##### 



EXHIBIT 13.0 ANNUAL REPORT TO SECURITY HOLDERS FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Report of Ernst & Young LLP, Independent Auditors Shareholders and Board of Directors

Inter-Tel, Incorporated We have audited the accompanying consolidated balance sheets of Inter-Tel, Incorporated and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, shareholders equity, and cash flows for each of the three years in the period ended
December 31, 2003. Our audits also included the financial statement schedule listed in the Index to consolidated financial statements and schedule. These financial statements and schedule are the responsibility of the Companys management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Inter-Tel, Incorporated and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash
flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial
statements taken as a whole, presents fairly in all material respects the information set forth therein. As discussed in Note A to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill. /s/ Ernst & Young
LLP Phoenix, Arizona

February 17, 2004




---



##### 



INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED
BALANCE SHEETS
   2003
    
    2002ASSETSCURRENT ASSETSCash and equivalents
    
    $
    115,197
    
    
    $
    84,923Short-term investments
    
    
    59,334
    
    
    
    40,916Total cash and short-term investments
    
    
    174,531
    
    
    
    125,839Accounts receivable, net of allowances of $11,010
in 2003 and $12,159 in 2002
    
    
    43,434
    
    
    
    42,566Inventories, net of allowances of $6,952 in 2003
and $10,558 in 2002
    
    
    14,648
    
    
    
    11,329Net investment in sales-leases, net of allowances
of $749 in 2003 and $516 in 2002
    
    
    15,502
    
    
    
    13,344Income taxes receivable
    
    
    8,196
    
    
    
    2,604Deferred income taxes
    
    
    13,789
    
    
    
    2,377Prepaid expenses and other assets
    
    
    6,432
    
    
    
    6,705TOTAL CURRENT ASSETS
    
    
    276,532
    
    
    
    204,764PROPERTY, PLANT & EQUIPMENT
    
    
    24,657
    
    
    
    24,795GOODWILL
    
    
    17,967
    
    
    
    17,646PURCHASED INTANGIBLE ASSETS
    
    
    8,191
    
    
    
    7,416NET INVESTMENT IN SALES-LEASES, net of allowances
of $1,985 in 2003 and $1,411 in 2002
    
    
    32,529
    
    
    
    24,692OTHER ASSETS
    
    
    
    
    
    
    2,749$
    359,876
    
    
    $
    282,062LIABILITIES AND SHAREHOLDERS EQUITYCURRENT
LIABILITIESAccounts payable
    
    $
    28,386
    
    
    $
    23,089Other current liabilities
    
    
    47,585
    
    
    
    50,051TOTAL CURRENT LIABILITIES
    
    
    75,971
    
    
    
    73,140DEFERRED TAX LIABILITY
    
    
    57,996
    
    
    
    16,320LEASE RECOURSE LIABILITY
    
    
    12,020
    
    
    
    11,125RESTRUCTURING RESERVE
    
    
    49
    
    
    
    1,049OTHER LIABILITIES
    
    
    6,535
    
    
    
    6,525SHAREHOLDERS EQUITYCommon stock, no par value-authorized 100,000,000
shares; issued  27,161,823 shares; outstanding 
25,429,642 shares at December 31, 2003 and
24,908,983 shares at December 31, 2002
    
    
    113,960
    
    
    
    111,639Less: Shareholder loans
    
    
    
    
    
    
    (338
    )Retained earnings
    
    
    113,299
    
    
    
    89,643Accumulated other comprehensive income
    
    
    1,025
    
    
    
    195228,284
    
    
    
    201,139Less: Treasury stock at cost  1,732,181 shares
in 2003 and 2,252,840 shares in 2002
    
    
    (20,979
    )
    
    
    (27,236
    )TOTAL SHAREHOLDERS EQUITY
    
    
    207,305
    
    
    
    173,903$
    359,876
    
    
    $
    282,062
 See accompanying notes. 52




---



##### 



INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS
OF INCOME
  (In thousands, except per share data) 2003
    
    2002
    
    2001NET SALESTelecommunications systems, software and related
    
    $
    335,570
    
    
    $
    351,414
    
    
    $
    346,094Resale of long distance
    
    
    38,266
    
    
    
    30,042
    
    
    
    25,575Inter-Tel.NET/Vianet
    
    
    
    
    
    
    
    
    
    
    13,986Total net sales
    
    
    373,836
    
    
    
    381,456
    
    
    
    385,655Cost of salesTelecommunications systems, software and related
    
    
    150,833
    
    
    
    165,567
    
    
    
    172,271Resale of long distance
    
    
    25,930
    
    
    
    21,416
    
    
    
    19,012Inter-Tel.NET/Vianet
    
    
    
    
    
    
    
    
    
    
    19,878Total cost of sales
    
    
    176,763
    
    
    
    186,983
    
    
    
    211,161GROSS PROFIT
    
    
    197,073
    
    
    
    194,473
    
    
    
    174,494Research and development
    
    
    21,978
    
    
    
    19,340
    
    
    
    17,556Selling, general and administrative
    
    
    128,964
    
    
    
    128,284
    
    
    
    128,604Amortization of goodwill
    
    
    
    
    
    
    
    
    
    
    1,876Amortization of purchased intangible assets
    
    
    1,803
    
    
    
    1,122
    
    
    
    677Other charges
    
    
    
    
    
    
    
    
    
    
    5,357152,745
    
    
    
    148,746
    
    
    
    154,070OPERATING INCOME
    
    
    44,328
    
    
    
    45,727
    
    
    
    20,424Litigation settlement (net of costs except for taxes)
    
    
    
    
    
    
    15,516
    
    
    
    Write-down/recovery of investment in
Inter-Tel.NET/Vianet
    
    
    124
    
    
    
    (1,200
    )
    
    
    Interest and other income
    
    
    1,683
    
    
    
    1,936
    
    
    
    1,081Foreign currency transaction gains (losses)
    
    
    18
    
    
    
    330
    
    
    
    (337
    )Interest expense
    
    
    (155
    )
    
    
    (156
    )
    
    
    (468
    )INCOME BEFORE INCOME TAXES
    
    
    45,998
    
    
    
    62,153
    
    
    
    20,700INCOME TAXES (BENEFIT)Current
    
    
    (12,784
    )
    
    
    18,495
    
    
    
    (3,647
    )Deferred
    
    
    30,264
    
    
    
    5,021
    
    
    
    11,30617,480
    
    
    
    23,516
    
    
    
    7,659NET INCOME
    
    $
    28,518
    
    
    $
    38,637
    
    
    $
    13,041NET INCOME PER SHAREBasic
    
    $
    1.14
    
    
    $
    1.58
    
    
    $
    0.53Diluted
    
    $
    1.08
    
    
    $
    1.49
    
    
    $
    0.52Weighted average basic common shares
    
    
    25,078
    
    
    
    24,444
    
    
    
    24,488Weighted average diluted common shares
    
    
    26,473
    
    
    
    25,864
    
    
    
    25,240
 See accompanying notes. 53




---



##### 



INTER-TEL, INCORPORATED
AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY

Years Ended December 31, 2003, 2002 and 2001 (in thousands) AccumulatedShare-
    
    
    
    
    
    OtherCommon
    
    holder
    
    Retained
    
    Comprehensive
    
    TreasuryStock
    
    Loans
    
    Earnings
    
    Income (loss)
    
    Stock
    
    TotalBalance at December 31, 2000
    
    $
    109,132
    
    
    $
    (1,018
    )
    
    $
    44,099
    
    
    $
    (280
    )
    
    $
    (15,497
    )
    
    $
    136,436Net income
    
    
    
    
    
    
    
    
    
    
    13,041
    
    
    
    
    
    
    
    
    
    
    
    13,041Gain on currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    431
    
    
    
    
    
    
    
    431Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,472Stock repurchase
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (28,905
    )
    
    
    (28,905
    )Exercise of stock options
    
    
    
    
    
    
    
    
    
    
    (509
    )
    
    
    
    
    
    
    1,806
    
    
    
    1,297Tax benefit from stock options
    
    
    263
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    263Shareholder loan repayments
    
    
    
    
    
    
    76
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    76Stock issued under ESPP
    
    
    
    
    
    
    
    
    
    
    (91
    )
    
    
    
    
    
    
    1,057
    
    
    
    966Issuance of treasury shares
in conversion of subsidiary
stock
    
    
    (427
    )
    
    
    
    
    
    
    (471
    )
    
    
    
    
    
    
    5,322
    
    
    
    4,424Dividends
    
    
    
    
    
    
    
    
    
    
    (1,192
    )
    
    
    
    
    
    
    
    
    
    
    (1,192
    )Balance at December 31, 2001
    
    
    108,968
    
    
    
    (942
    )
    
    
    54,877
    
    
    
    151
    
    
    
    (36,217
    )
    
    
    126,837Net income
    
    
    
    
    
    
    
    
    
    
    38,637
    
    
    
    
    
    
    
    
    
    
    
    38,637Gain on currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    44
    
    
    
    
    
    
    
    44Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    38,681Stock repurchase
    
    
    
    
    
    
    
    
    
    
    (16
    )
    
    
    
    
    
    
    3
    
    
    
    (13
    )Exercise of stock options
    
    
    
    
    
    
    
    
    
    
    (1,626
    )
    
    
    
    
    
    
    8,234
    
    
    
    6,608Tax benefit from stock options
    
    
    2,671
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,671Shareholder loan repayments
    
    
    
    
    
    
    604
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    604Stock issued under ESPP
    
    
    
    
    
    
    
    
    
    
    228
    
    
    
    
    
    
    
    744
    
    
    
    972Dividends
    
    
    
    
    
    
    
    
    
    
    (2,457
    )
    
    
    
    
    
    
    
    
    
    
    (2,457
    )Balance at December 31, 2002
    
    
    111,639
    
    
    
    (338
    )
    
    
    89,643
    
    
    
    195
    
    
    
    (27,236
    )
    
    
    173,903Net income
    
    
    
    
    
    
    
    
    
    
    28,518
    
    
    
    
    
    
    
    
    
    
    
    28,518Gain on currency translation
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    830
    
    
    
    
    
    
    
    830Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    29,348Stock repurchase
    
    
    
    
    
    
    
    
    
    
    (58
    )
    
    
    
    
    
    
    (149
    )
    
    
    (207
    )Exercise of stock options
    
    
    
    
    
    
    
    
    
    
    (465
    )
    
    
    
    
    
    
    5,701
    
    
    
    5,236Tax benefit from stock options
    
    
    2,321
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,321Shareholder loan repayments
    
    
    
    
    
    
    338
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    338Stock issued under ESPP
    
    
    
    
    
    
    
    
    
    
    210
    
    
    
    
    
    
    
    705
    
    
    
    915Dividends
    
    
    
    
    
    
    
    
    
    
    (4,549
    )
    
    
    
    
    
    
    
    
    
    
    (4,549
    )Balance at December 31, 2003
    
    $
    113,960
    
    
    $
    
    
    
    $
    113,299
    
    
    $
    1,025
    
    
    $
    (20,979
    )
    
    $
    207,305
 See accompanying notes. 54




---



##### 



INTER-TEL, INCORPORATED AND SUBSIDIARIES CONSOLIDATED STATEMENTS
OF CASH FLOWS
 Years ended December 31, 2003, 2002 and 2001 (In thousands) 2003
    
    2002
    
    2001OPERATING ACTIVITIES:Net income
    
    $
    28,518
    
    
    $
    38,637
    
    
    $
    13,041Adjustments to reconcile net income to net cash
provided by operating activities:Depreciation of fixed assets
    
    
    7,109
    
    
    
    7,310
    
    
    
    8,742Amortization of goodwill and purchased intangibles
    
    
    1,803
    
    
    
    1,122
    
    
    
    2,553Amortization of patents included in R&D expenses
    
    
    222
    
    
    
    222
    
    
    
    222Non-cash portion of other charges (recoveries)
    
    
    (124
    )
    
    
    1,200
    
    
    
    5,357Provision for losses on receivables
    
    
    3,164
    
    
    
    4,177
    
    
    
    6,260Provision for losses on leases
    
    
    4,528
    
    
    
    6,356
    
    
    
    5,840Provision for inventory valuation
    
    
    991
    
    
    
    1,526
    
    
    
    1,614Decrease in other liabilities
    
    
    (3,563
    )
    
    
    (3,937
    )
    
    
    (1,289
    )(Gain) loss on sale of property and equipment:
    
    
    118
    
    
    
    37
    
    
    
    (39
    )Deferred income tax expense
    
    
    30,263
    
    
    
    5,021
    
    
    
    11,306Effect of exchange rate changes
    
    
    830
    
    
    
    44
    
    
    
    431Changes in operating assets and liabilities
    
    
    (18,969
    )
    
    
    15,480
    
    
    
    20,968NET CASH PROVIDED BY OPERATING ACTIVITIES
    
    
    54,890
    
    
    
    77,195
    
    
    
    75,006INVESTING ACTIVITIES:Purchases of short-term investments
    
    
    (170,464
    )
    
    
    (67,682
    )
    
    
    (3,000
    )Maturities and sales of short-term investments
    
    
    152,046
    
    
    
    29,766
    
    
    
    Additions to property and equipment and equipment
held under lease
    
    
    (7,048
    )
    
    
    (7,600
    )
    
    
    (7,988
    )Proceeds from sale of property and equipment
and equipment held under lease
    
    
    76
    
    
    
    328
    
    
    
    173Proceeds from investment in Inter-Tel.NET/Vianet
    
    
    1,450
    
    
    
    
    
    
    
    Cash used in acquisitions and other investments
    
    
    (3,100
    )
    
    
    (11,377
    )
    
