revenues from a
      specific customer. For example, we may provide products to only one of our
      customers manufacturing facilities or for a specific product line within a
      manufacturing facility. We cannot be certain that we will be able to maintain
      or
      increase the amount of sales to our existing customers.




***Others
      may develop products that make our products obsolete or less competitive.***




The
      CAM2
      market is emerging and could be characterized by rapid technological change.
      Others may develop new or improved products, processes or technologies that
      may
      make our products obsolete or less competitive. We cannot assure you that we
      will be able to adapt to evolving markets and technologies or maintain our
      technological advantage.




Our
      success will depend, in part, on our ability to maintain our technological
      advantage by developing new products and applications and enhancing our existing
      products. Developing new products and applications and enhancing our existing
      products can be complex and time-consuming and will require substantial
      investment by us. Significant delays in new product releases or difficulties
      in
      developing new products could adversely affect our revenues and results of
      operations. Because our customers are concentrated in a few industries, a
      reduction in sales to any one of these industries could cause a significant
      decline in our revenues.




***An
      economic slowdown in manufacturing will affect our growth and profitability.***




A
      significant portion of our sales are to manufacturers in the automotive,
      aerospace and heavy equipment industries. We are dependent upon the continued
      growth, viability and financial stability of our customers in these industries,
      which are highly cyclical and dependent upon the general health of the economy
      and consumer spending. The cyclical nature of these industries may exert
      significant influence on our revenues and results of operations. In addition,
      the volume of orders from our customers and the prices of our products may
      be
      adversely impacted by decreases in capital spending by a significant portion
      of
      our customers during recessionary periods. In addition, we generate significant
      accounts receivable in connection with providing products and services to our
      customers. If one or more of our significant customers were to become insolvent
      or otherwise were unable to pay for the products provided by us, our operating
      results and financial condition would be adversely affected.




***Our
      inability to protect our patents and proprietary rights in the United States
      and
      foreign countries could adversely affect our revenues.***




Our
      success depends in large part on our ability to obtain and maintain patent
      and
      other proprietary right protection for our processes and products in the United
      States and other countries. We also rely upon trade secrets, technical know-how
      and continuing inventions to maintain our competitive position. We seek to
      protect our technology and trade secrets, in part, by confidentiality agreements
      with our employees and contractors. Our employees may breach these agreements
      or
      our trade secrets may otherwise become known or be independently discovered
      by
      inventors. If we are unable to obtain or maintain protection of our patents,
      trade secrets and other proprietary rights, we may not be able to prevent third
      parties from using our proprietary rights.




11


Our
      patent protection involves complex legal and technical questions. Our patents
      may be challenged, narrowed, invalidated or circumvented. We may be able to
      protect our proprietary rights from infringement by third parties only to the
      extent that our proprietary processes and products are covered by valid and
      enforceable patents or are effectively maintained as trade secrets. Furthermore,
      others may independently develop similar or alternative technologies or design
      around our patented technologies. Litigation or other proceedings to defend
      or
      enforce our intellectual property rights could require us to spend significant
      time and money and could otherwise adversely affect our business.




***Claims
      from others that we infringe their intellectual property rights may adversely
      affect our operations.***




From
      time
      to time we receive notices from others claiming we infringe their intellectual
      property rights. The number of these claims may grow. Responding to these claims
      may require us to enter into royalty or licensing agreements on unfavorable
      terms, require us to stop selling or to redesign affected products or require
      us
      to pay damages. Any litigation or interference proceedings, regardless of their
      outcome, may be costly and may require significant time and attention of our
      management and technical personnel.




On
      November 25, 2003, Cimcore-Romer (now a division of Hexagon) filed a patent
      infringement suit against us in the Federal District Court for the Southern
      District of California alleging that certain of our products sold in the United
      States, including the FARO Arm, infringe U.S. Patent 5,829,148 (‘148 patent). A
      summary of this litigation is set forth in Item 3 (Legal Proceedings) of this
      report.




In
      the
      event of an adverse ruling in the Cimcore-Romer litigation, we could be required
      to pay substantial damages, cease the manufacturing, use and sale of any
      infringing products, discontinue the use of certain processes or obtain a
      license, if available, from Cimcore-Romer with royalty payment obligations
      by
      us. At this time, however, the Company cannot estimate the potential impact,
      if
      any, that might result from this suit, and therefore, no provision has been
      made
      to cover such expense.




***We
      may not be able to achieve financial results within our target goals, and our
      operating results may fluctuate due to a number of factors, many of which are
      beyond our control.***




Our
      ability to achieve financial results that are within our goals is subject to
      a
      number of factors, some of which our beyond our control. Moreover, our annual
      and quarterly operating results have varied significantly in the past and likely
      will vary significantly in the future. Factors that cause our financial results
      to fluctuate include those set forth elsewhere in this report and the following:




·
            the
                size and timing of customer orders, many of which are received towards
                the
                end of the quarter;





·
            the
                effectiveness of sales promotions and sales of demonstration
                equipment;





·
            geographic
                expansion in the Asia/Pacific region and other regions and the effects
                of
                governmental or other actions relating to our operations in
                China;





·
            the
                loss of future business in China as a result of, among other things,
                the
                outcome of our investigation into potential violations of the Foreign
                Corrupt Practices Act including the expense, distraction and changes
                in
                personnel, as well as modifications to our business practices and
                compliance programs;


12





·
            training
                and ramp-up time for new sales
                people;





·
            investments
                in technologies and new products;





·
            our
                effective tax rate;





·
            the
                outcomes of the patent infringement lawsuit filed by Cimcore-Romer
                and the
                purported class action lawsuit;





·
            the
                amount of time that it takes to fulfill orders and ship our products;





·
            the
                length of our sales cycle to new customers and the time and expense
                incurred in further penetrating our existing customer base;





·
            increases
                in operating expenses for product development and new product marketing;





·
            costs
                associated with new product introductions, such as assembly line
                start-up
                costs and low introductory period production volumes;





·
            the
                timing and market acceptance of new products and product enhancements;




·
            customer
                order deferrals in anticipation of new products and product enhancements;





·
            our
                success in expanding our sales and marketing programs;





·
            start-up
                costs and ramp-up time associated with opening new sales offices
                outside
                of the United States;





·
            potential
                decreases in revenue without proportionate adjustments in fixed costs;





·
            the
                efficiencies achieved in managing inventories and fixed
                assets;





·
            investments
                in potential acquisitions or strategic sales, product or other
                initiatives;





·
            shrinkage
                or other inventory losses due to product obsolescence, scrap or material
                price changes; and





·
            adverse
                changes in the manufacturing industry and general economic conditions.





Any
      one
      or a combination of these factors could adversely affect our annual and
      quarterly operating results in the future and could cause us to fail to achieve
      our target financial results.




***The
      CAM2 market is an emerging market and our growth depends on the ability of
      our
      products to attain broad market acceptance.***




The
      market for traditional fixed-base CMMs, check fixtures, and other handheld
      measurement tools is mature. Part of our strategy is to continue to displace
      these traditional measurement devices. Displacing traditional measurement
      devices and achieving broad market acceptance of our products requires
      significant effort to convince manufacturers to reevaluate their historical
      measurement procedures and methodologies.




13


Because
      the CAM2 market is emerging, the potential size and growth rate of the CAM2
      market is uncertain and difficult to quantify. If the CAM2 market does not
      continue to expand or does not expand at least as quickly as we anticipate,
      we
      may not be able to continue our sales growth, which also may affect our
      profitability.




We
      market
      six closely interdependent products (Faro Arm, Digital Template, Scan Arm,
      Faro
      Laser Scanner LS, Faro Laser Tracker and Faro Gage) and related software for
      use
      in measurement and inspection applications. Substantially all our revenues
      are
      currently derived from sales of these products and software and we plan to
      continue our business strategy of focusing on the portable software-driven,
      3-D
      measurement and inspection market. Consequently, our financial performance
      will
      depend in large part on portable, computer-based measurement and inspection
      products achieving broad market acceptance. If our products cannot attain broad
      market acceptance, we will not grow as anticipated and may be required to make
      increased expenditures on research and development for new applications or
      new
      products.




***We
      compete with manufacturers of portable measurement systems and traditional
      measurement devices, many of which have more resources than us and may develop
      new products and technologies.***




The
      broad
      market for measurement devices is highly competitive. In the Faro Gage product
      line, we compete with manufacturers of handheld measurement tools and fixed-base
      CMMs, including some large, well-established companies. In the Faro Arm, Faro
      Scan Arm, Faro Laser Tracker, and Faro Laser Scanner LS product lines, we
      compete primarily with Hexagon Metrology, a division of Hexagon. We also compete
      in these product lines with a number of other smaller competitors.




We
      will
      be required to make continued investments in technology and product development
      to maintain the technological advantage that we believe we currently have over
      our competition. Some of our competitors, including some manufacturers of fixed
      based CMMs and Hexagon, possess substantially greater financial, technical,
      and
      marketing resources than we possess. Moreover, we cannot be certain that our
      technology or our product development efforts will allow us to successfully
      compete as the industry evolves. As the market for our portable measurement
      systems expands, additional competition may emerge and the Company’s existing
      and future competitors may commit more resources to the markets in which the
      Company participates. For example, fixed-base CMM manufacturers are introducing
      CAD-based inspection software in response to the trend toward CAD-based factory
      floor metrology. In addition, some fixed-base CMM manufacturers are
      miniaturizing and increasing the mobility of their conventional CMMs.




***We
      derive a substantial part of our revenues from our international operations,
      which are subject to greater volatility and often require more management time
      and expense to achieve profitability than our domestic operations.***




Since
      2000, we have derived approximately half of our sales from international
      operations. In our experience, entry into new international markets requires
      considerable management time as well as start-up expenses for market
      development, hiring and establishing office facilities before any significant
      revenues are generated. As a result, initial operations in a new market may
      operate at low margins or may be unprofitable.




14


Our
      international operations are subject to various risks, including:




·
            difficulties
                in staffing and managing foreign operations;





·
            political
                and economic instability;





·
            unexpected
                changes in regulatory requirements and laws;





·
            longer
                customer payment cycles and difficulty collecting accounts receivable;





·
            export
                duties, import controls and trade restrictions;





·
            governmental
                restrictions on the transfer of funds to us from our operations outside
                the United States;





·
            burdens
                of complying with a wide variety of foreign laws and labor practices;
                and





·
            fluctuations
                in currency exchange rates.





Because
      our foreign subsidiaries maintain their financial records and statements in
      their respective local currencies, our consolidated financial results are
      affected by foreign currency translation adjustments. Moreover, several of
      the
      countries where we operate have emerging or developing economies, which may
      be
      subject to greater currency volatility, negative growth, high inflation, limited
      availability of foreign exchange and other risks. These factors may harm our
      results of operations and any measures that we may implement to reduce the
      effect of volatile currencies and other risks of our international operations
      may not be effective.




In
      addition, our foreign operations are subject to the Foreign Corrupt Practices
      Act, which makes illegal any payments to foreign officials or employees of
      foreign governments that are intended to induce them to use their influence
      to
      assist us or to gain any improper advantage for us. As previously reported
      on
      the Company’s Form 8-K dated March 15, 2006, the Company learned that its China
      subsidiary had made payments to certain customers in China that may have
      violated the Foreign Corrupt Practices Act and other applicable laws. We
      voluntarily notified the United States Securities and Exchange Commission
      (“SEC”) and the United States Department of Justice (“DOJ”) of this matter. If
      the SEC or the DOJ determines that violations of the FCPA have occurred, they
      could seek civil and criminal sanctions, including monetary penalties, against
      the Company and/or certain of its employees, as well as additional changes
      to
      the Company’s business practices and compliance programs, any of which could
      have a material adverse effect on the Company business and financial condition.
      In addition, such actions, whether actual or alleged, could damage our
      reputation and ability to do business. Further, detecting, investigating, and
      resolving such actions is expensive and could consume significant time and
      attention of our senior management.




***We
      may not be able to identify, consummate or achieve expected benefits from
      acquisitions.***




We
      have
      completed three significant acquisitions since our initial public offering
      in
      1997. We may pursue access to additional technologies, complementary product
      lines and sales channels through selective acquisitions and strategic
      investments. We may not be able to identify and successfully negotiate suitable
      acquisitions, obtain financing for future acquisitions on satisfactory terms
      or
      otherwise complete acquisitions in the future. In the past we have used our
      stock as consideration for acquisitions. Our common stock may not remain at
      a
      price at which it can be used as consideration for acquisitions without diluting
      our existing shareholders, and potential acquisition candidates may not view
      our
      stock attractively.




15


Realization
      of the benefits of acquisitions often requires integration of some or all of
      the
      acquired companies’ sales and marketing, distribution, manufacturing,
      engineering, finance and administrative organizations. The integration of
      acquisitions demands substantial attention from senior management and the
      management of the acquired companies. Any acquisition may be subject to a
      variety of risks and uncertainties including:




·
            the
                inability to assimilate effectively the operations, products, technologies
                and personnel of the acquired companies (some of which may be located
                in
                diverse geographic regions);





·
            the
                inability to maintain uniform standards, controls, procedures and
                policies;





·
            the
                need or obligation to divest portions of the acquired companies;
                and





·
            the
                potential impairment of relationships with customers.





We
      cannot
      assure you that we will be able to integrate successfully any acquisitions,
      that
      any acquired companies will operate profitably or that we will realize the
      expected benefits from any acquisition.




***We
      may face difficulties managing growth.***




If
      our
      business continues to grow rapidly in the future, we expect it to result
      in :




·
            increased
                complexity





·
            increased
                responsibility for existing and new management personnel; and





·
            incremental
                strain on our operations and financial and management systems.





If
      we are
      not able to manage future growth, our business, financial condition and
      operating results may be harmed.




***Our
      dependence on suppliers for materials could impair our ability to manufacture
      our products.***




Outside
      vendors provide key components used by us in the manufacture of our products.
      Although we believe that alternative sources for these components are available,
      any supply interruption in a limited source component would harm our ability
      to
      manufacture our products until a new source of supply is identified. In
      addition, an uncorrected defect or supplier’s variation in a component, either
      known or unknown to us, or incompatible with our manufacturing processes, could
      harm our ability to manufacture our products. We may not be able to find a
      sufficient alternative supplier in a reasonable period, or on commercially
      reasonable terms, if at all. If we fail to obtain a supplier for the manufacture
      of components of our potential products, we may experience delays or
      interruptions in our operations, which would adversely affect our results of
      operations and financial condition.




***We
      may experience volatility in our stock price.***




The
      price
      of our common stock has been, and may continue to be, highly volatile in
      response to various factors, many of which are beyond our control, including:




·
            developments
                in the industries in which we operate;





·
            actual
                or anticipated variations in quarterly or annual operating results;


16





·
            speculation
                in the press or investment community; and





·
            announcements
                of technological innovations or new products by us or our competitors.





Our
      common stock’s market price may also be affected by our inability to meet
      analyst and investor expectations and failure to achieve projected financial
      results. Any failure to meet such expectations or projected financial results,
      even if minor, could cause the market price of our common stock to decline.
      Volatility in our stock price may result in your inability to sell your shares
      at or above the price at which you purchased them.




In
      addition, stock markets have generally experienced a high level of price and
      volume volatility, and the market prices of equity securities of many companies
      have experienced wide price fluctuations not necessarily related to the
      operating performance of such companies. These broad market fluctuations may
      adversely affect our common stock’s market price. In the past, securities class
      action lawsuits frequently have been instituted against such companies following
      periods of volatility in the market price of such companies’ securities. If any
      such litigation is instigated against us, it could result in substantial costs
      and a diversion of management’s attention and resources, which could have a
      material adverse effect on our business, results of operations and financial
      condition.




***We
      are a defendant in several shareholder class-action
      lawsuits.***




We
      and
      certain of our officers were named as defendants in
      purported class action complaints filed in the United States District Court
      for
      the Middle District of Florida, Orlando Division. The lead plaintiff in the
      securities litigation seeks an unspecified amount of damages, premised on
      allegations that each defendant made misrepresentations and omissions of
      material fact during the class period in violation of the Securities Exchange
      Act of 1934. A summary of the securities litigation is set forth in Item 3
      (Legal Proceedings) of this report. Although the Company believes that the
      material allegations made in the amended complaint are without merit and intends
      to vigorously defend the securities litigation, no assurances can be given
      with
      respect to the outcome of the securities litigation.




***Anti-takeover
      provisions in our articles of incorporation, our bylaws and provisions of
      Florida law could delay or prevent a change of control that you*** ***may
      favor.***




Our
      articles of incorporation, our bylaws and provisions of Florida law could make
      it more difficult for a third party to acquire us, even if doing so would be
      beneficial to you. These provisions could discourage potential takeover attempts
      and could adversely affect the market price of our shares. Because of these
      provisions, you might not be able to receive a premium on your investment.
      These
      provisions include:




·
            a
                limitation on shareholders’ ability to call a special meeting of our
                shareholders;





·
            advance
                notice requirements to nominate directors for election to our board
                of
                directors or to propose matters that can be acted on by shareholders
                at
                shareholder meetings;





·
            our
                classified board of directors, which means that approximately one-third
                of
                our directors are elected each year;
                and





·
            the
                authority of the board of directors to issue, without shareholder
                approval, preferred stock with such terms as the board of directors
                may
                determine.




17


The
      provisions described above could delay or make more difficult transactions
      involving a change in control of us, or our management.




**ITEM
                  1B.**
            **UNRESOLVED
                  STAFF
                  COMMENTS.**




We
      had no
      comments from the Securities and Exchange Commission staff regarding the
      Company’s periodic or current reports under the Securities Exchange Act of 1934
      that were unresolved as of the date of filing of this report.




**ITEM
                  2.**
            **PROPERTIES.**




**The
      Americas**




The
      Company’s headquarters are located in a leased building in Lake Mary, Florida
      containing approximately 35,000 square feet. This facility houses the Company’s
      U.S. production, research and development, administrative staff and customer
      service/application operations. The Company’s U.S. sales and marketing
      headquarters is in a leased building in Lake Mary, Florida consisting
      approximately 8,200 square feet. Additionally, the Company has a leased facility
      consisting of two buildings totaling approximately 37,000 square feet located
      in
      Kennett Square, Pennsylvania containing research and development, manufacturing
      and service operations of the laser tracker product lines.




**Europe/Africa**




The
      Company’s European headquarters are located in a leased building in Stuttgart,
      Germany containing approximately 62,000 square feet. This facility houses the
      manufacturing, administration, sales, marketing and service management personnel
      for the Company’s European operations. Additionally the Company has a leased
      facility consisting of approximately 16,000 square feet located in Schaffhausen,
      Switzerland containing manufacturing operations for the Company’s products,
      which are shipped to customers in Europe, Africa and Asia.




**Asia/Pacific**




The
      Company’s Asian headquarters are located in a leased building in Singapore
      containing approximately 22,000 square feet. This facility houses the
      administration, sales, marketing, production and service management personnel
      for the Company’s Asian operations. The Company’s Japan headquarters are located
      in a leased building in Nagoya, Japan containing approximately 5,000 square
      feet. This facility houses the Company’s Japan sales, marketing and service
      operations. The Company’s China headquarters are located in a leased building in
      Shanghai, China containing approximately 11,000 square feet for sales, marketing
      and service operations.




The
      Company believes that its current facilities will be adequate for its
      foreseeable needs and that it will be able to locate suitable space for
      additional regional offices or enhanced production needs as necessary.




The
      information required by the remainder of this item is incorporated herein by
      reference to Exhibit 99.1 attached hereto.




**ITEM
                  3.**
            **LEGAL
                  PROCEEDINGS.**




***Cimcore-Romer
      Litigation -*** On
      November 25, 2003, Cimcore-Romer (now a division of Hexagon) filed a patent
      infringement suit against us in the Federal District Court for the Southern
      District of California alleging that certain of our products sold in the United
      States, including the FARO Arm, infringe U.S. Patent 5,829,148 (‘148 patent).
      The Company believes, and has contended in this litigation, that the Company
      does not infringe the ‘148 patent and that the ‘148 patent is
      invalid.




18


On
      July
      12, 2005, the court issued an order granting Cimcore-Romer’s motion for summary
      judgment of infringement of three claims of the ‘148 patent. On July 22, 2005,
      the Company announced its decision to limit the capability of its U.S.-based
      FARO Arm products (the FARO Arm, the FARO Gage and the Digital Template) by
      removing what we call the “infinite rotation feature” by reducing this
      capability to 50 rotations or fewer. FARO believes that by limiting the range
      of
      the joint rotation to 50 rotations, it has removed from its U.S. products the
      ability to sweep through an unlimited arc, which is a feature of the ‘148 patent
      claims addressed by the court’s ruling required to infringe the ‘148 patent. The
      revised products have not, however, been considered by the courts. Accordingly,
      we cannot give assurance that the revised products will not be deemed to
      infringe the ‘148 patent.




On
      September 20, 2005, the Court vacated its order of summary judgment of
      infringement and agreed to reconsider its conclusions from the patent claim
      construction (“Markman”) ruling, which is a pretrial hearing often used in
      patent infringement cases. The new Markman hearing occurred on October 3, 2005
      and the hearing-on-summary judgments of infringement occurred on November 14,
      2005. On October 18, 2005, the Court issued a revised claim construction that
      the Company believes materially alters the Court’s previous Markman ruling by
      substantially narrowing what FARO believes to be key aspects of the claim
      construction. The Company believes that this narrower claim construction will
      ultimately lead to a finding that it does not infringe any claim of the ‘148
      patent. On November 14, 2005, the Court denied both the Plaintiffs’ Renewed
      Motion for Summary Judgment of Infringement and the Defendant’s Faro’s Renewed
      Motion for Summary Judgment of Non-Infringement, and determined that there
      existed a genuine issue of material fact with respect to whether Faro infringed
      the assert patent. The case was originally set for trial for January 31, 2006.
      On January 18, 2006, the Court vacated the trial date and remanded the case
      to
      the magistrate for resumption of discovery regarding Plaintiffs’ alleged
      compliance with the patent marking provisions of 35 U.S.C. § 287 and all related
      issues. A hearing on Faro’s Motion for Partial Summary Judgment Regarding
      Plaintiffs’ Failure to Comply With the Patent Marking Provisions of 35 U.S.C. §
287 was held on May 11, 2006. A new trial date has been set for July 17,
      2006.




In
      addition, the Company filed two separate requests for reexamination in the
      U.S.
      Patent and Trademark Office (“PTO”) of the ‘148 Patent, both of which requests
      were granted. The PTO ruled in the first reexamination in September 2005. The
      Company believes that the PTO ruling bolsters the Company’s previous position
      that it does not infringe the ‘148 patent. More specifically, in the first
      reexamination, the PTO construed critical claim terms in a relatively narrow
      manner, which the Company believes is consistent with its stated positions
      in
      the patent litigation. This narrow claim construction led the PTO to
      differentiate the claims for the references at issue in the first reexamination.
      The Company believes that this narrow construction, while allowing the ‘148
      claims to be confirmed valid over the aforementioned references in the first
      reexamination, will prevent the California District Court from ruling that
      Faro’s products infringe the ‘148 patent. The Company’s second reexamination
      request was granted by the PTO in November 2005 and is based on new “prior art”
(that is, earlier issued patent publications) submitted to the PTO which FARO
      believes will ultimately invalidate the ‘148 patent. This prior art reference
      was not at issue in the first reexamination proceeding. The PTO has not ruled
      in
      the second reexamination request.




In
      the
      event of an adverse ruling in the Cimcore-Romer litigation, however, we could
      be
      required to pay substantial damages, cease the manufacturing, use and sale
      of
      any infringing products, discontinue the use of certain processes or obtain
      a
      license, if available, from Cimcore-Romer with royalty payment obligations
      by
      us. An adverse decision in the Cimcore-Romer case could materially and adversely
      affect our financial condition and results of operations. At this time, however,
      the Company cannot estimate the potential impact, if any, that might result
      from
      this suit, and therefore, no provision has been made to cover such
      expense.




19


***Securities
      Litigation -*** On
      December 6, 2005, the first of four essentially identical class action
      securities fraud lawsuits were filed against the Company and certain officers
      of
      the Company (the “Securities Litigation”). On April 19, 2006, the four lawsuits
      were consolidated, and Kornitzer Capital Management, Inc. was appointed as
      the
      lead plaintiff. On May 16, 2006, Kornitzer filed its Consolidated Amended Class
      Action Complaint against the Company and the individual defendents. The amended
      complaint also names Grant Thornton LLP, the Company’s independent registered
      public accounting firm, as an additional defendant.




In
      the
      amended complaint, Kornitzer seeks to represent a class consisting of all
      persons who purchased or otherwise acquired the Company’s publicly traded
      securities between April 15, 2004 and March 15, 2006. On behalf of the alleged
      class, Kornitzer seeks an unspecified amount of damages, premised on allegations
      that each defendant made misrepresentations and omissions of material fact
      during the class period in violation of the Securities Exchange Act of 1934.
      Among other things, Kornitzer alleges that the Company’s reported gross margins
      and net income were knowingly overstated as a result of manipulation of the
      Company’s inventory levels, that the Company failed to disclose deficiencies
      associated with the Company’s implementation and use of its enterprise resource
      planning system and material requirements planning system, made false and
      misleading statements regarding the Company’s internal controls, failed to
      disclose the fact that the Company was accruing commissions and bonuses which
      would have a material, adverse effect upon the Company’s profitability, and
      improperly reported sales and net income based, in part, on sales and new orders
      obtained in violation of the Foreign Corrupt Practices Act.




The
      Company’s deadline for filing its response to the amended complaint is July 31,
      2006. The Company has timely notified the issuer of its Executive Liability
      and
      Entity Securities Liability insurance policy of the Securities Litigation,
      and
      has reserved the full amount of its $250,000 retention under the policy. The
      Company intends to file a motion to dismiss. Although the Company believes
      that
      the material allegations made in the amended complaint are without merit and
      intends to vigorously defend the Securities Litigation, no assurances can be
      given with respect to the outcome of the Securities Litigation.




***Voluntary
      Disclosure of Foreign Corrupt Practices Act Matter to the Securities and
      Exchange Commissions and Department of Justice*** - As
      previously reported on the Company’s Form 8-K dated March 15, 2006, the Company
      learned that its China subsidiary had made payments to certain customers in
      China that may have violated the FCPA and other applicable laws. The Company’s
      Audit Committee instituted an internal investigation into this matter in
      February 2006, and the Company voluntarily notified the SEC and the DOJ of
      this
      matter in March 2006. The internal investigation into this matter has been
      completed. The Company has provided to the SEC and the DOJ information obtained
      during the course of this investigation and is cooperating with both agencies.




