|FORM 10-K


U.S. SECURITIES AND
EXCHANGE COMMISSION WASHINGTON, D.C. 20549


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


For fiscal year ended
December 31, 2001



Commission file number:0-22340



PALOMAR MEDICAL TECHNOLOGIES, INC.(Exact name of registrant as specified in its charter)
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Delaware(State or other jurisdiction of incorporation or organization) | 04-3128178(I.R.S. Employer Identification No.)
|---------------------------------------------------------------------- | ----------------------------------------------

|82 Cambridge Street,
Burlington, Massachusetts 01803(Address of principal executive offices)



(781) 993-2300(Issuers telephone number, including area code)




Securities registered
pursuant to Section 12 (b) of the Act:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Title of each classNot Applicable | Name of each exchange on which registeredNot Applicable
|--------------------------------- | -------------------------------------------------------

|Securities registered
pursuant to Section 12 (g) of the Act:Common Stock, $.01 par value



Indicate
by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter period that the registrant was required to file such report(s)), and
(2) has been subject to such filing requirements for the past 90 days. Yes      NoX


Check
if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-K contained in this form, and no disclosure will be contained, to
the best of registrants knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.  _____


As
of February 28, 2002, 10,514,979 shares of common stock were outstanding. The
aggregate market value of the voting shares (based upon the closing price
reported by Nasdaq on February 28, 2002) of Palomar Medical Technologies, Inc.,
held by nonaffiliates was$5,675,513. For purposes of this disclosure,
shares of common stock held by entities and individuals who own 5% or more of
the outstanding common stock and shares of common stock held by each officer and
director have been excluded in that such persons may be deemed to be
affiliates as that term is defined under the Rules and Regulations
of the Securities Exchange Act of 1934. This determination of affiliate status
is not necessarily conclusive.



DOCUMENTS
INCORPORATED BY REFERENCE


Portions
of the definitive proxy statement to be filed prior to April 30, 2002, pursuant
to Regulation 14A of the Securities Exchange Act of 1934 are incorporated by
reference into Part III of this Form 10-K



Transitional Small
Business Disclosure Format:      Yes    X      No
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|INDEX
|-----

|Item                                                                                                     | Page No.
|-------------------------------------------------------------------------------------------------------- | --------
|                                                                                                         |         
|PART I                                                                                                   |         
|                                                                                                        
|Item 1. Business                                                                                         |         
|                                                                                                        
|(a) Introduction                                                                                         |         
|(b) Financial Information About Industry Segments                                                        |         
|(c) Description of Business                                                                              |         
|(d) Financial Information About Exports by Domestic Operations                                           |         
|                                                                                                        
|Item 2. Properties                                                                                       |         
|                                                                                                        
|Item 3. Legal Proceedings                                                                                |         
|                                                                                                        
|Item 4. Submission of Matters to a Vote of Security Holders                                              |         
|                                                                                                        
|PART II                                                                                                  |         
|                                                                                                        
|Item 5. Market for Registrants Common Equity and Related Stockholder Matters                            |         
|                                                                                                        
|Item 6. Selected Financial Data                                                                          |         
|                                                                                                        
|Item 7. Managements Discussion and Analysis of Financial Condition and Results of        Operations     |         
|                                                                                                        
|(a) Overview                                                                                             |         
|(b) Critical Accounting Policies                                                                         |         
|(c) Results                                                                                              |         
|(d) Liquidity and Capital Resources                                                                      |         
|(e) Recently Issued Accounting Standards                                                                 |         
|                                                                                                        
|Item 7A. Quantitative and Qualitative Disclosures About Market Risk                                      |         
|                                                                                                        
|Statement Under the Private Securities Litigation Reform Act                                             |         
|                                                                                                        
|Risk Factors                                                                                             |         
|                                                                                                        
|Item 8. Financial Statements                                                                             |         
|                                                                                                        
|Report of Independent Public Accountants                                                                 |         
|Consolidated Balance Sheets as of December 31, 2000 and 2001                                             |         
|Consolidated Statements of Operations for the years ended December 31, 1999, 2000               and 2001 |         
|Consolidated Statements of Stockholders Equity (Deficit) for the years ended                            |         
|December 31, 1999, 2000 and 2001                                                                         |         
|Consolidated Statements of Cash Flows for the years ended December 31, 1999, 2000 and               2001 |         
|Notes to Consolidated Financial Statements                                                               |         
|                                                                                                        
|Item 9. Changes and Disagreements with Accountants on Accounting and Financial        Disclosures        |         