    
    (6,789
    )NET CASH USED IN INVESTING ACTIVITIES
    
    
    (27,040
    )
    
    
    (56,565
    )
    
    
    (17,604
    )FINANCING ACTIVITIES:Cash dividends paid
    
    
    (3,756
    )
    
    
    (2,192
    )
    
    
    (983
    )Payments on term debt
    
    
    (102
    )
    
    
    (481
    )
    
    
    (1,548
    )Treasury stock purchases
    
    
    (207
    )
    
    
    (13
    )
    
    
    (28,905
    )Proceeds from term debt
    
    
    
    
    
    
    
    
    
    
    3,387Proceeds from stock issued under the
Employee Stock Purchase Plan
    
    
    915
    
    
    
    972
    
    
    
    966Proceeds from exercise of stock options, including
shareholder loan repayments
    
    
    5,574
    
    
    
    7,212
    
    
    
    1,373NET CASH PROVIDED BY (USED IN) FINANCING
ACTIVITIES
    
    
    2,424
    
    
    
    5,498
    
    
    
    (25,710
    )INCREASE IN CASH AND EQUIVALENTS
    
    
    30,274
    
    
    
    26,128
    
    
    
    31,692CASH AND EQUIVALENTS AT BEGINNING OF YEAR
    
    
    84,923
    
    
    
    58,795
    
    
    
    27,103CASH AND EQUIVALENTS AT END OF YEAR
    
    $
    115,197
    
    
    $
    84,923
    
    
    $
    58,795
 See accompanying notes. 55




---



##### 



INTER-TEL, INCORPORATED AND SUBSIDIARIES NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
 December 31, 2003, 2002 and 2001 NOTE A SIGNIFICANT ACCOUNTING POLICIES Description of Business. Inter-Tel, incorporated in 1969, is a single
point of contact, full service provider of converged voice and data business
communications systems, voice mail systems and networking applications. We
market and sell voice processing and unified messaging software, call
accounting software, Internet Protocol (IP) telephony software,
computer-telephone integration (CTI) applications, local and long distance
calling services, and other communications services. Our products and services
include the Axxessby Inter-Tel and EncoreCX by Inter-Tel business
communication systems, with integrated voice processing and unified messaging
systems, IP telephony voice and data routers, and e-commerce software. We also
provide maintenance, leasing and support services for our products. Our
customers include business enterprises, government agencies and non-profit
organizations. Our common stock is quoted on the Nasdaq National Market System
under the symbol INTL. Principles of Consolidation.The consolidated financial statements
include the accounts of Inter-Tel, Incorporated and all significant
subsidiaries. Intercompany accounts and transactions have been eliminated in
consolidation. Cash and Equivalents and Short-Term Investments. Cash and equivalents
include all highly liquid investments with a remaining maturity of three months
or less at date of acquisition. Cash and equivalents are primarily invested in
mutual funds comprised of foreign and domestic high quality dollar denominated
money market instruments rated A-1 by Standard & Poors Ratings Group, or
equivalent. The Company accounts for short-term investments in accordance with
Financial Accounting Standard No. 115, Accounting for Certain Investments in
Debt and Equity Securities. The Companys short-term investments are
classified as available for sale, and have been recorded at fair value, which
approximates cost. Allowance for Doubtful Accounts. We maintain allowances for doubtful
accounts for estimated losses resulting from the inability of our customers to
make required payments. Additional reserves or allowances for doubtful
accounts are recorded for our sales-type leases, discussed below in
Sales-Leases. We establish and maintain reserves against estimated losses
based upon historical loss experience, past due accounts and specific account
analysis. Management reviews the level of the allowances for doubtful
accounts on a regular basis and adjusts the level of the allowances as needed.
In evaluating our allowance we consider accounts in excess of 60 days old as
well as other risks in the more current portions of the accounts included. At
December 31, 2003, our allowance for doubtful accounts for accounts receivable
was $11.0 million of our $54.4 million in gross accounts receivable. If the
financial condition of our customers or channel partners were to deteriorate,
resulting in an impairment of their ability to make payments, additional
allowances may be required. Inventories. We value our inventories at the lower of cost (principally
on a standard cost basis, which approximates the first-in, first-out (FIFO)
method) or market. Significant management judgment is required to determine
the reserve for obsolete or excess inventory and we make our assessment
primarily on a significant product by product basis for the immediately
preceding twelve-month period, adjusted for expected changes in projected sales
or marketing demand. Inventory on hand may exceed future demand either because
the product is outdated or obsolete, or because the amount on hand is more than
can be used to meet estimated future needs. We consider criteria such as
customer demand, product life-cycles, changing technologies, slow moving
inventory and market conditions. We write down our excess and obsolete
inventory equal to the difference between the cost of inventory and the
estimated market value. At December 31, 2003, our inventory reserves were $7.0
million of our $21.6 million gross inventories. If actual customer demand,
product life cycles, changing technologies and market conditions are less
favorable than those projected by management, additional inventory write-downs
may be required. Property, Plant and Equipment. Property, plant and equipment is stated at
cost. Depreciation is computed using the straight-line method over the
estimated useful lives of the related real and personal property, which range
from 3 years to 30 years. Leasehold improvements are depreciated over the
shorter of the related lease terms or the estimated useful lives of the
improvements. Within the category computer 56




---



##### 



systems and equipment, including database and enterprise software, WAN
and LAN equipment and software, personal computers, servers and related
software, the range for estimated useful lives is 3 years to 7 years. Goodwill and Other Intangible Assets.On January 1, 2002, Inter-Tel
adopted SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and
Other Intangible Assets.Purchase prices of acquired businesses that are
accounted for as purchases have been allocated to the assets and liabilities
acquired based on the estimated fair values on the respective acquisition
dates. Based on these values, the excess purchase prices over the fair value of
the net assets acquired were allocated to goodwill. Prior to January 1, 2002, Inter-Tel amortized goodwill over the useful
life of the underlying asset, not to exceed 40 years. On January 1, 2002,
Inter-Tel began accounting for goodwill under the provisions of SFAS Nos. 141
and 142 and discontinued the amortization of goodwill. As at December 31, 2003,
Inter-Tel had gross goodwill of $23.0 million and accumulated amortization of
$5.0 million. For the year ended December 31, 2003, Inter-Tel did not recognize
amortization expense related to goodwill. Inter-Tel completed two acquisitions
in 2002 and one in 2003 and has not recorded any amortization for these
acquisitions on amounts allocated to goodwill in accordance with SFAS No. 141. In assessing the recoverability of Inter-Tels goodwill and other
intangibles, Inter-Tel must make assumptions regarding estimated future cash
flows and other factors to determine the fair value of the respective assets.
If these estimates or their related assumptions change in the future, Inter-Tel
may be required to record impairment charges for these assets not previously
recorded. Some factors considered important which could trigger an impairment
review include significant underperformance relative to expected historical or
projected future operating results, significant changes in the manner of use of
the acquired assets or the strategy for the overall business, Inter-Tels
market capitalization relative to net book value, and significant negative
industry or economic trends. The Company has tested goodwill for impairment using the two-step process
prescribed in SFAS No. 142. The first step is a screen for potential
impairment, while the second step measures the amount of the impairment, if
any. Inter-Tel performed the first of the required impairment tests for
goodwill as of December 31, 2003 and determined that goodwill is not impaired
and it is not necessary to record any impairment losses related to goodwill and
other intangible assets. Net income, basic earnings per share and diluted earnings per share for
the years ended December 31, 2003, 2002 and 2001, respectively, adjusted to
exclude amortization expense for goodwill, are as follows (net of tax, in
thousands, except per share data): Years Ended December 31,2003
    
    2002
    
    2001Reported net income
    
    $
    28,518
    
    
    $
    38,637
    
    
    $
    13,041Add back: goodwill amortization
    
    
    
    
    
    
    
    
    
    
    694Adjusted net income
    
    $
    28,518
    
    
    $
    38,637
    
    
    $
    13,735Reported earnings per share  basic
    
    $
    1.14
    
    
    $
    1.58
    
    
    $
    0.53Add back: goodwill amortization
    
    
    
    
    
    
    
    
    
    
    0.03Adjusted earnings per share  basic
    
    $
    1.14
    
    
    $
    1.58
    
    
    $
    0.56Reported earnings per share  diluted
    
    $
    1.08
    
    
    $
    1.49
    
    
    $
    0.52Add back: goodwill amortization
    
    
    
    
    
    
    
    
    
    
    0.03Adjusted earnings per share  diluted
    
    $
    1.08
    
    
    $
    1.49
    
    
    $
    0.54
 At December 31, 2003, goodwill, net of accumulated amortization, totaled
$18.0 million. Other acquisition-related intangibles, net of accumulated
amortization, totaled $8.2 million at December 31, 2003. Accumulated
amortization through December 31, 2003 was $11.0 million. This amount includes
$5.0 million of amortization of goodwill and $6.0 million of amortization of
other acquisition-related intangibles. Other acquisition-related intangibles,
comprised primarily of developed technology, customer lists and non-competition
agreements, are amortized on a straight-line basis over periods ranging from
5-17 years. See Note F to Consolidated Financial Statements for additional
information. 57




---



##### 



Sales-Leases. For our sales-type lease accounting, we follow the guidance
provided by FASB Statement No. 13, Accounting for Leases and FASB Statement No.
140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities  A Replacement of FASB Statement No. 125. We
record the discounted present values of minimum rental payments under
sales-type leases as sales, net of provisions for continuing administration and
other expenses over the lease period. We record the lease sales at the time of
system sale and installation pursuant to Staff Accounting Bulletin No. 104, as
discussed above for sales to end user customers, and upon receipt of the
executed lease documents. The costs of systems installed under these
sales-leases are recorded as costs of sales. The net rental streams are sold
to funding sources on a regular basis with the income streams discounted by
prevailing like-term rates at the time of sale. Gains or losses resulting from
the sale of net rental payments from such leases are recorded as net sales. We
establish and maintain reserves against potential recourse following the
resales based upon historical loss experience, past due accounts and specific
account analysis. The allowance for uncollectible minimum lease payments and
recourse liability at the end of the year represents reserves against the
entire lease portfolio. Management reviews the adequacy of the allowance on a
regular basis and adjusts the allowance as required. These reserves are either
netted in the accounts receivable, current and long-term components of Net
investments in Sales-Leases on the balance sheet, or included in long-term
liabilities on our balance sheet for off-balance sheet leases. Income Taxes. Deferred income taxes result from temporary differences in
the recognition of revenues and expenses for financial reporting and income tax
purposes. Advertising. The cost of advertising is expensed as incurred. We
incurred $331,000; $443,000; and $596,000 in advertising costs during 2003,
2002, and 2001, respectively. Revenue Recognition. In December 2003, the Securities and Exchange
Commission (SEC) issued Staff Accounting Bulletin No. 104 (SAB 104), Revenue
Recognition. The Company applies the provisions of SAB 104 to all revenue
transactions. SAB 104 supercedes SAB 101, Revenue Recognition in Financial
Statements. The primary purpose of SAB 104 is to rescind accounting guidance
contained in SAB 101 related to multiple element revenue arrangements,
superceded as a result of the issuance of EITF 00-21. Additionally, SAB 104
rescinds the SECs Revenue Recognition in Financial Statements Frequently Asked
Questions and Answers (the FAQ) issued with SAB 101 that had been codified in
SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been
incorporated into SAB 104. While the wording of SAB 104 has changed to reflect
the issuance of EITF 00-21, the revenue recognition principles of SAB 101
remain largely unchanged by the issuance of SAB 104. The issuance of SAB 104
did not have a material impact on the Companys financial position, results of
operations or cash flows. Accordingly, revenue is recognized when all four of the following criteria
are met: (i) persuasive evidence that arrangement exists; (ii) delivery of the
products and/or services has occurred; (iii) the selling price is both fixed
and determinable and; (iv) collectibility is reasonably probable. Revenue
derived from sales of systems and services to end-user customers is recognized
upon installation of the systems and performance of the services, respectively,
allowing for use by our customers of these systems. Pre-payments for
communications services are deferred and recognized as revenue as the
communications services are provided. For shipments to dealers and other distributors, our revenues are recorded
as products are shipped and services are rendered, because the sales process is
complete. These shipments are primarily to third-party dealers and
distributors and title passes when goods are shipped (free-on-board shipping
point). Long distance services revenues are recognized as service is provided. Shipping and Handling Costs.EITF 00-10 Accounting for Shipping and
Handling Fees and Costs, addresses the accounting for shipping and handling
fees and costs. Our policy is primarily not to bill customers for shipping
costs, unless the customer requests priority shipping. Any amounts billed are
recorded net in cost of goods sold. Billed shipping and handling costs in
2003, 2002 and 2001 were approximately $1.3 million, $1.1 million, and $1.2
million, respectively, and are not a significant component of our operations. Stock Based Compensation. We grant stock options for a fixed number of
shares to employees and directors with an exercise price equal to the fair
market value of the shares at the date of grant. We account for such stock
option grants using the intrinsic-value method of accounting in accordance with
Accounting 58




---



##### 



Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, (APB 25) and related Interpretations. Under APB 25, we generally
recognize no compensation expense with respect to such awards. Also, we do not
record any compensation expense in connection with our Employee Stock Purchase
Plan as long as the purchase price is not less than 85% of the fair market
value at the beginning or end of each offering period, whichever is lower. The pro forma impact on net income and net income per share as if the fair
value of stock-based compensation plans had been recorded as a component of
compensation expense in the consolidated financial statements as of the date of
grant of awards related to such plans, pursuant to the provisions of the
Statement of Financial Accounting Standards No. 123, Accounting for Stock
Based Compensation and Statement of Financial Accounting Standards No. 148,
Accounting for Stock-Based Compensation  Transition and Disclosure an
amendment of FASB Statement No. 123, is disclosed as follows and in Note L. Years Ended December 31,(in thousands, except per share data)
    