The
      Company’s internal investigation has identified certain improper payments made
      in China and deficiencies in its controls with respect to its operations in
      China in possible violation of the FCPA. If the SEC or the DOJ determines that
      violations of the FCPA have occurred, they could seek civil and criminal
      sanctions, including monetary penalties, against the Company and/or certain
      of
      its employees, as well as additional changes to the Company’s business practices
      and compliance programs. Based on current information, it is not possible to
      predict at this time when the SEC or DOJ investigations will be resolved, what
      the outcome will be, what sanctions, if any, will be imposed, or the effect
      that
      such matters may ultimately have on the Company or its consolidated financial
      statements. Results of the investigation revealed that referral fee payments
      in
      possible violation of the FCPA were $165,000 and $265,000 in 2004 and 2005,
      respectively, which were recorded in selling expenses in the Company’s statement
      of income. The related sales to customers to which payment of these referral
      fees had been made totaled approximately $1.3 million and $3.24 million in
      2004
      and 2005, respectively. Additional improper referral fee payments of $122,000
      were made in January and February 2006 related to sales contracts in 2005.
      The
      Company anticipates incurring expenses of at least $3.5 million in 2006 relating
      to its internal investigation of the FCPA matter.




20


The
      Company has terminated certain personnel in the Asia-Pacific Region and has
      re-assigned the duties of other personnel in both the Asia-Pacific Region and
      the U.S. as a result of the internal investigation. The Company is instituting
      the following remedial measures:




·
            Contracted
                with a third party forensics accounting team to conduct an in-depth
                audit
                of the operations in China and in other countries in the Asia-Pacific
                region and to make recommendations for improvement to the internal
                control
                systems.




·
            Reviewing
                third party distributor arrangements in an effort to assure that
                all
                contracts include adherence to the FCPA.




·
            Performing
                due diligence on all third party distributors and implementing a
                process
                to assess potential new distributors.




·
            Established
                an in-house internal audit function including hiring a Director of
                Internal Audit.




·
            Consolidating
                the human resources, financial accounting and reporting functions
                for the
                Asia region into the Singapore
                Operations.




·
            Implemented
                an internal certification process to ascertain whether similar issues
                may
                exist elsewhere in the Company.




·
            Implemented
                a quarterly internal certification process to confirm adherence to
                company
                policy and all applicable laws and regulations that will include
                all
                regional leadership, country management and other sales
                management.




·
            Implementing
                additional training on FCPA and other matters for employees and a
                confidential compliance reporting
                system.




The
      Company reported sales in China of $9.0 million in 2005 and $4.2 million in
      2004, approximately 7% and 4% of total sales, respectively. Depending on how
      this matter is resolved, the Company’s sales in China could be significantly
      impacted. The termination of certain personnel and cessation of improper
      payments in China may have a significant adverse effect on future operations
      in
      China because such action could negatively influence the decisions of a
      significant number of customers of the Chinese subsidiary to do business with
      that subsidiary. The potential magnitude of the loss of sales in China as a
      result of potential violations of the FCPA cannot be estimated at this
      time.




During
      the Company’s internal investigation of its business practices in China, it
      became aware that income taxes related to certain commissions and bonus payments
      to its employees had not been properly reported. The Company will promptly
      remit
      any deficiencies after it has completed its investigation. At this time, the
      Company does not anticipate the amount will have a material effect on its
      financial condition or results of operations. The Company may be subject to
      penalties by the Chinese tax authorities, but we are not able to determine
      the
      amount, if any, of the assessment.




21


Other
      than the litigation mentioned above, the Company is not involved in any other
      legal proceedings other than routine litigation arising in the normal course
      of
      business. The Company does not believe the results of such litigation, even
      if
      the outcome were unfavorable to the Company, would have a material adverse
      effect on the Company’s business, financial condition or results of
      operations.




**ITEM
                  4.**
            **SUBMISSIONOF
                  MATTERSTO
                  A VOTEOF
                  SECURITY
                  HOLDERS.**




No
      matters were submitted to a vote of security holders during the fourth quarter
      of 2005.




22


**PART
        II**
 **I****TEM****5.**
                **M****ARKET****F****OR
                    REGISTRANT’S****C****OMMON****E****QUITY
                    AND****R****ELATED****S****TOCKHOLDER****M****ATTERS.**
 The
        Company’s common stock, par value $.001 per share, began trading on the NASDAQ
        Stock Market in September 1997 under the symbol FARO. Before that date, there
        was no established public trading market for the common stock. The following
        table sets forth the high and low sale price of the Company’s common stock for
        its two most recent fiscal years:
  **2005**
              
              **2004****High**
              
              **Low**
              
              **High**
              
              **Low**First
                  Quarter
              
              
              30.33
              
              
              22.85
              
              
              33.23
              
              
              20.27Second
                  Quarter
              
              
              30.31
              
              
              24.11
              
              
              27.89
              
              
              17.63Third
                  Quarter
              
              
              28.37
              
              
              19.14
              
              
              24.60
              
              
              18.62Fourth
                  Quarter
              
              
              22.47
              
              
              16.50
              
              
              31.85
              
              
              20.55
  The
        Company has not paid any cash dividends on its common stock to date. The
        payment
        of dividends, if any, in the future is within the discretion of the Board
        of
        Directors and will depend on the Company’s earnings, its capital requirements
        and financial condition, and may be restricted by future credit arrangements
        entered into by the Company. The Company expects to retain future earnings
        for
        use in operating and expanding its business and does not anticipate paying
        any
        cash dividends in the reasonably foreseeable future. As of June 19, 2006
        the
        last sale price of the Company’s common stock was $12.89, and there were 74
        holders of record of common stock. The Company believes that there are a
        significantly larger number of beneficial owners of its common
        stock.
  On
        November 12, 2003, the Company sold 1,158,000 shares of its common stock,
        and
        two of the Company’s founders sold 772,000 shares of the Company’s common stock
        to institutional investors in a private placement that was not registered
        under
        the Securities Act of 1933. The shares were sold for $21.50 per share, resulting
        in total proceeds before placement agent fees and other offering expenses
        of
        $24.9 million and $16.6 million to the Company and the co-founders,
        respectively. The purchasers of the shares sold in the transaction were 31
        institutional investors. Robert W. Baird & Co. served as the placement agent
        for the transaction, and received a fee equal to $2,489,700, or 6% of the
        aggregate sales proceeds. The Company also reimbursed Robert W. Baird & Co.
        for $50,000 in expenses incurred in connection with the transaction.  The
        private placement transaction was exempt from registration under the Securities
        Act of 1933, as amended, pursuant to section 4(2) thereof and Rule 506 under
        Regulation D promulgated by the Securities and Exchange Commission there
        under.
        These exemptions were available for the private placement transaction on
        the
        basis that the transaction did not involve a public offering and satisfied
        each
        of the criteria under Rule 506 of Regulation D.
  On
        January 10, 2005, the Company filed a Registration Statement on Form S-3
        with
        the Securities and Exchange Commission allowing it to raise proceeds of up
        to
        $125 million. The proceeds from any offerings with respect to this registration
        statement, if any, would be used for either repayment or refinancing of debt,
        acquisition of additional businesses or technologies or for working capital
        and
        general corporate purposes. To date, we have not raised any capital under
        this
        Form S-3 Registration Statement. The Company must file in a timely manner
        all
        reports under the Securities and Exchange Act of 1934 (with certain exceptions)
        with the SEC for a period of 12 months in order to be able to use its S-3
        registration statement.
  23
  **I****TEM
                    6.**
                **S****ELECTED****F****INANCIAL****D****ATA.**
  **Historical
                  -Year ended December 31,**in
                  thousands, except share and per-share data
              
              **2005**
              
              **2004**
              
              **2003**
              
              **2002**
              
              **2001****Statement
                  of Operations Data:**Sales
              
              $
              125,590
              
              $
              97,020
              
              $
              71,786
              
              $
              46,246
              
              $
              36,122Gross
                  profit
              
              
              72,932
              
              
              59,996
              
              
              42,266
              
              
              25,137
              
              
              21,818Income
                  (loss) from operations
              
              
              10,226
              
              
              14,584
              
              
              7,440
              
              
              (2,939
              )
              
              (3,362
              )Income
                  (loss) before income taxes
              
              
              9,898
              
              
              15,289
              
              
              9,436
              (1)
              
              (1,805
              )
              
              (2,506
              )Net
                  income (loss)
              
              
              8,179
              
              
              14,931
              
              
              8,278
              
              
              (2,016
              )
              
              (2,848
              )Net
                  income (loss) per common share:Basic
              
              $
              0.58
              
              $
              1.08
              
              $
              0.68
              
              $
              (0.17
              )
              $
              (0.26
              )Diluted
              
              $
              0.57
              
              $
              1.06
              
              $
              0.64
              
              $
              (0.17
              )
              $
              (0.26
              )Weighted
                  average common sharesoutstanding:Basic
              
              
              14,169,140
              
              
              13,833,590
              
              
              12,181,221
              
              
              11,853,732
              
              
              11,032,449Diluted
              
              
              14,442,248
              
              
              14,023,159
              
              
              12,845,992
              
              
              11,853,732
              
              
              11,032,449
  **Historical
                  - as at December 31,****2005**
              
              **2004**
              
              **2003**
              
              **2002**
              
              **2001****Consolidated
                  Balance Sheet Data:**Working
                  capital
              
              $
              64,619
              
              $
              65,686
              
              $
              51,368
              
              $
              18,339
              
              $
              22,303Total
                  assets
              
              
              122,648
              
              
              105,078
              
              
              81,914
              
              
              45,195
              
              
              39,654Total
                  debt
              
              
              340
              
              
              250
              
              
              107
              
              
              1,556
              
              
              81Total
                  shareholders’ equity
              
              
              98,860
              
              
              89,158
              
              
              68,921
              
              
              33,384
              
              
              32,336
  (1)
        Includes a favorable legal settlement of $1.1 million in other
        income.
 **I****TEM
                    7.**
                **M****ANAGEMENT’S****D****ISCUSSION
                    AND****A****NALYSIS
                    OF****F****INANCIAL****C****ONDITION
                    AND****R****ESULTS
                    OF****O****PERATIONS.**
 The
        following information should be read in conjunction with the Consolidated
        Financial Statements of the Company, including the notes thereto, included
        elsewhere in this document.
  **Overview**
  We
        design, develop, manufacture, market and support portable, software driven,
        3-D
        measurement systems that are used in a broad range of manufacturing, industrial,
        building construction and forensic applications. The Company’s Faro Arm, Faro
        Scan Arm and Faro Gage articulated measuring devices, the Faro Laser Tracker,
        and their companion CAM2 software, provide for Computer-Aided Design (CAD)-based
        inspection and/or factory-level statistical process control. Together, these
        products integrate the measurement, quality inspection, and reverse engineering
        functions with CAD software to improve productivity, enhance product quality
        and
        decrease rework and scrap in the manufacturing process. The Company uses
        the
        acronym “CAM2” for this process, which stands for computer-aided manufacturing
        measurement. The Company’s Digital Template articulated measuring device and its
        related software are used to measure the shape of existing counter tops and
        other structures in residential or commercial buildings to provide the data
        required to manufacture replacement countertops or other structures. The
        Digital
        Template reduces the time required to measure these existing products and
        to
        provide the data to manufacturing machines to create the replacement structures,
        compared to traditional techniques. In March 2005 the Company acquired
        iQvolution AG, a German designer, developer and manufacturer of a portable
        laser-based device for measuring the detailed composition of factories, oil
        refineries and other structures. This device and its related software, which
        the
        Company sells under the product name Laser Scanner LS also has forensic
        applications such as capturing detailed 3-D crime scene information. As of
        June
        2006, the Company’s products have been purchased by approximately 4,900
        customers worldwide, ranging from small machine shops to such large
        manufacturing and industrial companies as Audi, Bell Helicopter, Boeing,
        British
        Aerospace, Caterpillar, Daimler Chrysler, General Electric, General Motors,
        Honda, Johnson Controls, Komatsu Dresser, Lockheed Martin, Nissan, Siemens
        and
        Volkswagen, among many others.
  24
  We
        continue to pursue international markets. We established sales offices in
        France
        and Germany in 1996, Great Britain in 1997, Japan and Spain in 2000, Italy
        in
        2001, and China in 2003. We opened sales offices in South Korea and India
        in
        2004. We established sales offices in Poland, Netherlands, Malaysia, Vietnam,
        and Singapore in 2005 and added a new regional headquarters in Singapore
        in the
        third quarter of 2005 along with a new manufacturing and service facility
        there
        in the fourth quarter of 2005. In 2003 we began to manage and report our
        global
        sales in three regions: the Americas, Europe/Africa and Asia/Pacific. In
        2005,
        44.5% of our sales were in the Americas compared to 43.0% in 2004, 35.7%
        were in
        the Europe/Africa region compared to 44.4% in 2004 and 19.7% were in the
        Asia/Pacific region, compared to 12.6% in 2004 (see also Note 20 Geographic
        Data
        to the financial statements below).
  We
        derive
        revenues primarily from the sale of our Faro Arm, Faro Scan Arm, Faro Gage,
        Faro
        Laser Tracker and Faro Laser Scanner LS 3-D measurement equipment, and their
        related multi-faceted software. Revenue related to these products is recognized
        upon shipment. In addition, we sell one and three-year extended warranties
        and
        training and technology consulting services relating to our products. We
        recognize the revenue from extended warranties on a straight-line basis.
        We also
        receive royalties from licensing agreements for our historical medical
        technology and generally recognize the revenue from these royalties as licensees
        use the technology.
  In
        2003,
        we began to manufacture our Faro Arm products in Switzerland for customer
        orders
        from the Europe/Africa and Asia/Pacific regions. We began to manufacture
        our
        Faro Gage product, and parts of our Faro Laser Tracker product in our Swiss
        plant in the third quarter of 2004. We began complete production of the Faro
        Laser Tracker product in our Swiss plant in 2005. We began to manufacture
        our
        Faro Arm products in our Singapore plant in the fourth quarter of 2005 and
        expect to begin production of our Faro Gage and Faro Laser Tracker there
        in the
        first half of 2006. We expect our Singapore plant will take over from our
        Swiss
        plant in supplying our Asia/Pacific region’s needs for these products. The
        manufacture of these products for customer orders from the Americas will
        be done
        in our manufacturing facilities located in Florida and Pennsylvania. Our
        Faro
        Laser Scanner LS product is currently manufactured in our new German facility,
        located in Stuttgart. We expect all our existing plants to have the production
        capacity necessary to support our growth, at least through 2006.
  As
        previously reported on the Company’s Form 8-K dated March 15, 2006, the Company
        learned that its China subsidiary had made payments to certain customers
        in
        China that may have violated the FCPA and other applicable laws. The Company’s
        Audit Committee instituted an internal investigation into this matter in
        February 2006, and the Company voluntarily notified the SEC and the DOJ of
        this
        matter in March 2006. The internal investigation into this matter has been
        completed. The Company has provided to the SEC and the DOJ information obtained
        during the course of this investigation and is cooperating with both agencies.
  25
  The
        Company’s internal investigation has identified certain improper payments made
        in China and deficiencies in its controls with respect to its operations
        in
        China in possible violation of the FCPA. If the SEC or the DOJ determines
        that
        violations of the FCPA have occurred, they could seek civil and criminal
        sanctions, including monetary penalties, against the Company and/or certain
        of
        its employees, as well as additional changes to the Company’s business practices
        and compliance programs. Based on current information, it is not possible
        to
        predict at this time when the SEC or DOJ investigations will be resolved,
        what
        the outcome will be, what sanctions, if any, will be imposed, or the effect
        that
        such matters may ultimately have on the Company or its consolidated financial
        statements. Results of the investigation revealed that referral fee payments
        in
        possible violation of the FCPA were $165,000 and $265,000 in 2004 and 2005,
        respectively, which were recorded in selling expenses in the Company’s statement
        of income. The related sales to customers to which payment of these referral
        fees had been made totaled $1.3 million and $3.24 million in 2004 and 2005,
        respectively. Additional improper referral fee payments of $122,000 were
        made in
        January and February 2006 related to sales contracts in 2005. The Company
        anticipates incurring expenses of at least $3.5 million in 2006 relating to its
        internal investigation of the FCPA matter.
  The
        Company has terminated certain personnel in the Asia-Pacific Region and has
        re-assigned the duties of other personnel in both the Asia-Pacific Region
        and
        the U.S. as a result of the internal investigation. The Company is instituting
        the following remedial measures:
  ·
            Contracted
                with a third party forensics accounting team to conduct an in-depth
                audit
                of the operations in China and in other countries in the Asia-Pacific
                region and to make recommendations for improvement to the internal
                control
                systems.  ·
            Reviewing
                third party distributor arrangements in an effort to assure that
                all
                contracts include adherence to the FCPA.  ·
            Performing
                due diligence on all third party distributors and implementing a
                process
                to assess potential new distributors.  ·
            Established
                an in-house internal audit function including hiring a Director of
                Internal Audit.  ·
            Consolidating
                the human resources, financial accounting and reporting functions
                for the
                Asia region into the Singapore
                Operations.  ·
            Implemented
                an internal certification process to ascertain whether similar issues
                may
                exist elsewhere in the Company.  ·
            Implemented
                a quarterly internal certification process to confirm adherence to
                company
                policy and all applicable laws and regulations that will include
                all
                regional leadership, country management and other sales management.  ·
            Implementing
                additional training on FCPA and other matters for employees and a
                confidential compliance reporting system. 
 The
        Company had sales in China of $9.0 million in 2005 and $4.2 million in 2004,
        approximately 7% and 4% of total sales, respectively. Depending on how this
        matter is resolved, the Company’s sales in China could be significantly
        impacted. The termination of certain personnel and the cessation of improper
        payments in China may have a significant adverse effect on future operations
        in
        China because such action could negatively influence the decisions of a
        significant number of customers of the Chinese subsidiary to do business
        with
        that subsidiary. The potential magnitude of the loss of sales in China as
        a
        result of potential violations of the Foreign Corrupt Practices Act cannot
        be
        estimated at this time.
  26
  During
        the Company’s internal investigation of its business practices in China, it
        became aware that income taxes related to certain commissions and bonus payments
        to its employees had not been properly reported. The Company will promptly
        remit
        any deficiencies after it has completed its investigation. At this time,
        the
        Company does not anticipate the amount will have a material effect on its
        financial condition or results of operations. The Company may be subject
        to
        penalties by the Chinese tax authorities, but we are not able to determine
        the
        amount, if any, of the assessment.
  With
        respect to the financial performance in 2005, cost of sales consists primarily
        of material, production overhead and labor. Since our IPO in 1997, annual
        gross
        margin has been in the range of 54%-64% of sales. Gross margin for fiscal
        2005
        was within that range at 58.1%.
  Selling
        expenses as a percentage of sales grew significantly in 2005 to 29.7% compared
        to 26.7% in 2004. The higher percentage in 2005 was due to the addition of
        new
        sales personnel and related costs while the additional sales people become
        fully
        trained and productive.
  General
        and administrative expenses consist primarily of salaries for administrative
        personnel, rent, utilities and professional and legal expenses. General and
        administrative expenses were higher in 2005 due in part to an increase in
        professional and legal expenses of approximately $2.0 million directly related
        to increased patent litigation costs, compliance with Sarbanes-Oxley section
        404
        regarding internal controls and procedures and professional and legal fees
        resulting from the internal investigation in China.
  Research
        and development expenses represent salaries, equipment and third-party services.
        We have a commitment to support ongoing research and development and intend
        to
        continue to fund these efforts at the level of 5-7% of sales going
        forward.
  We
        expect
        to incur minimal expenses in 2006 as calculated under the Black-Scholes method
        of SFAS 123, related to our adoption of SFAS 123(R) for the expensing of
        stock
        options as we vested substantially all of our unvested options in the fourth
        quarter of 2005. The reduction in pre-tax charges estimated by the Company
        as a
        result of the acceleration amounts to approximately $7.7 million over the
        course
        of the original vesting periods. Options to purchase approximately 704,310
        shares of the Company’s stock or 52.5% of the Company’s outstanding options were
        accelerated. The weighted average exercise price of the options subject to
        acceleration were $21.30. The aggregate pretax expense for the shares subject
        to
        acceleration that would have been reflected in the Company’s consolidated
        financial statements beginning in 2006 is approximately $7.7 million, including
        $4.3 million in 2006, $2.7 million in 2007, and $0.7 million in 2008. The
        fair
        value for any future grants will be included in expense over the vesting
        periods. These expenses will be apportioned according to the classification
        of
        the employees who have received stock options into cost of sales, selling,
        general and administrative or research and development costs.
  In
        2005,
        our worldwide effective tax rate was 17.4%. In 2004 we were able to use
        previously reserved net operating loss carry-forwards, which combined with
        our
        release of $1.7 million in valuation allowance reduced our effective tax
        rate to
        2.3% for 2004. We have received a favorable income tax rate commitment from
        the
        Swiss government as an incentive to establish a manufacturing plant in
        Switzerland, and in 2005 have entered into an agreement with the Singapore
        Economic Development Board for a favorable multi-year income tax rate commitment
        covering our Singapore headquarters and manufacturing operations. (See Critical
        Accounting Policies - Income Taxes below).
  27
  Accounting
        for wholly owned foreign subsidiaries is maintained in the currency of the
        respective foreign jurisdiction and, therefore, fluctuations in exchange
        rates
        may have an impact on inter-company accounts reflected in our consolidated
        financial statements. We are aware of the availability of off-balance sheet
        financial instruments to hedge exposure to foreign currency exchange rates,
        including cross-currency swaps, forward contracts and foreign currency options
        (see Foreign Exchange Exposure below). However, we do not regularly use such
        instruments, and none were utilized in 2005, 2004, or 2003.
  We
        have
        had fourteen consecutive profitable quarters through December 31, 2005. Our
        sales growth and profitability has been a result of a number of factors,
        including: the acquisition of SMX, which manufactured the predecessor to
        the
        Faro Laser Tracker, the introduction in October 2002 of the latest generation
        of
        our traditional Faro Arm product, the introduction of the Faro Gage in September
        2003, the introduction of our Faro Scan Arm product in 2004, and an increase
        in
        the number of sales people worldwide. Our worldwide sales and marketing
        headcount in 2005, 2004 and 2003 was 289, 167, and 120,
        respectively.
  In
        2003,
        the Company recorded approximately $1.1 million in other income as a result
        of
        receiving approximately 100,000 shares of Company stock related to a positive
        arbitration settlement between the Company and the former SMX shareholders.
  On
        November 12, 2003, we sold 1,158,000 shares of common stock to certain
        institutional investors in a private placement. The shares were sold for
        $21.50
        per share, resulting in total proceeds before placement agent fees and other
        offering expenses of $24.9 million. This transaction significantly increased
        our
        cash available for a variety of potential uses including working capital,
        acquisitions, capital expenditures and our ongoing international
        expansion.
  On
        January 10, 2005, the Company filed a Registration Statement on Form S-3
        with
        the Securities and Exchange Commission allowing it to raise proceeds of up
        to
        $125 million. The proceeds from any offerings with respect to this registration
        statement, if any, would be used for either repayment or refinancing of debt,
        acquisition of additional businesses or technologies or for working capital
        and
        general corporate purposes. To date, we have not raised any capital under
        this
        Form S-3 Registration Statement. The Company must file in a timely manner
        all
        reports under the Securities and Exchange Act of 1934 (with certain exceptions)
        with the SEC for a period of 12 months in order to be able to use its S-3
        registration statement. (See also Liquidity and Capital Resources
        below).
  28
  **Results
        of Operations**
  The
        following table sets forth, for the periods presented, the percentage of
        sales
        represented by certain items in the Company’s consolidated statements of
        income:
  **Years
                  ended December 31,****2005**
              
              **2004**
              
              **2003**Statement
                  of Operations Data:Sales
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %Cost
                  of sales
              
              
              41.9
              %
              
              38.2
              %
              
              41.1
              %Gross
                  margin
              
              
              58.1
              %
              
              61.8
              %
              
              58.9
              %Operating
                  expenses:Selling
              
              
              29.7
              %
              
              26.7
              %
              
              25.6
              %General
                  and administrative
              
              
              12.4
              %
              
              12.1
              %
              
              13.7
              %Depreciation
                  and amortization
              
              
              2.7
              %
              
              2.4
              %
              
              3.0
              %Research
                  and development
              
              
              5.1
              %
              
              5.6
              %
              
              6.3
              %Total
                  operating expenses
              
              
              49.9
              %
              
              46.8
              %
              
              48.5
              %Income
                  from operations
              
              
              8.2
              %
              
              15.0
              %
              
              10.4
              %Interest
                  income
              
              
              0.6
              %
              
              0.4
              %
              
              0.1
              %Other
                  (expense) income, net
              
              
              (0.6
              %)
              
              0.4
              %
              
              2.7
              %Interest
                  expense
              
              
              (0.1
              %)
              
              (0.0
              %)
              