|-i-
|---

|
|

|                                                                         |  |    | 
|------------------------------------------------------------------------ |  | -- | 
|PART III                                                                 |  | 44 | 
|                                                                        
|Item 10. Directors and Executive Officers of the Registrant              |  | 44 | 
|                                                                        
|Item 11. Executive Compensation                                          |  | 44 | 
|                                                                        
|Item 12. Security Ownership of Certain Beneficial Owners and Management  |  | 44 | 
|                                                                        
|Item 13. Certain Relationships and Related Transactions                  |  | 44 | 
|                                                                        
|PART IV                                                                  |  | 45 | 
|                                                                        
|Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K |  | 45 | 
|                                                                        
|(a) Index to Consolidated Financial Statements and Schedules             |  | 45 | 
|(b) Reports on Form 8-K                                                  |  | 45 | 
|(c) Exhibits                                                             |  | 45 | 
|                                                                        
|SIGNATURES                                                               |  | 48 | 

|-ii-
|----

|PART I



Item 1.
Business.
|---------------------------

|(a) |  | Introduction
|--- |  | ------------

|Palomar
Medical Technologies, Inc. (the Company) was organized in 1987 to
design, manufacture and market lasers, delivery systems and related disposable
products for use in medical procedures. In December 1992, the Company filed its
initial public offering. Subsequently, the Company pursued an
acquisition program, acquiring companies in its core laser business as well as
others, principally in the electronics industry, in order to spread risk and
bolster operating assets. By the beginning of 1997, the Company had more than a
dozen subsidiaries. At the same time, having obtained FDA clearance to market
its EpiLaser® ruby laser hair removal laser system in March 1997, the
Company was well positioned to focus on what it believed was at that time the
most promising product in its core laser business. Hence, under the direction of
a new Board and management team, the Company undertook a program in 1997,
completed in May of 1998, of exiting from all non-core businesses and
investments and focusing only on those businesses which it believes hold the
greatest promise for maximizing stockholder value. The Companys exclusive
focus is now the use of lasers and light based products in dermatology and
cosmetic procedures, with an emphasis on laser / light based hair removal and
research and development relating to that and other cosmetic laser / light based
products. On December 7, 1998, the Company entered into an Agreement and Plan of
Reorganization (the Agreement) with Coherent, Inc. to sell all of
the issued and outstanding common stock of Palomars Star Medical
Technologies, Inc. (Star) subsidiary. The Company completed the sale
of Star to Coherent on April 27, 1999 (Coherent Medical Group was subsequently
sold to ESC Medical, now known as Lumenis, Inc. and hereinafter
Lumenis). Currently, the Company has two operating subsidiaries,
Palomar Medical Products, Inc. (PMP) and Esthetica Partners, Inc.
(formerly Cosmetic Technology International, Inc. and hereinafter
Esthetica). PMP, located at the Companys headquarters in
Burlington, Massachusetts, oversees the manufacture and sale of the
Companys laser / light systems currently on the market. Esthetica is also
based in Burlington, Massachusetts. (See Item 7. Managements
Discussion and Analysis of Financial Condition and Results of Operations 
Overview.)
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b) |  | Financial
Information About Industry Segments
|--- |  | ---------------------------------------------

|The
Company conducts business in one industry segment, medical products and
services.
|-------------------------------------------------------------------------------------

|(c) |  | Description
of Business
|--- |  | -----------------------

| |  | (i) |  | Principal
Products
| |  | --- |  | ------------------

|Hair Removal/Vascular
Lasers and Light Based Systems


During
2001, Palomar received FDA clearance to market and sell the Palomar
EsteLux light-based system. The Palomar EsteLux light-based system
has the fastest coverage rate, a long pulsewidth and SpectruMax filtering.
It combines the latest flashlamp technology with simple, streamlined engineering
and is both effective and economical. The system features a large spot size that
makes the system effective when treating large areas such as legs and
backs. Users can treat more customers in less time, maximizing their return on
investment. The system is smaller and lighter than current systems, which is
especially desirable for mobile and/or small physician offices. The
systems simple operation opens its applications to a wider band of
worldwide users. Palomar intends on introducing, complimentary handpieces,
pending 510(k) approval, for the Palomar EsteLux light-based system.