    2003
    
    2002
    
    2001Net income, as reported
    
    $
    28,518
    
    
    $
    38,637
    
    
    $
    13,041Deduct: Total stock-based employee
compensation expense determined under
fair value based method for all
awards, net of related tax effects
    
    
    (3,007
    )
    
    
    (3,062
    )
    
    
    (2,446
    )Pro forma net income
    
    $
    25,511
    
    
    $
    35,575
    
    
    $
    10,595Earnings per share:Basic  as reported
    
    $
    1.14
    
    
    $
    1.58
    
    
    $
    0.53Basic  pro forma
    
    $
    1.02
    
    
    $
    1.46
    
    
    $
    0.43Diluted  as reported
    
    $
    1.08
    
    
    $
    1.49
    
    
    $
    0.52Diluted  pro forma
    
    $
    0.96
    
    
    $
    1.38
    
    
    $
    0.42
 Pro forma results disclosed are based on the provisions of SFAS 123 using
the Black-Scholes option valuation model and are not likely to be
representative of the effects on pro forma net income for future years. In
addition, the Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options, which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because our stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in our
opinion, the estimating models do not necessarily provide a reliable single
measure of the fair value of our stock options. See Note L for further
discussion of the Companys stock-based employee compensation. Foreign Currency Translation and Transactions. For our foreign
operations, the local currency is the functional currency. All assets and
liabilities are translated at period-end exchange rates and all income
statement amounts are translated at an average of month-end rates. Adjustments
resulting from this translation are recorded in accumulated other comprehensive
income. Foreign currency transaction gains and losses also result from
transactions denominated in a currency other than U.S. dollars; gains and
losses resulting from remeasuring monetary assets and liability accounts that
are denominated in currencies other than a subsidiarys functional currency are
included in other income under the caption Foreign currency transaction gains
(losses). Contingencies. We are a party to various claims and litigation in the
normal course of business. Managements current estimated range of liability
related to various claims and pending litigation is based on claims for which
our management can estimate the amount and range of loss, or can estimate a
minimum amount of a loss. Because of the uncertainties related to both the
amount and range of loss on the remaining pending claims and litigation,
management is unable to make a reasonable estimate of the liability that could
result from an unfavorable outcome. As additional information becomes
available, we will assess the potential liability related to our claims and
pending litigation, revise our estimates and accrue for any losses to the
extent that they are probable and the amount is estimable. Such revisions in
our estimates of the potential liability could materially impact our results of
operations and financial position. However, at December 31, 2003, management
did not believe that the ultimate impact of various claims and pending
litigation would have a materially adverse impact on the Company. 59




---



##### 



Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has provided Inter-Tel with only a limited description of the
evidence on which the investigations are based. Inter-Tel is presently unable
to predict or determine the final outcome of, or to estimate the potential
range of loss with respect to, the investigations. Based upon the information
known at this time, we do not know what, if any, impact the investigations may
have on the Companys business or financial condition. If Inter-Tel is
convicted of any crime or subjected to sanctions, or debarred from certain
government contracts or if penalties, damages or other monetary remedies are
assessed against Inter-Tel in connection with or related to these and other
investigations, our business and operating results could be materially and
adversely affected. The existence and disclosure of the investigations may
have already caused competitive harm to Inter-Tel, and any unfavorable
resolution to these matters may further harm Inter-Tels business. Use of Estimates. The preparation of the consolidated financial
statements in conformity with accounting principles generally accepted in the
United States requires management to make estimates and assumptions that affect
the amounts reported in the consolidated financial statements and accompanying
notes. Actual results could differ from those estimates. Reclassifications. Certain reclassifications have been made to the 2002
and 2001 financial statements to conform to the 2003 presentation. Recent Accounting Pronouncements In June 2002, the Financial Accounting Standards Board (FASB) issued
SFAS No. 146, Accounting for Costs Associated with Exit or Disposal
Activities. SFAS No. 146 supersedes Emerging Issues Task Force (EITF) No.
94-3, Liability Recognition for Certain Employee Termination Benefits and
Other Costs to Exit an Activity (Including Certain Costs Incurred in a
Restructuring). SFAS No. 146 eliminates the provisions of EITF No. 94-3 that
required a liability to be recognized for certain exit or disposal activities
at the date an entity committed to an exit plan. SFAS No. 146 requires a
liability for costs associated with an exit or disposal activity to be
recognized when the liability is incurred. SFAS No. 146 is effective for exit
or disposal activities that are initiated after December 31, 2002. The
adoption of this statement did not have a material impact on the Companys
results of operations or financial position. In December 2002, the FASB issued SFAS No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure. SFAS No. 148 amends FASB
Statement No. 123, Accounting for Stock-Based Compensation, to provide
alternative methods of transition to SFAS No. 123s fair value method of
accounting for stock-based employee compensation. Statement 148 also amends
the disclosure provisions of SFAS No. 123 and APB Opinion No. 28, Interim
Financial Reporting, to require disclosure in the summary of significant
accounting policies of the effects of an entitys accounting policy with
respect to stock-based employee compensation on reported net income and
earnings per share in annual and interim financial statements. While SFAS No.
148 does not amend SFAS No. 123 to require companies to account for employee
stock options using the fair value method, the disclosure provisions of SFAS
No. 148 are applicable to all companies with stock-based employee compensation,
regardless of whether they account for that compensation using the fair value
method of SFAS No. 123 or the intrinsic value method of APB Opinion No. 25. As
allowed by SFAS No. 123, the Company has elected to continue to utilize the
accounting method prescribed by APB Opinion No. 25 and has adopted the
disclosure requirements of SFAS No. 123 as of December 31, 2002. The adoption
of this statement did not have a material impact on the Companys results of
operations or financial position. In November 2002, the FASB issued FASB Interpretation No. 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (FIN 45). This statement requires that a
liability be recorded in the guarantors balance sheet upon issuance of a
guarantee. In addition, FIN 45 requires disclosures about the guarantees that
an entity has issued, including a rollforward of the entitys product warranty
liabilities. We will apply the recognition provisions of FIN 45 prospectively
to guarantees issued after December 31, 2002. The disclosure provisions of FIN
45 were effective for financial statements of interim and annual periods ending
December 15, 2002. The adoption of this statement did not have a material
impact on the Companys results of operations or financial position. 60




---



##### 



In January 2003, the FASB issued FASB Interpretation No. 46,
Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51
(FIN 46). This statement requires specified variable interest entities to be
consolidated by the primary beneficiary of the entity if the equity investors
in the entity do not have the characteristics of a controlling financial
interest or do not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support from other
parties. FIN 46 is effective for all new variable interest entities created or
acquired after January 31, 2003 and beginning July 1, 2003 for variable
interest entities created or acquired prior to February 1, 2003. Our exposure
to variable interest entities is limited and the adoption of FIN 46 did not
have a material impact on the Companys financial position or results of
operations. In May 2003, the FASB issued Statement of Financial Accounting Standards
No. 150, Accounting for Certain Financial Instruments with Characteristics of
both Liabilities and Equity (SFAS 150). SFAS 150 establishes standards for how
an issuer classifies and measures certain financial instruments with
characteristics of both liabilities and equity. SFAS 150 is effective for
financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first interim period beginning
after June 15, 2003. The adoption of SFAS 150 did not have a material effect on
the Companys financial position, results of operations, or cash flows. NOTE B  ACQUISITIONS, TECHNOLOGY INVESTMENTS, DISPOSITIONS AND RESTRUCTURING
CHARGES New Sales Office in Philadelphia.In connection with opening a new sales
office in Pennsylvania during December 2003, we acquired certain assets and
assumed certain liabilities relating to a customer base of a former dealer.
The total assets acquired and liabilities assumed were approximately $0.5
million and $0.9 million, respectively. Total goodwill and purchased
intangibles recorded as a result of the transaction were $0.3 million and $0.1
million, respectively. The goodwill balance will be accounted for in
accordance with SFAS 141 and 142. The balance included in the $0.1 million in
other purchased intangible assets will be amortized over a period of five
years. Technology Investment. In connection with the acquisition of the rights
to certain developed technology for a capitalized purchase price of $2.25
million (included in purchased intangible assets) during the year ended
December 31, 2003, the Company entered into an arrangement with the selling
entity under which the selling entity will perform additional development
activities on a cost reimbursement basis through August 15, 2004. Under the
terms of the arrangement, the selling entity can also earn bonus payments
totaling up to $1.0 million during 2004 for meeting certain development
milestones. As of December 31, 2003, we did not consider the milestone bonuses
to be probable or reasonably estimable, nor had technological feasibility of
the underlying technology been achieved to provide for viable product sales;
therefore, no bonus payments have been accrued, and the monthly cost of
services performed totaling approximately $0.5 million has been expensed in
research and development costs for the year ended December 31, 2003. McLeod.On January 24, 2002, we acquired certain assets of McLeodUSA
Integrated Business Systems, Inc. (McLeod) for cash plus the assumption of
various specific liabilities and related acquisition costs. Inter-Tel acquired
McLeods voice customer base in Minnesota, Iowa and Colorado and DataNet
operations in South Dakota, which also included the related accounts
receivable, inventory and fixed assets along with assumption of scheduled
specific liabilities for warranty and maintenance obligations. The aggregate
purchase price of $7.9 million was allocated to the fair value of the assets
and liabilities acquired. We recorded goodwill of approximately $4.0 million and other purchased
intangible assets of $0.5 million, for a total of $4.5 million, in connection
with the McLeod acquisition. The goodwill balance will be accounted for in
accordance with SFAS 141 and 142. The balances included in the $0.5 million in
other purchased intangible assets will be amortized over periods ranging from
two to five years from the date of the acquisition. During each of the years
ended December 31, 2003 and 2002, the amortization of purchased intangible
assets from McLeod was approximately $138,000. Swan.On December 3, 2002, Inter-Tel Integrated Systems, Inc., our
wholly-owned subsidiary, acquired 100% of the capital stock of Swan Solutions
Limited (Swan) in England and Wales, for $4.0 million in cash. $3.0 million
was paid at closing, $250,000 is payable in six months and $250,000 is payable
one year from closing date. The remaining $500,000 is subject to the
achievement of five performance milestones at $100,000 each. As of March 5,
2004, portions of four of the five $100,000 milestones were 61




---



##### 



achieved for which $350,436 was paid to the Swan shareholders. The final
milestone is due on June 3, 2004. Payments relating to the achievement of
performance milestones were capitalized and are being amortized as purchased
intangible assets over five years. In total, the Company recorded amortizable
intangible technology assets totaling $3.9 million in connection with this
acquisition. These technology assets are being amortized over five years.
During the years ended December 31, 2003 and 2002, the amortization of
purchased intangible assets from Swan was approximately $796,000 and $57,000
respectively. Convergent.On January 26, 2001, Inter-Tel Technologies, Inc., our
wholly-owned subsidiary, acquired certain assets of Convergent Communications
Services, Inc. (Convergent) for cash plus the assumption of various specific
liabilities and related acquisition costs. The Company acquired segments of
the voice customer base, accounts receivable, specified inventory and fixed
assets, and assumed liabilities for warranty, maintenance and specified leased
premises costs. The adjusted purchase price paid by us in the Convergent transaction
included cash of $3.9 million plus assumption of specific liabilities totaling
$6.3 million. The final purchase price was adjusted pursuant to a settlement
agreement with Convergent representatives which specified the return of $6.7
million to Inter-Tel, representing funds from escrow and other amounts owed to
Inter-Tel by Convergent that were previously set aside by the bankruptcy court,
as well as adjustments for assets to be acquired and liabilities to be assumed.
The settlement payments only required adjustments or reallocations based on
the specified assets acquired and liabilities assumed in connection with the
purchase, and differences have been represented as adjustments to the net
assets acquired. The Company recorded goodwill of $880,000 and other
intangible assets of $120,000 in connection with this acquisition. Goodwill
and intangibles were amortized through December 31, 2001. The net goodwill
balance of $810,000 as of December 31, 2001 will no longer be amortized, but
accounted for in accordance with SFAS 141 and 142. The net balance of $98,000
in other intangible assets will continue to be amortized for five years from
the date of the acquisition. MasterMind.On October 19, 2001, Inter-Tel Integrated Systems, Inc., our
wholly-owned subsidiary, acquired certain of the assets and assumed certain
stated liabilities from MasterMind Technologies, Inc. (MasterMind), for $2.0
million. $1.79 million was paid at or before closing with the balance placed
into a bonus pool with earn-out provisions for MasterMind shareholders and
employees based on performance parameters. The portion relating to employees
who have joined Inter-Tel will be charged to expenses. The Company recorded
amortizable intangible technology assets totaling $1.4 million in connection
with this acquisition. These technology assets are being amortized over 5
years. Each of the acquisitions discussed above were not material business
acquisitions either individually or collectively and have been accounted for
using the purchase method of accounting. The results of operations of each of
these acquisitions have been included in our accompanying consolidated
statements of operations from the date of acquisitions. Inter-Tel.NET/Comm-Services/Vianet.During the second quarter of 2000,
Inter-Tel recorded a pre-tax charge associated with Inter-Tel.NET operations of
$2.0 million ($1.2 million after-tax), related to the write-down to net
realizable value of network equipment and lease termination costs of certain
redundant facilities. The reserves established at the time of the write-down
have been fully utilized as of December 31, 2001. On July 24, 2001, Inter-Tel sold 83% of the stock of Inter-Tel.NET, Inc.
to Comm-Services Corporation for a note of $4.95 million, collateralized by
Comm-Services stock, other marketable securities of the shareholders of
Comm-Services and 100% of the net assets of Inter-Tel.NET. In connection with
the sale of 83% of Inter-Tel.NET, we assessed the fair value of the remaining
17% investment in Inter-Tel.NET. Pursuant to SFAS 121, we recorded a charge as
of the close of the second quarter of 2001 of $5.4 million ($3.4 million after
tax) associated with the impairment of our investment in Inter-Tel.NET. After
the impairment charge, the carrying value of our investment (the note
receivable from Vianet plus the 17% ownership interest in Vianet) totaled $3.7
million as of December 31, 2001. The charge was primarily non-cash. Inter-Tels management has not participated in the management of
Inter-Tel.NET since the sale in July 2001. As a result, since July 24, 2001,
we have accounted for the remaining Inter-Tel.NET/Comm-Services investment
using the cost method of accounting. On December 30, 2001, Comm-Services
entered into a merger agreement with Vianet. Inter-Tels 17% investment in
Comm-Services was converted to 62




---



##### 



approximately 10% of Vianet stock and as a result, the loan for the purchase was
assumed by Vianet and Inter-Tel continued to hold collateral from the former
shareholders of Comm-Services until March 2003. During 2002, the net
investment in the notes receivable and 10% interest in Vianet (formerly
Comm-Services) was written down by $1.2 million and was recorded in other
assets at a carrying value of approximately $2.5 million as of December 31,
2002, which approximated managements estimate of the related collateral value
at that time.