              (0.1
              %)Income
                  before income taxes
              
              
              8.1
              %
              
              15.8
              %
              
              13.1
              %Income
                  tax expense
              
              
              1.5
              %
              
              0.4
              %
              
              1.6
              %Net
                  income
              
              
              6.6
              %
              
              15.4
              %
              
              11.5
              %
 
 **2005
        Compared to 2004**
  *Sales* .
          Sales increased $28.6 million or 29.5% from $97.0 million for the
        year ended December 31, 2004 to $125.6 million for the year ended December
        31,
        2005. This increase resulted from higher unit sales of the Faro Arm, Faro
        Laser
        Tracker and Faro Gage products, the introduction of the Faro Laser Scanner
        LS
        and the effect of an overall increase in headcount in sales and marketing
        of
        122, or 73.1% from 167 in 2004 to 289 in 2005.  Geographically,
        sales increased $14.1 million or 33.8% in the Americas, $1.8 million or 4.2%
        in
        Europe/Africa, and $12.6 million or 103.3% in the Asia/Pacific region. Our
        sales
        growth is driven to a large extent by the growth in the number of sales people
        we have. We expect that new sales people will have a learning curve of 6-12
        months. In 2005 our sales and marketing headcount increased 63.0% from 54
        to 88
        in the Americas, 53.9% from 76 to 117 in Europe/Africa, and 127.0% from 37
        to 84
        in the Asia/Pacific region. We cannot quantify the impact, if any, on future
        sales in China resulting from actions taken to ensure compliance with all
        applicable foreign and US regulations.
  *Gross
        profit* .
          Gross profit increased $12.9 million or 21.5% from $60.0 million for
        the year ended December 31, 2004 to $72.9 million for the year ended December
        31, 2005. Gross margin decreased from 61.8% for the year ended December 31,
        2004
        to 58.1% for the year ended December 31, 2005 due primarily to product mix,
        higher service costs and price discounts.
  29
  *Selling
        expenses* .
          Selling expenses increased by $11.4 million or 44.0%, from $25.9
        million for the year ended December 31, 2004 to $37.3 million for the year
        ended
        December 31, 2005. This increase was a result of higher commissions related
        to
        increased volume of $3.1 million, higher salaries of $4.6 million related
        to the
        increase in sales and marketing personnel, higher product demonstration costs
        of
        $0.6 million and higher marketing costs of $3.1 million. As a percentage
        of
        sales, selling expenses increased to 29.7% of sales in 2005 from 26.7% in
        2004.
  *General
        and administrative expenses* .
          General and administrative expenses increased by $3.8 million or
        32.5% from $11.7 million for the year ended December 31, 2004 to $15.5 million
        for the year ended December 31, 2005. This increase was due to higher salaries
        and bonuses of $1.1 million, higher professional and legal fees of $2.7 million,
        of which $1.3 million was related to patent litigation, and higher facilities
        and rent of $0.6 million, partially offset by reduced stock option expense
        of
        $0.4 million. General and administrative expenses as percentage of sales
        rose
        slightly to 12.4% of sales in 2005 from 12.1% of sales in 2004.
  *Depreciation
        and amortization expenses* .
          Depreciation and amortization expenses increased by $1.2 million or
        52.2% from $2.3 million for the year ended December 31, 2004 to $3.5 million
        in
        2005, due
        to an
        increase in depreciation of new equipment from our Asia/Pacific expansion
        and
        from additions to our leased space in the U.S., and an increase in amortization
        from our purchase of iQvolution.
  *Research
        and development expenses* .
          Research and development expenses increased by $1.0 million or 18.5%
        from $5.4 million for the year ended December 31, 2004 to $6.4 million for
        the
        year ended December 31, 2005. This was due to an increase in salaries and
        bonuses of $0.6 million stemming from the hiring of personnel to support
        the new
        Laser Scanner LS and an increase in external services and other project expenses
        of $0.2 million. Research and development expenses as a percentage of sales
        were
        5.1% in 2005 compared to 5.6% in 2004.
  *Interest
        income / expense* .
          Interest income increased by $0.2 million or 50% from $0.4 million
        for the year ended December 31, 2004 to $0.6 million for the year ended December
        31, 2005 primarily from an increase in interest rates in 2005 which was
        partially offset by reduced investment balances. Interest expense increased
        slightly due to our purchase of iQvolution and subsequent retirement of their
        debt obligations.
  *Other
        (expense) income, net* .
        Other
        (expense) income, net decreased by $1.2 million from income of $0.4 million
        for
        the year ended December 31, 2004 to expense of $0.8 million for the year
        ended
        December 31, 2005. This decrease was primarily due to foreign exchange losses
        of
        $0.8 million in 2005.
  *Income
        tax expense.* Income tax expense increased $1.3 million from $0.4 million for the year
        ended
        December 31, 2004 to $1.7 million for the year ended December 31, 2005. The
        effective tax rate in 2005 was 17.4% of income before income tax compared
        to
        2.3% in 2004. The primary reason for the higher tax rate was the prior year
        tax
        benefit attributable to a reduction in the valuation allowance of approximately
        $3.2 million. Of that reduction, $1.5 million related to usage of “net operating
        losses” in foreign jurisdictions and $1.7 million of the reduction in the
        valuation allowance related to the partial release of the valuation allowance
        taken in the fourth quarter of 2004 on foreign deferred tax assets which
        the
        Company believed were more likely than not to be realized. The Company has
        $6.0
        million in net deferred tax assets remaining, which will more likely than
        not be
        realized in 2006 and thereafter if the Company remains consistently profitable
        (See also Note 14-Income Taxes). Separate from income tax expenses, the Company
        recorded an addition to shareholders’ equity of $0.4 million in 2005 for the
        income tax benefit received from the exercise of unqualified stock options
        by
        employees.
  30
  *Net
        income.* Net
        income decreased $6.7 million or 45.0% from $14.9 million for the year ended
        December 31, 2004 to $8.2 million for the year ended December 31, 2005 as
        a
        result of the factors described above.
  **2004
        Compared to 2003**
  *Sales* .
          Sales increased $25.2 million or 35.1% from $71.8 million for the
        year ended December 31, 2003 to $97.0 million for year ended December 31,
        2004.
        This increase resulted from higher unit sales of the Faro Arm, Faro Laser
        Tracker and Faro Gage products, and an overall increase in headcount in sales
        and marketing of 47, or 39.2% from 120 in 2003 to 167 in 2004.  Geographically,
        sales increased $3.8 million or 10.0% in the Americas, $15.4 million or 55.6%
        in
        Europe/Africa, and $6.0 million or 96.8% in the Asia/Pacific region. Our
        sales
        growth is driven to a large extent by the growth in the number of sales people
        we have. We expect that new sales people will have a learning curve of 3-6
        months before they are fully functional. In 2004 our sales and marketing
        headcount increased 23% from 44 to 54 in the Americas, 13% from 67 to 76
        in
        Europe /Africa, and 311% from 9 to 37 in the Asia/Pacific region.
  *Gross
        profit* .
          Gross profit increased $17.7 million or 41.8% from $42.3 million for
        the year ended December 31, 2003 to $60.0 million for the year ended December
        31, 2004. Gross margin increased from 58.9% for the year ended December 31,
        2003
        to 61.8% for the year ended December 31, 2004 due to reduced price discounts,
        reduced service costs as a percentage of sales from 9.0% in 2003 to 8.5%
        in
        2004, as a result of improvements in product quality and efficiencies in
        production.
  *Selling
        expenses* .
          Selling expenses increased by $7.6 million or 41.5%, from $18.3
        million for the year ended December 31, 2003 to $25.9 million for the year
        ended
        December 31, 2004. This increase was a result of higher commissions of $3.0
        million, higher salaries and bonuses of $2.5 million related to the increase
        in
        sales and marketing personnel, higher product demonstration costs of $1.2
        million and higher marketing costs of $0.9 million. As a percentage of sales,
        selling expenses increased to 26.7% of sales in 2004 from 25.6% in 2003.
  *General
        and administrative expenses* .
          General and administrative expenses increased by $1.9 million or
        19.4% from $9.8 million for the year ended December 31, 2003 to $11.7 million
        for the year ended December 31, 2004. This increase was due to higher salaries
        and bonuses of $1.4 million, higher professional and legal fees of $0.8 million
        and higher facilities and rent of $0.3 million, partially offset by reduced
        stock option expense of $0.4 million. General and administrative expenses
        as
        percentage of sales fell to 12.1% of sales in 2004 from 13.7% of sales in
        2003.
        In filings prior to Form 10-Q for the third quarter of 2004 we represented
        the
        cost of employee stock options as a separate line item in our consolidated
        statements of income. In accordance with SEC Regulation S-X we have eliminated
        the separate line item for all periods presented, and have included the cost
        of
        employee stock options in the appropriate expense category, according to
        each
        employee’s function. Virtually all of the employees who had stock options that
        gave rise to an expense were in administration. As a result, the $9.8 million
        in
        general and administration expenses for 2003 reported above is higher than
        the
        $9.1 million previously reported in our Form 10-K for 2003 by $0.7 million
        in
        employee stock option expense in 2003.
  *Depreciation
        and amortization expenses* .
          Depreciation and amortization expenses increased by $0.2 million or
        10.5% from $2.1 million for the year ended December 31, 2003 to $2.3 million
        in
        2004, due
        to an
        increase in depreciation of new equipment and capital leases.
  *Research
        and development expenses* .
          Research and development expenses increased by $0.9 million or 20.2%
        from $4.5 million for the year ended December 31, 2003 to $5.4 million for
        the
        year ended December 31, 2004. This was due to an increase in salaries and
        bonuses of $0.7 million and an increase in external services and other project
        expenses of $0.2 million. Research and development expenses as a percentage
        of
        sales were 5.6% in 2004 compared to 6.3% in 2003.
  31
  *Interest
        income / expense* .
          Interest income increased by $0.3 million or 334% from $0.1 million
        for the year ended December 31, 2003 to $0.4 million for the year ended December
        31, 2004 primarily from an increase in investments in 2004 related to the
        proceeds from the Company’s sale of stock in November 2003 (see also *Overview* above
        and *Liquidity
        and Capital Resources* below).
        Interest expense decreased slightly for the year ended December 31, 2004
        (See *Liquidity
        and Capital Resources* below).
  *Other
        (expense) income, net* .
        Other
        (expense) income, net decreased by $1.6 million from $2.0 million for the
        year
        ended December 31, 2003 to $0.4 million for the year ended December 31, 2004.
        This decrease was primarily due to a settlement of litigation with the former
        shareholders of SMX for $1.1 million in 2003 (see also Note 2 - Acquisition)
        and
        a reduction in foreign exchange gains of $0.2 million in 2004.
  *Income
        tax expense.* Income tax expense decreased $0.8 million from $1.2 million for the year
        ended
        December 31, 2003 to $0.4 million for the year ended December 31, 2004. The
        effective tax rate in 2004 was 2.3% of income before income tax compared
        to
        12.3% in 2003. The primary reason for the lower than expected tax rate was
        the
        tax benefit attributable to a reduction in the valuation allowance of
        approximately $3.2 million. Of that reduction, $1.5 million relates to usage
        of
“net operating losses” in foreign jurisdictions and $1.7 million of the
        reduction in the valuation allowance relates to the partial release of the
        valuation allowance taken in the fourth quarter on foreign deferred tax assets
        which the Company now believes are more likely than not to be realized. The
        Company determined that the amount of deferred tax assets relating to the
        net
        operating loss carryforwards of foreign subsidiaries was understated by
        approximately $3.7 million at December 31, 2003. As these net operating loss
        carryforwards were fully reserved at December 31, 2003 by a valuation allowance,
        there is no income statement or balance sheet impact to be recognized for
        2003.
        The Company has $5.0 million in net deferred tax assets remaining, which
        will
        more likely than not be realized in 2005 and thereafter if the Company remains
        consistently profitable (See also Note 14-Income Taxes). Separate from income
        tax expenses, the Company recorded an addition to shareholders’ equity of $2.4
        million for the income tax benefit received from the exercise of unqualified
        stock options by employees.
  *Net
        income.* Net
        income increased $6.6 million or 79.5% from $8.3 million for the year ended
        December 31, 2003 to $14.9 million for the year ended December 31, 2004 as
        a
        result of the factors described above.
  **Liquidity
        and Capital Resources**
  The
        Company has financed its operations primarily from cash provided by operating
        activities and from the proceeds of its 1997 initial public offering of common
        stock (approximately $31.7 million), and its 2003 private placement of its
        common stock with various institutional investors (approximately $24.9
        million).
  On
        September 17, 2003, the Company entered into a loan agreement with SunTrust
        Bank
        for a line of credit of $5 million. This agreement, which bears interest
        at the
        rate of LIBOR plus 1.75%, was renewed in August 2005 and is due on demand.
        The
        Company has not drawn on this line of credit. The Company has received a
        term
        sheet and is currently negotiating a new loan agreement which is expected
        to
        increase the term to three years and increase the amount of the credit line
        to
        $30.0 million.
  On
        January 10, 2005, the Company filed a Registration Statement on Form S-3
        with
        the Securities and Exchange Commission allowing it to raise proceeds of up
        to
        $125 million. The proceeds from any offerings with respect to this registration
        statement, if any, would be used for either repayment or refinancing of debt,
        acquisition of additional businesses or technologies or for working capital
        and
        general corporate purposes.
  32
  Cash
        and
        cash equivalents at December 31, 2005 were $9.3 million, compared to $16.4
        million at December 31, 2004. The decrease of $7.1 million was primarily
        attributable to changes in operating assets and liabilities of $14.6 million,
        cash used for the purchase of iQvolution of $6.4 million and cash used for
        the
        purchase of property and equipment and payments for intangible assets of
        $4.9
        million. This was offset by net income of $8.2 million, non-cash charges
        of $2.9
        million, net proceeds from sales of investments of $6.0 million, proceeds
        of
        $0.4 million from employee stock plan activity and the effect of exchange
        rate
        changes on cash of $1.2 million.
  We
        believe that our working capital, together with anticipated cash flow from
        our
        operations, our credit facility and previously announced shelf registration
        will
        be sufficient to fund our liquidity requirements through 2006.
  **Off
        Balance Sheet Items**
  The
        Company is not party to any off-balance sheet items that have not already
        been
        appropriately disclosed in these financial statements.
  **Contractual
        Obligations and Commercial Commitments**
  The
        Company is party to capital leases on automotive and other equipment with
        an
        initial term of 36 to 60 months and other non-cancelable operating leases,
        including leases with related parties that expire on or before 2010. These
        obligations are presented below as of December 31, 2005:
  **Payments
                  Due bv Period****Contractual
                  Obligations**
              
              **Total**
              
              **<
                  1 Year**
              
              **1-3
                  Years**
              
              **3-5
                  Years**
              
              **>
                  5 Years**Capital
                  lease obligations
              
              $
              227
              
              $
              119
              
              $
              104
              
              $
              4
              
              
              -Operating
                  lease obligations
              
              
              7,263
              
              
              2,257
              
              
              3,318
              
              
              1,688
              
              
              -Purchase
                  obligations
              
              
              8,044
              
              
              8,044
              
              
              -
              
              
              -
              
              
              -Total
              
              $
              15,534
              
              $
              10,420
              
              $
              3,422
              
              $
              1,692
              
              $
              -
  The
        Company enters into purchase commitments for products and services in the
        ordinary course of business. These purchases generally cover production
        requirements for 60 to 90 days. On August 11, 2005, FARO entered into an
        agreement with DELCAM plc under which the Company agreed to purchase
        approximately $1.4 million in products over a 12-month term. At December
        31,
        2005, the Company had completed the purchase of $0.6 million in products
        under
        this agreement. Effective November 1, 2005, FARO entered into an agreement
        with
        Metrologic Group S.A. under which the Company agreed to purchase approximately
        $0.4 million in products over a 12-month term. At December 31, 2005, no products
        had been purchased under this agreement. Other than the agreements listed
        above,
        the Company does not have any long-term commitments for purchases.
  **Critical
        Accounting Policies**
  In
        response to the SEC’s financial reporting release, FR-60, *“Cautionary
        Advice Regarding Disclosure About Critical Accounting
        Policies,”* we have
        selected our critical accounting policies for purposes of explaining the
        methodology used in the calculation in addition to any inherent uncertainties
        pertaining to the possible effects on our financial condition. The critical
        policies discussed below are our processes of recognizing revenue, the reserve
        for obsolescence, income taxes, and the reserve for warranties. These policies
        affect current assets and operating results and are therefore critical in
        assessing our financial and operating status. These policies involve certain
        assumptions that, if incorrect, could create an adverse impact on our operations
        and financial position.
  33
  **Revenue
        Recognition**
  Revenue
        related to the Company’s measurement systems (integrated combinations of a
        measurement device, a computer and software loaded on the computer and the
        measurement device) is recognized upon shipment as the Company considers
        the
        earnings process substantially complete as of the shipping date. The Company
        warrants its products against defects in design, materials and workmanship
        for
        one year. A provision for estimated future costs relating to warranty expenses
        is recorded when products are shipped. The Company separately sells one and
        three year extended warranties. Extended warranty revenues are recognized
        on a
        straight-line basis over the term of the warranty. Costs relating to extended
        maintenance plans are recognized as incurred. Revenue from sales of software
        only is recognized when no further significant production, modification or
        customization of the software is required and when the following criteria
        are
        met: persuasive evidence of a sales agreement exists, delivery has occurred,
        and
        the sales price is fixed or determinable and deemed collectible. Revenues
        resulting from sales of comprehensive support, training and technology
        consulting services are recognized as such services are performed and are
        deferred when billed in advance of the performance of services. Revenue from
        the
        licensing agreements for the use of its technology for medical applications
        is
        generally recognized as licensees use the technology. Amounts representing
        royalties for the current year and not received as of year-end are estimated
        as
        due based on historical data and recognized in the current year.
  **The
        Reserve for Excess and Obsolete Inventory**
  Since
        the
        amount of inventoriable cost that we will recoup through sales cannot be
        known
        with exact certainty, we rely upon both past sales experience and future
        sales
        forecasts. Inventory is considered obsolete if we have withdrawn those products
        from the market or if we had no sales of the product for the past 12 months,
        and
        have no sales forecasted for the next 12 months. Inventory is considered
        excess
        if the quantity on hand exceeds one year of remaining usage. The resulting
        obsolete and excess parts are then reviewed to determine if a substitute
        usage
        or a future need exists. Items without an identified current or future usage
        will be reserved for in an amount equal to 100% of the average FIFO cost
        of such
        inventory.
  **Income
        Taxes**
  We
        review
        our deferred tax assets on a regular basis to evaluate their recoverability
        based upon expected future reversals of deferred tax liabilities, projections
        of
        future taxable income, and tax planning strategies that we might employ to
        utilize such assets, including net operating loss carryforwards. Based on
        the
        positive and negative evidence described in Financial Accounting Standards
        Board
        (FASB) Statement No. 109, *“Accounting
        for Income Taxes”* (SFAS
        109), we establish a valuation allowance against the net deferred assets
        of a
        taxing jurisdiction in which we operate unless it is “more likely than not” that
        we will recover such assets through the above means. In the future, our
        evaluation of the need for the valuation allowance will be significantly
        influenced by our ability to achieve profitability and our ability to predict
        and achieve future projections of taxable income.
  The
        Company operates in a number of different countries around the world. In
        2003,
        the Company began to manufacture its products in Switzerland, where it has
        received a favorable income tax rate commitment from the Swiss government
        as an
        incentive to establish a manufacturing plant there. In 2005, the Company
        opened
        a regional headquarters and began to manufacture its products in Singapore,
        where it has received a favorable multi-year income tax rate commitment from
        the
        Singapore Economic Development Board as an incentive to establish a
        manufacturing plant and regional headquarters there.
  34
  Significant
        judgment is required in determining our worldwide provision for income taxes.
        In
        the ordinary course of global business, there are many transactions for which
        the ultimate tax outcome is uncertain. We have appropriately reserved for
        our
        tax uncertainties based on the criteria established by SFAS 5, *“Accounting
        for Loss Contingencies.”*
  **The
        Reserve for Warranties**
  The
        Company establishes a liability for included twelve-month warranties by the
        creation of a warranty reserve, which is an estimate of the repair expenses
        likely to be incurred for the remaining period of warranty measured in
        installation-months in each major product group. Warranty reserve is reflected
        in accrued liabilities in the accompanying consolidated balance sheets. The
        warranty expense is estimated by determining the total repair expenses for
        each
        product group in the period and determining a rate of repair expense per
        installation month. The rate is multiplied by the number of machine-months
        of
        warranty for each product group sold during the period to determine the
        provision for warranty expenses for the period. The Company reevaluates its
        exposure to warranty costs at the end of each period using the estimated
        expense
        per installation month for each major product group, the number of machines
        remaining under warranty and the remaining number of months each machine
        will be
        under warranty. While such expenses have historically been within its
        expectations, we cannot guarantee this will continue in the future.
  **Transactions
        with Related and Other Parties**
  The
        Company leases its headquarters in Lake Mary, Florida from Xenon Research,
        Inc.,
        all of the issued and outstanding capital stock of which is owned by Simon
        Raab,
        the Company’s Chairman and Co-Chief Executive Officer, and Diana Raab, his
        spouse. The term of the lease expired on February 28, 2006, and is continuing
        on
        a month to month basis. The Company expects to renew the lease for an additional
        3 - 5 years under similar terms. Base rent under the lease is  $398,000 per
        year.
  **Foreign
        Exchange Exposure**
  We
        conduct a significant portion of our business outside the United States.
        At
        present, approximately 50% of our revenues are invoiced, and a significant
        portion of our operating expenses paid, in foreign currencies. Fluctuations
        in
        exchange rates between the U.S. dollar and such foreign currencies may have
        a
        material adverse effect on our business, results of operations and financial
        condition, and could specifically result in foreign exchange gains and losses.
        The impact of future exchange rate fluctuations on the results of our operations
        cannot be accurately predicted. To the extent that the percentage of our
        non-U.S. dollar revenues derived from international sales increases (or
        decreases) in the future, our exposure to risks associated with fluctuations
        in
        foreign exchange rates may increase (or decrease).
  **Inflation**
  The
        Company believes that inflation has not had a material impact on its results
        of
        operations in recent years and does not expect inflation to have a material
        impact on its operations in 2006.
  35
  **Impact
        of Recently Issued Accounting Standards**
  In
        January 2003, the Financial Accounting Standards Board (“FASB”) issued and
        subsequently revised in December 2003, FIN 46, *“Consolidation
        of Variable Interest Entities”* (FIN
        46) *.* This
        interpretation of ARB No. 51, *“Consolidated
        Financial Statements,”* addresses consolidation by business enterprises of variable interest entities.
        Under current practice, two enterprises generally have been included in
        consolidated financial statements because one enterprise controls the other
        through voting interests. FIN 46 defines the concept of “variable interests” and
        requires existing unconsolidated variable interest entities to be consolidated
        by their primary beneficiaries if the entities do not effectively disperse
        the
        risks among the parties involved. FIN 46 applied immediately to variable
        interest entities created after January 31, 2003, and to variable interest
        entities in which an enterprise obtains an interest after that date. It applied
        to the first fiscal year or interim period beginning after June 15, 2003,
        to
        variable interest entities in which an enterprise holds a variable interest
        that
        it acquired before February 1, 2003. FIN 46(R) deferred the effective date
        of
        FIN 46 to the first reporting period ending after December 15, 2003. If it
        is
        reasonably possible that an enterprise will consolidate or disclose information
        about a variable interest entity when this interpretation becomes effective,
        the
        enterprise shall disclose information about those entities in all financial
        statements issued after January 31, 2003. FIN 46 may be applied prospectively
        with a cumulative-effect adjustment as of the date on which it is first applied
        or by restating previously issued financial statements for one or more years
        with a cumulative-effect adjustment as of the beginning of the first year
        restated. The Company has determined that it is not party to any variable
        interest entities.
  In
        November 2004, the FASB issued SFAS No. 151, *“Inventory
        Costs, an Amendment of ARB No. 43, Chapter 4.”* SFAS No.
        151 retains the general principle of ARB No. 43, Chapter 4, *“Inventory
        Pricing,”* that
        inventories are presumed to be stated at cost; however, it amends ARB No.
        43 to
        clarify that abnormal amounts of idle facilities, freight, handling costs
        and
        spoilage should be recognized as current period expenses. Also, SFAS No.
        151
        requires fixed overhead costs be allocated to inventories based on normal
        production capacity. The guidance in SAFS No. 151 is effective for inventory
        costs incurred during fiscal years beginning after June 15, 2005. The Company
        believes that implementing SFAS No. 151 will not have a material impact on
        its
        financial position or results of operations.
  In
        December 2004, the FASB issued SFAS No. 123R, *“Share-Based
        Payment.”* SFAS No.
        123R requires employee stock options and rights to purchase shares under
        stock
        participation plans to be accounted for under the fair value method, and
        eliminates the ability to account for these instruments under the intrinsic
        value method prescribed by APB Opinion No. 25, as allowed under the original
        provisions of SFAS No. 123. SFAS No. 123R requires the use of an option pricing
        model for estimating fair value, which is amortized to expense over the service
        periods. SFAS No. 123R allows for two alternative transition methods. The
        first
        method is the modified prospective application whereby compensation cost
        for the
        portion of awards for which the requisite service has not yet been rendered
        that
        are outstanding as of the adoption date will be recognized over the remaining
        service period. The compensation cost for that portion of awards will be
        based
        on the grant date fair value of those awards as calculated for pro forma
        disclosures under SFAS No. 123, as originally issued. All new awards and
        awards
        that are modified, repurchased, or cancelled after the adoption date will
        be
        accounted for under the provisions of SFAS No. 123R. The second method is
        the
        modified retrospective application, which requires that the Company restates
        prior period financial statements. The modified retrospective application
        may be
        applied either to all periods or only to prior interim periods in the year
        of
        adoption of this statement. The Company will adopt the provisions of SFAS
        No.
        123R effective January 1, 2006 using the modified prospective application
        transition method. The Company accelerated the vesting for substantially
        all of
        its outstanding options prior to December 31, 2005, and expects to record
        minimal expenses for its remaining unvested stock options during 2006. The
        reduction in pre-tax charges estimated by the Company as a result of the
        acceleration amounts to approximately $7.7 million over the course of the
        original vesting periods. The fair value for any future grants will be included
        in expense over the vesting periods.
  36
  **I****TEM****7A****.**
                **Q****UANTITATIVE
                    AND****Q****UALITATIVE****D****ISCLOSURES****A****BOUT****M****ARKET****R****ISK.**
 **Foreign
        Exchange Exposure**
  The
        Company conducts a significant portion of its business outside the United
        States. At present, a slight majority of the Company’s revenues are invoiced,
        and a significant portion of its operating expenses paid, in foreign currencies.
        Fluctuations in exchange rates between the U.S. dollar and such foreign
        currencies may have a material adverse effect on the Company’s business, results
        of operations and financial condition, and could specifically result in foreign
        exchange gains and losses. The impact of future exchange rate fluctuations
        on
        the results of the Company’s operations cannot be accurately predicted. To the
        extent that the percentage of the Company’s non-U.S. dollar revenues derived
        from international sales increases in the future, the Company’s exposure to
        risks associated with fluctuations in foreign exchange rates will increase
        further.
  **Inflation**
  The
        Company believes that inflation has not had a material impact on its results
        of
        operations in recent years and does not expect inflation to have a material
        impact on its operations in 2006.
  37
 **I****TEM****8****.**
                **F****INANCIAL****S****TATEMENTS
                    AND****S****UPPLEMENTARY****D****ATA.**
 **REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
  To
        the
        Board of Directors and Shareholders of FARO Technologies, Inc.:
  We
        have
        audited the accompanying consolidated balance sheets of FARO Technologies,
        Inc.
        (a Florida Corporation) and subsidiaries (collectively, the “Company”) as of
        December 31, 2005 and 2004, and the related consolidated statements of income,
        shareholders’ equity and cash flows for the years then ended. These financial
        statements are the responsibility of the Company’s management. Our
        responsibility is to express an opinion on these financial statements based
        on
        our audits.
  We
        conducted our audits in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audit to obtain reasonable assurance about whether the financial
        statements are free of material misstatement. An audit includes examining,
        on a
        test basis, evidence supporting the amounts and disclosures in the financial
        statements. An audit also includes assessing the accounting principles used
        and
        significant estimates made by management, as well as evaluating the overall
        financial statement presentation. We believe that our audits provide a
        reasonable basis for our opinion.
  In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the financial position of FARO Technologies, Inc.
        and
        subsidiaries as of December 31, 2005 and 2004, and the results of their
        operations and their cash flows for the years then ended in conformity with
        accounting principles generally accepted in the United States of
        America.
  We
        also
        have audited, in accordance with the standards of the Public Company Accounting
        Oversight Board (United States), the effectiveness of FARO Technologies,
        Inc.
        and subsidiaries internal control over financial reporting as of December
        31,
        2005, based on criteria established in Internal Control-Integrated Framework
        issued by the Committee of Sponsoring Organizations of the Treadway Commission
        (COSO) and our report dated June 21, 2006 expressed an unqualified opinion
        on
        management’s assessment of internal controls over financial reporting and an
        adverse opinion on the Company’s internal controls over financial
        reporting.
  Our
        audits were conducted for the purpose of forming an opinion on the basic
        financial statements taken as a whole. Schedule II - Valuation and Qualifying
        Accounts is presented for purposes of additional analysis and is not a required
        part of the basic financial statements. This schedule has been subjected
        to the
        auditing procedures applied in the audit of the basic financial statements
        and,
        in our opinion, is fairly stated in all material respects to the basic financial
        statements taken as a whole.
  /s/
                GRANT THORNTON LLP
  Orlando,
        Florida
 June
        21,
        2006
 
 38




**REPORT
      OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING
      FIRM**




To
      the
      Board of Directors and Shareholders of FARO Technologies, Inc.:




We
      have
      audited the accompanying consolidated statement of income, shareholders’ equity,
      and cash flows of FARO Technologies, Inc. and subsidiaries (the Company) for
      the
      year ended December 31, 2003. These financial statements are the responsibility
      of the Company’s management. Our responsibility is to express an opinion on
      these financial statements based on our audit.