During
2000, Palomar received FDA clearance to market and sell the Palomar SLP1000®
diode laser system. The Palomar SLP1000® is a high-powered diode laser that
delivers energy over a relatively long time period using a technology called
Super Long Pulse Technology. The SLP1000® diode laser system is
the first diode laser using Super Long Pulse Technology to provide hair removal
and vascular treatments to virtually all skin types. Furthermore, the Palomar
SLP1000® diode laser system is the first laser system utilizing
interchangeable hand pieces to provide hair removal or vascular treatments. In
addition to the Palomar SLP1000® diode laser systems broad treatment
range, it is compact and easy to use. These proprietary delivery systems are
essential to providing safe and effective treatment. This new generation of
lasers promises to be much gentler to the skin, capable of treating a wide range
of skin types, and less costly to produce than current systems on the market.


-1-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In
December 1997 and January 1998, respectively, Palomar was also the first company
to receive FDA clearance for a diode laser for hair removal and for leg vein
treatment, the LightSheer diode laser system manufactured by Star. The
LightSheer was the first generation of high-powered diode lasers designed
for hair removal. These diode lasers also incorporate patented technology
licensed exclusively to Palomar. In turn, Palomar has sublicensed this patented
technology to several competitors at a royalty rate of 7.5%. High-powered diode
laser systems are compact, solid-state lasers that are significantly smaller
than most current systems, and relatively easy to install and service.


During
1998, Palomar introduced its second-generation ruby laser, the Palomar
E2000 hair removal laser system, a product that was superior to hair
removal lasers then available in a number of respects, including speed and
efficacy. The Palomar E2000 has also received FDA clearance for hair
removal.


Using
its core ruby laser technology, originally developed for tattoo removal and
pigmented lesions, Palomar developed a long pulse ruby laser, the EpiLaser®,
that is specifically configured to allow the appropriate wavelength, energy
level and pulse duration to be absorbed effectively by the hair follicle without
being absorbed by the surrounding tissue. That, combined with the patented
cooling handpiece, allows for safe and effective hair removal. In March 1997,
Palomar was the first company to receive FDA clearance to sell and market a ruby
laser (the EpiLaser® system) in the U.S. for hair removal.


Studies
using Palomars laser hair removal process demonstrated significant
permanent reduction of hair following treatment with the EpiLaser® and the
Palomar E2000. The first treatment causes a portion of the hair (typically
the hair in the growth mode) to be reduced in size, color and/or quantity (based
on studies followed for up to three years) and causes significant growth delay
(three to six months) of most of the rest of the hair. Since the partial
re-growth tends to occur in synchrony, the follow-up treatment is often more
effective than the first treatment. The EpiLaser® and the Palomar
E2000 were the first hair removal lasers on the market that were cleared
by the FDA for permanent hair reduction labeling.


Market
surveys report that the great majority of women in the United States employ one
or more techniques for temporary hair removal from various parts of the body,
including waxing, depilatories, tweezing, shaving, and electrolysis. The market
for laser / light based hair removal is in its early stages. Benefits of
Palomars laser / light based hair removal process, as compared to other
hair removal methods currently available, include significant long term cosmetic
improvement, treatment of larger areas in each treatment session than that of
other laser / light based hair removal devices, a procedure that is relatively
painless and non-invasive, reduced risk of scarring and cross-contamination, and
better efficacy rates.


Tattoo
Removal/Pigmented Lesion Laser


During
2001, Palomar received FDA clearance to market and sell the Palomar Q-YAG
5 laser system for tattoo and pigmented lesion removal. The Palomar Q-YAG
5 is a state-of-the-art, Q-switched, frequency-doubled Neodymium laser.
This laser system allows users to switch between a 1064-nm single-wavelength
beam and a 1064/532-nm mixed-wavelength beam. The combination of wavelengths
allows users to treat a full spectrum of colors and inks, and the systems
design lowers costs and allows broader use of the instrument. The single 1064-nm
wavelength is ideal for treating darker tattoo inks and dermal-pigmented
lesions, such as Nevi of Ota. The mixed 1064/532-nm wavelength is better suited
for brighter colors and epidermal-pigmented lesions, such as solar lentigines.
In addition, the mixed wavelength permits brighter/more superficial and
deeper/darker target areas to be treated simultaneously. The Palomar Q-YAG
5 incorporates the laser into the hand piece making it smaller and lighter
than current systems, which is especially desirable for mobile and/or small
physician offices. These attributes reduce the cost of the system and eliminate
costly optics and service problems that are common with other high power
Q-Switched lasers.