During 1999, 2000 and 2001, Inter-Tel.NET entered into operating lease
agreements totaling approximately $6.5 million from an equipment vendor for
network equipment and software. The lease agreements required Inter-Tel.NET to
purchase vendor maintenance on their products. Inter-Tel originally
guaranteed the indebtedness. In February 2003, we executed an agreement with
Vianet and this vendor releasing Inter-Tel from its guarantee of any and all of
these obligations, and Inter-Tel and Vianet released the vendor from claims
arising from the failure of the network equipment and software previously
leased. As part of this agreement, Inter-Tel also received payment from the
Vianet shareholders of $1.45 million, in exchange for the release of the
remaining collateral and as payment of the loan. Inter-Tel had also retained
a collateral interest in a Vianet shareholders variable forward option
contract that matured in April and May of 2003, and for which we received no
value for the collateral interest. After an adjustment of $124,000 in 2003
related to a recovery of our investment and adjustment of projected costs to
actual costs associated with the 2002 write-down in the Vianet investment, the
estimated value received in this transaction was equivalent to our remaining
investment value, less accruals for potential obligations to the vendor
discussed above.

Inter-Tel retains its ownership interest in Vianet and will account for
the remaining investment interest of approximately 10% in Vianet using the cost
method of accounting. At December 31, 2003, our net investment in Vianet was
recorded at no value.

Executone.On January 1, 2000 Inter-Tel purchased certain computer
telephony assets and assumed certain liabilities of Executone Information
Systems, Inc. (Executone). The Executone transaction was accounted for using
the purchase method of accounting. The aggregate purchase price was allocated
to the fair value of the assets and liabilities acquired, of which $5.4 million
($3.4 million after taxes) was written-off as purchased in-process research and
development. In connection with the Executone acquisition, we sold Executones
manufacturing assets and liabilities to Varian of Tempe, Arizona at a net book
value of $6.6 million.

During the second quarter of 2000, we decided to close the primary
Executone facility in Milford, Connecticut and to recognize a restructuring
charge related to our exit plan and closure of the Executone operations. We
have accounted for the restructuring of the Executone operations, including
severance and related costs, the shut down and consolidation of the Milford
facility and the impairment of assets associated with the restructuring. We
finalized our plan for the exiting of activities and the involuntary
termination or relocation of the employees. Accrued costs associated with this
plan were estimates, although the original estimates made for the second
quarter of 2000 for reserve balances have not changed significantly as of
December 31, 2003.

Exit costs associated with the closure of the Milford facility also
included liabilities for building, furniture and equipment lease, and other
contractual obligations. We are liable for the lease on the Milford buildings
through January 2005. Various other furniture, computer and equipment leases
terminated on varying dates through September 2002. To date, we have entered
into sublease agreements with third parties to sublease portions of the
facility. The reserve for lease and other contractual obligations is
identified in the table below.

The total restructuring charge from this event totaled $50.9 million. The
following tables summarize details of the restructuring charge in connection
with the Executone acquisition, including the description of the type and
amount of liabilities assumed, and activity in the reserve balances from the
date of the charge through December 31, 2003. Activity represents payments
made or amounts written off.

63



---



##### 



|                                                                                   |                                      |      |          |        |               |          |         |          |      |          |                |          |      |             |         |  |   |       |       |  |   |     |       |  |         |        |        |   |  |  |  |  | 
|---------------------------------------------------------------------------------- | ------------------------------------ | ---- | -------- | ------ | ------------- | -------- | ------- | -------- | ---- | -------- | -------------- | -------- | ---- | ----------- | ------- |  | - | ----- | ----- |  | - | --- | ----- |  | ------- | ------ | ------ | - |  |  |  |  | 
|                                                                                   |                                      |      |          |        |               |          |         |          |      |          | (In thousands) |          |      |             |         |  |   |       |       |  |   |     |       |  |         |        |       
|                                                                                   |                                      |      | Cash/    |        |               |          |         |          |      |          |                |          |      |             |         |  |   |       |       |  |   |     |       |  | Reserve |        |        |   | 
|                                                                                   |                                      |      | Non-     |        | Restructuring |          | 2000    |          | 2001 |          | 2002           |          | 2003 |             | Balance |  |   |       |      
|Description                                                                        |                                      | Cash |          | Charge |               | Activity |         | Activity |      | Activity |                | Activity |      | At 12/31/03 |         |  |   |      
|                                                                                   |                                      |      |          |        |               |          |         |          |      |          |                |          |      |             |         |  |   |      
|Personnel Costs:                                                                   |                                      |      |          |        |               |          |         |          |      |          |                |          |      |             |         |  |   |       |       |  |   |     |       |  |         |        |        |  
|                                                                                   | Severance and termination costs      |      | Cash     |        | $             | (1,583   | )       |          | $    | 1,558    |                |          | $    | 2           |         |  | $ | 20    |       |  | $ | 3   |       |  | $       |       |       
|                                                                                   | Other Plant closure costs            |      | Cash     |        |               | (230     | )       |          |      | 30       |                |          |      | 200         |         |  |   |      |       |  |   |    |       |  |         |       |       
|Lease termination and other
contractual obligations (net
of anticipated recovery): |                                      |      |          |        |               |          |         |          |      |          |                |          |      |             |         |  |   |       |       |  |   |     |       |  |         |        |        |  
|                                                                                   | Building and equipment leases        |      | Cash     |        |               | (7,444   | )       |          |      | 1,348    |                |          |      | 1,489       |         |  |   | 2,594 |       |  |   | 767 |       |  |         | (1,246 | )     
|                                                                                   | Other contractual obligations        |      | Cash     |        |               | (1,700   | )       |          |      |         |                |          |      | 1,700       |         |  |   |      |       |  |   |    |       |  |         |       |       
|Impairment of Assets:                                                              |                                      |      |          |        |               |          |         |          |      |          |                |          |      |             |         |  |   |       |       |  |   |     |       |  |         |        |        |  
|                                                                                   | Inventories                          |      | Non-Cash |        |               | (3,454   | )       |          |      | 1,376    |                |          |      | 209         |         |  |   | 1,869 |       |  |   |    |       |  |         |       |       
|                                                                                   | Prepaid inventory and other expenses |      | Non-Cash |        |               | (2,485   | )       |          |      | 2,485    |                |          |      |            |         |  |   |      |       |  |   |    |       |  |         |       |       
|                                                                                   | Accounts receivable                  |      | Non-Cash |        |               | (1,685   | )       |          |      | 521      |                |          |      | 245         |         |  |   | 88    |       |  |   | 831 |       |  |         |       |       
|                                                                                   | Fixed assets                         |      | Non-Cash |        |               | (3,151   | )       |          |      | 2,942    |                |          |      |            |         |  |   | 53    |       |  |   | 14  |       |  |         | (142   | )     
|                                                                                   | Net intangible assets                |      | Non-Cash |        |               | (29,184  | )       |          |      | 29,184   |                |          |      |            |         |  |   |      |       |  |   |     |       |  |         |        |       
|                                                                                   |                                      |      |          |        |               |          |         |          |      |          |                |          |      |             |         |  |   |       |       |  |   |     |       |  |         |        |        |  
|Total                                                                              |                                      |      |          |        |               | $        | (50,916 | )        |      | $        | 39,444         |          |      | $           | 3,845   |  |   | $     | 4,624 |  |   | $   | 1,615 |  |         | $      | (1,388 | )
|                                                                                   |                                      |      |          |        |               |          |         |          |      |          |                |          |      |             |         |  |   |       |       |  |   |     |       |  |         |        |        |  

Included in the total Executone restructuring costs of $50.9 million is a $43.3
million restructuring charge for exit costs and asset impairment, and $7.6
million associated with the impairment of inventories, which has accordingly
been recorded as additional costs of sales.

NOTE C  SHORT-TERM INVESTMENTS

The Company accounts for short-term investments in accordance with
Financial Accounting Standard No. 115, Accounting for Certain Investments in
Debt and Equity Securities. The Companys short-term investments are all
classified as available for sale, and have been recorded at fair value, which
approximates cost. At December 31, 2003 and December 31, 2002, $59.3 million
and $40.9 million, respectively, were recorded as short-term investments.
Short-term investments include certificates of deposit, auction rate

certificates, auction rate preferred securities, municipal preferred securities
and mutual funds. The auction rate securities are adjustable-rate securities
with dividend rates that are reset periodically by bidders through periodic
Dutch auctions generally conducted every 7 to 49 days by a trust company or
broker/dealer on behalf of the issuer. The Company believes these securities
are highly liquid investments through the related auctions; however, the
collateralizing securities have stated terms of up to thirty (30) years. These
instruments are rated A or higher by Standard & Poors Ratings Group, or
equivalent.

The Companys short-term investments are intended to establish a
high-quality portfolio that preserves principal, meets liquidity needs, avoids
inappropriate concentrations and delivers an appropriate yield in relationship
to the Companys investment guidelines and market conditions.

The following is a summary of available-for-sale securities:

|                  |  |      |        |       |  |                  |   |                  |  |   |   |  |  |   |        | 
|----------------- |  | ---- | ------ | ----- |  | ---------------- | - | ---------------- |  | - | - |  |  | - | ------ | 
|December 31, 2003 |  |      |        |       |  | Gross Unrealized |   | Gross Unrealized |  |   |   | 
|(in thousands)    |  | Cost |        | Gains |  | Losses           |   | Gross Fair Value
|                  |  |      |        |       |  |                  |   |                 
|Equity securities |  | $    | 57,855 |       |  | $                |  |                  |  | $ |  |  |  | $ | 57,855 | 
|Mutual funds      |  |      | 1,479  |       |  |                  |  |                  |  |   |  |  |  |   | 1,479  | 
|                  |  |      |        |       |  |                  |   |                  |  |   |   |  |  |   |        | 
|December 31, 2003 |  | $    | 59,334 |       |  | $                |  |                  |  | $ |  |  |  | $ | 59,334 | 
|                  |  |      |        |       |  |                  |   |                  |  |   |   |  |  |   |        | 

NOTE D  NET INVESTMENT IN SALES-LEASES

Net investment in sales-leases represents the value of sales-leases
presently held under our Total Solution program. We currently sell the rental
payments due to us from some of the sales-leases. We maintain reserves against
our estimate of potential recourse for the balance of sales-leases and for the
balance of sold rental payments remaining unbilled. The following table
provides detail on the total net balances in sales-leases (In thousands):

64



---



##### 



|                                                                                                                                                            |                                                                                                                                                                       |   |             |        |      |   |         |        |  |   |         |        | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------- | - | ----------- | ------ | ---- | - | ------- | ------ |  | - | ------- | ------ | 
|                                                                                                                                                            |                                                                                                                                                                       |   | December 31
|                                                                                                                                                            |                                                                                                                                                                       |   |            
|                                                                                                                                                            |                                                                                                                                                                       |   | 2003        |        | 2002 |   | 2001   
|                                                                                                                                                            |                                                                                                                                                                       |   |             |        |      |   |        
|Lease balances included in consolidated accounts                                                                                                            |                                                                                                                                                                       | $ | 7,240       |        |      | $ | 6,470   |        |  | $ | 7,924   |       
|receivable, net of allowances of $1,774 in 2003; $2,562
in 2002; and $3,112 in 2001                                                                         |                                                                                                                                                                       |   |             |        |      |   |         |        |  |   |         |       
|Net investment in Sales-Leases:                                                                                                                             |                                                                                                                                                                       |   |             |        |      |   |         |        |  |   |         |       
|                                                                                                                                                            | Current portion, net of allowances of $749 in 2003;
$516 in 2002; and $640 in 2001                                                                                    |   |             | 15,502 |      |   |         | 13,344 |  |   |         | 13,799 | 
|                                                                                                                                                            | Long-term portion, includes residual amounts of
$652 in 2003; $518 in 2002; and $907 in 2001,
net of allowances of $1,985 in 2003; $1,411 in
2002; and $1,206 in 2001 |   |             | 32,529 |      |   |         | 24,692 |  |   |         | 21,735 | 
|                                                                                                                                                            |                                                                                                                                                                       |   |             |        |      |   |         |        |  |   |         |       
|Total investment in Sales-Leases, net of allowances of
$4,508 in 2003; $4,489 in 2002; and $4,958 in 2001                                                   |                                                                                                                                                                       |   | 55,271      |        |      |   | 44,506  |        |  |   | 43,458  |       
|Sold rental payments remaining unbilled (subject to
limited recourse provisions), net of allowances of
$12,020 in 2003; $11,125 in 2002; and $8,890 in
2001 |                                                                                                                                                                       |   | 198,091     |        |      |   | 194,684 |        |  |   | 193,825 |       
|                                                                                                                                                            |                                                                                                                                                                       |   |             |        |      |   |         |        |  |   |         |       
|Total balance of sales-leases and sold rental payments
remaining unbilled, net of allowances                                                                |                                                                                                                                                                       | $ | 253,362     |        |      | $ | 239,190 |        |  | $ | 237,283 |       
|                                                                                                                                                            |                                                                                                                                                                       |   |             |        |      |   |         |        |  |   |         |       
|Total allowances for entire lease portfolio (including
limited recourse liabilities)                                                                        |                                                                                                                                                                       | $ | 16,528      |        |      | $ | 15,614  |        |  | $ | 13,848  |       
|                                                                                                                                                            |                                                                                                                                                                       |   |             |        |      |   |         |        |  |   |         |       