We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. We were not engaged to perform
      an
      audit of the Company’s internal control over financial reporting. Our audit
      included consideration of internal control over financial reporting as a basis
      for designing audit procedures that are appropriate in the circumstances, but
      not for the purpose of expressing an opinion on the effectiveness of the
      Company’s internal control over financial reporting. Accordingly, we express no
      such opinion. An audit includes examining, on a test basis, evidence supporting
      the amounts and disclosures in the financial statements, assessing the
      accounting principles used and significant estimates made by management, and
      evaluating the overall financial statement presentation. We believe that our
      audit provides a reasonable basis for our opinion.




In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the consolidated results of the Company’s operations and cash
      flows for the year ended December 31, 2003, in conformity with U.S. generally
      accepted accounting principles.




/s/ ERNST & YOUNG LLPOrlando,
                Florida
              February
                20, 2004





39




**FARO
      TECHNOLOGIES, INC. AND SUBSIDIARIES**


CONSOLIDATED
      BALANCE SHEETS




(in
                  thousands, except share data)
              
              
              December
                  31,
                2005
              
              
              December
                  31,
                2004**ASSETS**Current
                  Assets:Cash
                  and cash equivalents
              
              $
              9,278
              
              $
              16,357Short-term
                  investments
              
              
              16,490
              
              
              22,485Accounts
                  receivable, net
              
              
              28,654
              
              
              22,484Inventories
              
              
              28,650
              
              
              16,378Deferred
                  income taxes, net
              
              
              2,155
              
              
              744Prepaid
                  expenses and other current assets
              
              
              2,200
              
              
              2,538Total
                  current assets
              
              
              87,427
              
              
              80,986Property
                  and Equipment:Machinery
                  and equipment
              
              
              6,940
              
              
              4,352Furniture
                  and fixtures
              
              
              3,334
              
              
              2,394Leasehold
                  improvements
              
              
              1,710
              
              
              910Property
                  and equipment at cost
              
              
              11,984
              
              
              7,656Less:
                  accumulated depreciation and amortization
              
              
              (5,920
              )
              
              (3,641
              )Property
                  and equipment, net
              
              
              6,064
              
              
              4,015Goodwill
              
              
              14,574
              
              
              8,077Intangible
                  assets, net
              
              
              6,395
              
              
              3,568Service
                  inventory
              
              
              4,333
              
              
              4,159Deferred
                  income taxes, net
              
              
              3,855
              
              
              4,273Total
                  Assets
              
              $
              122,648
              
              $
              105,078**LIABILITIES
                  AND SHAREHOLDERS' EQUITY**Current
                  Liabilities:Account
                  payable
              
              $
              12,301
              
              $
              4,736Accrued
                  liabilities
              
              
              5,569
              
              
              7,252Income
                  taxes payable
              
              
              1,406
              
              
              104Current
                  portion of unearned service revenues
              
              
              3,168
              
              
              2,663Customer
                  deposits
              
              
              201
              
              
              441Current
                  portion of long-term debt and obligations under capital
                  leases
              
              
              163
              
              
              104Total
                  current liabilities
              
              
              22,808
              
              
              15,300Unearned
                  service revenues - less current portion
              
              
              803
              
              
              474Long-term
                  debt and obligations under capital leases - less current
                  portion
              
              
              177
              
              
              146Total
                  Liabilities
              
              
              23,788
              
              
              15,920Commitments
                  and contingencies - See notes 11 and 16Shareholders'
                  Equity:Common
                  stock - par value $.001, 50,000,000 shares authorized; 14,481,178
                  and
                  14,004,092 issued; 14,290,917 and 13,964,092 outstanding,
                  respectively
              
              
              14
              
              
              14Additional
                  paid-in-capital
              
              
              83,792
              
              
              78,282Deferred
                  compensation
              
              
              148
              
              
              505Retained
                  earnings
              
              
              17,256
              
              
              9,077Accumulated
                  other comprehensive (loss) income
              
              
              (2,199
              )
              
              1,431Common
                  stock in treasury, at cost - 40,000 shares
              
              
              (151
              )
              
              (151
              )Total
                  Shareholders' Equity
              
              
              98,860
              
              
              89,158Total
                  Liabilities and Shareholders' Equity
              
              $
              122,648
              
              $
              105,078





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




40


**FARO
        TECHNOLOGIES, INC. AND SUBSIDIARIES**
 CONSOLIDATED
        STATEMENTS OF INCOME


**Years
                  ended December 31,**(in
                  thousands, except share and per share data)
              
              **2005**
              
              **2004**
              
              **2003**SALES
              
              $
              125,590
              
              $
              97,020
              
              $
              71,786COST
                  OF SALES (exclusive of depreciation and amortization, shown separately
                  below)
              
              
              52,658
              
              
              37,025
              
              
              29,520Gross
                  profit
              
              
              72,932
              
              
              59,995
              
              
              42,266OPERATING
                  EXPENSES:Selling
              
              
              37,274
              
              
              25,887
              
              
              18,342General
                  and administrative
              
              
              15,539
              
              
              11,745
              
              
              9,835Depreciation
                  and amortization
              
              
              3,453
              
              
              2,339
              
              
              2,119Research
                  and development
              
              
              6,440
              
              
              5,441
              
              
              4,530Total
                  operating expenses
              
              
              62,706
              
              
              45,412
              
              
              34,826INCOME
                  FROM OPERATIONS
              
              
              10,226
              
              
              14,583
              
              
              7,440OTHER
                  INCOME (EXPENSE)Interest
                  income
              
              
              567
              
              
              356
              
              
              82Other
                  (expense) income, net
              
              
              (806
              )
              
              362
              
              
              1,960Interest
                  expense
              
              
              (89
              )
              
              (12
              )
              
              (46
              )INCOME
                  BEFORE INCOME TAX
              
              
              9,898
              
              
              15,289
              
              
              9,436INCOME
                  TAX EXPENSE
              
              
              1,719
              
              
              358
              
              
              1,158NET
                  INCOME
              
              $
              8,179
              
              $
              14,931
              
              $
              8,278NET
                  INCOME PER SHARE - BASIC
              
              $
              0.58
              
              $
              1.08
              
              $
              0.68NET
                  INCOME PER SHARE - DILUTED
              
              $
              0.57
              
              $
              1.06
              
              $
              0.64Weighted
                  average shares - Basic
              
              
              14,169,140
              
              
              13,833,590
              
              
              12,181,221Weighted
                  average shares - Diluted
              
              
              14,442,248
              
              
              14,023,159
              
              
              12,845,992





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


41


**FARO
      TECHNOLOGIES, INC. AND SUBSIDIARIES**


**CONSOLIDATED
      STATEMENTS OF SHAREHOLDERS’ EQUITY**




Common
                    Stock
                
                Additional
                    Paid-in
                
                Deferred
                
                Retained
                    Earnings
                
                Accumulated
                    Other Comprehensive
                
                Common
                    Stock in(in
                    thousands, except share data)
                
                Shares
                
                Amounts
                
                Capital
                
                Compensation
                
                (Deficit)
                
                (Loss)
                    Income
                
                Treasury
                
                TotalBALANCE
                    DECEMBER 31, 2002
                
                
                11,931,726
                
                $
                12
                
                $
                49,463
                
                $
                (15
                )
                $
                (14,132
                )
                $
                (1,794
                )
                $
                (151
                )
                $
                33,383Net
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                8,278
                
                
                
                
                
                
                
                
                8,278Currency
                    translation adjustment, net of tax
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,800
                
                
                
                
                
                1,800Comprehensive
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                10,078Options
                    subject to variable accounting
                
                
                
                
                
                
                
                
                931
                
                
                (931
                )
                
                
                
                
                
                
                
                
                
                
                -Amortization
                    of unearned compensation
                
                
                
                
                
                
                
                
                
                
                
                719
                
                
                
                
                
                
                
                
                
                
                
                719Stock
                    option exercised
                
                
                528,839
                
                
                1
                
                
                1,300
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,301Settlement
                    of SMX arbitration settled in stock
                
                
                (99,567
                )
                
                
                
                
                (1,156
                )
                
                
                
                
                
                
                
                
                
                
                
                
                
                (1,156
                )Tax
                    benefit from employee stock option exercises
                
                
                
                
                
                
                
                
                1,420
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,420Issuance
                    of common stock, net of expenses
                
                
                1,158,000
                
                
                1
                
                
                23,175
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                23,176BALANCE
                      DECEMBER 31, 2002
                
                
                13,518,998
                
                $
                14
                
                $
                75,133
                
                $
                (227
                )
                $
                (5,854
                )
                $
                6
                
                $
                (151
                )
                $
                68,921Net
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                14,931
                
                
                
                
                
                
                
                
                14,931Currency
                    translation adjustment, net of tax
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,425
                
                
                
                
                
                1,425Comprehensive
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                16,356Options
                    subject to variable accounting
                
                
                
                
                
                
                
                
                (455
                )
                
                455
                
                
                
                
                
                
                
                
                
                
                
                -Amortization
                    of unearned compensation
                
                
                
                
                
                
                
                
                
                
                
                277
                
                
                
                
                
                
                
                
                
                
                
                277Stock
                    option exercised
                
                
                485,512
                
                
                
                
                
                1,171
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,171Tax
                    benefit from employee stock option exercises
                
                
                
                
                
                
                
                
                2,434
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                2,434Cancellation
                    of SMX shares
                
                
                (418
                )
                
                
                
                
                (1
                )
                
                
                
                
                
                
                
                
                
                
                
                
                
                (1
                )BALANCE
                    DECEMBER 31, 2002
                
                
                14,004,092
                
                $
                14
                
                $
                78,282
                
                $
                505
                
                $
                9,077
                
                $
                1,431
                
                $
                (151
                )
                $
                89,158Net
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                8,179
                
                
                
                
                
                
                
                
                8,179Currency
                    translation adjustment, net of tax
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (3,630
                )
                
                
                
                
                (3,630
                )Comprehensive
                    income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                4,549Options
                    subject to variable accounting
                
                
                
                
                
                
                
                
                207
                
                
                (207
                )
                
                
                
                
                
                
                
                
                
                
                -Amortization
                    of unearned compensation
                
                
                
                
                
                
                
                
                
                
                
                (150
                )
                
                
                
                
                
                
                
                
                
                
                (150
                )Amortization
                    of restricted stock units
                
                
                
                
                
                
                
                
                93
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                93Accrual
                    for iQvolution milestone earn-outs
                
                
                
                
                
                
                
                
                675
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                675Stock
                      issued for iQvolution milestone earn-outs
                
                
                12,183
                
                
                
                
                
                252
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                252Stock
                      option exercised
                
                
                137,499
                
                
                
                
                
                340
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                340Tax
                      benefit from employee stock option exercises
                
                
                
                
                
                
                
                
                382
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                382Stock
                      issued for iQvolution purchase
                
                
                152,292
                
                
                
                
                
                3,499
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                3,499Board
                      compensation
                
                
                24,851
                
                
                
                
                
                62
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                62BALANCE
                    DECEMBER 31, 2002
                
                
                14,330,917
                
                $
                14
                
                $
                83,792
                
                $
                148
                
                $
                17,256
                
                $
                (2,199
                )
                $
                (151
                )
                
                98,860


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




42


**FARO
        TECHNOLOGIES, INC. AND SUBSIDIARIES**
 CONSOLIDATED
        STATEMENTS OF CASH FLOWS




**Year
                ended December 31,****(in
                thousands)**
            
            **2005**
            
            **2004**
            
            **2003**CASH
              FLOWS FROM:OPERATING
              ACTIVITIES:Net
                income
            
            $
            8,179
            
            $
            14,931
            
            $
            8,278Adjustments
                to reconcile net income to net cash (used in) provided by operating
                activities:Depreciation
                and amortization
            
            
            3,453
            
            
            2,339
            
            
            2,119Settlement
                of SMX arbitration received in stock
            
            
            -
            
            
            -
            
            
            (1,156
            )Provision
                for bad debts
            
            
            112
            
            
            154
            
            
            140Income
                tax benefit from exercise of stock options
            
            
            382
            
            
            2,434
            
            
            1,420Deferred
                income taxes
            
            
            (854
            )
            
            (3,309
            )
            
            (1,709
            )Employee
                stock plans (income) expense
            
            
            (57
            )
            
            277
            
            
            719Change
              in operating
              assets and liabilities:Decrease
                (increase) in:Accounts
                receivable, net
            
            
            (7,830
            )
            
            (5,474
            )
            
            (898
            )Inventories
            
            
            (13,788
            )
            
            (5,354
            )
            
            (4,996
            )Prepaid
                expenses and other current assets
            
            
            508
            
            
            (1,019
            )
            
            (229
            )Increase
                (decrease) in:Accounts
                payable and accrued liabilities
            
            
            4,309
            
            
            2,138
            
            
            961Income
                taxes payable
            
            
            1,454
            
            
            (502
            )
            
            (321
            )Customer
                deposits
            
            
            (302
            )
            
            69
            
            
            245Unearned
                service revenues
            
            
            1,030
            
            
            611
            
            
            102Net
                cash (used in) provided by operating activities
            
            
            (3,404
            )
            
            7,295
            
            
            4,675INVESTING
                ACTIVITIES:Acquisition
                of iQvolution
            
            
            (6,385
            )
            
            -
            
            
            -Purchases
                of property and equipment
            
            
            (3,937
            )
            
            (2,451
            )
            
            (1,430
            )Payments
                for intangible assets
            
            
            (937
            )
            
            (1,004
            )
            
            (868
            )Proceeds
                from repayment of notes receivable
            
            
            -
            
            
            -
            
            
            1,240Purchases
                of short-term investments
            
            
            (10,900
            )
            
            (30,390
            )
            
            (15,847
            )Proceeds
                from short-term investments
            
            
            16,895
            
            
            23,942
            
            
            1,675Net
                cash used in investing activities
            
            
            (5,264
            )
            
            (9,903
            )
            
            (15,230
            )FINANCING
                ACTIVITIES:Payments
                on line of credit, capital leases and long-term debt
            
            
            (34
            )
            
            (38
            )
            
            (1,459
            )Proceeds
                from issuance of stock, net
            
            
            402
            
            
            1,171
            
            
            24,478Net
                cash provided by financing activities
            
            
            368
            
            
            1,133
            
            
            23,019EFFECT
                OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS
            
            
            1,221
            
            
            407
            
            
            937(DECREASE)
                INCREASE IN CASH AND CASH EQUIVALENTS
            
            
            (7,079
            )
            
            (1,068
            )
            
            13,401CASH
              AND CASH EQUIVALENTS, BEGINNING OF
              PERIOED
            
            
            16,357
            
            
            17,425
            
            
            4,024CASH
                AND CASH EQUIVALENTS, END OF PERIOD
            
            $
            9,278
            
            $
            16,357
            
            $
            17,425




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




43


**FARO
        TECHNOLOGIES, INC. AND SUBSIDIARIES**
  **NOTES
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 **YEARS
        ENDED DECEMBER 31, 2005, 2004 and 2003**
 (in
        thousands, except share and per share data, or as otherwise
        noted)
  **1.    SUMMARY
        OF SIGNIFICANT ACCOUNTING POLICIES**
  ***Description
        of Business*** —  FARO
        Technologies, Inc. and subsidiaries (collectively the “Company” or “FARO”)
        design, develop, manufacture, market and support software-based
        three-dimensional measurement devices for manufacturing, industrial, building
        construction and forensic applications. The Company’s principal products include
        the Faro Arm, Faro Scan Arm, Digital Template and Faro Gage, all articulated
        electromechanical measuring devices, and the Faro Laser Tracker and the Faro
        Laser Scanner LS, both laser-based measuring devices. Markets for the Company’s
        products include automobile, aerospace, heavy equipment, countertop
        manufacturers and law enforcement agencies. The Company sells the vast majority
        of its products though a direct sales force located in many of the world’s
        largest industrialized countries.
  ***Principles
        of Consolidation*** —The
        consolidated financial statements of the Company include the accounts of
        FARO
        Technologies, Inc. and all its subsidiaries. All intercompany transactions
        and
        balances have been eliminated. The financial statements of the foreign
        subsidiaries are translated into U.S. dollars using exchange rates in effect
        at
        period-end for assets and liabilities and average exchange rates during each
        reporting period for results of operations. Adjustments resulting from financial
        statement translations are reflected as a separate component of accumulated
        other comprehensive (loss) income.
  ***Revenue
        Recognition, Product Warranty and Extended Maintenance
        Contracts*** —Revenue
        related to the Company’s measurement systems (integrated combinations of a
        measurement device, a computer and software loaded on the computer and the
        measurement device) is recognized upon shipment as the Company considers
        the
        earnings process substantially complete as of the shipping date. The Company
        warrants its products against defects in design, materials and workmanship
        for
        one year. A provision for estimated future costs relating to warranty expenses
        is recorded when products are shipped. The Company separately sells one and
        three year extended warranties. Extended warranty revenues are recognized
        on a
        straight-line basis over the term of the warranty. Costs relating to extended
        maintenance plans are recognized as incurred. Revenue from sales of software
        only is recognized when no further significant production, modification or
        customization of the software is required and when the following criteria
        are
        met: persuasive evidence of a sales agreement exists, delivery has occurred,
        and
        the sales price is fixed or determinable and deemed collectible. Revenues
        resulting from sales of comprehensive support, training and technology
        consulting services are recognized as such services are performed and are
        deferred when billed in advance of the performance of services. Revenue from
        the
        licensing agreements for the use of its technology for medical applications
        is
        generally recognized as licensees use the technology. Amounts representing
        royalties for the current year and not received as of year-end are estimated
        as
        due based on historical data and recognized in the current year.
  ***Cash
        and Cash Equivalents*** —The
        Company considers cash on hand and amounts on deposit with financial
        institutions which have maturities of three months or less when purchased
        to be
        cash and cash equivalents. The Company had deposits with foreign banks totaling
        $7,336 and $14,044 as of December 31, 2005 and 2004, respectively.
  ***Short-term
        investments*** —Short-term
        investments ordinarily consist of short-term debt securities acquired with
        cash
        not immediately needed in operations, and are held at fair value.
  44
  Management
        determines the appropriate classification of its short-term investments at
        the
        time of the purchase and reevaluates such determinations at each balance
        sheet
        date. The Company’s short-term investments are diversified among high credit
        quality securities in accordance with the Company’s investment policy.
  ***Accounts
        receivable and related allowance for doubtful accounts*** — Credit
        is
        extended to customers based on an evaluation of a customer’s financial condition
        and, generally, collateral is not required. Accounts receivable are generally
        due within 30-90 days and are stated at amounts due from customers net of
        an
        allowance for doubtful accounts. Accounts outstanding longer than the
        contractual payment terms are considered past due. The Company makes judgments
        as to the collectibility of accounts receivable based on historical trends
        and
        future expectations. Management estimates an allowance for doubtful accounts
        which adjusts gross trade accounts receivable to its net realizable value.
        The
        allowance for doubtful accounts is based on an analysis of all receivables
        for
        possible impairment issues, and historical write-off percentages. The Company
        writes off accounts receivable when they become uncollectible, and payments
        subsequently received on such receivables are credited to the allowance for
        doubtful accounts. The Company does not generally charge interest on past
        due
        receivables.
  ***Inventories*** —Inventories
        are stated at the lower of cost or net realizable value using the first-in
        first-out method. Shipping and handling costs are classified as a component
        of
        cost of sales in the consolidated statements of income. Sales demonstration
        inventory is comprised of measuring devices utilized by sales representatives
        to
        present the Company’s products to customers. These products remain in sales
        demonstration inventory for six to twelve months and are subsequently sold
        at
        prices that produce slightly reduced gross margins. Service inventory is
        comprised of inventory that is not expected to be sold within twelve months,
        such as training and loaned equipment. During the second quarter of 2005,
        the
        Company changed its method of computing the pricing of inventory from average
        cost to FIFO. This change was made as a result of an inventory system
        conversion, to allow for improved system efficiencies. The underlying
        calculation between average cost and FIFO cost is not materially different.
        This
        change did not have a material impact on the results of operations for the
        fiscal 2005 total year.
  ***Property
        and Equipment*** —Property
        and equipment purchases exceeding a thousand dollars are capitalized and
        recorded at cost. Depreciation is computed using the straight-line method
        over
        the estimated useful lives of the various classes of assets as follows:
  Machinery
                  and equipment
              
              
              2
                  to 5 yearsFurniture
                  and fixtures
              
              
              3
                  to 10 years
  Leasehold
        improvements are amortized on the straight-line basis over the lesser of
        the
        life of the asset or the term of the lease, not to exceed 7 years.
 
 Depreciation
        expense was $2,154, $1,453 and $1,132 in 2005, 2004 and 2003, respectively.
        Accelerated methods of depreciation are used for income tax purposes in contrast
        to book purposes, and as a result, appropriate provisions are made for the
        related deferred income taxes.
  ***Goodwill
        and Intangibles*** —
        Goodwill represents the excess cost of a business acquisition over the fair
        value of the net assets acquired. In accordance with Statement of Financial
        Accounting Standards (SFAS) No. 142, *“Goodwill
        and Other Intangible Assets,”* indefinite-life identifiable intangible assets and goodwill are not amortized.
        The Company periodically reviews its identifiable intangible assets and
        goodwill, considering factors such as projected cash flows and revenue and
        earnings multiples, to determine whether the value of the assets are impaired
        and the amortization periods are appropriate. If an asset is impaired, the
        difference between the value of the asset reflected on the financial statements
        and its current fair value is recognized as an expense in the period in which
        the impairment occurs.
  45
  Other
        acquired intangibles principally include core technology, existing product
        technology and customer relationships that arose in connection with the
        acquisition of CATS GmbH and iQvolution AG (See note 2). Other acquired
        intangibles are recorded at fair value at the date of acquisition and are
        amortized over their estimated useful lives of 3 to 15 years.
  Patents
        are recorded at cost. Amortization is computed using the straight-line method
        over the lives of the patents.
  ***Research
        and Development*** —Research
        and development costs incurred in the discovery of new knowledge and the
        resulting translation of this new knowledge into plans and designs for new
        products, prior to the attainment of the related products’ technological
        feasibility, are recorded as expenses in the period incurred.
  ***The
        Reserve for Warranties*** **** - The
        Company establishes a liability for included twelve-month warranties by the
        creation of a warranty reserve, which is an estimate of the repair expenses
        likely to be incurred for the remaining period of warranty measured in
        installation-months in each major product group. Warranty reserve is reflected
        in accrued liabilities in the accompanying consolidated balance sheets. The
        warranty expense is estimated by determining the total repair expenses for
        each
        product group in the period and determining a rate of repair expense per
        installation month. The rate is multiplied by the number of machine-months
        of
        warranty for each product group sold during the period to determine the
        provision for warranty expenses for the period. The Company reevaluates its
        exposure to warranty costs at the end of each period using the estimated
        expense
        per installation month for each major product group, the number of machines
        remaining under warranty and the remaining number of months each machine
        will be
        under warranty. While such expenses have historically been within its
        expectations, we cannot guarantee this will continue in the future.
 
 ***Income
        Taxes*** — We
        review our deferred tax assets on a regular basis to evaluate their
        recoverability based upon expected future reversals of deferred tax liabilities,
        projections of future taxable income, and tax planning strategies that we
        might
        employ to utilize such assets, including net operating loss carryforwards.
        Based
        on the positive and negative evidence described in Financial Accounting
        Standards Board (FASB) Statement No. 109, *“Accounting
        for Income Taxes”* (SFAS
        109), we establish a valuation allowance against the net deferred assets
        of a
        taxing jurisdiction in which we operate unless it is “more likely than not” that
        we will recover such assets through the above means. In the future, our
        evaluation of the need for the valuation allowance will be significantly
        influenced by our ability to achieve profitability and our ability to predict
        and achieve future projections of taxable income.
  The
        Company operates in a number of different countries around the world. In
        2003,
        the Company began to manufacture its products in Switzerland, where it has
        received a permanent income tax rate commitment from the Swiss government
        as an
        incentive to establish a manufacturing plant there. In 2005, the Company
        opened
        a regional headquarters and began to manufacture its products in Singapore,
        where it has received a favorable multi-year income tax rate commitment from
        the
        Singapore Economic Development Board as an incentive to establish a
        manufacturing plant and regional headquarters there.
  Significant
        judgment is required in determining our worldwide provision for income taxes.
        In
        the ordinary course of global business, there are many transactions for which
        the ultimate tax outcome is uncertain. We have appropriately reserved for
        our
        tax uncertainties based on the criteria established by SFAS 5, *“Accounting
        for Loss Contingencies.”*
  46
  ***Fair
        Value of Financial Instruments*** —The
        Company’s financial instruments include cash and cash equivalents, short-term
        investments, accounts receivable and accounts payable and accruals. The carrying
        amounts of such financial instruments approximate their fair value due to
        the
        short-term nature of these instruments.
 
 ***Earnings
        Per Share*** —Basic
        earnings per share (EPS) is computed by dividing earnings available to common
        shareholders by the weighted-average number of common shares outstanding
        for the
        period. Diluted EPS includes the effect of all dilutive stock options and
        equity
        instruments. A reconciliation of the number of common shares used in calculation
        of basic and diluted EPS is presented in Note 18.
 
 ***Concentration
        of Credit Risk*** —Financial
        instruments which potentially expose the Company to concentrations of credit
        risk consist principally of short-term investments and operating demand deposit
        accounts. The Company’s policy is to place its operating demand deposit accounts
        with high credit quality financial institutions.
  ***Stock-Based
        Compensation*** —  In
        December 2002, the FASB issued SFAS No. 148, *“Accounting
        for Stock-Based Compensation-Transition and Disclosure.”* SFAS No.
        148 provides alternative methods of transition for a voluntary change to
        the
        fair value based method of accounting for stock-based compensation. In addition,
        SFAS No. 148 amends the disclosure requirements of SFAS No. 123, “Accounting for
        Stock-Based Compensation,” to require prominent disclosures in both annual and
        interim financial statements about the method of accounting for stock-based
        compensation and the effect of the method used on reported results. SFAS
        No. 148
        is effective for financial statements for fiscal years ending after December
        15,
        2002 and for interim periods beginning after December 15, 2002. The annual
        disclosure requirements of SFAS No. 148 were adopted by the Company on January
        1, 2003.
  In
        accordance with SFAS No. 123, the Company has elected to continue to account
        for
        its employee stock compensation plans using the intrinsic value based method
        with pro-forma disclosures of net earnings and earnings per share, as if
        the
        fair value based method of accounting defined in SFAS No. 123 had been applied.
        Under the intrinsic value based method, compensation cost is measured by
        the
        excess, if any, of the quoted market price of the stock at the grant date
        over
        the amount an employee must pay to acquire the stock. Under the fair value
        based
        method, compensation cost is measured at the grant date based on the fair
        value
        of the award and is recognized over the service period, which is usually
        the
        vesting period. Included in net income are certain compensation expenses
        subject
        to variable accounting treatment.
  Had
        compensation cost for the Company’s stock-based compensation plans been
        determined consistent with SFAS No. 123, the Company’s net income and earnings
        per share would have been as follows:
  47
  Years
                  Ended December 312005
              
              2004
              
              2003Net
                  income, as reported
              
              $
              8,179
              
              $
              14,931
              
              $
              8,278(Deduct)
                  Add: Stock-based employee compensation (income) expenseincluded
                  in reported net income, net of;related
                  tax effects*
              
              
              (94
              )
              
              173
              
              
              448Deduct:
                  Total stock-based employeecompensation
                  expense determined under fair value based method for allawards,
                  net of related tax effects
              
              
              (7,468
              )
              
              (1,358
              )
              
              (317
              )Pro
                  forma net income
              
              $
              617
              
              $
              13,746
              
              $
              8,409Earnings
                  per share:Basic
                  - as reported
              
              $
              0.58
              
              $
              1.08
              
              $
              0.68Basic
                  - pro forma
              
              $
              0.04
              
              $
              0.99
              
              $
              0.69Diluted
                  - as reported
              
              $
              0.57
              
              $
              1.06
              
              $
              0.64Diluted
                  - pro forma
              
              $
              0.04
              
              $
              0.98
              
              $
              0.65
  *The
        years ended 2005, 2004 and 2003 assume a U.S. tax rate of 37.6%
 
 The
        Company used the Black-Scholes option-pricing model to determine the fair
        value
        of grants made. The following assumptions were applied in determining the
        pro
        forma compensation cost:
 
 Years
                  Ended December 31,2005
              
              2004
              
              2003Risk-free
                  interest rate
              
              
              3.30%
                  to 4.47
              %
              
              2.54%
                  to 3.82
              %
              
              2.48%
                  to 3.43
              %Expected
                  dividend yield
              
              
              0
              %
              
              0
              %
              
              0
              %Expected
                  option life
              
              
              4
                  years
              
              
              5
                  years
              
              
              3
                  - 10 yearsStock
                  price volatility
              
              
              62.7
              %
              
              80.5
              %
              
              74.20
              %
  ***Long-Lived
        Assets*** —Effective
        January 1, 2002, the Company adopted SFAS No. 144, *“Accounting
        for the Impairment or Disposal of Long-Lived Assets.”* SFAS No.
        144 supersedes SFAS No. 121 and requires that one accounting impairment model
        be
        used for long-lived assets to be held and used and to be disposed of by sale,
        whether previously held and used or newly acquired, and broadens the
        presentation of discontinued operations to include more disposal transactions.
        The adoption of SFAS No. 144 had no financial impact on the results of
        operations or financial position of the Company. During the fourth quarter
        of
        2005, management reviewed the Company’s long-lived assets and concluded that
        there was no impairment of these assets for the year ended December 31,
        2005.
 
 ***Estimates*** —The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States of America requires management to
        make
        estimates and assumptions that affect the reported amounts of assets and
        liabilities and disclosure of contingent assets and liabilities at the date
        of
        the financial statements and the reported amounts of revenues and expenses
        during the reporting period. Actual results could differ from those estimates.
  48
  ***Impact
        of Recently Issued Accounting Standards***
 
 In
        January 2003, the Financial Accounting Standards Board (“FASB”) issued and
        subsequently revised in December of 2003, FIN 46, *“Consolidation
        of Variable Interest Entities.”* This
        interpretation of ARB No. 51, *“Consolidated
        Financial Statements,”* addresses consolidation by business enterprises of variable interest entities.
        Under current practice, two enterprises generally have been included in
        consolidated financial statements because one enterprise controls the other
        through voting interests. FIN 46 defines the concept of “variable interests” and
        requires existing unconsolidated variable interest entities to be consolidated
        by their primary beneficiaries if the entities do not effectively disperse
        the
        risks among the parties involved. FIN 46 applied immediately to variable
        interest entities created after January 31, 2003, and to variable interest
        entities in which an enterprise obtains an interest after that date. It applied
        in the first fiscal year or interim period beginning after June 15, 2003,
        to
        variable interest entities in which an enterprise holds a variable interest
        that
        it acquired before February 1, 2003. FIN 46(R) deferred the effective date
        of
        FIN 46 to the first reporting period ending after December 15, 2003. If it
        is
        reasonably possible that an enterprise will consolidate or disclose information
        about a variable interest entity when this interpretation becomes effective,
        the
        enterprise shall disclose information about those entities in all financial
        statements issued after January 31, 2003. FIN 46 may be applied prospectively
        with a cumulative-effect adjustment as of the date on which it is first applied
        or by restating previously issued financial statements for one or more years
        with a cumulative-effect adjustment as of the beginning of the first year
        restated. The Company has determined that it is not party to any variable
        interest entities.
 
 In
        November 2004, the FASB issued SFAS No. 151, *“Inventory
        Costs, an Amendment of ARB No. 43, Chapter 4.”* SFAS No.
        151 retains the general principle of ARB No. 43, Chapter 4, *“Inventory
        Pricing,”* that
        inventories are presumed to be stated at cost; however, it amends ARB No.
        43 to
        clarify that abnormal amounts of idle facilities, freight, handling costs
        and
        spoilage should be recognized as current period expenses. Also, SFAS No.
        151
        requires fixed overhead costs be allocated to inventories based on normal
        production capacity. The guidance in SFAS No. 151 is effective for inventory
        costs incurred during fiscal years beginning after June 15, 2005. The Company
        believes that implementing SFAS No. 151 will not have a material impact on
        its
        financial position or results of operations.
  In
        December 2004, the FASB issued SFAS No. 123R, *“Share-Based
        Payment.”* SFAS No.
        123R requires employee stock options and rights to purchase shares under
        stock
        participation plans to be accounted for under the fair value method, and
        eliminates the ability to account for these instruments under the intrinsic
        value method prescribed by APB Opinion No. 25, as allowed under the original
        provisions of SFAS No. 123. SFAS No. 123R requires the use of an option pricing
        model for estimating fair value, which is amortized to expense over the service
        periods. SFAS No. 123R allows for two alternative transition methods. The
        first
        method is the modified prospective application whereby compensation cost
        for the
        portion of awards for which the requisite service has not yet been rendered
        that
        are outstanding as of the adoption date will be recognized over the remaining
        service period. The compensation cost for that portion of awards will be
        based
        on the grant date fair value of those awards as calculated for pro forma
        disclosures under SFAS No. 123, as originally issued. All new awards and
        awards
        that are modified, repurchased, or cancelled after the adoption date will
        be
        accounted for under the provisions of SFAS No. 123R. The second method is
        the
        modified retrospective application, which requires that the Company restates
        prior period financial statements. The modified retrospective application
        may be
        applied either to all periods or only to prior interim periods in the year
        of
        adoption of this statement. The Company will adopt the provisions of SFAS
        No.
        123R effective January 1, 2006 using the modified prospective application
        transition method.
  49
  The
        Company accelerated the vesting for substantially all of its outstanding
        options
        prior to December 31, 2005, and expects to record minimal expenses for its
        remaining unvested stock options during 2006. The reduction in pre-tax charges
        estimated by the Company as a result of the acceleration amounts to
        approximately $7.7 million over the course of the original vesting periods.
        Options to purchase approximately 704,310 shares of the Company’s stock or 52.5%
        of the Company’s outstanding options were accelerated. The weighted average
        exercise price of the options subject to acceleration were $21.30. The aggregate
        pretax expense for the shares subject to acceleration that would have been
        reflected in the Company’s consolidated financial statements beginning in 2006
        is approximately $7.7 million, including $4.3 million in 2006, $2.7 million
        in
        2007, and $0.7 million in 2008. The fair value for any future grants will
        be
        included in expense over the vesting periods. These expenses will be apportioned
        according to the classification of the employees who have received stock
        options
        into cost of sales, selling, general and administrative or research and
        development costs. The fair value for any future grants will be included
        in
        expense over the vesting periods.
 
 **Reclassification** -
        Certain
        2004 and 2003 amounts have been reclassified to conform with the 2005
        presentation.
 
 **2. ACQUISITION**
 
 ***iQvolution
        -*** On March
        29, 2005, the Company acquired 100% of the outstanding stock of privately
        held
        iQvolution AG (“iQvolution”). iQvolution, a German company, designs,
        manufactures and supplies three-dimensional laser scanning products and
        services. This purchase was a strategic acquisition to enable the Company
        to
        enter broader three-dimensional measurement markets. The purchase price for
        the
        transaction was approximately $13.6 million, including an initial cash payment
        of approximately $3.8 million and 314,736 shares of common stock valued at
        approximately $7.2 million based on the average closing price for the three
        days
        immediately preceding the closing, 152,292 shares of which were payable
        immediately. The remaining 162,444 shares of common stock, valued at
        approximately $3.7 million, were placed in escrow and may be paid over the
        following five years subject to achieving predetermined milestones with respect
        to purchased assets. Subsequent to the purchase, approximately $1.8 million
        in
        cash was paid out for the repayment of loans and approximately $0.4 million
        was
        paid in fees associated with the purchase. Additionally, the purchase price
        was
        adjusted downward by $0.1 million, and these funds were repaid to the Company
        in
        the third quarter relating to the settlement of a purchase price adjustment
        clause within the purchase agreement. In the fourth quarter of 2005, 12,183
        shares were issued as a result of the successful qualification of milestones,
        with a corresponding addition to goodwill of $252. At December 31, 2005,
        there
        were 150,261 shares being held in escrow. In February of 2006, 43,871 shares
        were issued as a result of milestones being met, for which $675 was accrued
        into
        goodwill and additional paid-in capital at December 31, 2005. An additional
        1,288 shares were returned to the Company in February 2006 for cancellation
        as a
        result of milestone disqualification.
 
 During
        the third quarter, approximately $3.8 million of the purchase price was
        allocated to intangible assets reflecting the Company’s preliminary estimate of
        the fair value of technology and software assets acquired. The hardware assets
        acquired were valued at approximately $2.3 million with an estimated life
        of 17
        years, while the software assets were valued at approximately $1.6 million
        with
        an estimated life of 10 years. As of December 31, 2005, these estimates were
        in
        the process of being reviewed and validated by a third party. The current
        purchase price and the allocation between goodwill and intangible assets
        is
        subject to adjustment before the March 29, 2006 deadline based on the Company’s
        completion of the purchase accounting for this transaction. The Company
        completed in the first quarter of 2006 the third party valuation of the assets
        acquired. The allocation between goodwill and intangible assets was recorded
        in
        the first quarter of 2006 and was not materially different from the preliminary
        estimates. A preliminary beginning balance sheet for iQvolution follows below,
        as adjusted for purchase accounting items through December 31, 2005.
  50
  Assets:Accounts
                  receivable
              
              $
              361Inventories
              
              
              280Prepaids
              
              
              266Fixed
                  assets
              
              
              595Deferred
                  tax assets
              
              
              141Intangible
                  assets
              
              
              3,840Goodwill
              
              
              6,803Total
                  Assets
              
              $
              12,286LiabilitiesAccounts
                  payable and accruals
              
              $
              2,235Long-term
                  debt
              
              
              167Total
                  Liabilities
              
              $
              2,402
  The
        operating results of iQvolution have been included in the consolidated
        statements of income since the date of acquisition. The following unaudited
        pro-forma results of operations for the years ended December 31, 2005 and
        December 31, 2004 are presented for informational purposes only and do not
        purport to be indicative of the results of operations which actually would
        have
        resulted had the acquisition occurred on the date indicated, or the results
        of
        operations which may result in the future.
 
 Years
                  ended December 31,2005
              
              2004(unaudite
                  d)
              
              (unaudited)Revenues
              
              $
              125,961
              
              $
              103,022Net
                  income
              
              $
              7,463
              
              $
              13,891Income
                  per share:Basic
              
              $
              0.53
              
              $
              099Diluted
              
              $
              0.52
              
              $
              0.98
  ***SpatialMetrix
        -*** On
        January 16, 2002, the Company acquired SpatialMetriX Corporation (SMX). In
        2003
        the Company recorded approximately $1.1 million in other (expense) income,
        net
        in the accompanying consolidated statements of operations as a result of
        receiving approximately 100,000 shares of Company stock related to a positive
        arbitration settlement between the Company and the former SMX
        shareholders.
  51
  **3.    SUPPLEMENTAL
        CASH FLOW INFORMATION**
  Selected
        cash payments and non-cash activities were as follows:
 
 Years
                  ended December 31,2005
              
              2004
              
              2003Cash
                  paid for interest
              
              $
              91
              
              $
              12
              
              $
              47Cash
                  paid for income taxes
              
              
              2,027
              
              
              357
              
              
              1,526Cash
                  received from income tax refund
              
              
              1,161
              
              
              -
              
              
              -Non-cash
                  investing and financing activities:Value
                  of shares issued for acquisition of lQvolution
              
              
              3,756
              
              
              -
              
              
              -Fixed
                  assets acquired under capital lease obligations
              
              
              -
              
              
              317
              
              
              61Retirement
                  of fully depreciated property and equipment
              
              
              -
              
              
              4,016
              
              
              -
 
 **4.
        ALLOWANCE FOR DOUBTFUL ACCOUNTS**
 
 The
        allowance for doubtful accounts is as follows:
  Years
                  Ended December 31,2005
              
              2004
              
              2003Balance,beginning
                  of year
              
              $
              339
              
              $
              255
              
              $
              852Provision
              
              
              112
              
              
              154
              
              
              140Amounts
                  written off, net of recoveries
              
              
              (237
              )
              
              (70
              )
              
              (737
              )Balance,end
                  of year
              
              $
              214
              
              $
              339
              
              $
              255
 
 **5.
        SHORT-TERM INVESTMENTS**
 
 The
        underlying investments of the Company’s variable rate municipal bonds are long
        term tax-exempt municipal bonds. These variable rate municipal bonds mature
        every seven days, at which time the interest rate adjusts to current market
        conditions. As they are considered available-for-sale securities, the Company
        has classified them as short-term investments on the accompanying consolidated
        balance sheets.
 
 **6.    INVENTORIES**
  Inventories
        consist of the following:
 
 December
                  31,2005
              
              2004Raw
                  materials
              
              $
              11,621
              
              $
              6,620Work-in-process
              
              
              199
              
              
              428Finished
                  goods
              
              
              4,976
              
              
              1,424Sales
                  Demonstration Inventory
              
              
              12,227
              
              
              8,097Reserve
                  for Obsolescence
              
              
              (373
              )
              
              (191
              )Inventory
              
              
              28,650
              
              
              16,378Service
                  Inventory
              
              
              4,333
              
              
              4,159Total
              
              $
              32,983
              
              $
              20,537
  52
  **7.    GOODWILL**
  The
        Company’s goodwill at December 31, 2005 and 2004 is related to its acquisition
        of three previous businesses. The Company tests for goodwill impairment in
        accordance with SFAS No. 142, *“Goodwill
        and Other Intangible Assets.”* The
        Company evaluates each reporting unit’s fair value versus its carrying value in
        the fourth quarter of each year or more frequently if events or changes in
        circumstances indicate that the carrying value may exceed the fair value.
        When
        estimating the reporting unit’s fair value, the Company utilizes gross profit
        for each reporting unit and a multiple based on industry averages for each
        reporting unit and compares this against the carrying value. Impairments
        to
        goodwill are charged against earnings in the period the impairment is
        identified. The Company has three reporting units for which goodwill was
        tested
        on December 31, 2005. As of December 31, 2005 and 2004, the Company did not
        have
        any goodwill that was identified as impaired. The increase in goodwill of
        $6.6
        million in 2005 relates primarily to the purchase of iQvolution while the
        $0.1
        million increase in 2004 relates entirely to the translation of foreign currency
        balances.
 
 **8.    INTANGIBLE
        ASSETS**
 
 Intangible
        assets consist of the following:
 December
                  31,2005
              
              2004Arnortizable
                  intangible assets:Existing
                  product technology
              
              $
              8,767
              
              $
              6,616Patents
              
              
              2,544
              
              
              2,625Other
              
              
              5,755
              
              
              5,855Total
              
              
              17,066
              
              
              15,096Accumulated
                  amortization
              
              
              (10,921
              )
              
              (11,778
              )Total
                  arnortizable intangible assets, net
              
              
              6,145
              
              
              3,318Non-arnortizable
                  intangible assets:Customer
                  lists
              
              
              250
              
              
              250Intangible
                  assets - net
              
              $
              6,395
              
              $
              3,568
 
 In
        2005,
        the Company wrote off patents with an original cost of $503 and a net book
        value
        of $334 which had been abandoned. Amortization expense was $1,299, $886 and
        $ 987 ,
        in
        2005, 2004, and 2003, respectively. The estimated amortization expense for
        each
        of the five succeeding fiscal years is as follows :
 **Years
                    ending December 31,**
                
                **Amount**2006
                
                $
                1,2682007
                
                
                4122008
                
                
                3872009
                
                
                3872010
                
                
                387Thereafter
                
                
                3,304$
                6,145
  53
 
 **9.    ACCRUED
        LIABILITIES**
  Accrued
        liabilities consist of the following:
 December31,2005
                
                2004Accrued
                    compensation and benefits
                
                $
                2,641
                
                $
                3,046Accrued
                    warranties
                
                
                861
                
                
                565Professional
                    and legal fees
                
                
                1,239
                
                
                930Other
                    accrued liabilities
                
                
                828
                
                
                2,711$
                5,569
                
                $
                7,252
 
 Activity
        related to accrued warranties was as follows:
 December
                    31,2005
                
                2004Beginning
                    Balance
                
                $
                565
                
                $
                590Provision
                    for warranty expense
                
                
                1,050
                
                
                740Warranty
                    expired
                
                
                (754
                )
                
                (765
                )Ending
                    Balance
                
                $
                861
                
                $
                565
  **10.    LINE
        OF CREDIT**
  The
        Company has an available line of credit of $5 million. Terms of this line
        of
        credit require the Company to maintain certain ratios and balances with respect
        to a debt covenant agreement, including current ratio, consolidated EBITDA,
        indebtedness to consolidated net worth, fixed charge coverage ratio and
        consolidated tangible net worth. As of December 31, 2005 and 2004, the Company
        was in compliance with the required ratios. Drawings under the line of credit
        bear interest at a rate equivalent to LIBOR plus 1.75%. The line of credit
        is
        due on demand. There were no amounts outstanding under the line of credit
        at
        December 31, 2005 or 2004.
 
 The
        Company has received a term sheet and is currently negotiating a new loan
        agreement which is expected to increase the term to three years and increase
        the
        amount of the credit line to $30.0 million.
 
 54
 
 **11.    CAPITAL
        LEASES AND LONG-TERM DEBT**
 
 Required
        future payments of obligations under capital leases are as
        follows:
 **Capital****Lease****Year
                    ending December 31,**
                
                **Obligations**2006
                
                $
                1242007
                
                
                702008
                
                
                392008
                
                
                42009
                
                
                2Total
                    future minimum lease payments
                
                
                239Less
                    - Amounts representing interest
                
                
                (11
                )Total
                    obligations
                
                
                228Less
                    - Current maturities
                
                
                (119
                )$
                109
  Assets
        under capital leases were $384 and $406 at December 31, 2005 and 2004,
        respectively. Accumulated depreciation under capital leases was $235 and
        $178 at
        December 31, 2005 and 2004, respectively.
 
 Long-term
        debt of $112 is included in capital leases and long-term debt in the
        accompanying consolidated balance sheets as of December 31, 2005. $44 of
        the
        long-term debt is due in 2006, with the balance of $68 being due in
        2007.
 
 **12.    RELATED
        PARTY TRANSACTIONS**
  ***Related
        party lease*** —The
        Company leases its plant and office building from Xenon Research, Inc., all
        of
        the issued and outstanding capital stock of which is owned by Simon Raab,
        our
        Chairman and Co-Chief Executive Officer, and Diana Raab, his spouse. The
        term
        of the lease expired on February 28, 2006, and is continuing on a month to
        month
        basis. The Company expects to renew the lease for an additional 3 - 5 years
        under similar terms .
        Rent
        expense under this lease was approximately
        $398 in 2005, 2004 and 2003. The Company has determined that the assets subject
        to this lease are not subject to the requirements of FIN 46(R).
  ***Related
        party loans*** —In
        May
        1998, the Company acquired CATS. On June 20, 2000 the Company and each of
        the
        former CATS shareholders entered into an Amended and Restated Loan Agreement
        pursuant to which the Company granted loans to the former CATS shareholders
        in
        the aggregate amount of $1.1 million (The Loans). The Loans outstanding were
        for
        a term of three years, at an interest rate of approximately 4.7%, and granted
        the borrowers an option to extend the term for an additional three years.
        The
        loans were repaid to the Company in 2003.
  55
  **13.    OTHER
        (EXPENSE) INCOME, NET**
  Other
        (expense) income, net consists of the following:
 Years
                    ended December 31,2005
                
                2004
                
                2003Foreign
                    exchange (losses) gains
                
                $
                (794
                )
                $
                337
                
                $
                490Disposal
                    of patents
                
                
                (334
                )
                
                -
                
                
                -Litigation
                    settlement
                
                
                -
                
                
                -
                
                
                1,156Other
                
                
                322
                
                
                25
                
                
                314Total
                    other (expense) income, net
                
                $
                (806
                )
                $
                362
                
                $
                1,960
  **14.    INCOME
        TAXES**
  Income
        before income taxes consists of the following:
 Years
                    ended December 31,2005
                
                2004
                
                2003Domestic
                
                $
                5,304
                
                $
                5,729
                
                $
                6,455Foreign
                
                
                4,594
                
                
                9,560
                
                
                2,981Income
                    before income taxes
                
                $
                9,898
                
                $
                15,289
                
                $
                9,436
  The
          components of the income tax expense are as follows:
 Yearsended
                      December 31,2005
                  
                  2004
                  
                  2003Current:Federal
                  
                  $
                  1,792
                  
                  $
                  987
                  
                  $
                  1,535State
                  
                  
                  173
                  
                  
                  65
                  
                  
                  101Foreign
                  
                  
                  1,317
                  
                  
                  1,316
                  
                  
                  5723,282
                  
                  
                  2,368
                  
                  
                  2,208Deferred:Federal
                  
                  
                  (395
                  )
                  
                  (278
                  )
                  
                  (985
                  )State
                  
                  
                  (38
                  )
                  
                  (18
                  )
                  
                  (65
                  )Foreign
                  
                  
                  (1,130
                  )
                  
                  (1,714
                  )
                  
                  -(1,563
                  )
                  
                  (2,010
                  )
                  
                  (1,050
                  )$
                  1,719
                  
                  $
                  358
                  
                  $
                  1,158
  56
  Income
        tax expense for the years ended December 31, 2005, 2004, and 2003 differ
        from
        the amount computed by applying the federal statutory corporate rate to income
        before income taxes. The differences are reconciled as follows:
 Years
                    ended December 31,2005
                
                2004
                
                2003Tax
                    expense at statutory rate of 35%
                
                $
                3,464
                
                $
                5,351
                
                $
                3,302State
                    income taxes, net of federal benefit
                
                
                84
                
                
                147
                
                
                292Foreign
                    tax rate difference
                
                
                (2,771
                )
                
                (1,309
                )
                
                602Research
                    and development credit
                
                
                (274
                )
                
                (270
                )
                
                (106
                )Change
                    in valuation allowance
                
                
                1,247
                
                
                (3,191
                )
                
                (3,974
                )Change
                    in foreign tax rate
                
                
                -
                
                
                -
                
                
                381Other
                
                
                (31
                )
                
                (370
                )
                
                661Total
                    income tax expense
                
                $
                1,719
                
                $
                358
                
                $
                1,158
  The
        components of the Company’s net deferred income tax asset are as follows:
 December
                    31,2005
                
                2004Net
                    deferred income tax asset - CurrentProduct
                    design costs
                
                $
                -
                
                $
                (175
                )Intercompany
                    profit in inventory
                
                
                2,166
                
                
                993Warranty
                    costs
                
                
                242
                
                
                141Bad
                    debt reserve
                
                
                32
                
                
                9Inventory
                    reserve
                
                
                59
                
                
                -Unearned
                    service revenue
                
                
                723
                
                
                -Other
                
                
                4
                
                
                20Deferred
                    income tax asset - Current
                
                
                3,226
                
                
                988Valuation
                    Allowance
                
                
                (1,071
                )
                
                (244
                )Net
                    deferred income tax asset - Current
                
                $
                2,155
                
                $
                744
  Net
                    deferred income tax asset - Non-currentDepreciation
                
                $
                886
                
                $
                853Goodwill
                    amortization
                
                
                (880
                )
                
                (650
                )Product
                    design costs
                
                
                (128
                )
                
                -Employee
                    stock options
                
                
                55
                
                
                188Unearned
                    service revenue
                
                
                199
                
                
                617Tax
                    credits
                
                
                716
                
                
                1,019Loss
                    carryforwards
                
                
                5,442
                
                
                3,469Deferred
                    income tax asset - Non-current
                
                
                6,270
                
                
                5,676Valuation
                    Allowance
                
                
                (2,415
                )
                
                (1,403
                )Net
                    deferred income tax asset - Non-current
                
                $
                3,855
                
                $
                4,273
  57
  At
        December 31, 2005 and 2004, the Company’s domestic entities had deferred income
        tax assets in the amount of $4,074 and $3,306, respectively. The Company
        has
        determined that these amounts are fully realizable and have not established
        any
        valuation allowance based on the assessment that they are more-likely-than-not
        to be utilized.
 
 At
        December 31, 2005 and 2004, the Company’s foreign subsidiaries had deferred
        income tax assets relating to net operating loss carry forwards, which do
        not
        expire, of $5,422 and $3,359, respectively. For financial reporting purposes,
        a
        valuation allowance of $3,486 and $1,647, respectively has been recognized
        to
        offset the deferred tax assets relating to net operating losses.
 