Reserve levels are established based on portfolio size, loss experience,
levels of past due accounts and periodic, detailed reviews of the portfolio.
Recourse on the sold rental payments is contractually limited to a percentage
of the net credit losses in a given annual period as compared to the beginning
portfolio balance for a specific portfolio of sold leases. While our recourse
is limited, we maintain reserves at a level sufficient to cover all anticipated
credit losses. The aggregate reserve for uncollectible lease payments and
recourse liability represents the reserve for the entire lease portfolio.
These reserves are either netted from consolidated accounts receivable, netted
against current or long-term investment in sales-leases or included in
long-term liabilities for sold rental payments remaining unbilled. Sales of
rental payments per period:

|                                                |  |                         |         |      |  |      |         |  |  |   |         | 
|----------------------------------------------- |  | ----------------------- | ------- | ---- |  | ---- | ------- |  |  | - | ------- | 
|                                                |  | Years Ended December 31
|                                                |  |                        
|(In thousands)                                  |  | 2003                    |         | 2002 |  | 2001
|                                                |  |                         |         |      |  |     
|Sales of rental payments                        |  | $                       | 88,352  |      |  | $    | 83,141  |  |  | $ | 86,788  | 
|Sold payments remaining unbilled at end of year |  | $                       | 210,111 |      |  | $    | 205,809 |  |  | $ | 202,715 | 
|                                                |  |                         |         |      |  |      |         |  |  |   |         | 

Sales of rental payments represents the gross selling price or total
present value of the payment stream on the sale of the rental payments to third
parties. Sold payments remaining unbilled at the end of the year represents
the total balance of leases that are not included in our balance sheet. We do
not expect to incur any significant losses in excess of reserves from the
recourse provisions related to the sale of rental payments. Inter-Tel is
compensated for administration and servicing of rental payments sold.

At December 31, 2003, future minimum lease payments related to the sold
rental streams remaining unbilled are: 2004  $67.5 million, 2005  $57.6
million, 2006  $44.2 million, 2007  $27.8, 2008  $12.9 million, thereafter
 $177,000.

At December 31, 2003, future minimum lease receipts due from customers
related to the lease portfolio included in our December 31, 2003 balance sheet
are: 2004  $16.9 million, 2005  $19.9 million, 2006  $5.9 million, 2007 
$3.9 million, 2008  $2.8, thereafter  $2.2 million.

NOTE E  PROPERTY, PLANT & EQUIPMENT

65



---



##### 



|                                                             |  |             |        |      |  |   |        | 
|------------------------------------------------------------ |  | ----------- | ------ | ---- |  | - | ------ | 
|                                                             |  | December 31
|                                                             |  |            
|(In thousands)                                               |  | 2003        |        | 2002
|                                                             |  |             |        |     
|Computer systems, data processing and other office equipment |  | $           | 38,906 |      |  | $ | 40,089 | 
|Transportation equipment                                     |  |             | 3,761  |      |  |   | 2,328  | 
|Furniture and fixtures                                       |  |             | 3,899  |      |  |   | 4,942  | 
|Leasehold improvements                                       |  |             | 4,501  |      |  |   | 4,215  | 
|Building                                                     |  |             | 7,297  |      |  |   | 7,297  | 
|Land                                                         |  |             | 2,499  |      |  |   | 2,499  | 
|                                                             |  |             |        |      |  |   |        | 
|                                                             |  |             | 60,863 |      |  |   | 61,370 | 
|Less: Accumulated depreciation and amortization              |  |             | 36,206 |      |  |   | 36,575 | 
|                                                             |  |             |        |      |  |   |        | 
|Net property, plant & equipment                              |  | $           | 24,657 |      |  | $ | 24,795 | 
|                                                             |  |             |        |      |  |   |        | 

NOTE F  GOODWILL AND PURCHASED INTANGIBLE ASSETS

|                                             |                                               |      |             |        |  |   |        |       | 
|-------------------------------------------- | --------------------------------------------- | ---- | ----------- | ------ |  | - | ------ | ----- | 
|                                             |                                               |      | December 31
|                                             |                                               |      |            
|(In thousands)                               |                                               | 2003 |             | 2002  
|                                             |                                               |      |             |       
|Goodwill                                     |                                               | $    | 22,992      |        |  | $ | 22,671 |      
|Less: Accumulated amortization               |                                               |      | 5,025       |        |  |   | 5,025  |      
|                                             |                                               |      |             |        |  |   |        |      
|Net Goodwill                                 |                                               |      | 17,967      |        |  |   | 17,646 |      
|Purchased intangible assets:                 |                                               |      |             |        |  |   |        |      
|                                             | Acquired developed technology                 |      |             | 11,765 |  |   |        | 9,065 | 
|                                             | Customer lists and non-competition agreements |      |             | 2,418  |  |   |        | 2,319 | 
|                                             |                                               |      |             |        |  |   |        |      
|                                             |                                               |      | 14,183      |        |  |   | 11,384 |      
|Less: Accumulated amortization               |                                               |      | 5,992       |        |  |   | 3,968  |      
|                                             |                                               |      |             |        |  |   |        |      
|Net purchased intangible assets              |                                               |      | 8,191       |        |  |   | 7,416  |      
|                                             |                                               |      |             |        |  |   |        |      
|Net goodwill and purchased intangible assets |                                               | $    | 26,158      |        |  | $ | 25,062 |      
|                                             |                                               |      |             |        |  |   |        |      

66



---



##### 



NOTE G  OTHER ASSETS

|                                                                  |  |             |   |      |  |   |       | 
|----------------------------------------------------------------- |  | ----------- | - | ---- |  | - | ----- | 
|                                                                  |  | December 31
|                                                                  |  |            
|(In thousands)                                                    |  | 2003        |   | 2002
|                                                                  |  |             |   |     
|Note receivable and investment in Vianet (formerly Inter-Tel.Net) |  | $           |  |      |  | $ | 2,500 | 
|Other assets                                                      |  |             |  |      |  |   | 249   | 
|                                                                  |  |             |   |      |  |   |       | 
|                                                                  |  | $           |  |      |  | $ | 2,749 | 
|                                                                  |  |             |   |      |  |   |       | 

Refer to Note B to Consolidated Financial Statements for additional
information regarding our investment in Vianet.

NOTE H  OTHER CURRENT LIABILITIES

|                                   |  |             |        |      |  |   |        | 
|---------------------------------- |  | ----------- | ------ | ---- |  | - | ------ | 
|                                   |  | December 31
|                                   |  |            
|(In thousands)                     |  | 2003        |        | 2002
|                                   |  |             |        |     
|Compensation and employee benefits |  | $           | 18,118 |      |  | $ | 18,325 | 
|Customer deposits                  |  |             | 4,451  |      |  |   | 5,331  | 
|Restructuring charge               |  |             | 1,194  |      |  |   | 955    | 
|Deferred revenues                  |  |             | 7,641  |      |  |   | 7,324  | 
|Miscellaneous taxes payable        |  |             | 3,331  |      |  |   | 2,569  | 
|Other accrued expenses             |  |             | 12,850 |      |  |   | 15,547 | 
|                                   |  |             |        |      |  |   |        | 
|                                   |  | $           | 47,585 |      |  | $ | 50,051 | 
|                                   |  |             |        |      |  |   |        | 

NOTE I  CREDIT LINE

We maintain a $10 million unsecured bank credit line at prime rate to
cover international letters of credit and for other purposes. The credit
agreement matures June 1, 2004 and contains certain restrictions and financial
covenants. At December 31, 2003, none of the credit line was committed under
letter of credit arrangements.

NOTE J  LEASES

Rental expense amounted to $9,591,000; $9,800,000; and $9,679,000 in 2003,
2002, and 2001, respectively. Noncancellable operating leases are primarily
for buildings. Including in the preceding rental expense totals are payments
on our building lease in Milford, Connecticut associated with the Executone
acquisition in 2000. In connection with the Executone charge taken in 2000, we
included in the charge anticipated lease costs through the lease termination
date, offset by expected sublease receipts. The total costs included in gross
rental expense above associated with the Milford lease totaled $2.8 million in
each of the years ended 2003, 2002, and 2001. The Milford lease expires on
January 14, 2005 and we will not renew that lease. Certain of the leases
contain provisions for renewal options and scheduled rent increases. At
December 31, 2003, future minimum commitments under noncancellable leases are
as follows: 2004  $9,896,000; 2005  $5,646,000; 2006  $3,963,000; 2007 
$2,502,000; 2008  $733,000.

NOTE K  INCOME TAXES

We account for income taxes under Statement of Financial Accounting
Standards No. 109, Accounting for Income Taxes (SFAS 109). Under SFAS 109,
the liability method is used in accounting for income taxes. Under this
method, deferred tax assets and liabilities are determined (and classified as
current or long-term) based on differences between financial reporting and tax
bases of assets and liabilities and are measured using the enacted tax rates
and laws that will be in effect when the differences are expected to reverse.

67



---



##### 



Significant components of our deferred tax liabilities and assets as of
December 31 are as follows:

|                               |                                     |      |             |        |  |   |        |        | 
|------------------------------ | ----------------------------------- | ---- | ----------- | ------ |  | - | ------ | ------ | 
|                               |                                     |      | December 31
|                               |                                     |      |            
|(in thousands)                 |                                     | 2003 |             | 2002  
|                               |                                     |      |             |       
|Deferred tax liabilities:      |                                     |      |             |        |  |   |        |       
|                               | Lease  sales and capitalized costs |      | $           | 73,823 |  |   | $      | 36,739 | 
|                               | Other                               |      |             | 5,841  |  |   |        | 4,929  | 
|                               |                                     |      |             |        |  |   |        |        | 
|Total deferred tax liabilities |                                     |      | 79,664      |        |  |   | 41,668 |       
|                               |                                     |      |             |        |  |   |        |        | 
|Deferred tax assets:           |                                     |      |             |        |  |   |        |       
|                               | Net operating loss carryforward     |      |             | 7916   |  |   |        |       | 
|                               | Tax credit carryforward             |      |             | 3,421  |  |   |        |       | 
|                               | Inventory basis differences         |      |             |       |  |   |        | 1,224  | 
|                               | Accounts receivable reserves        |      |             | 3,758  |  |   |        | 4,244  | 
|                               | Accrued vacation pay                |      |             | 1,652  |  |   |        | 1,524  | 
|                               | Book over tax depreciation          |      |             |       |  |   |        | 277    | 
|                               | Foreign loss carryforwards          |      |             | 880    |  |   |        | 537    | 
|                               | In-process R&D write-off            |      |             | 5,428  |  |   |        | 5,949  | 
|                               | Restructuring reserves              |      |             | 1,968  |  |   |        | 2,227  | 
|                               | Lease receivable reserves           |      |             | 5,169  |  |   |        | 4,766  | 
|                               | Other  net                         |      |             | 6,145  |  |   |        | 7,514  | 
|                               |                                     |      |             |        |  |   |        |        | 
|Deferred tax assets            |                                     |      | 36,337      |        |  |   | 28,262 |       
|                               | Less valuation reserve              |      |             | 880    |  |   |        | 537    | 
|                               |                                     |      |             |        |  |   |        |        | 
|Net deferred tax assets        |                                     |      | 35,457      |        |  |   | 27,725 |       
|                               |                                     |      |             |        |  |   |        |        | 
|Net deferred tax liabilities   |                                     | $    | 44,207      |        |  | $ | 13,943 |       
|                               |                                     |      |             |        |  |   |        |        | 

The net deferred tax liabilities increased significantly in 2003 due
primarily to accelerated depreciation of fixed assets, and temporary
differences relating to leases in our Total Solution program. Most of the
increase arose from deductions taken in the companys 2002 federal income tax
return wherein the company decided in 2003 to elect to take bonus depreciation
and accelerated depreciation of fixed assets and certain leases when filing its
2002 return in 2003. The company filed a change in accounting method with the
Internal Revenue Service to utilize accelerated depreciation for the 2002 tax
year. Effective May 6, 2003, the bonus depreciation increased from a 30% to
50% depreciation deduction, which favorably impacted the 2003 tax deduction and
increased the deferred liabilities for 2003.

The depreciation deductions identified above generated a net operating
loss that was not fully utilized in a carryback claim to 2001; accordingly, the
loss was carried forward. This net operating loss created deferred assets for
net operating loss carryforwards and certain tax credit carryforwards, each of
which is separately identified in the components of deferred tax assets and
liabilities schedule above. We expect these carryforwards to be fully utilized
by 2004. Our effective income tax rate for 2003 was not impacted by these
carryforwards.