 The
        Company continues to maintain a valuation allowance on net operating losses
        in
        jurisdictions for which it does not have a history of earnings over the last
        three years and where the Company believes that the deferred tax assets are
        not
        more-likely-than-not to be realized. The Company increased the overall valuation
        allowance in 2005 on its deferred tax assets in the amount of $1,839. The
        increase in the valuation allowance for 2005 relates to the net generation
        of
        deferred tax assets in foreign jurisdictions, combined with $809 from the
        purchase of iQvolution and the release of $44 in valuation allowance in a
        foreign jurisdiction in the second quarter. The release of the valuation
        allowance was based on one of its foreign units having demonstrated a history
        of
        earnings over the past three years, and with management’s assessment that the
        unit will be more-likely-than-not to utilize their deferred tax assets.
        Management calculated the amount to release from the valuation allowance
        using
        projections of future taxable earnings over the next two years.
 
 At
        December 31, 2005 and 2004, the Company had $716 and $1,019 in tax credits,
        respectively. These credits are related to the Company’s research and
        development activities and expire in 16 to 20 years. The Company fully expects
        to realize these credits before expiration.
 
 The
        Company operates in a number of different countries around the world. In
        2003,
        the Company began to manufacture its products in Switzerland, where it has
        received a favorable income tax rate commitment from the Swiss government
        as an
        incentive to establish a manufacturing plant there. In 2005, the Company
        opened
        a regional headquarters and began to manufacture its products in Singapore,
        where it has received a temporary reduced income tax rate commitment from
        the
        Singapore Economic Development Board as an incentive to establish a
        manufacturing plant and regional headquarters there.
 
 We
        have
        not recognized any U.S. tax expense on undistributed international earnings
        since we intend to reinvest the earnings outside the U.S. for the foreseeable
        future. Our net undistributed international earnings were approximately $20.6
        million and $5.4 million at December 31, 2005, and 2004,
        respectively.
 
 Significant
        judgment is required in determining our worldwide provision for income taxes.
        In
        the ordinary course of a global business, there are many transactions for
        which
        the ultimate tax outcome is uncertain. The Company reviews its tax contingencies
        on a regular basis and makes appropriate accruals as necessary.
  **15.    SHARE
        ISSUANCE**
  On
        November 12, 2003, the Company sold 1,158,000 shares of its common stock,
        and
        two of the Company’s founders sold 772,000 shares of the Company’s common stock
        to institutional investors in a private placement that was not registered
        under
        the Securities Act of 1933. The shares were sold for $21.50 per share, resulting
        in total proceeds before placement agent fees and other offering expenses
        of
        $24.9 million and $16.6 million to the Company and the co-founders,
        respectively. The purchasers of the shares sold in the transaction were 31
        institutional investors. Robert W. Baird & Co. served as the placement agent
        for the transaction, and received a fee equal to $2,489,700, or 6% of the
        aggregate sales proceeds. The Company also reimbursed Robert W. Baird & Co.
        for $50,000 in expenses incurred in connection with the transaction.
 
 58
 
 **16.    COMMITMENTS
        AND CONTINGENCIES**
  ***Leases*** —The
        following is a schedule of future minimum lease payments required under
        non-cancelable operating leases with initial terms in excess of one year,
        including leases with related parties (see Note 12), in effect at
        December 31, 2005:
 **Years
                    ending December 31,**
                
                **Amount**2006
                
                $
                2,5192007
                
                
                1,8232008
                
                
                1,4952009
                
                
                1,2202010
                
                
                468Thereafter
                
                
                -Total
                    future minimum lease payments
                
                $
                7,525
 
 Rent
        expense for 2005, 2004, and 2003, was approximately $2,306, $ 1,651
        and
        $ 1,148 ,
        respectively.
  ***Patent
        Litigation*** — On
        November 25, 2003, Cimcore-Romer (now a division of Hexagon) filed a patent
        infringement suit against us in the Federal District Court for the Southern
        District of California alleging that certain of our products sold in the
        United
        States, including the FARO Arm, infringe U.S. Patent 5,829,148 (‘148 patent).
        The Company believes, and has contended in this litigation, that the Company
        does not infringe the ‘148 patent and that the ‘148 patent is
        invalid.
 
 On
        July
        12, 2005, the court issued an order granting Cimcore-Romer’s motion for summary
        judgment of infringement of three claims of the ‘148 patent. On July 22, 2005,
        the Company announced its decision to limit the capability of its U.S.-based
        FARO Arm products (the FARO Arm, the FARO Gage and the Digital Template)
        by
        removing what we call the “infinite rotation feature” by reducing this
        capability to 50 rotations or fewer. FARO believes that by limiting the range
        of
        the joint rotation to 50 rotations, it has removed from its U.S. products
        the
        ability to sweep through an unlimited arc, which is a feature of the ‘148 patent
        claims addressed by the court’s ruling required to infringe the ‘148 patent. The
        revised products have not, however, been considered by the courts. Accordingly,
        we cannot give assurance that the revised products will not be deemed to
        infringe the ‘148 patent.
  On
        September 20, 2005, the Court vacated its order of summary judgment of
        infringement and agreed to reconsider its conclusions from the patent claim
        construction (“Markman”) ruling, which is a pretrial hearing often used in
        patent infringement cases. The new Markman hearing occurred on October 3,
        2005
        and the hearing-on-summary judgments of infringement occurred on November
        14,
        2005. On October 18, 2005, the Court issued a revised claim construction
        that
        the Company believes materially alters the Court’s previous Markman ruling by
        substantially narrowing what FARO believes to be key aspects of the claim
        construction. The Company believes that this narrower claim construction
        will
        ultimately lead to a finding that it does not infringe any claim of the ‘148
        patent. On November 14, 2005, the Court denied both the Plaintiffs’ Renewed
        Motion for Summary Judgment of Infringement and the Defendant’s Faro’s Renewed
        Motion for Summary Judgment of Non-Infringement, and determined that there
        existed a genuine issue of material fact with respect to whether Faro infringed
        the assert patent. The case was originally set for trial for January 31,
        2006.
        On January 18, 2006, the Court vacated the trial date and remanded the case
        to
        the magistrate for resumption of discovery regarding Plaintiffs’ alleged
        compliance with the patent marking provisions of 35 U.S.C. § 287 and all related
        issues. A hearing on Faro’s Motion for Partial Summary Judgment Regarding
        Plaintiffs’ Failure to Comply With the Patent Marking Provisions of 35 U.S.C. §
287 was held on May 11, 2006. A new trial date has been set for July 17,
        2006.
  59
  In
        addition, the Company filed two separate requests for reexamination in the
        U.S.
        Patent and Trademark Office (“PTO”) of the ‘148 Patent, both of which requests
        were granted. The PTO ruled in the first reexamination in September 2005.
        The
        Company believes that the PTO ruling bolsters the Company’s previous position
        that it does not infringe the ‘148 patent. More specifically, in the first
        reexamination, the PTO construed critical claim terms in a relatively narrow
        manner, which the Company believes is consistent with its stated positions
        in
        the patent litigation. This narrow claim construction led the PTO to
        differentiate the claims for the references at issue in the first reexamination.
        The Company believes that this narrow construction, while allowing the ‘148
        claims to be confirmed valid over the aforementioned references in the first
        reexamination, will prevent the California District Court from ruling that
        Faro’s products infringe the ‘148 patent. The Company’s second reexamination
        request was granted by the PTO in November 2005 and is based on new “prior art”
(that is, earlier issued patent publications) submitted to the PTO which
        FARO
        believes will ultimately invalidate the ‘148 patent. This prior art reference
        was not at issue in the first reexamination proceeding. The PTO has not ruled
        in
        the second reexamination request.
  In
        the
        event of an adverse ruling in the Cimcore-Romer litigation, however, we could
        be
        required to pay substantial damages, cease the manufacturing, use and sale
        of
        any infringing products, discontinue the use of certain processes or obtain
        a
        license, if available, from Cimcore-Romer with royalty payment obligations
        by
        us. An adverse decision in the Cimcore-Romer case could materially and adversely
        affect our financial condition and results of operations. At this time, however,
        the Company cannot estimate the potential impact, if any, that might result
        from
        this suit, and therefore, no provision has been made to cover such
        expense
  ***Securities
        Litigation*** —
On
        December 6, 2005, the first of four essentially identical class action
        securities fraud lawsuits were filed against the Company and certain officers
        of
        the Company. On April 19, 2006, the four lawsuits were consolidated, and
        Kornitzer Capital Management, Inc. was appointed as the lead plaintiff. On
        May
        16, 2006, Kornitzer filed its Consolidated Amended Class Action Complaint
        against the Company and the individual defendents. The amended complaint
        also
        names Grant Thornton LLP, the Company’s independent registered public accounting
        firm, as an additional defendant.
  In
        the
        amended complaint, Kornitzer seeks to represent a class consisting of all
        persons who purchased or otherwise acquired the Company’s publicly traded
        securities between April 15, 2004 and March 15, 2006. On behalf of the alleged
        class, Kornitzer seeks an unspecified amount of damages, premised on allegations
        that each defendant made misrepresentations and omissions of material fact
        during the class period in violation of the Securities Exchange Act of 1934.
        Among other things, Kornitzer alleges that the Company’s reported gross margins
        and net income were knowingly overstated as a result of manipulation of the
        Company’s inventory levels, that the Company failed to disclose deficiencies
        associated with the Company’s implementation and use of its enterprise resource
        planning system and material requirements planning system, made false and
        misleading statements regarding the Company’s internal controls; failed to
        disclose the fact that the Company was accruing commissions and bonuses which
        would have a material, adverse effect upon the Company’s profitability, and
        improperly reported sales and net income based, in part, on sales and new
        orders
        obtained in violation of the Foreign Corrupt Practices Act.
  60
  The
        Company’s deadline for filing its response to the amended complaint is July 31,
        2006. The Company intends to file a motion to dismiss. The Company has timely
        notified the issuer of its Executive Liability and Entity Securities Liability
        insurance policy of the Securities Litigation, and has reserved the full
        amount
        of its $250,000 retention under the policy. Although the Company believes
        that
        the material allegations made in the amended complaint are without merit
        and
        intends to vigorously defend the Securities Litigation, no assurances can
        be
        given with respect to the outcome of the Securities Litigation.
  ***Purchase
        Commitments*** ***—*** The
        Company enters into purchase commitments for products and services in the
        ordinary course of business. These purchases generally cover production
        requirements for 60 to 90 days. On August 11, 2005, FARO entered into an
        agreement with DELCAM plc under which the Company agreed to purchase
        approximately $1.4 million in products over a 12-month term. At December
        31,
        2005, the Company had completed the purchase of $0.6 million in products
        under
        this agreement. Effective November 1, 2005, FARO entered into an agreement
        with
        Metrologic Group S.A. under which the Company agreed to purchase approximately
        $0.4 million in products over a 12-month term. At December 31, 2005, no products
        had been purchased under this agreement. Other than the agreements listed
        above,
        the Company does not have any long-term commitments for purchases.
  ***Voluntary
        Disclosure of Foreign Corrupt Practices Act Matter to the Securities and
        Exchange Commission and Department of Justice. -*** As
        previously reported on the Company’s Form 8-K dated March 15, 2006, the Company
        learned that its China subsidiary had made payments to certain customers
        in
        China that may have violated the FCPA and other applicable laws. The Company’s
        Audit Committee instituted an internal investigation into this matter in
        February 2006, and the Company voluntarily notified the SEC and the DOJ of
        this
        matter in March 2006. The internal investigation into this matter has been
        completed. The Company has provided to the SEC and the DOJ information obtained
        during the course of this investigation and is cooperating with both agencies.
  The
        Company’s internal investigation has identified certain improper payments made
        in China and deficiencies in its controls with respect to its operations
        in
        China in possible violation of the FCPA. If the SEC or the DOJ determines
        that
        violations of the FCPA have occurred, they could seek civil and criminal
        sanctions, including monetary penalties, against the Company and/or certain
        of
        its employees, as well as additional changes to the Company’s business practices
        and compliance programs. Based on current information, it is not possible
        to
        predict at this time when the SEC or DOJ investigations will be resolved,
        what
        the outcome will be, what sanctions, if any, will be imposed, or the effect
        that
        such matters may ultimately have on the Company or its consolidated financial
        statements. Results of the investigation revealed that referral fee payments
        in
        possible violation of the FCPA were $165,000 and $265,000 in 2004 and 2005,
        respectively, which were recorded in selling expenses in the Company’s statement
        of income. The related sales to customers to which payment of these referral
        fees had been made totaled $1.3 million and $3.24 million in 2004 and 2005,
        respectively. Additional improper referral fee payments of $122,000 were
        made in
        January and February 2006 related to sales contracts in 2005. The Company
        anticipates incurring expenses of at least $3.5 million in 2006 relating
        to its
        internal investigation of the FCPA matter.
  61
  The
        Company has terminated certain personnel in the Asia-Pacific Region and has
        re-assigned the duties of other personnel in both the Asia-Pacific Region
        and
        the U.S. as a result of the internal investigation. The Company is instituting
        the following remedial measures:
  ·
            Contracted
                with a third party forensics accounting team to conduct an in-depth
                audit
                of the operations in China and in other countries in the Asia-Pacific
                Region and to make recommendations for improvement to the internal
                control
                systems.  ·
            Reviewing
                third party distributor arrangements in an effort to assure that
                all
                contracts include adherence to the FCPA.  ·
            Performing
                due diligence on all third party distributors and implementing a
                process
                to assess potential new distributors.  ·
            Established
                an in-house internal audit function including hiring a Director of
                Internal Audit.  ·
            Consolidating
                the human resources, financial accounting and reporting functions
                for the
                Asia region into the Singapore
                Operations.  ·
            Implemented
                an internal certification process to ascertain whether similar issues
                may
                exist elsewhere in the Company.  ·
            Implemented
                a quarterly internal certification process to confirm adherence to
                company
                policy and all applicable laws and regulations that will include
                all
                regional leadership, country management and other sales
                management.  ·
            Implementing
                additional training on FCPA and other matters for employees and a
                confidential compliance reporting system.  The
        Company reported sales in China of $9.0 million in 2005 and $4.2 million
        in
        2004, approximately 7% and 4% of total sales, respectively. Depending on
        how
        this matter is resolved, the Company’s sales in China could be significantly
        impacted. The termination of certain personnel and cessation of improper
        payments in China may have a significant adverse effect on future operations
        in
        China because such action could negatively influence the decisions of a
        significant number of customers of the Chinese subsidiary to do business
        with
        that subsidiary. The potential magnitude of the loss of sales in China as
        a
        result of potential violations of the FCPA cannot be estimated at this
        time.
  During
        the Company’s internal investigation of its business practices in China, it
        became aware that income taxes related to certain commissions and bonus payments
        to its employees had not been properly reported. The Company will promptly
        remit
        any deficiencies after it has completed its investigation. At this time,
        the
        Company does not anticipate the amount will have a material effect on its
        financial condition or results of operations. The Company may be subject
        to
        penalties by the Chinese tax authorities, but we are not able to determine
        the
        amount, if any, of the assessment.
  Other
        than the litigation mentioned above, the Company is not involved in any other
        legal proceedings other than routine litigation arising in the normal course
        of
        business. The Company does not believe the results of such litigation, even
        if
        the outcome were unfavorable to the Company, would have a material adverse
        effect on the Company’s business, financial condition or results of
        operations.
  **17.    STOCK
        COMPENSATION PLANS**
  The
        Company has four stock option plans that provide for the granting of stock
        options to key employees and non-employee members of the Board of Directors.
        The
        1993 Stock Option Plan (1993 Plan) and the 1997 Employee Stock Option Plan
        (1997
        Plan) provide for granting incentive stock options and nonqualified stock
        options to officers and key employees of the Company. The 1997 Non-employee
        Director Plan provides for granting nonqualified stock options and formula
        options to non-employee directors. The 2004 Equity Incentive Plan (2004 Plan)
        provides for granting options or stock appreciation rights to employees and
        non-employee directors.
  62
  The
        Company is authorized to grant options for up to 703,100 shares of common
        stock
        under the 1993 Plan, of which 1 option is currently outstanding at an exercise
        price of $3.60. This option vests over a 3-year period. The Company is also
        authorized to grant options for up to 1,400,000 shares of common stock under
        the
        1997 Plan, of which 382,047 options are currently outstanding at exercise
        prices
        between $1.50 and $27.40. These options vest over a 3-year period. The Company
        is also authorized to grant up to 250,000 shares of common stock under the
        1997
        Non-employee Director Plan of which 80,000 options are currently outstanding
        at
        exercise prices between $1.61 and $21.56. Each non-employee director is granted
        3,000 options upon election to the Board of Directors and then annually upon
        attending the annual meeting of shareholders (formula options). Formula options
        granted to directors are generally granted upon the same terms and conditions
        as
        options granted to officers and employees. These options vest over a 3-year
        period. The Company is also authorized to grant options for up to 1,750,000
        shares of common stock under the 2004 Plan, of which 877,986 options are
        currently outstanding at exercise prices between $19.34 to $31.45, and 57,259
        restricted stock units are outstanding at a stock price of $19.49. These
        options
        and restricted stock units vest over a 3-year period. The restricted stock
        unit
        grants have a performance-based annual vesting on the anniversary date over
        their respective terms. The Company records compensation cost associated
        with
        its restricted stock unit grants on a straight-line basis over the vesting
        term.
 
 In
        addition to the four stock option plans, the Company has the 1997 Non-Employee
        Directors Fee Plan (1997 Fee Plan) under which the Company is authorized
        to
        issue up to 250,000 shares of Common Stock and permits non-employee directors
        to
        elect to receive directors’ fees in the form of common stock rather than cash.
        Common stock issued in lieu of cash directors’ fees is issued at the end of the
        quarter in which the fees are earned, with the number of shares being based
        on
        the fair market value of the common stock for the five trading days immediately
        preceding the last business day of the quarter. The 1997 Fee Plan also permits
        non-employee directors to irrevocably elect to defer receipt of all or any
        portion of the shares of common stock which would otherwise be payable. As
        of
        December 31, 2005 and 2004 there were 11,090 and 35,941 shares, respectively,
        which were accrued but not yet issued in connection with director’s
        elections.
  In
        the
        fourth quarter of 2001, the Company cancelled approximately 548,000 “out of the
        money” options, including approximately 440,000 options issued under the 1997
        Plan and approximately 108,000 options issued under the 1997 Non-employee
        Director Plan. As a result, 62,806 options granted in 2001, under the 1997
        Plan
        and to holders of some of the options cancelled, were subjected to variable
        accounting treatment. Under FIN 44, stock options issued within six months
        of a
        cancellation must be accounted for as variable under certain circumstances.
        Variable accounting requires companies to re-measure compensation costs for
        the
        variable options based on the Company’s share price until the options are
        exercised, cancelled or forfeited without replacement. Compensation is dependent
        on fluctuations in the quoted market prices for the Company’s common stock. Such
        compensation costs will be recognized over a three-year vesting schedule
        until
        the options are fully vested, exercised, cancelled or forfeited, after which
        time the compensation will be recognized immediately at each reporting period.
        With the adoption of FAS 123(R) in January of 2006, FIN 44 will be superseded
        and the Company will no longer be required to account for these options under
        variable accounting.
  In
        the
        fourth quarter of 2005, the Company accelerated the vesting for substantially
        all of its outstanding options, and expects to record minimal expenses for
        its
        remaining unvested stock options during 2006. The pre-tax charge estimated
        by
        the Company to be avoided as a result of the acceleration amounts to
        approximately $7.7 million over the course of the original vesting periods.
        The
        fair value for any future grants will be included in expense over the vesting
        periods.
  63
  Compensation
        (income) costs charged to operations associated with the Company’s stock option
        plans were ($150), $277,  and
        $719
        in 2005, 2004, and 2003, respectively. The changes in stock option associated
        compensation cost were due to the vesting of options combined with market
        price
        fluctuations in the Company’s common stock under variable accounting and the
        accrual of expenses relating to the issuance of restricted stock.
 
 A
        summary
        of stock option activity and weighted average exercise prices follows:
 Years
                    Ended December 31,2005
                
                2004
                
                2003Options
                
                Weighted-AverageExercisePrice
                
                Options
                
                Weighted-AverageExercisePrice
                
                Options
                
                Weighted-AverageExercisePriceOutstanding
                    at beginning of year
                
                
                1,215,240
                
                $
                13.69
                
                
                978,952
                
                $
                2.42
                
                
                1,554,513
                
                $
                2.41Granted
                
                
                314,123
                
                
                22.75
                
                
                750,730
                
                
                20.86
                
                
                22,500
                
                
                5.39Forfeited
                
                
                (51,830
                )
                
                20.06
                
                
                (28,930
                )
                
                8.06
                
                
                (69,222
                )
                
                2.13Exercised
                
                
                (137,499
                )
                
                2.47
                
                
                (485,512
                )
                
                2.41
                
                
                (528,839
                )
                
                2.46Outstanding
                    at end of year
                
                
                1,340,034
                
                $
                16.72
                
                
                1,215,240
                
                $
                13.69
                
                
                978,952
                
                $
                2.42Outstanding
                    exercisable at year-end
                
                
                1,329,366
                
                $
                16.82
                
                
                339,465
                
                $
                6.40
                
                
                501,631
                
                $
                2.61Weighted-average
                    fair value of optionsgranted
                    during the year
                
                $
                11.03
                
                
                
                
                $
                13.67
                
                
                
                
                $
                3.35
  A
        summary
        of stock options outstanding and exercisable as of December 31, 2005 follows:
 Exercise
                    Price
                
                OptionsOutstanding
                
                Weighted-AverageRemainingContractual Life (years)
                
                AverageExercisePrice
                
                OptionsExercisable
                
                AverageExercisePriceUp
                    to $1.50
                
                
                30,312
                
                
                5.84
                
                $
                1.50
                
                
                30,312
                
                $
                1.50$1.51-$3.00
                
                
                283,812
                
                
                6.23
                
                
                2.23
                
                
                280,645
                
                
                2.23$3.01-$10.00
                
                
                26,503
                
                
                6.21
                
                
                4.46
                
                
                19,002
                
                
                4.09$10.01-$20.00
                
                
                505,460
                
                
                8.85
                
                
                19.27
                
                
                505,460
                
                
                19.27Over
                    $20.00
                
                
                493,947
                
                
                8.82
                
                
                24.03
                
                
                493,947
                
                
                24.031,340,034
                
                
                8.17
                
                $
                16.72
                
                
                1,329,366
                
                $
                16.82
  Remaining
        non-exercisable options as of December 31, 2005 become exercisable as follows:
 Years
                    ending December 31,
                
                Amount2006
                
                
                10,66810,668
 
 64
  **18.    EARNINGS
        PER SHARE**
  A
        reconciliation of the number of common shares used in the calculation of
        basic
        and diluted earnings per share (EPS) is presented below:
 Years
                    ended December 31,2005
                
                2004
                
                2003Shares
                
                Per-ShareAmount
                
                Shares
                
                Per-ShareAmount
                
                Shares
                
                Per-Share
                    AmountBasic
                    EPS
                
                
                14,169,140
                
                $
                0.58
                
                
                13,833,590
                
                $
                1.08
                
                
                12,181,221
                
                $
                0.68Effect
                    of dilutive securities
                
                
                273,108
                
                
                (0.01
                )
                
                189,569
                
                
                (0.02
                )
                
                664,771
                
                
                (0.04
                )Diluted
                    EPS
                
                
                14,442,248
                
                $
                0.57
                
                
                14,023,159
                
                $
                1.06
                
                
                12,845,992
                
                $
                0.64
  The
        effect of 237,419 dilutive securities was not included for 2005 as they were
        antidilutive.
 
 **19.    EMPLOYEE
        RETIREMENT BENEFIT PLAN**
  The
        Company maintains a 401(k) defined contribution retirement plan for its U.S.
        employees, which provides benefits for all employees meeting certain age
        and
        service requirements. The Company may make a discretionary contribution each
        plan year, as determined by its Board of Directors. Discretionary contributions
        or employer matches can be made to the participant’s account but cannot exceed
        100% of compensation. Costs charged to operations in connection with the
        Plan
        during 2005, 2004, and 2003 aggregated $201, $172, and $113, respectively.
 
 **20.
        GEOGRAPHIC DATA**
 
 The
        Company develops, manufactures, markets and supports CAD-based quality assurance
        products integrated with CAD-based inspection and statistical process control
        software. This one line of business represents approximately 99% of consolidated
        sales and is the Company’s only segment. The Company operates through sales
        teams established by geographic area. Each team is equipped to deliver the
        entire line of Company products to customers within its geographic area.
 
 The
        following table presents information about the Company by geographic area:
 As
                    of and for the year ended December 31,2005
                
                2004
                
                2003Sales
                
                Long-livedAssets
                
                Sales
                
                Long-livedAssets
                
                Sales
                
                Long-livedAssetsAmericas
                    Region
                
                $
                55,884
                
                $
                2,307
                
                $
                41,680
                
                $
                2,315
                
                $
                37,863
                
                $
                1,467Europe/Africa
                    Region
                
                
                44,940
                
                
                3,288
                
                
                43,111
                
                
                1,239
                
                
                27,701
                
                
                1,106Asia
                    Pacific Region
                
                
                24,766
                
                
                469
                
                
                12,229
                
                
                461
                
                
                6,222
                
                
                180$
                125,590
                
                $
                6,064
                
                $
                97,020
                
                $
                4,015
                
                $
                71,786
                
                $
                2,753
  The
        geographical sales information presented above represents sales to customers
        located in each respective region whereas the long-lived assets information
        represents assets held in the respective regions.
 
 65
 
 **21.    QUARTERLY
        RESULTS OF OPERATIONS (UNAUDITED)**
 
 **April
                    2,**
                
                **July
                    2,**
                
                **October
                    1,**
                
                **December
                    31,****Quarter
                    ended**
                
                **2005**
                
                **2005**
                
                **2005**
                
                **2005**Sales
                
                $
                27,617
                
                $
                30,895
                
                $
                32,598
                
                $
                34,480Gross
                    profit
                
                
                17,343
                
                
                18,390
                
                
                17,685
                
                
                19,514Net
                    income
                
                
                3,469
                
                
                1,912
                
                
                2,615
                
                
                183Net
                    income per share:Basic
                
                $
                0.25
                
                $
                0.13
                
                $
                0.18
                
                $
                0.01Diluted
                
                $
                0.24
                
                $
                0.13
                
                $
                0.18
                
                $
                0.01**April
                    3,**
                
                
                **July
                    3,**
                
                
                **October
                    2,**
                
                **December
                    31,****Quarter
                    ended**
                
                
                **2004**
                
                
                **2004**
                
                
                **2004**
                
                
                **2004**Sales
                
                $
                21,025
                
                $
                24,077
                
                $
                23,376
                
                $
                28,542Gross
                    profit
                
                
                13,464
                
                
                15,228
                
                
                14,757
                
                
                16,547Net
                    income
                
                
                2,848
                
                
                4,103
                
                
                3,065
                
                
                4,915Net
                    income per share:Basic
                
                $
                0.21
                
                $
                0.30
                
                $
                0.22
                
                $
                0.35Diluted
                
                $
                0.20
                
                $
                0.29
                
                $
                0.22
                
                $
                0.34
  66
  **I****TEM****9.**
              **C****HANGES********IN
                  AND****D****ISAGREEMENTS****W****ITH****A****CCOUNTANTS********ON****A****CCOUNTING********AND****F****INANCIAL****D****ISCLOSURE****.**
  None.
  **I****TEM****9A.**
              **C****ONTROLS********AND****P****ROCEDURES****.**
  **Evaluation
        of Disclosure Controls and Procedures**
  As
        of
        December 31, 2005, management carried out an evaluation, under the supervision
        and with the participation of its Chief Executive Officer and Chief Financial
        Officer, of the effectiveness of the design and operation of its disclosure
        controls and procedures as such term is defined under Securities Exchange
        Act of
        1934, as amended (the “Exchange Act”) Rule 13a-15(e). Based on this evaluation,
        management has concluded that as of December 31, 2005, such disclosure controls
        and procedures were effective to provide reasonable assurance that the Company
        records, processes, summarizes and reports the information the Company must
        disclose in reports that the Company files or submits under the Exchange
        Act
        within the time periods specified in the SEC’s rules and forms.
  **Management’s
        Report on Internal Control Over Financial Reporting**
  Our
        Co-Chief Executive Officers and Chief Financial Officer, together with other
        members of management of FARO Technologies Inc., are responsible for
        establishing and maintaining adequate internal control over financial reporting.
  Internal
        control over financial reporting is the process designed under our supervision,
        and effected by our Board of Directors, management and other personnel, to
        provide reasonable assurance regarding the reliability of financial reporting
        and the preparation of our financial statements for external purposes in
        accordance with accounting principles generally accepted in the United States
        of
        America.
  There
        are
        inherent limitations in the effectiveness of internal control over financial
        reporting, including the possibility that misstatements may not be prevented
        or
        detected. Accordingly, an effective control system, no matter how well designed
        and operated, can provide only reasonable assurance of achieving the designed
        control objectives, and management is required to apply its judgment in
        evaluating the cost-benefit relationship of possible controls and procedures.
        Because of the inherent limitations in all control systems, no evaluation
        of **** controls
        can provide absolute assurance that all control issues and instances of fraud,
        if any, within the company have been detected. These inherent limitations
        include the realities that judgments in decision-making can be faulty, and
        that
        breakdowns can occur because of simple error or mistake. Additionally, controls
        can be circumvented by the individual acts of some persons, by collusion
        of two
        or more people, or by management over ride of the control. The design of
        any
        system of controls also is based in part upon certain assumptions about the
        likelihood of future events, and there can be no assurance that any design
        will
        succeed in achieving its stated goals under all potential future conditions.
        Because of the inherent limitations in a cost-effective control system,
        misstatements due to error or fraud may occur and not be detected.
  As
        previously reported on the Company’s Form 8-K dated March 15, 2006, the Company
        learned that its China subsidiary had made payments to certain customers
        in
        China that may have violated the FCPA and other applicable laws. The Company’s
        Audit Committee instituted an internal investigation into this matter, and
        the
        Company voluntarily notified the SEC and the DOJ of this matter and provided
        them with information obtained during the course of the investigation and
        is
        cooperating fully with both agencies. The Company’s internal investigation has
        identified certain payments made in China and deficiencies in its controls
        with
        respect to its operations in China in possible violation of the
        FCPA.
  67
  Management
        has evaluated the effectiveness of internal control over financial reporting
        as
        of December 31, 2005, in relation to criteria described in Internal
        Control-Integrated Framework issued by the Committee of Sponsoring Organizations
        Commission of the Treadway Commission (COSO). Based upon this evaluation
        and the
        new facts that have arisen prior to filing Form 10-K, management has concluded
        that certain deficiencies exist in the design and operation of internal controls
        related to financial reporting, which represent a material weakness in internal
        control over financial reporting.
  As
        a
        result of these findings, management has undertaken the following actions
        to
        address the control deficiencies:
  ·
            Contracted
                with a third party forensics accounting team to conduct an in-depth
                audit
                of the operations in China and in other countries in the Asia-Pacific
                Region and to make recommendations for improvement to the internal
                control
                systems.  ·
            Reviewing
                third party distributor arrangements in an effort to assure that
                all
                contracts include adherence to the FCPA.  ·
            Performing
                due diligence on all third party distributors and implementing a
                process
                to assess potential new distributors.  ·
            Established
                an in-house internal audit function including hiring a Director of
                Internal Audit.  ·
            Consolidating
                the human resources, financial accounting and reporting functions
                for the
                Asia region into the Singapore
                Operations.  ·
            Implemented
                an internal certification process to ascertain whether similar issues
                may
                exist elsewhere in the Company.  ·
            Implemented
                a quarterly internal certification process to confirm adherence to
                company
                policy and all applicable laws and regulations that will include
                all
                regional leadership, country management and other sales management.  ·
            Implementing
                additional training on FCPA and other matters for employees and a
                confidential compliance reporting system.  Grant
        Thornton LLP, our independent registered public accounting firm, has issued
        their report on management’s assessment of internal control over financial
        reporting, which appears below.
  **Changes
        in Internal Control Over Financial Reporting**
  There
        were no other changes in the Company’s internal control over financial reporting
        during the year ended December 31, 2005 that have materially affected, or
        are
        reasonably likely to materially affect, the Company’s internal control over
        financial reporting.
  68


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




To
      the
      Board of Directors and Shareholders of FARO Technologies, Inc.:




We
      have
      audited management's assessment, included in the accompanying Management’s
      Report on Internal Control Over Financial Reporting, that FARO Technologies,
      Inc. (a Florida Corporation) and subsidiaries did not maintain effective
      internal control over financial reporting as of December 31, 2005, because
      of
      the effect of the lack of controls in place to prevent unauthorized payments
      made to intermediaries that resulted in violations of the Foreign Corrupt
      Practices Act, based on criteria established in Internal Control—Integrated
      Framework issued by the Committee of Sponsoring Organizations of the Treadway
      Commission (COSO). FARO Technologies, Inc. and subsidiaries management is
      responsible for maintaining effective internal control over financial reporting
      and for its assessment of the effectiveness of internal control over financial
      reporting. Our responsibility is to express an opinion on management's
      assessment and an opinion on the effectiveness of the company's internal control
      over financial reporting based on our audit.




We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether effective
      internal control over financial reporting was maintained in all material
      respects. Our audit included obtaining an understanding of internal control
      over
      financial reporting, evaluating management's assessment, testing and evaluating
      the design and operating effectiveness of internal control, and performing
      such
      other procedures as we considered necessary in the circumstances. We believe
      that our audit provides a reasonable basis for our opinions.




A
      company's internal control over financial reporting is a process designed to
      provide reasonable assurance regarding the reliability of financial reporting
      and the preparation of financial statements for external purposes in accordance
      with generally accepted accounting principles. A company's internal control
      over
      financial reporting includes those policies and procedures that (1) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the company; (2)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company are
      being made only in accordance with authorizations of management and directors
      of
      the company; and (3) provide reasonable assurance regarding prevention or timely
      detection of unauthorized acquisition, use, or disposition of the company's
      assets that could have a material effect on the financial
      statements.




Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate.




A
      material weakness is a control deficiency, or combination of control
      deficiencies, that results in more than a remote likelihood that a material
      misstatement of the annual or interim financial statements will not be prevented
      or detected. The following material weakness has been identified and included
      in
      management’s assessment. The controls were not in place to provide reasonable
      assurance regarding prevention or timely detection of unauthorized acquisition,
      use, or disposition of the company’s assets that could have a material effect on
      the financial statements which resulted in unauthorized payments made to
      intermediaries that violated the Foreign Corrupt Practices Act. This material
      weakness was considered in determining the nature, timing, and extent of audit
      tests applied in our audit of the 2005 financial statements, and this report
      does not affect our report dated June 21, 2006 on those financial
      statements.




69




In
      our
      opinion, management's assessment that FARO Technologies, Inc. and subsidiaries
      did not maintain effective internal control over financial reporting as of
      December 31, 2005, is fairly stated, in all material respects, based on criteria
      established in Internal Control—Integrated Framework issued by COSO. Also in our
      opinion, because of the effect of the material weakness described above on
      the
      achievement of the objectives of the control criteria, Faro Technologies, Inc.
      and subsidiaries has not maintained effective internal control over financial
      reporting as of December 31, 2005, based on criteria established in Internal
      Control—Integrated Framework issued by COSO.




We
      have
      also audited, in accordance with the standards of the Public Company Accounting
      Oversight Board (United States), the consolidated balance sheets of FARO
      Technologies, Inc. and subsidiaries as of December 31, 2005 and 2004, and the
      related consolidated statements of income, shareholders’ equity and cash flows
      for the years then ended and our report dated June 21, 2006 expressed an
      unqualified opinion on those financial statements.




/s/
                GRANT THORNTON LLPOrlando,
                Florida
              June
                21, 2006




70


**I****TEM****9B.**
            **O****THER****I****NFORMATION****.**




On
      June
      28, 2006, Greg Fraser entered into an agreement with the Company pursuant to
      which Mr. Fraser will be retiring from the Company and from his position as
      Executive Vice President and as a Director of the Company on December 29,
      2006.




Pursuant
      to Mr. Fraser's employment agreement, Mr. Fraser will be employed as an
      Executive Vice President and a director at an annual salary of $245,000 through
      his retirement on December 29, 2006. In his capacity as an Executive Vice
      President, Mr. Fraser will report to the Company's Co-Chief Executive Officers
      and shall have such responsibilities, duties, and authority assigned to him
      by
      them. Mr. Fraser is entitled to severance equal to the continuation of his
      salary through December 29, 2006 in the event that the Company terminates his
      employment without good cause or in the event that Mr. Fraser terminates his
      own
      employment with good reason prior to December 29, 2006. Mr. Fraser's employment
      agreement contains a three-year non-compete provision, a two year
      non-solicitation provision, and confidentiality and assignment of inventions
      provisions.


71


**PART
      III** ****




**I****TEM****10.**
            **D****IRECTORS********AND****E****XECUTIVE****O****FFICERS********OF****T****HE****R****EGISTRANT****.**




**Executive
      Officers and Directors**




The
      following table sets forth information regarding the executive officers,
      directors, and key management personnel of the Company as of June 19, 2006:




**Name**
            
            **Age**
            
            **Principal
                Position**Simon
                Raab, Ph.D.
            
            53
            
            Chairman
                of the Board and Co-Chief Executive OfficerJay
                W. Freeland
            
            36
            
            Co-Chief
                Executive Officer, President, and DirectorBarbara
                R. Smith
            
            47
            
            Senior
                Vice President and Chief Financial OfficerGregory
                A. Fraser, Ph.D.
            
            51
            
            Executive
                Vice President and DirectorRobert
                P. Large
            
            56
            
            Senior
                Vice President and Managing Director of FARO
                Asia/PacificSiegfried
                K. Buss
            
            40
            
            Senior
                Vice President andManaging
                Director of FARO EuropeAllen
                Sajedi
            
            46
            
            Vice
                President andChief
                Technical OfficerStephen
                R. Cole(1)(3)(4)
            
            53
            
            DirectorJohn
                Caldwell(1)(2)(3)(4)
            
            56
            
            DirectorNorman
                Schipper, Q.C.(3)(4)
            
            75
            
            DirectorAndre
                Julien(2)(3)(4)
            
            62
            
            DirectorHubert
                d’Amours(1)(3)(4)
            
            67
            
            Director





(1)
      Member of the Audit Committee




(2)
      Member of the Operational Audit Committee




(3)
      Member of the Compensation Committee




(4)
      Member of the Nominating Committee





***Simon
      Raab, Ph.D*** **** is
      a
      co-founder of the Company and has served as the Chairman of the Board and
      Co-Chief Executive Officer since January 2006. Previously, he served as the
      Chairman of the Board and Chief Executive Officer of the Company since its
      inception in 1982, and as President of the Company from 1986 until 2004. Mr.
      Raab holds a Ph.D. in Mechanical Engineering from McGill University, Montreal,
      Canada, a Masters of Engineering Physics from Cornell University and a Bachelor
      of Science in Physics with a minor in Biophysics from the University of
      Waterloo, Canada.




***Jay
      W. Freeland*** has
      served as President and Co-Chief Executive Officer since January 2006. Prior
      to
      that he served as President and Chief Operating Officer of the Company since
      November 2004. Mr. Freeland was elected to the Board of Directors of the Company
      in February 2006. Prior to that Mr. Freeland was president of his own consulting
      company for two years. Mr. Freeland began his career at General Electric
      (GE-NYSE) in their financial management program in 1991, spent four years on
      their corporate audit staff and served in financial, business development,
      strategic planning, sales and operational management roles of increasing
      responsibility until 2003. Mr. Freeland holds a Bachelor of Arts in Economics
      from Union College, Schenectady, New York.




***Barbara
      R. Smith*** has
      served as Senior Vice President and Chief Financial Officer of the Company
      since
      February 2005. Prior to that Ms. Smith served as Vice President, Finance of
      Alcoa’s (AA-NYSE) aerospace, automotive and commercial transportation group,
      based in Cleveland, Ohio. Ms. Smith has held senior financial management
      positions at Alcoa since 1993, after joining that company in 1981. **** Ms.
      Smith
      holds a Bachelor of Science in Accounting degree from Purdue University, West
      Lafayette, Indiana.




72


***Gregory
      A. Fraser, Ph.D.*** ,
      a
      co-founder of the Company, has served as Executive Vice President since February
      2005. Mr. Fraser served as Chief Financial Officer and Executive Vice President
      from May 1997 through February 2005, as Secretary and Treasurer through June
      2006, and a director of the Company since its inception in 1982. Mr. Fraser
      holds a Ph.D. in Mechanical Engineering from McGill University, Montreal,
      Canada, a Masters of Theoretical and Applied Mechanics from Northwestern
      University and a Bachelor of Science and Bachelor of Mechanical Engineering
      from
      Northwestern University.




***Robert
      P. Large*** has
      served as Senior Vice President and Managing Director of FARO Asia/Pacific
      since
      June 2005. He previously served as Vice President of Sales from June 2001 until
      June 2005. Prior to that, Mr. Large was Vice President of Sales of the Hill
      -
      Rom Company, a division of Hillenbrand Industries, Batesville, Indiana
      (HB-NYSE). Mr. Large has held upper management positions in sales and marketing
      with Hillenbrand, as well as Biomet Corp. (BMET-NASDAQ), OEC Co., and AHS Corp.
      Mr. Large holds a Bachelor of Business Management degree from Baldwin - Wallace
      College, Berea, Ohio and attended New England School of Law, Boston,
      Massachusetts and Western New England School of Law, Springfield,
      Massachusetts.




***Siegfried
      K. Buss,*** a
      co-founder of CATS GmbH, a predecessor of FARO Europe, the Company’s principal
      subsidiary in Europe, has served as Senior Vice President and Managing Director
      of FARO Europe since February 2006. He previously served as Co-managing Director
      of FARO Europe from May 1998 until February 2006. Prior to that Mr. Buss was
      Managing Director of CATS GmbH.




***Allen
      Sajedi*** has
      served as Vice President and Chief Technical Officer since 2002 and as Chief
      Engineer of the Company since 1990. Mr. Sajedi holds a Bachelor’s Degree in Mechanical
      Engineering from McGill
      University, Montreal, Canada .




***Stephen
      R. Cole*** has been
      a director of the company since 2002.  He was appointed lead director in
      2005.  Since 1975, Mr. Cole has been President and Founding Partner of Cole
& Partners, a Toronto, Canada based mergers and acquisition and corporate
      finance advisory service company.  Mr. Cole is a Fellow of the Institute of
      Chartered Accountants of Ontario, Fellow of the Canadian Chartered Institute
      of
      Business Valuators, Senior Member of the American Society of Appraisers and
      Full
      Member of the ADR Institute of Canada, Inc.  He is currently serving or has
      held positions as advisory committee member of various private and public
      companies *,* charitable and professional organizations, including FARO Technologies, Inc.,
      H.
      Paulin & Co. Limited, Bosa Group, GPX International Tire Corporation,
      Enterprise Capital LP II, The Canadian Institute of Chartered Business
      Valuators, Quetico Foundation, Nature Conservancy of Canada (Ontario Division),
      UJA Federation and Foundation and past Chairman of Baycrest Centre for Geriatric
      Care.  He also provides servivces as an expert witness and business
      valuator.  Qualified as an expert and testified before the Federal Court of
      Canada (Trial Division), the Supreme Court of Ontario, the Ontario Court
      (General Division), Competition Tribunal and other tribunals and panels as
      an
      expert witness in business valuation, damage quantification and other related
      matters




***John
      E. Caldwell*** has been
      a director of the Company since 2002. Mr. Caldwell is President and Chief
      Executive Officer of SMTC Corporation, a publicly held electronics manufacturing
      services company whose shares are traded on the Nasdaq National Market and
      on
      the Toronto Stock Exchange. Mr. Caldwell has served as a director of SMTC since
      March 2003 and as President and Chief Executive Officer of SMTC since October
      2003. Mr. Caldwell previously was the Chairman of the Restructuring Committee
      of
      the Board of Mosaic Group Inc., a marketing services provider, from October
      2002
      to September 2003. Mr. Caldwell was a consultant to GEAC Computer Corporation
      Limited, a computer software company, from December 2001 to October 2002 and
      was
      President and Chief Executive Officer of GEAC from October 2000 to December
      2001. Mr. Caldwell served in several roles with CAE Inc., a world leading flight
      simulation and training services company, from January 1988 to October 1999,
      including President and Chief Executive Officer from June 1993 to October 1999.
      Currently, he also serves on the board of directors of ATI Technologies Inc.,
      Cognos Inc., IAMGOLD Corporation, Parmalat Canada, Rothmans Inc., and SMTC
      Corporation.




73


***Norman
      Schipper, Q.C.*** has been
      a director of the Company since its inception in 1982. From 1962 until his
      mandatory retirement as Partner on December 31, 1997, Mr. Schipper was a Partner
      in the Toronto office of the law firm of Goodmans, LLP. Since 1998, Mr. Schipper
      has been Of Counsel to the firm.




***Andre
      Julien*** has been
      a director of the Company since 1986. Mr. Julien retired in 2004. Previously
      Mr.
      Julien served as President of Chemirco Chemicals, Inc., a privately held company
      in Toronto, Canada and as President of LAB Pharmacological Research
      International, a privately held company in Montreal Canada. From 1969 until
      1994, Mr. Julien was President and owner of Chateau Paints, Inc., a privately
      held coatings and paint manufacturer in Montreal, Canada. Mr. Julien is also
      a
      director of Eterna Trust, a privately held company in Quebec City, Canada,
      and
      Goodfellow Lumber, Inc., a public company in Montreal, Canada.




***Hubert
      d’Amours*** has been
      a director of the Company since 1990. Since 1990, Mr. D’Amours has served as
      President of Montroyal Capital, Inc. and Capimont, Inc., two venture capital
      investment firms in Montreal, Canada. Mr. d’Amours also serves as a director of
      a number of privately held companies.




**Board
      of Directors**




***Term
      of Directors***




The
      Board
      of Directors is divided into three classes, as nearly equal as possible, with
      one class of directors elected each year for a three-year term. The Board
      currently consists of eight members: three with terms that expire at the 2006
      annual meeting of shareholders, two with terms that expire at the 2007 annual
      meeting of shareholders, and two with terms that expire at the 2008 annual
      meeting of shareholders. The terms of Simon Raab, Andre Julien, and Hubert
      d’Amours will expire at the 2006 annual meeting of shareholders. The terms of
      John Caldwell and Norman Schipper, Q.C. will expire at the 2007 annual meeting
      of shareholders. The terms of Jay Freeland, Gregory Fraser, and Stephen Cole
      will expire at the 2008 annual meeting of shareholders, although Mr. Fraser
      has
      agreed to resign from the Board upon his retirement from the Company in December
      2006.




***Committees***




The
      Board
      of Directors has four standing committees: an Audit Committee, an Operational
      Audit Committee, a Compensation Committee, and a Nominating
      Committee.




The
      Board
      has determined that Norman Schipper, John Caldwell, Hubert d’Amours, Stephen
      Cole, and Andre Julien are independent directors under Nasdaq rules. The Board
      also has determined that John Caldwell, Stephen Cole, and Hubert d’Amours meet
      the additional independence and qualification standards for Audit Committee
      members under Nasdaq rules.




74


*Audit
      Committee*




The
      Audit
      Committee consists of Messrs. d’Amours, Caldwell, and Cole. Mr. Caldwell is the
      Chairman of the Audit Committee. The Audit Committee reviews the independence
      and qualifications of the Company’s independent public accountants and the
      Company’s financial policies, control procedures and accounting staff. The Audit
      Committee recommends to the Board the appointment of the independent public
      accountants and reviews and approves the Company’s financial statements. The
      Audit Committee also reviews transactions between the Company and any officer
      or
      director or any entity in which an officer or director of the Company has a
      material interest. The Audit Committee is governed by a written charter approved
      by the Board of Directors. The Board has determined that John Caldwell and
      Stephen Cole each qualify as an “audit committee financial expert,” as defined
      in the SEC rules. The Board has also determined that both John Caldwell and
      Stephen Cole are “independent,” as that term is defined in the SEC rules.




*Operational
      Audit Committee*




In
      December 2002, the Board of Directors created an Operational Audit Committee,
      and appointed Messrs’ Caldwell and Julien as the members of this committee. The
      Operational Audit Committee is responsible for reviewing the operational metrics
      of the Company. The operational audit committee meets with department directors
      to review progress against goals.




*Compensation
      Committee*




The
      Compensation Committee consists of Norman Schipper, John Caldwell, Stephen
      Cole,
      Hubert d’Amours, and Andre Julien. Mr. Cole currently serves as Chairman of the
      Compensation Committee. The Compensation Committee is responsible for
      establishing the compensation of the Company’s directors, officers and other
      managerial personnel, including salaries, bonuses, termination arrangements
      and
      other benefits. In addition, the Compensation Committee administers the
      Company’s 1993 Stock Option Plan, 1997 Employee Stock Option Plan, 1997
      Non-employee Director Stock Option Plan, 1997 Non-employee Directors’ Fee Plan
      and 2004 Equity Compensation Plan.




*Nominating
      Committee*




The
      Nominating Committee consists of Norman Schipper, John Caldwell, Stephen Cole,
      Huber d’Amours, and Andre Julien.




**Section
      16(a) Beneficial Ownership Reporting Compliance**




During
      2005, the named executive officers and directors of the Company filed with
      the
      Securities and Exchange Commission (the “Commission”) on a timely basis all
      required Forms 3, 4 and 5 pursuant to Section 16 (a) of the Securities Exchange
      Act of 1934 except as follows: Restricted stock grants received by Hubert
      d’Amour, Andre Julien, Norman Schipper, John Caldwell, and Stephen Cole pursuant
      to the 2004 Equity Incentive Plan and the final distribution of phantom stock
      units to Hubert d’Amour, Andre Julien, and Stephen Cole from the terminated
      Non-employee Directors’ Fee Plan in May 2005. Each of these forms subsequently
      were filed. The Company has relied on the written representations of its
      executive officers and directors and copies of the reports they have filed
      with
      the Commission in providing this information.




75


**Code
      of Business Conduct and Ethics**




The
      Board
      of Directors has adopted a Code of Ethics, entitled “Code of Ethics for Senior
      Financial Officers,” that is applicable to its principal executive officer,
      principal financial officer, principal accounting officer or controller, and
      persons performing similar functions. The Board of Directors has also adopted
      a
      Global Ethics Policy which is applicable to those officers as well as all of
      the
      Company’s employees. Both the Code of Ethics for Senior Financial Officers and
      the Global Ethics Policy are available on the Internet web site at www.faro.com .
      The
      Company is not including the information contained on or available through
      its
      website as a part of, or incorporating such information by reference into,
      this
      Form 10-K.




76




**ITEM
                  11.**
            **E****XECUTIVE****C****OMPENSATION****.**




**Executive
      Compensation**




The
      following table provides information regarding the compensation awarded or
      paid
      to, or earned by, our Co-Chief Executive Officers and each of our named
      executive officers:


**SUMMARY
        COMPENSATION TABLE**




**Long-Term****Annual****Compensation**
            
            **Compensation****Shares****Other
                Annual**
            
            **Underlying**
            
            
            **All
                Other****Name
                and Positions**
            
            **Year**
            
            **Salary**
            
            
            **Bonus
                (3)**
            
            **Compensation**
            
            **Options
                Granted**
            
            
            **Compensation**Simon
                Raab
            
            
            2005
            
            $
            398,077
            
            $
            79,615
            
            
            -
            
            
            -
            
            
            -*Co-Chief
                Executive Officer,*
            
            
            2004
            
            $
            347,644
            
            $
            200,000
            
            
            -
            
            
            -
            
            
            -*Chairman*
            
            
            2003
            
            $
            288,000
            
            $
            200,000
            
            
            -
            
            
            -
            
            
            -Jay
                Freeland (1)
            
            
            2005
            
            $
            238,492
            
            $
            48,187
            
            
            -
            
            
            40,000
            
            
            -*Co-Chief
                Executive Officer,*
            
            
            2004
            
            $
            22,115
            
            $
            -
            
            
            -
            
            
            50,000
            
            
            -*President*
            
            
            2003
            
            $
            -
            
            $
            -
            
            
            -
            
            
            -
            
            
            -Barbara
                R. Smith (2)
            
            
            2005
            
            $
            169,519
            
            $
            28,038
            
            
            -
            
            
            69,000
            
            
            -*Chief
                Financial Officer,*
            
            
            2004
            
            $
            *-*
            
            $
            -
            
            
            -
            
            
            -
            
            
            -*Senior
                Vice President*
            
            
            2003
            
            $
            *-*
            
            $
            -
            
            
            -
            
            
            -
            
            
            -Gregory
                A. Fraser
            
            
            2005
            
            $
            234,423
            
            $
            46,885
            
            
            -
            
            
            37,600
            
            
            -*Executive
                Vice President*
            
            
            2004
            
            $
            218,969
            
            $
            110,000
            
            
            -
            
            
            -
            
            
            -2003
            
            $
            193,000
            
            $
            125,000
            
            
            -
            
            
            -
            
            
            -








(1)  Jay
      Freeland was hired on November 15, 2004.




(2)  Barbara
      R. Smith was hired on February 21, 2005.




(3)  Bonuses
      are paid after the end of the year based on performance for that year (e.g.,
      2005 bonus reflects 2005 performance and is paid in 2006). In previous years,
      the Company reported bonuses during the year in which they were paid.
      Accordingly, the bonus amounts for 2004 and 2003 have been revised from the
      amounts previously reported by the Company.