During 2003, 2002 and 2001, we recorded income of $1,037,000, $295,000,
and a loss of $437,000, respectively, from foreign operations. At December
31, 2003, we had foreign loss carryforwards of approximately $2,200,000, a
portion of which began to expire in 2002. The valuation allowance in 2003
increased by $343,000 and decreased by $277,000 in 2002 due to expiration of
foreign loss carryforwards and greater losses in the most current year.

Federal and state income taxes consisted of the following:

|               |  |      |        |      |  |      |        |  |  |   |       | 
|-------------- |  | ---- | ------ | ---- |  | ---- | ------ |  |  | - | ----- | 
|(In thousands) |  | 2003 |        | 2002 |  | 2001
|               |  |      |        |      |  |     
|Federal        |  | $    | 15,126 |      |  | $    | 20,206 |  |  | $ | 5,076 | 
|State          |  |      | 1,620  |      |  |      | 2,584  |  |  |   | 2,583 | 
|Foreign        |  |      | 734    |      |  |      | 726    |  |  |   |      | 
|               |  |      |        |      |  |      |        |  |  |   |       | 
|               |  | $    | 17,480 |      |  | $    | 23,516 |  |  | $ | 7,659 | 
|               |  |      |        |      |  |      |        |  |  |   |       | 

The principal reasons for the difference between total income tax expense
(benefit) and the amount computed by applying the statutory federal income tax
rate to income before taxes are as follows:

68



---



##### 



|                                                         |  |      |    |      |  |      |    |   |  |  |    |  
|-------------------------------------------------------- |  | ---- | -- | ---- |  | ---- | -- | - |  |  | -- | -
|                                                         |  | 2003 |    | 2002 |  | 2001
|                                                         |  |      |    |      |  |     
|Federal tax at statutory rates
Applied to pre-tax income |  |      | 35 | %    |  |      | 35 | % |  |  | 35 | %
|State tax net of federal benefit                         |  |      | 2  |      |  |      | 2  |   |  |  | 5  |  
|Credit for research activities                           |  |      | (1 | )    |  |      | (1 | ) |  |  | (5 | )
|Other  net                                              |  |      | 2  |      |  |      | 2  |   |  |  | 2  |  
|                                                         |  |      |    |      |  |      |    |   |  |  |    |  
|                                                         |  |      | 38 | %    |  |      | 38 | % |  |  | 37 | %
|                                                         |  |      |    |      |  |      |    |   |  |  |    |  

NOTE L  EQUITY TRANSACTIONS

Treasury Stock. During the first quarter of 2001, we initiated a stock
repurchase program under which the Board of Directors authorized the repurchase
of up to 4,000,000 shares of Inter-Tel Common Stock. Under this and prior
authorizations, we repurchased 8,271 and 662 shares during 2003 and 2002,
respectively, expending $207,000 and $13,000 to repurchase shares for cash
pay-outs to former employees in place of ESOP share distributions during 2003
and 2002, respectively. During 2001, we expended approximately $28.9 million
for stock repurchases, which was funded primarily through existing cash
balances. We reissued approximately 529,000, 743,000 and 740,000 shares in
2003, 2002 and 2001, respectively, through stock option and employee stock
purchase plan exercises and issuances, and stock issued in conversion of
subsidiary stock through an acquisition. The proceeds received for the stock
reissued were less than our total cost basis. Accordingly, the difference was
recorded as a reduction to retained earnings. Attached below is a summary of
treasury share activity for the past three years.

|                                  |  |      |           |      |  |      |           |  |  |  |           | 
|--------------------------------- |  | ---- | --------- | ---- |  | ---- | --------- |  |  |  | --------- | 
|Treasury shares                   |  | 2003 |           | 2002 |  | 2001
|                                  |  |      |           |      |  |     
|Balance on January 1              |  |      | 2,252,840 |      |  |      | 2,995,393 |  |  |  | 1,210,854 | 
|Stock repurchases, including ESOP |  |      | 8,271     |      |  |      | 662       |  |  |  | 2,524,582 | 
|Shares reissued                   |  |      | 528,930   |      |  |      | 743,215   |  |  |  | 740,043   | 
|Balance on December 31            |  |      | 1,732,181 |      |  |      | 2,252,840 |  |  |  | 2,995,393 | 

Dividend Policy. From December 31, 1997 through the third quarter of
2001, we paid quarterly cash dividends (the cash dividend) of $0.01 for every
share of Common Stock, to shareholders of record. On October 23, 2001, our
Board of Directors increased the cash dividend from $0.01 to $0.02 for every
share of Common Stock, payable quarterly to shareholders of record beginning
December 31, 2001. On July 16, 2002, our Board of Directors increased the cash
dividend from $0.02 to $0.03 for every share of Common Stock, payable quarterly
to shareholders of record beginning September 30, 2002. On July 21, 2003, our
Board of Directors increased the cash dividend from $0.03 to $0.06 for every
share of Common Stock, payable quarterly to shareholders of record beginning
September 30, 2003. Dividend payments commence on or about 15 days after the
end of each fiscal quarter. Attached below is a summary of our dividends
accrued and paid since December 31, 1997, the date we first declared cash
dividends on our Common Stock.

|       |  |    |      |    |  |    |      |    |  |        |      |  |  |   |      |  |  |   |      | 
|------ |  | -- | ---- | -- |  | -- | ---- | -- |  | ------ | ---- |  |  | - | ---- |  |  | - | ---- | 
|Period |  | Q1 |      | Q2 |  | Q3 |      | Q4 |  | Totals
|1997   |  |    |     |    |  |    |     |    |  |        |     |  |  | $ | 0.01 |  |  | $ | 0.01 | 
|1998   |  | $  | 0.01 |    |  | $  | 0.01 |    |  | $      | 0.01 |  |  | $ | 0.01 |  |  | $ | 0.04 | 
|1999   |  | $  | 0.01 |    |  | $  | 0.01 |    |  | $      | 0.01 |  |  | $ | 0.01 |  |  | $ | 0.04 | 
|2000   |  | $  | 0.01 |    |  | $  | 0.01 |    |  | $      | 0.01 |  |  | $ | 0.01 |  |  | $ | 0.04 | 
|2001   |  | $  | 0.01 |    |  | $  | 0.01 |    |  | $      | 0.01 |  |  | $ | 0.02 |  |  | $ | 0.05 | 
|2002   |  | $  | 0.02 |    |  | $  | 0.02 |    |  | $      | 0.03 |  |  | $ | 0.03 |  |  | $ | 0.10 | 
|2003   |  | $  | 0.03 |    |  | $  | 0.03 |    |  | $      | 0.06 |  |  | $ | 0.06 |  |  | $ | 0.18 | 

69



---



##### 



Stock Option Plans.In July 1990, we adopted the Director Stock Option
Plan (the Director Plan) and reserved a total of 500,000 shares of Common
Stock for issuance thereunder. Commencing with the adoption of the Plan through
2001, each Eligible Director received a one-time automatic grant of an option
to purchase 5,000 shares of our Common Stock. In addition, through 2001 each
Eligible Director was granted an option to purchase 5,000 shares upon the date
five (5) days after such person became Director, and an additional option to
purchase 5,000 shares five (5) days after the date of the regularly scheduled
board meeting following the close of our third quarter. All options granted
through 2001 had a five-year term and fully vested at the end of six months
from the grant date.

In July 2001, as approved by shareholders at the annual shareholders
meeting in April 2002, the board of directors extended the term of the Director
Plan to 2010. Our shareholders also approved amendments to change the date of
the annual grant to directors under the Director Plan to five (5) business days
after the re-election of directors at the annual meeting of shareholders,
increased the initial automatic option grant and each annual option grant from
5,000 to 7,500 shares. The term of options granted under the Director Plan was
also increased from five (5) years to ten (10) years. These amendments did not
increase the number of shares authorized for the Director Plan. In each
instance, Director Plan options must be granted at not less than 100% of the
fair market value of our stock at the dates of grant.

In November 1993, the Board of Directors authorized the Inter-Tel,
Incorporated Long-Term Incentive Plan (the 1994 Long Term Plan). 2,000,000
shares of Common Stock have been reserved for issuance under the 1994 Long Term
Plan to selected officers and key employees. Options must be granted at not
less than 100% of the fair market value of our stock at the dates of grant.
Options generally vest over four or five years and expire five to ten years
from the date of grant. The 1994 Long Term Plan does not allow incentive stock
options to be granted after November 19, 2003, but other forms of awards, as
defined in the plan, may be continue to be granted to participants.

In February 1997, the Board of Directors authorized the Inter-Tel,
Incorporated 1997 Long-Term Incentive Plan (the 1997 Long Term Plan). Option
must be granted at not less than 100% of the fair market value of our stock at
the dates of grant. Options generally vest over four or five years and expire
ten years from the date of grant. In March 2000, the Board of Directors
authorized an amendment to the 1997 Long Term Plan to limit our ability to
reprice options under the 1997 Long Term Plan. Prior to January 1, 2002, a
total of 3,650,000 shares of Common Stock had been reserved for issuance under
the 1997 Long Term Plan to selected officers and key employees.

On February 27, 2001 our Board of Directors authorized an amendment to the
1997 Long Term Plan, approved by the stockholders, that provides for an
automatic increase in the number of shares of Common Stock reserved thereunder
on the first day of each fiscal year equal to the lesser of (a) 2.5% of the
outstanding shares on that date, (b) 750,000 shares (subject to appropriate
adjustment for all stock splits, dividends, subdivisions, combinations,
recapitalizations and like transactions) or (c) a lesser amount as determined
by the Board of Directors (the Renewal Feature). For 2002, based on shares
outstanding at January 1, 2002 and as approved by the Board of Directors in
February 2002, this renewal feature provided for an increase of 604,161 shares
for issuance under the 1997 Long Term Plan. For 2003, based on shares
outstanding at January 1, 2003 and as approved by the Board of Directors in
February 2003, this renewal feature provided for an increase of 622,725 shares
for issuance under the 1997 Long Term Plan. For 2004, based on shares
outstanding at January 1, 2004 and as approved by the Board of Directors in
February 2004, this renewal feature provided for an increase of 635,741 shares
for issuance under the 1997 Long Term Plan.

Under the 1994 and 1997 Long Term Plans, in some instances, predetermined
share market value increases must be met to allow acceleration of option
vesting provisions before the end of the option term.

In April 1998, the Board of Directors authorized the Inter-Tel,
Incorporated Acquisition Stock Option Plan (the Acquisition Plan). A total of
82,428 shares of Common Stock was reserved for issuance under the Acquisition
Plan to selected key employees hired as a result of the acquisition of TMSI.
New options must be granted at not less than 100% of the fair market value of
our stock at the dates of grant. Options generally vest over four or five
years and expire ten years from the date of grant. A portion of the options
granted were replacements for options held to purchase shares of stock of the
selling company; such replacement grants retained the original terms, including
grant dates for vesting purposes and the original grant prices, adjusted

70



---



##### 



using the applicable conversion ratio of the fair value of Inter-Tels
stock compared to that of the selling company.

In March 2000, the Board of Directors authorized an additional 216,000
shares of Common Stock for issuance under the Acquisition Plan to selected
employees hired as a result of the acquisition of selected assets of Executone.
In February 2001, the Board of Directors authorized an additional 300,000
shares of Common Stock for issuance under the Acquisition Plan to selected
employees hired as a result of the acquisition of selected assets of
Convergent. In addition, in October 2001, the Board of Directors authorized an
additional 150,000 shares of Common Stock for issuance under the Acquisition
Plan to selected employees hired as a result of the acquisition of Mastermind
Technologies. Options in each instance must be granted at not less than 100% of
the fair market value of our stock at the dates of grant. Options vest over
five years and expire ten years from the date of grant.

Option activity for the past three years under all plans is as follows:

|                                                                         |  |                          |           |      |  |      |           |   |  |   |           |  
|------------------------------------------------------------------------ |  | ------------------------ | --------- | ---- |  | ---- | --------- | - |  | - | --------- | -
|                                                                         |  | Years Ended December 31,
|                                                                         |  |                         
|(Number of shares)                                                       |  | 2003                     |           | 2002 |  | 2001
|                                                                         |  |                          |           |      |  |     
|Outstanding at beginning of year                                         |  |                          | 4,188,641 |      |  |      | 4,567,945 |   |  |   | 3,143,292 |  
|Granted                                                                  |  |                          | 879,950   |      |  |      | 608,000   |   |  |   | 2,007,500 |  
|Exercised                                                                |  |                          | (476,410  | )    |  |      | (710,304  | ) |  |   | (210,633  | )
|Expired or canceled                                                      |  |                          | (176,050  | )    |  |      | (277,000  | ) |  |   | (372,214  | )
|                                                                         |  |                          |           |      |  |      |           |   |  |   |           |  
|Outstanding at end of year                                               |  |                          | 4,416,131 |      |  |      | 4,188,641 |   |  |   | 4,567,945 |  
|                                                                         |  |                          |           |      |  |      |           |   |  |   |           |  
|Exercisable at end of year                                               |  |                          | 1,877,151 |      |  |      | 1,628,533 |   |  |   | 1,458,388 |  
|                                                                         |  |                          |           |      |  |      |           |   |  |   |           |  
|Weighted-average grant price of
options granted                          |  | $                        | 13.66     |      |  | $    | 13.40     |   |  | $ | 12.26     |  
|Weighted-average fair value
(FAS 123) of options granted
during the year |  | $                        | 7.04      |      |  | $    | 9.32      |   |  | $ | 6.42      |  

At December 31, 2003, we have reserved 4,961,607 shares of Common Stock
for issuance in connection with the stock option plans.

As permitted under Statement of Financial Accounting Standards No. 123
(FAS 123) Accounting for Stock-Based Compensation, we have elected to follow
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, and related Interpretations, in accounting for stock based awards
to employees. Under APB 25, we generally recognize no compensation expense
with respect to such awards.

The following table summarizes information about stock options outstanding
at December 31, 2003:

|                |  |             |           |                  |  |                |  |   |       |  |  | 
|--------------- |  | ----------- | --------- | ---------------- |  | -------------- |  | - | ----- |  |  | 
|                |  | Number      |           | Weighted-Average |  | Weighted      
|Range of        |  | Outstanding |           | Remaining        |  | Average       
|Exercise Price  |  | at 12-31-03 |           | Contractual Life |  | Exercise Price
|                |  |             |           |                  |  |               
|$2.24 - $5.24   |  |             | 81,979    |                  |  | 1 years        |  | $ | 3.00  | 
|$5.25 - $7.68   |  |             | 92,900    |                  |  | 3 years        |  | $ | 6.07  | 
|$7.69 - $15.12  |  |             | 2,908,230 |                  |  | 7 years        |  | $ | 11.09 | 
|$15.13 - $43.44 |  |             | 1,333,022 |                  |  | 7 years        |  | $ | 20.45 | 

71



---



##### 



The following table summarizes information about stock options exercisable
at December 31, 2003:

|                |  |             |           |                  |  |                |  |   |       |  |  | 
|--------------- |  | ----------- | --------- | ---------------- |  | -------------- |  | - | ----- |  |  | 
|                |  | Number      |           | Weighted-Average |  | Weighted      
|Range of        |  | Exercisable |           | Remaining        |  | Average       
|Exercise Price  |  | at 12-31-03 |           | Contractual Life |  | Exercise Price
|                |  |             |           |                  |  |               
|$2.24 - $5.24   |  |             | 81,979    |                  |  | 1 years        |  | $ | 3.00  | 
|$5.25 - $7.68   |  |             | 92,900    |                  |  | 3 years        |  | $ | 6.07  | 
|$7.69 - $15.12  |  |             | 1,009,570 |                  |  | 7 years        |  | $ | 10.04 | 
|$15.13 - $43.44 |  |             | 692,702   |                  |  | 7 years        |  | $ | 21.14 | 

During 2003, the weighted average exercise price of options granted,
exercised, and expired or canceled was $14.50, $11.30 and $17.99, respectively.

Pro forma information regarding net income and net income per share, as
disclosed in Note A, has been determined as if the Company had accounted for
its employee stock-based compensation plans under the fair value method of SFAS
No. 123.

The fair value for these options was estimated at the date of grant using
a Black-Scholes option pricing model using the low end of reasonable
assumptions for input variables rather than attempting to identify a best-point
estimate. The option pricing model utilized the following weighted average
assumptions for 2003, 2002 and 2001, respectively: risk free interest rates of
3.05% for 2003, 2.73% for 2002 and 4.5% for 2001; dividend yields of 1.2% for
2003, .75% for 2002 and .50% for 2001; volatility factors of the expected
market price of our stock averaged .770 for 2003, .576 for 2002 and .766 for
2001; and a weighted average expected life of the option of 4 to 5 years for
employee stock options which vest over four to five year periods with a
weighted average life of 2.5 years and 1.5 years for director options which
vest at the end of six months from the grant date.

1997 Employee Stock Purchase Plan. In April 1997, the Board of Directors
and stockholders adopted the Employee Stock Purchase Plan (the Purchase Plan)
and reserved 500,000 shares for issuance to eligible employees. In April 2002,
the Board of Directors and stockholders approved an amendment to the Plan to
increase the number of authorized shares by 500,000 shares for a total of
1,000,000 authorized thereunder. Under the Purchase Plan, employees are
granted the right to purchase shares of Common Stock at a price per share that
is 85% of the lesser of the fair market value of the shares at: (i) the
participants entry date into each six-month offering period, or (ii) the end
of each six-month offering period. Employees may designate up to 10% of their
compensation for the purchase of stock. Under the Plan, we sold 58,242 shares
for approximately $915,000 ($15.71 per share) to employees in 2003, 61,562
shares for approximately $972,000 ($15.80 per share) to employees in 2002, and
108,742 shares for approximately $966,000 ($8.89 per share) to employees in
2001. At December 31, 2003, 516,342 shares remained authorized under the
Plan.

Stock Option Loans. During 1999, selected officers and employees of
Inter-Tel were offered loans to acquire Inter-Tel common stock. Promissory
Notes were established to cover the cost of exercise of stock options,
including applicable taxes, or the cost of Inter-Tel common stock purchased in
the open market during May and June of 1999. The loans were interest-only
notes with balloon payments due on or before March 15, 2004. Interest was
charged on the loans at the mid-term applicable federal interest rate,
compounded annually. Interest payments were due on or before March 15 of each
anniversary beginning on March 15, 2000. The loans were recorded in our
balance sheet as reductions to shareholders equity. The notes were full
recourse loans and we retained the common stock certificates as collateral.
All of the loans have been paid in full prior to the end of 2003.

72



---



##### 



NOTE M - EARNINGS PER SHARE

The following table sets forth the computation of basic and diluted
earnings per share:

|                                                                                                      |                                                                    |      |                          |        |  |      |        |        |  |   |        |        | 
|----------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------ | ---- | ------------------------ | ------ |  | ---- | ------ | ------ |  | - | ------ | ------ | 
|                                                                                                      |                                                                    |      | Years Ended December 31,
|(In thousands, except per share amounts)                                                              |                                                                    | 2003 |                          | 2002   |  | 2001
|                                                                                                      |                                                                    |      |                          |        |  |     
|Numerator:                                                                                            |                                                                    |      |                          |        |  |      |        |        |  |   |        |       
|                                                                                                      | Net income                                                         |      | $                        | 28,518 |  |      | $      | 38,637 |  |   | $      | 13,041 | 
|                                                                                                      |                                                                    |      |                          |        |  |      |        |        |  |   |        |        | 
|Denominator:                                                                                          |                                                                    |      |                          |        |  |      |        |        |  |   |        |       
|                                                                                                      | Denominator for basic earnings per
share - weighted average shares |      |                          | 25,078 |  |      |        | 24,444 |  |   |        | 24,488 | 
|Effect of dilutive securities:                                                                        |                                                                    |      |                          |        |  |      |        |        |  |   |        |       
|                                                                                                      | Employee and director stock options                                |      |                          | 1,395  |  |      |        | 1,420  |  |   |        | 752    | 
|                                                                                                      |                                                                    |      |                          |        |  |      |        |        |  |   |        |        | 
|Denominator for diluted earnings per
share - adjusted weighted average
shares and assumed conversions |                                                                    |      | 26,473                   |        |  |      | 25,864 |        |  |   | 25,240 |       
|                                                                                                      |                                                                    |      |                          |        |  |      |        |        |  |   |        |        | 
|Basic income per share                                                                                |                                                                    | $    | 1.14                     |        |  | $    | 1.58   |        |  | $ | 0.53   |       
|                                                                                                      |                                                                    |      |                          |        |  |      |        |        |  |   |        |        | 
|Diluted income per share                                                                              |                                                                    | $    | 1.08                     |        |  | $    | 1.49   |        |  | $ | 0.52   |       
|                                                                                                      |                                                                    |      |                          |        |  |      |        |        |  |   |        |        | 

In 2003, 2002 and 2001, options to purchase 227,150; 280,580 and 577,800
shares, respectively, of Inter-Tel stock were excluded from the calculation of
diluted net earnings per share because the exercise price of these options was
greater than the average market price of the common shares for the respective
fiscal years, and therefore the effect would have been antidilutive.

NOTE N  RETIREMENT PLANS

We have two retirement plans for the benefit of our employees. Under our
401(k) Retirement Plan, participants may contribute on an annual basis up to
the maximum amount allowed by the Internal Revenue Service. We make voluntary
annual contributions to the Plan of 50% of contributions made by Plan
participants of up to 6 percent of each participants compensation. Our
matching contributions to the Plan totaled $1,627,000; $1,567,000; and
$1,476,000; in 2003, 2002 and 2001, respectively.

In 1992, we initiated an Employee Stock Ownership Plan (ESOP), advancing
$500,000 to the ESOP Trust for the purpose of purchasing Common Stock of the
Company. The Trust purchased 307,000 shares of Inter-Tel Common Stock in July
1992. The loan was paid in full during 1997. As the principal amount of the
loan was repaid to Inter-Tel through Company annual contributions, the
equivalent number of shares released were allocated to employees accounts to
be held until retirement. Total shares so allocated were 32,380 in 1997.
Contributions to the ESOP totaled $62,500 in 1997, and were based upon the
historic cost of the shares purchased by the ESOP. After the final allocation
of shares in 1997, the ESOP plan was frozen, so that all eligible
participants as of July 1, 1997 became 100% vested in their accounts,
regardless of length of service. No further purchases are anticipated through
the ESOP, and we do not anticipate making future allocations of shares from
this plan. In October 2002, our Board of Directors authorized the termination
of this plan, allowing one-time rollover contributions to be made to
participants in our 401(k) Retirement Plan, other qualified plans or as early
taxable distributions. With the exception of a few of our former employees
whom we could not locate, the Plan assets were distributed in their entirety
during 2003, as allowed pursuant to a favorable determination letter that was
issued by the Internal Revenue Service on January 16, 2003.

NOTE O  SEGMENT INFORMATION

Inter-Tel adopted Statement of Financial Accounting Standards No. 131,
Disclosures about Segments of an Enterprise and Related Information (SFAS
131) in the fiscal year ended December 31, 1998. SFAS 131 establishes
standards for reporting information regarding operating segments in annual
financial statements and requires selected information for those segments to be
presented in interim financial reports issued to stockholders. SFAS 131 also
establishes standards for related disclosures about products and services and
geographic areas. Operating segments are identified as components of an
enterprise about which separate discrete financial information is available for
evaluation by the chief operating decision maker,

73



---



##### 



or decision making group, in making decisions as to how to allocate
resources and assess performance. The Companys chief decision maker, as
defined under SFAS 131, is the Chief Executive Officer.

Prior to 2000, we had viewed our operations as principally one segment:
telephone systems, telecommunications software and hardware, and related long
distance calling services. These services are provided through the Companys
direct sales offices and dealer network to business customers throughout the
United States, Europe, Asia, Mexico and South America. As a result, financial
information disclosed previously represented substantially all of the financial
information related to the Companys principal operating segment.

During 2000, we determined that the operations of Inter-Tel.NET,
Inter-Tels former IP long distance subsidiary, would be separately disclosed
as a business segment. The operations represented a more significant component
of the consolidated operations in 2000 compared to prior years and had a
significant impact on the revenues and net losses. On July 24, 2001, Inter-Tel
agreed to sell 83% of Inter-Tel.NET to Comm-Services Corporation. As a result,
since July 24, 2001, we have accounted for the remaining 17%
Inter-Tel.NET/Comm-Services investment using the cost method of accounting. On
December 30, 2001, Comm-Services entered into a merger agreement with Vianet.
Inter-Tels 17% investment in Inter-Tel.NET/Comm-Services was converted to
approximately 10% of Vianet stock. Inter-Tel will account for the remaining
10% investment in Vianet using the cost method of accounting.

Commencing the third quarter of 2001, we began disclosing as a separate
business segment operating results relating to local and long distance resale
services. Inter-Tel offers these services to its customers as part of a total
telephony solution approach. Results of operations for this segment, if the
operations were not included as part of the consolidated group, could differ
materially, as the operations are integral to the total telephony solution
offered by us to our customers.

For the years ended December 31, we generated income from business
segments, including charges, as follows:

|                                      |  |           |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  |           |        |   |  |   |         |  
|------------------------------------- |  | --------- | ------- | ---------- |  | --------- | ------ | ------------- |  | -------- | ------- | ----- |  | - | ------ | ---- |  | --------- | ------ | - |  | - | ------- | -
|                                      |  |           |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  | Resale of |        |   |  |  
|                                      |  |           |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  | Local and |        |   |  |  
|                                      |  |           |         |            |  |           |        |               |  | Subtotal |         |       |  |   |        | Long |  |           |        |  
|(In thousands, except per             |  | Principal |         | Litigation |  | Principal |        | Inter-Tel.NET |  | Distance |         |       |  |  
|share amounts)                        |  | Segment   |         | Settlement |  | Segment   |        | /Vianet       |  | Services |         | Total
|                                      |  |           |         |            |  |           |        |               |  |          |         |      
|2003                                  |  |           |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  |           |        |   |  |   |         |  
|Net sales                             |  | $         | 335,570 |            |  | $         |       |               |  | $        | 335,570 |       |  | $ |       |      |  | $         | 38,266 |   |  | $ | 373,836 |  
|Gross profit                          |  |           | 184,737 |            |  |           |       |               |  |          | 184,737 |       |  |   |       |      |  |           | 12,336 |   |  |   | 197,073 |  
|Operating income                      |  |           | 38,697  |            |  |           |       |               |  |          | 38,697  |       |  |   |       |      |  |           | 5,631  |   |  |   | 44,328  |  
|Interest and other income             |  |           | 1,526   |            |  |           |       |               |  |          | 1,526   |       |  |   | 124    |      |  |           | 157    |   |  |   | 1,807   |  
|Gain on foreign currency
transactions |  |           | 18      |            |  |           |       |               |  |          | 18      |       |  |   |       |      |  |           |       |   |  |   | 18      |  
|Interest expense                      |  |           | (153    | )          |  |           |       |               |  |          | (153    | )     |  |   |       |      |  |           | (2     | ) |  |   | (155    | )
|Net income                            |  | $         | 24,831  |            |  | $         |       |               |  | $        | 24,831  |       |  | $ | 77     |      |  | $         | 3,610  |   |  | $ | 28,518  |  
|Net income per diluted share
(1)      |  | $         | 0.94    |            |  | $         |       |               |  | $        | 0.94    |       |  | $ |       |      |  | $         | 0.14   |   |  | $ | 1.08    |  
|Weighted average diluted
shares (1)   |  |           | 26,473  |            |  |           | 26,473 |               |  |          | 26,473  |       |  |   | 26,473 |      |  |           | 26,473 |   |  |   | 26,473  |  
|Total assets                          |  | $         | 341,550 |            |  | $         |       |               |  | $        | 341,550 |       |  | $ |       |      |  | $         | 18,326 |   |  | $ | 359,876 |  
|Depreciation and amortization         |  |           | 9,083   |            |  |           |       |               |  |          | 9,083   |       |  |   |       |      |  |           | 51     |   |  |   | 9,134   |  