77




***Stock
      Option Grants and Exercises***




The
      following table sets forth information concerning individual grants of stock
      options made during the 2005 fiscal year to each of the named executive
      officers:


**OPTIONS
        GRANTED LAST YEAR**




Individual
                Grants
            
            Potential
                  RealizableNumber
                of
            
            Percentage
                of
            
            
            
            
            
            
            
            Value
                  at Assumed AnnualSecurities
            
            Total
                Options
            
            
            
            Market
                Price
            
            
            
            Rates
                  of Stock PriceUnderlying
            
            Granted
                to
            
            Exercise
                of
            
            of
                Underlying
            
            
            
            Appreciation
                  for OptionOptions
            
            Employees
                in
            
            Base
                Price
            
            Security
                on
            
            Expiration
            
            TermGranted
                (#)
            
            2005
            
            ($
                /
                Share)
            
            Date
                of Grant
            
            Date
            
            5%
                ($)
            
            10%
                  ($)Jay
                Freeland
            
            
            40,000
            
            
            12.73
            
            
            19.38
            
            
            19.38
            
            
            12/05/2015
            
            
            487,519
            
            
            1,235,469Gregory
                A. Fraser
            
            
            37,600
            
            
            11.97
            
            
            19.38
            
            
            19.38
            
            
            12/05/2015
            
            
            458,268
            
            
            1,161,341Barbara
                R. Smith
            
            
            30,000
            
            
            9.55
            
            
            19.38
            
            
            19.38
            
            
            12/05/2015
            
            
            365,639
            
            
            926,60239,000
            
            
            12.42
            
            
            26.68
            
            
            26.68
            
            
            02/21/2015
            
            
            654,397
            
            
            1,658,321




**Aggregated
      Option Exercises in 2005 and Option Values at December 31, 2005**




The
      following table sets forth information with respect to aggregate stock option
      exercises by the named executive officers and the year-end value of unexercised
      options held by such executive officers.


**Number
                  of**
                **Shares
                  Acquired**
              
              **Value**
              
              **Number
                  of**
                **Unexercised**
                **Options/**
                **SARs**
                **At
                  FY-End**
              
              **Value
                  of**
                **Unexercised**
                **In-the-Money**
                **Options/SARs
                  at**
                **FY-End
                  ($)(1)****Name**
              
              **on
                  Exercise**
              
              **Realized
                  ($)**
              
              **(#)**
              
              **Exercisable**
              
              **Unexercisable**Simon
                  Raab (2)
              
              
              -
              
              
              -
              
              
              90,000
              
              $
              1,599,300
              
              
              --Jay
                  Freeland (3)
              
              
              -
              
              
              -
              
              
              90,000
              
              $
              24,800
              
              
              --Barbara
                  R. Smith (4)
              
              
              -
              
              
              -
              
              
              69,000
              
              $
              18,600
              
              
              --Gregory
                  A. Fraser (5)
              
              
              -
              
              
              -
              
              
              97,600
              
              $
              1,093,712
              
              
              --





(1)
            Based
                on the closing price of $20.00 per share of the Company’s Common Stock on
                December 30, 2005 as quoted on The Nasdaq Stock Market.(2)
            The
                90,000 stock option held by Mr. Raab that was granted on May 29,
                2002,
                expiring on May 29, 2012, is exercisable.(3)
            The
                stock options held by Mr. Freeland include a 50,000 stock option
                which was
                granted on November 15, 2005, expiring on November 15, 2015, is currently
                exercisable and the 40,000 stock option which was granted on December
                5,
                2005, expiring on December 5, 2015, is currently
                exercisable.(4)
            The
                stock options held by Ms. Smith include a 39,000 stock option which
                was
                granted on February 21, 2005, expiring on February 21, 2015, is currently
                exercisable; and the 30,000 stock option which was granted on December
                5,
                2005, expiring on December 5, 2015, is currently exercisable(5)
            The
                stock options held by Mr. Fraser include a 60,000 stock option which
                was
                granted on May 27, 2002, expiring on May 27, 2012, is currently
                exercisable; and the 37,600 stock option which was granted on December
                5,
                2005, expiring on December 5, 2015, is currently
                exercisable.




78




**Employment
      Agreements**





The
      Company has entered into employment agreements with each of our co-founders,
      Simon Raab and Greg Fraser.




Pursuant
      to Mr. Raab’s employment agreement, which was effective January 1, 2006, Mr.
      Raab was employed initially as our Chief Executive Officer and served as our
      Chairman of the Board and a director. Mr. Raab, pursuant to the employment
      agreement, became Co-Chief Executive Officer during 2006 and altered his
      full-time commitment to a commitment to no more than 80 hours per month, with
      a
      corresponding reduction in his salary to $200,000, which is 50% of his previous
      salary. The term of Mr. Raab’s employment agreement expires January 1, 2007. If
      Mr. Raab remains an employee of the Company after January 1, 2007, the Company
      will pay Mr. Raab such amount as the Board of Directors and Mr. Raab agree
      is
      reasonable based upon his role in the Company. In the event that Mr. Raab does
      not remain employed with the Company in 2007, he will continue to receive his
      $200,000 annual salary for 2007. Pursuant to Mr. Raab’s employment agreement,
      all stock options and RSUs shall vest upon occurrence of the first of the
      following events: (a) his death or disability, (b) the termination of his
      employment by the Company other than for good cause, (c) the termination of
      his
      employment for good reason, (d) a change of control, or (e) Board approval
      of
      any sale, exchange or transfer of all or substantially all of the assets of
      the
      Company or Board adoption of any plan or proposal for the liquidation or
      dissolution of the Company. Mr. Raab is entitled to severance equal to the
      continuation of his salary that is then in effect for a period of one year
      in
      the event that the Company terminates his employment without good cause or
      in
      the event that Mr. Raab terminates his own employment with good reason prior
      to
      January 1, 2007. Mr. Raab’s employment agreement contains a five-year
      non-compete provision, a two year non-solicitation provision, and
      confidentiality and assignment of inventions provisions.




Pursuant
      to Mr. Fraser’s employment agreement, which was effective June 28, 2006, Mr.
      Fraser was employed as an Executive Vice President and a director at an annual
      salary of $245,000. Mr. Fraser will retire from the Company on December 29,
      2006. On that date, Mr. Fraser will resign both as an employee and as a member
      of the Company’s Board of Directors. In his capacity as an Executive Vice
      President, Mr. Fraser will report to the Company’s Co-Chief Executive Officers
      and shall have such responsibilities, duties, and authority assigned to him
      by
      them. Mr. Fraser is entitled to severance equal to the continuation of his
      salary through December 29, 2006 in the event that the Company terminates his
      employment without good cause or in the event that Mr. Fraser terminates his
      own
      employment with good reason prior to December 29, 2006. Mr. Fraser’s employment
      agreement contains a three-year non-compete provision, a two year
      non-solicitation provision, and confidentiality and assignment of inventions
      provisions.




**Director
      Compensation**




Generally,
      upon election to the Board, the director receives an initial equity grant of
      3,400 shares of restricted Common Stock, and then annually on the day following
      the annual meeting of shareholders, each director who is not an executive
      officer is granted 2,000 shares of restricted Common Stock.




79


Directors
        of the Company who are not executive officers are entitled to receive an
        annual
        retainer of $17,850, and fees of $1,875 per board or committee meeting.
        Chairpersons of the Audit and Operational Audit Committees receive an additional
        annual retainer of $4,000 and the Chairperson of the Compensation Committee
        receives an annual retainer of $2,500, and the Chairperson of the Nominating
        Committee receives an annual retainer of $1,500. The lead director is entitled
        to receive a retainer of $11,500.
  In
        2005,
        non-employee directors earned the following directors’ fees: Messrs. d’Amours
        $40,400 Caldwell $57,225, Cole, $50,625, Julien $31,700, and Schipper $32,381.
        Mr. Cole, the Company’s lead director did not receive his lead director retainer
        for 2005 and, accordingly, will receive both his 2005 and 2006 retainer in
        2006.


**Compensation
      Committee Interlocks and Insider Participation**





The
      compensation committee consists of Messrs. Hubert d’Amours, Andre Julien, Norman
      Schipper, Stephen Cole, and John Caldwell, none of whom has ever been an
      employee of the company or any of its subsidiaries. None of the Company’s
      executive officers serves as a member of the board of directors or compensation
      committee of any entity that has one or more executive officers serving as
      members of our board of directors or compensation committee.


80


**I****TEM****12.**
            **S****ECURITY****O****WNERSHIP********OF****C****ERTAIN****B****ENEFICIAL****O****WNERS********AND****M****ANAGEMENT****.**




**Security
      Ownership of Management and Principal Stockholders**




The
      following table sets forth certain information regarding the beneficial
      ownership of the Company’s Common Stock as of June 19, 2006 (except as noted) by
      each person known to the Company to own beneficially more than five percent
      of
      the Company’s Common Stock, each director, each nominee for election as a
      director, the named executive officers (which are Simon Raab, Jay Freeland,
      Barbara Smith, and Greg Fraser), and all executive officers and directors as
      a
      group.




The
      information in the percentage ownership column in the following table is based on 14,349,726 shares
      of common stock outstanding as of June 19, 2006, adjusted as required by rules
      promulgated by the Securities and Exchange Commission. To our knowledge, except
      as indicated in the footnotes to the following table, the persons named in
      this
      table have sole voting and investment power with respect to all shares of our
      common stock shown as beneficially owned by them.




**Beneficial
      Ownership Table**




**Name
                of Beneficial Owner**
            
            **Number
                of**
              **Shares**
            
            **Percent**Simon
                Raab, Ph.D.(1)
            
            
            1,250,552
            
            
            8.7
            %Gregory
                A. Fraser, Ph.D.(2)
            
            
            181,785
            
            
            1.3
            %Jay
                Freeland (3)
            
            
            95,040
            
            
            *Barbara
                R. Smith (4)
            
            
            71,373
            
            
            *Hubert
                d’Amours (5)
            
            
            25,234
            
            
            *Andre
                Julien (6)
            
            
            59,839
            
            
            *Norman
                H. Schipper, Q.C.(7)
            
            
            14,799
            
            
            *Stephen
                R. Cole (8)
            
            
            20,781
            
            
            *John
                Caldwell (9)
            
            
            16,373
            
            
            *All
                directors and executive officers as a group (9 persons)
            
            
            1,735,776
            
            
            12.1
            %





*
            Represents
                less than one percent of the Company’s outstanding Common Stock. Except as
                otherwise noted, all persons have sole voting and investment power
                of the
                shares listed.(1)
            Includes
                944,031 shares held by Xenon Research, Inc. (“Xenon”), and includes an
                option to purchase 90,000 shares at $2.23 per share that is currently
                exercisable. Simon Raab and Diana Raab, his spouse, own all of the
                outstanding capital stock of Xenon.“”(2)
            Includes
                options to purchase (i) 60,000 shares at $2.16 per share and (ii)
                37,600
                shares at $19.38 per share that are currently exercisable.(3)
            Includes
                options to purchase (i) 50,000 shares at $24.35 per share and (ii)
                40,000
                shares at $19.38 per share that are currently
                exercisable.(4)
            Includes
                options to purchase (i) 39,000 shares at $26.68 per share and (ii)
                30,000
                shares at $19.38 per share that are currently
                exercisable.




81




(5)
            Includes
                options to purchase (i) 3,000 shares at $3.13 per share, (ii) 3,000
                shares
                at $2.57 per share, (iii) 3,000 shares at $2.46 per share, (iv) 3,000
                shares at $4.42 per share, and (v) 2,000 shares at $21.56 per share
                that
                are currently exercisable. Does not include an option to purchase
                1,000
                shares at $21.56 per share that is not exercisable or 3,601 restricted
                stock units that have not vested or will not vest within the next
                60
                days.(6)
            Includes
                options to purchase (i) 3,000 shares at $4.88 per share, (ii) 3,000
                shares
                at $3.13 per share, (iii) 3,000 shares at $2.57 per share, (iv) 24,000
                shares at $2.49 per share, (v) 3,000 shares at $4.42 per share, and
                (vi)
                2,000 shares at $21.56 per share that are currently exercisable.
                Does not
                include an option to purchase 1,000 shares at $21.56 per share that
                is not
                exercisable or 3,601 restricted stock units that have not vested
                or will
                not vest within the next 60 days.(7)
            Includes
                options to purchase (i) 2,000 shares at $2.21 per share, (ii) 3,000
                shares
                at $4.42 per share, and (iii) 2,000 shares at $21.56 that are currently
                exercisable. Does not include an option to purchase 1,000 shares
                at $21.56
                per share that is not exercisable or 3,601 restricted stock units
                that
                have not vested or will not vest within the next 60
                days.(8)
            Includes
                options to purchase (i) 3,000 shares at $2.57 per share, (ii) 3,000
                shares
                at $4.42 per share, and (iii) 2,000 shares at $21.56 per share that
                are
                currently exercisable. Does not include an option to purchase 1,000
                shares
                at $21.56 per share that is not exercisable or 3,601 restricted stock
                units that have not vested or will not vest within the next 60
                days.(9)
            Includes
                options to purchase (i) 3,000 shares at $1.61 per share, (ii) 3,000
                shares
                at $4.42 per share, and (iii) 2,000 shares at $21.56 per share that
                are
                currently exercisable Does not include an option to purchase 1,000
                shares
                at $21.56 per share that is not exercisable or 3,601 restricted stock
                units that have not vested or will not vest within the next 60
                days.




82


**Equity
      Compensation Plan Information**




The
      following table sets forth information regarding compensation plans under which
      equity securities of the Company are authorized for issuance as of December
      31,
      2005.




**Plan
                Category**
            
            **Number
                of Securities To be Issued upon Exercise of Outstanding Options,
                Warrants,
                and Rights**
            
            **Weighted
                Average Exercise Price of Outstanding Options, Warrants, and
                Rights**
            
            **Number
                of Securities Remaining Available for Future
                Issuance**Equity
                compensation plans approved by security holders
            
            
            1,340,034
            
            $
            16.72
            
            
            803,591Equity
                compensation plans not approved by security holders
            
            
            —
            
            
            —
            
            
            —Total
            
            
            1,340,034
            
            $
            16.72
            
            
            803,591




**I****TEM****13.**
            **C****ERTAIN****R****ELATIONSHIPS********AND****R****ELATED****T****RANSACTIONS****.**




The
      Company leases its headquarters from Xenon Research, Inc. (“Xenon”), all of the
      issued and outstanding capital stock of which is owned by Simon Raab, the
      Company’s President and Chief Executive Officer, and Diana Raab, his spouse. The
      term of the lease expired on February 28, 2006, and is continuing on a month
      to
      month basis. The Company expects to renew the lease for an additional 3 - 5
      years under similar terms. Base rent under the lease is $398,000 per
      year.




**I****TEM****14.**
            **P****RINCIPAL****A****CCOUNTANT****F****EES********AND****S****ERVICES****.**




**Independent
      Public Accountants**




Grant
      Thornton LLP, independent public accountants, audited the Company’s consolidated
      financial statements for the fiscal years ended December 31, 2004 and December
      31, 2005. Grant Thornton LLP has been selected by the Audit Committee to serve
      as the Company’s independent auditors for the current fiscal year.




**Fees
      Paid to Grant Thornton LLP :**


**2004**
              
              **2005**Audit
                  fees(1)
              
              $
              770,000
              
              $
              976,868Audit
                  related fees
              
              
              -
              
              
              -Tax
                  fees-preparation and compliance
              
              
              -
              
              
              -Total
                  audit, audit related and tax preparation and compliance
                  fees
              
              
              770,000
              
              
              976,868Other
                  non-audit fees(2)
              
              
              
              
              
              32,100Tax
                  fees-other
              
              
              -
              
              
              -All
                  other fees
              
              
              -
              
              
              -Total
                  other fees
              
              
              -
              
              
              32,100Total
                  fees
              
              $
              770,000
              
              $
              1,008.968
  83


(1)
              Audit
                  of financial statements,reviews of financial statements included
                  in
                  Quarterly Reports on Form 10-Q,and audit of management’s assessment of the
                  Company’s internal control over financial reporting and the effectiveness
                  of the Company’s internal control over financial
                  reporting
 
 (2)
              Primarily
                  fees in connection with the Company’s employee benefit plan audit and Form
                  S-3 registration statement (File
                  No.333-110670)




The
      Audit
      Committee has concluded that provision of the audit and permitted non-audit
      services described above by Grant Thornton LLP is compatible with maintaining
      independence of Grant Thornton LLP.




Pursuant
      to the Audit Committee Charter, the Audit Committee pre-approved all of such
      services. The Audit Committee has established pre-approval policies and
      procedures with respect to audit and permitted non-audit services to be provided
      by its independent auditors. Pursuant to these policies and procedures, the
      Audit Committee may form, and delegate authority to, subcommittees consisting
      of
      one or more members when appropriate to grant such pre-approvals, provided
      that
      decisions of such subcommittee to grant pre-approvals are presented to the
      full
      Audit Committee at its next scheduled meeting. The Audit Committee’s
      pre-approval policies do not permit the delegation of the Audit Committee’s
      responsibilities to management.




84


**PART
      IV** ****




**I****TEM****15.**
            **E****XHIBITS********AND****F****INANCIAL****S****TATEMENT****S****CHEDULES****.**




**(a)**  **Documents
      Filed as Part of this Report.** The
      following documents are filed as part of this Report:




***(1)
      Consolidated Financial Statements.*** Included
      in Part II, Item 8 are the consolidated financial statements, the notes thereto
      and the report of the Independent Registered Public Accounting Firm.





***(2)
      Financial Statement Schedules.*** Schedule
      II - Valuation and Qualifying Accounts is filed as a part hereof along with
      the
      related report of the Independent Registered Public Accounting Firm on the
      Company’s financial statement schedule. All other schedules have been omitted
      because the information required to be set forth therein is not applicable
      or is
      included in the consolidated financial statements or notes thereto.





***(3)
      Exhibits.***





**Exhibit No.**
            
            **Description**3.1
            
            Articles
                of Incorporation, as amended*(Filed
                as Exhibit 3.1 to Registrant’s Registration Statement on Form S-1, No.
                333-32983, and incorporated herein by reference)*3.2
            
            Bylaws,
                as amended*(Filed
                as Exhibit 3.2 to Registrant’s Registration Statement on Form S-1, No.
                333-32983, and incorporated herein by reference)*4.1
            
            Specimen
                Stock Certificate*(Filed
                as Exhibit 4.1 to Registrant’s Registration Statement on Form S-1, No.
                333-32983, and incorporated herein by reference)*10.1
            
            1993
                Stock Option Plan, as amended*(Filed
                as Exhibit 10.1 to Registrant’s Registration Statement on Form S-1, No.
                333-32983, and incorporated herein by reference)*10.2
            
            1997
                Amended and Restated Employee Stock Option Plan*(Filed
                as Exhibit 4. 2 to Registrant’s Registration Statement on Form S-8,
                No.******333-125021****,
                and incorporated herein by reference)*10.3
            
            2004
                Equity Incentive Plan*(Filed
                as Exhibit 4.1 to Registrant’s Registration Statement on Form S-8, No.**333-125021**,
                and incorporated herein by reference)*10.4
            
            1997
                Non-Employee Director Stock Option Plan*(Filed
                as Exhibit 10.3 to Registrant’s Registration Statement on Form S-1, No.
                333-32983, and incorporated herein by reference)*10.5
            
            1997
                Non-Employee Directors Fee Plan*(Filed
                as Exhibit 10.4 to Registrant’s Registration Statement on Form S-1, No.
                333-32983, and incorporated herein by reference)*10.6
            
            Form
                of Patent and Confidentiality Agreement between the Company and each
                of
                its employees*(Filed
                as Exhibit 10.10 to Registrant’s Registration Statement on Form S-1, No.
                333-32983, and incorporated herein by reference)*10.7
            
            Agreement
                and Plan of Merger dated September 14, 2001, as amended, between
                the
                Company and SpatialMetriX Corporation*(Filed
                as Exhibit 2.1 to Registrant’s Current report on Form 8-K dated January
                16, 2002 and incorporated herein by
                reference)*




85




10.8
            
            Securities
                Purchase Agreement, dated November 11, 2003, among the Company, Xenon
                Research, Inc., a Florida corporation, and Gregory A. Fraser, and
                the
                investors named on the signature pages thereto.*(Filed as Exhibit 10.1 to Registrant’s Current report on Form 8-K dated**November
                11, 2003**and
                incorporated herein by reference)*10.9
            
            Loan
                Agreement, dated as of September 17, 2003, between the Company and
                SunTrust Bank.*(Filed
                as Exhibit 10.2 to Registrant’s Current report on Form 8-K dated**November
                11, 2003**and
                incorporated herein by reference)*10.10
            
            Employment
                Agreement dated January 30, 2006, by and between the Company and
                Simon
                Raab*(Filed
                as Exhibit 10.1 to Registrant’s Current report on Form 8-K dated**January
                30, 2006**and
                incorporated herein by reference)*10.11
            
            Employment
                Agreement dated June 28, 2006, by and between the Company and Gregory
                A.
                Fraser10.12
            
            Consulting
                Agreement dated June 20, 2006, by and between the Company and Joanne
                Karimi21.1
            
            List
                of Subsidiaries23.1
            
            Consent
                of Grant Thornton LLP23.2
            
            Consent
                of Ernst & Young LLP





24.1
            
            Power
                of Attorney relating to subsequent amendments (included on the signature
                page(s) of this report).31-A
            
            Certification
                of the Chief Executive Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 200231-B
            
            Certification
                of the Principal Financial Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 200232-A
            
            Certification
                of the Chief Executive Officer Pursuant to Section 906 of the
                Sarbanes-Oxley Act of 200232-B
            
            Certification
                of the Principal Financial Officer Pursuant to Section 906 of the
                Sarbanes-Oxley Act of 200299.1
            
            Properties




86




**S** **CHEDULE** **II - V** **ALUATION** **** **AND** **Q** **UALIFYING** **A** **CCOUNTS**




Valuation
      and Qualifying Accounts were as follows for the three years ended December
      31,
      2005:


DeductionsAdditions
              
              for
                  purposescharged
                  to
              
              for
                  whichBalance
                  at
              
              costs
                  and
              
              accomitsbeginning
                  of
              
              expenses
                  or
              
              were
                  set up
              
              Balance
                  atDescription
              
              period
              
              revenues
              
              period
              
              end
                  ofYear
                  ended December 31, 2005Deducted
                  from assets which applyUncollectible
                  accounts
              
              $
              339
              
              $
              112
              
              $
              237
              
              $
              214Reserve
                  for inventory obsolescence
              
              
              191
              
              
              1,314
              
              
              1,132
              
              
              373Total
              
              $
              530
              
              $
              1,426
              
              $
              1,369
              
              $
              587Year
                  ended December 31, 2004Deducted
                  from assets which applyUncollectible
                  accounts
              
              $
              255
              
              $
              154
              
              $
              70
              
              $
              339Reserve
                  for inventory obsolescence
              
              
              155
              
              
              895
              
              
              859
              
              
              191Total
              
              $
              410
              
              $
              1,049
              
              $
              929
              
              $
              530Year
                  ended December 31, 2003Deducted
                  from assets which applyUncollectible
                  accounts
              
              $
              852
              
              $
              140
              
              $
              737
              
              $
              255Reserve
                  for inventory obsolescence
              
              
              90
              
              
              905
              
              
              840
              
              
              155Total
              
              $
              942
              
              $
              1,045
              
              $
              1,577
              
              $
              410




87


**REPORT
      OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING
      FIRM**




To
      the
      Board of Directors and Shareholders of FARO Technologies, Inc.:




We
      have
      audited the consolidated financial statements of FARO Technologies, Inc. for
      the
      year ended December 31, 2003, and have issued our report thereon dated February
      20, 2004 (included elsewhere in this annual report). Our audit also included
      the
      information related to the year ended December 31, 2003, shown in Schedule
      II of
      this annual report. This schedule is the responsibility of the Company’s
      management. Our responsibility is to express an opinion based on our
      audit.




In
      our
      opinion, the financial statement schedule referred to above, when considered
      in
      relation to the basic financial statements taken as a whole, present fairly
      in
      all material respects the information set forth therein.




/s/ ERNST & YOUNG LLPOrlando,
                Florida
              February
                20, 2004




88




**SIGNATURES**




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


**FARO
              TECHNOLOGIES, INC.**Date:June
              29, 2006
            By:
            /s/
              Barbara R. SmithBarbara
              R. Smith, Senior Vice President and Chief Financial
              Officer
              (Duly
                Authorized Officer and Principal Financial
                Officer)




Pursuant
      to the requirements of the Securities Exchange Act of 1934, this report has
      been
      signed below by the following persons on behalf of the registrant and in the
      capacities and on the dates indicated. Each person whose signature appears
      below
      constitutes and appoints SIMON RAAB, and JAY W. FREELAND, and each of them
      individually, his true and lawful attorney-in-fact and agent, with full power
      of
      substitution and revocation, for him and in his name, place and stead, in any
      and all capacities, to sign any and all amendments to this Report and to file
      the same, with all exhibits thereto, and other documents in connection
      therewith, with the Securities and Exchange Commission, granting unto said
      attorneys-in-fact and agents, and each of them, full power and authority to
      do
      and perform each and every act and thing requisite and necessary to be done
      in
      connection therewith, as fully to all intents and purposes as he might or could
      do in person, hereby ratifying and confirming all that said attorneys-in-fact
      and agents, or either of them, may lawfully do or cause to be done by virtue
      hereof.




Signature
            
            Title
            
            Date/s/
                Simon Raab
              Simon
                Raab
            
            Chairman
                of the Board, Co-Chief Executive Officer (Principal Executive Officer),
                and Director
            
            June
                29, 2006/s/
                Jay W. Freeland
              Jay
                W. Freeland
            
            Co-Chief
                Executive Officer, President, Chief Operating Officer (Principal
                Executive
                Officer), and Director
            
            June
                29, 2006/s/
                Barbara R. Smith
              Barbara
                R. Smith
            
            Senior
                Vice President and Chief Financial Officer (Principal Financial Officer
                and Principal Accounting Officer),
            
            June
                29, 2006/s/
                Gregory A. Fraser
              Gregory
                A. Fraser
            
            Executive
                Vice President, Secretary, and Director
            
            June
                29, 2006/s/
                John Caldwell
              John
                Caldwell
            
            Director
            
            June
                29, 2006




89




/s/
                Hubert d’Amours
              Hubert
                d’Amours
            
            Director
            
            June
                29, 2006/s/
                Stephen R. Cole
              Stephen
                R. Cole
            
            Director
            
            June
                29, 2006/s/
                Norman H. Schipper
              Norman
                H. Schipper
            
            Director
            
            June
                29, 2006/s/
                Andre Julien
              Andre
                Julien
            
            Director
            
            June
                29, 2006





90