74



---



##### 



|                                        |  |           |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  |           |        |   |  |   |         |  
|--------------------------------------- |  | --------- | ------- | ---------- |  | --------- | ------ | ------------- |  | -------- | ------- | ----- |  | - | ------ | ---- |  | --------- | ------ | - |  | - | ------- | -
|                                        |  |           |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  | Resale of |        |   |  |  
|                                        |  |           |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  | Local and |        |   |  |  
|                                        |  |           |         |            |  |           |        |               |  | Subtotal |         |       |  |   |        | Long |  |           |        |  
|(In thousands, except per               |  | Principal |         | Litigation |  | Principal |        | Inter-Tel.NET |  | Distance |         |       |  |  
|share amounts)                          |  | Segment   |         | Settlement |  | Segment   |        | /Vianet       |  | Services |         | Total
|                                        |  |           |         |            |  |           |        |               |  |          |         |      
|2002                                    |  |           |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  |           |        |   |  |   |         |  
|Net sales                               |  | $         | 351,414 |            |  | $         |       |               |  | $        | 351,414 |       |  | $ |       |      |  | $         | 30,042 |   |  | $ | 381,456 |  
|Gross profit                            |  |           | 185,847 |            |  |           |       |               |  |          | 185,847 |       |  |   |       |      |  |           | 8,626  |   |  |   | 194,473 |  
|Operating income                        |  |           | 41,837  |            |  |           |       |               |  |          | 41,837  |       |  |   |       |      |  |           | 3,890  |   |  |   | 45,727  |  
|Interest and other income               |  |           | 1,772   |            |  |           | 15,516 |               |  |          | 17,288  |       |  |   | (1,200 | )    |  |           | 164    |   |  |   | 16,252  |  
|Gain on foreign currency
transactions   |  |           | 330     |            |  |           |       |               |  |          | 330     |       |  |   |       |      |  |           |       |   |  |   | 330     |  
|Interest expense                        |  |           | (155    | )          |  |           |       |               |  |          | (155    | )     |  |   |       |      |  |           | (1     | ) |  |   | (156    | )
|Net income (loss)                       |  | $         | 27,371  |            |  | $         | 9,492  |               |  | $        | 36,863  |       |  | $ | (746   | )    |  | $         | 2,520  |   |  | $ | 38,637  |  
|Net income (loss) per
diluted share (1) |  | $         | 1.06    |            |  | $         | 0.37   |               |  | $        | 1.43    |       |  | $ | (0.03  | )    |  | $         | 0.10   |   |  | $ | 1.49    |  
|Weighted average diluted
shares (1)     |  |           | 25,864  |            |  |           | 25,864 |               |  |          | 25,864  |       |  |   | 24,444 |      |  |           | 25,864 |   |  |   | 25,864  |  
|Total assets                            |  | $         | 266,015 |            |  | $         |       |               |  | $        | 266,015 |       |  | $ |       |      |  | $         | 16,047 |   |  | $ | 282,062 |  
|Depreciation and amortization           |  |           | 8,574   |            |  |           |       |               |  |          | 8,574   |       |  |   |       |      |  |           | 80     |   |  |   | 8,654   |  

|                                         |  |           |         |               |  |          |         |       |  |           |        |   |  |   |         |  
|---------------------------------------- |  | --------- | ------- | ------------- |  | -------- | ------- | ----- |  | --------- | ------ | - |  | - | ------- | -
|                                         |  |           |         |               |  |          |         |       |  | Resale of |        |   |  |  
|                                         |  |           |         |               |  |          |         |       |  | Local and |        |   |  |  
|                                         |  |           |         |               |  |          |         |       |  | Long      |        |   |  |  
|                                         |  | Principal |         | Inter-Tel.NET |  | Distance |         |       |  |          
|(In thousands, except per share amounts) |  | Segment   |         | /Vianet       |  | Services |         | Total
|                                         |  |           |         |               |  |          |         |      
|2001                                     |  |           |         |               |  |          |         |       |  |           |        |   |  |   |         |  
|Net sales                                |  | $         | 346,094 |               |  | $        | 13,986  |       |  | $         | 25,575 |   |  | $ | 385,655 |  
|Gross profit (loss)                      |  |           | 173,823 |               |  |          | (5,892  | )     |  |           | 6,563  |   |  |   | 174,494 |  
|Charge (see Note B)                      |  |           |        |               |  |          | (5,357  | )     |  |           |       |   |  |   | (5,357  | )
|Operating income (loss)                  |  |           | 30,911  |               |  |          | (13,718 | )     |  |           | 3,231  |   |  |   | 20,424  |  
|Interest and other income                |  |           | 970     |               |  |          | (1      | )     |  |           | 112    |   |  |   | 1,081   |  
|Loss on foreign currency transactions    |  |           | (337    | )             |  |          |        |       |  |           |       |   |  |   | (337    | )
|Interest expense                         |  |           | (293    | )             |  |          | (173    | )     |  |           | (2     | ) |  |   | (468    | )
|Net income (loss)                        |  | $         | 19,688  |               |  | $        | (8,752  | )     |  | $         | 2,105  |   |  | $ | 13,041  |  
|Net income (loss) per diluted share (1)  |  | $         | 0.78    |               |  | $        | (0.36   | )     |  | $         | 0.08   |   |  | $ | 0.52    |  
|Weighted average diluted shares (1)      |  |           | 25,240  |               |  |          | 24,488  |       |  |           | 25,240 |   |  |   | 25,240  |  
|Total assets                             |  | $         | 215,340 |               |  | $        |        |       |  | $         | 12,122 |   |  | $ | 227,462 |  
|Depreciation and amortization            |  |           | 9,367   |               |  |          | 1,994   |       |  |           | 156    |   |  |   | 11,517  |  



| |  | (1) Options that are antidilutive because the exercise price was greater than
the average market price of the common shares are not included in the
computation of diluted earnings per share when a net loss is recorded. See
Note M for additional information.
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Our revenues are generated predominantly in the United States. Total
revenues generated from U.S. customers totaled $362.8 million, $371.3 million,
and $375.6 million, of total revenues for the years ended December 31, 2003,
2002 and 2001, respectively. Revenues from international sources were
primarily generated from customers located in the United Kingdom, Europe, Asia,
and Mexico. In 2003, 2002 and 2001, revenues from customers located
internationally accounted for 3.0%, 2.7% and 2.6% of total revenues,
respectively.

NOTE P  FINANCIAL INSTRUMENTS

Concentration of Credit Risk. Financial instruments that potentially
subject Inter-Tel to significant concentrations of credit risk consist
principally of cash investments, trade accounts receivable, and net investment
in sales-leases. We maintain cash and equivalents not invested in money market
funds with a major bank in our marketplace. We perform periodic evaluations of
the relative credit standing of the financial institution. Concentrations of
credit risk with respect to trade accounts receivable and net investment in
sales-leases are limited due to the large number of entities comprising our
customer base.

75



---



##### 



Fair Value of Financial Instruments. The carrying amount of cash and
equivalents, accounts receivable, net investment in sales-leases, and accounts
payable reported in the consolidated balance sheets approximate their fair
value.

NOTE Q  SUPPLEMENTAL CASH FLOW

|                                                |                                                                                  |      |                          |        |   |      |        |        |   |   |        |         |  
|----------------------------------------------- | -------------------------------------------------------------------------------- | ---- | ------------------------ | ------ | - | ---- | ------ | ------ | - | - | ------ | ------- | -
|                                                |                                                                                  |      | Years Ended December 31,
|                                                |                                                                                  |      |                         
|(In thousands)                                  |                                                                                  | 2003 |                          | 2002   |   | 2001
|                                                |                                                                                  |      |                          |        |   |     
|Cash paid for:                                  |                                                                                  |      |                          |        |   |      |        |        |   |   |        |        
|                                                | Interest                                                                         |      | $                        | 156    |   |      | $      | 156    |   |   | $      | 468     |  
|                                                | Income taxes paid (received)                                                     |      | $                        | (9,384 | ) |      | $      | 15,424 |   |   | $      | (11,398 | )
|                                                |                                                                                  |      |                          |        |   |      |        |        |   |   |        |         |  
|Additional disclosure of cash flow information: |                                                                                  |      |                          |        |   |      |        |        |   |   |        |        
|                                                | Tax benefit from stock options                                                   |      | $                        | (2,321 | ) |      | $      | (2,671 | ) |   | $      | (263    | )
|                                                |                                                                                  |      |                          |        |   |      |        |        |   |   |        |         |  
|Changes in operating assets and liabilities:    |                                                                                  |      |                          |        |   |      |        |        |   |   |        |        
|                                                | (Increase) decrease in receivables and
current net investment in sales-leases    |      | $                        | (6,096 | ) |      | $      | 1,907  |   |   | $      | 7,556   |  
|                                                | (Increase) decrease in inventories                                               |      |                          | (4,069 | ) |      |        | 9,759  |   |   |        | 14,647  |  
|                                                | (Increase) decrease in prepaid expenses
and other assets                         |      |                          | (2,935 | ) |      |        | 4,248  |   |   |        | 15,883  |  
|                                                | (Increase) decrease in long-term net
investment in sales-leases and other
assets |      |                          | (6,962 | ) |      |        | (3,448 | ) |   |        | 927     |  
|                                                | Increase (decrease) in accounts payable
and other current liabilities            |      |                          | 1,093  |   |      |        | 3,014  |   |   |        | (18,045 | )
|                                                |                                                                                  |      |                          |        |   |      |        |        |   |   |        |         |  
|                                                |                                                                                  | $    | (18,969                  | )      |   | $    | 15,480 |        |   | $ | 20,968 |        
|                                                |                                                                                  |      |                          |        |   |      |        |        |   |   |        |         |  

NOTE R  QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

A summary of the quarterly results of operations for the years ended
December 31, 2003 and 2002 follows:

|                                         |  |         |        |         |  |         |        |         |  |   |        |  |  |   |         | 
|---------------------------------------- |  | ------- | ------ | ------- |  | ------- | ------ | ------- |  | - | ------ |  |  | - | ------- | 
|(In thousands, except per share amounts) |  |         |        |         |  |         |        |         |  |   |        |  |  |   |         | 
|2003                                     |  | 1st Qtr |        | 2nd Qtr |  | 3rd Qtr |        | 4th Qtr
|                                         |  |         |        |         |  |         |        |        
|Net sales                                |  | $       | 84,169 |         |  | $       | 95,102 |         |  | $ | 94,545 |  |  | $ | 100,020 | 
|Gross profit                             |  | $       | 44,074 |         |  | $       | 50,250 |         |  | $ | 49,244 |  |  | $ | 53,505  | 
|Net income                               |  | $       | 4,672  |         |  | $       | 7,269  |         |  | $ | 7,218  |  |  | $ | 9,359   | 
|Net income per share  Basic             |  | $       | 0.19   |         |  | $       | 0.29   |         |  | $ | 0.29   |  |  | $ | 0.37    | 
|Net income per share  Diluted           |  | $       | 0.18   |         |  | $       | 0.28   |         |  | $ | 0.27   |  |  | $ | 0.35    | 
|Weighted average basic common shares     |  |         | 24,920 |         |  |         | 24,947 |         |  |   | 25,107 |  |  |   | 25,338  | 
|Weighted average diluted common shares   |  |         | 26,039 |         |  |         | 25,970 |         |  |   | 26,865 |  |  |   | 27,020  | 

|                                                      |  |         |        |         |  |         |        |         |  |   |        |  |  |   |        | 
|----------------------------------------------------- |  | ------- | ------ | ------- |  | ------- | ------ | ------- |  | - | ------ |  |  | - | ------ | 
|2002                                                  |  | 1st Qtr |        | 2nd Qtr |  | 3rd Qtr |        | 4th Qtr
|                                                      |  |         |        |         |  |         |        |        
|Net sales                                             |  | $       | 90,070 |         |  | $       | 95,948 |         |  | $ | 96,665 |  |  | $ | 98,774 | 
|Gross profit                                          |  |         | 45,054 |         |  |         | 48,475 |         |  |   | 49,050 |  |  |   | 51,895 | 
|Litigation settlement (net of costs
except for taxes) |  |         | 15,302 |         |  |         | 214    |         |  |   |       |  |  |   |       | 
|Net income                                            |  |         | 15,395 |         |  |         | 7,035  |         |  |   | 7,543  |  |  |   | 8,664  | 
|Net income per share  Basic                          |  | $       | 0.64   |         |  | $       | 0.29   |         |  | $ | 0.31   |  |  | $ | 0.35   | 
|Net income per share  Diluted                        |  | $       | 0.60   |         |  | $       | 0.28   |         |  | $ | 0.29   |  |  | $ | 0.33   | 
|Weighted average basic common shares                  |  |         | 24,179 |         |  |         | 24,270 |         |  |   | 24,544 |  |  |   | 24,783 | 
|Weighted average diluted common shares                |  |         | 25,550 |         |  |         | 25,562 |         |  |   | 26,033 |  |  |   | 26,307 | 

76