The
Company sells a Q-switched ruby laser for tattoo removal and treating pigmented
lesions, the RD-1200. The RD-1200 has been on the market for ten
years. Intense competition in the medical device industry and market saturation
for this type of laser have reduced RD-1200 sales over the last five
years. In addition, there are less expensive products now available for this
purpose. Palomar expects sales of this product to continue in 2002 at a low
volume to foreign countries where the advantages of the ruby laser for treatment
of pigmented lesions is especially important.


-2-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Distribution and Service


Palomar
has changed its distribution method over the past few years to address changes
in market conditions and composition of its product line. The Company has
continued to hire a number of direct sales representatives to support products
introduced in 2001 and additional products to be introduced in 2002. The Company
further intends to tailor distribution methods to different geographic regions
and may include a combination of exclusive and non-exclusive distributors,
independent representatives and a direct sales force. Palomar sells and services
products through distributors internationally. In the United States and in
certain other countries, Palomar provides service through its own service
organization.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (ii) |  | Products
Under Development
| |  | ---- |  | --------------------------

|The
Company is engaged in developing products for the dermatology and cosmetic
market. Products under development include lasers and light based products in
hair removal, tattoo and pigmented lesion removal, leg vein and other vascular
lesion removal, acne treatment and fat reduction, skin rejuvenation and wrinkle
removal. Palomar performs its own research as well as research with other
partners, including Massachusetts General Hospital (MGH). Product
development is performed by scientists and engineers at the Companys
headquarters. The Company splits its efforts between new products for existing
markets such as hair, vascular and pigmented lesion and tattoo removal, and new
products for markets, such as acne treatment, fat reduction and wrinkle removal.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (iii) |  | Production
and Sources and Availability of Materials
| |  | ----- |  | ----------------------------------------------------

|Palomars
manufacturing operations are currently located in Burlington, Massachusetts.
Palomar maintains control of and manufactures most key components in-house.
Manufacturing consists of the assembly and testing of components purchased from
outside suppliers and contract manufacturers. The entire fully assembled system
is subjected to a rigorous set of tests prior to shipment to the customer or
distributor.


Palomar
depends and will depend upon a number of outside suppliers for components used
in its manufacturing process. Palomar has also contracted with a key overseas
supplier of a major component of the Super Long Pulse Technology. The component
is matched with a specific delivery system developed by Palomar and is
incorporated into a full system. Most of Palomars components and raw
materials are available from a number of qualified suppliers. Ruby rods for the
ruby lasers are available through only one qualified supplier. To date, the
Company has not experienced, nor does it expect to experience, any significant
delays in obtaining component parts or raw materials. Palomar has expanded its
manufacturing capabilities to satisfy projected demand. Palomar has the approval
for the CE Mark for the EpiLaser® and E2000 laser systems, and has
obtained ISO 9001, ISO 13485 and EN 46001 registration.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (iv) |  | Patents
and Licenses
| |  | ---- |  | --------------------

|The
Companys success and ability to compete are dependent on its ability to
develop and maintain the proprietary aspects of its technology and operate
without infringing on the proprietary rights of others. The Company relies on a
combination of patents, trademarks, trade secret and copyright laws and
contractual restrictions to protect the proprietary aspects of its technology.
These legal protections afford only limited protection for its technology. The
Company presently has numerous patent applications pending in the United States
and in foreign countries. Furthermore, the Company cannot be certain that
patents will be granted based on these or any other applications.


The
Company seeks to limit disclosure of its intellectual property by requiring
employees, consultants and any third party with access to the Companys
proprietary information to execute confidentiality agreements with the Company.
Due to rapid technological change, the Company believes that factors such as the
technological and creative skills of its personnel, new product developments and
enhancements to existing products are as important as the various legal
protections of the Companys technology to establishing and maintaining a
technology leadership position.


Despite
the Companys efforts to protect its proprietary rights, unauthorized
parties may attempt to copy aspects of the products or to obtain and use
information that the Company regards as proprietary. Policing unauthorized use
of the Companys products is difficult. Litigation may be necessary to
enforce intellectual property rights, to protect our trade secrets, to determine
the validity and scope of the proprietary rights of others or to defend against
claims of infringement or invalidity. Any such resulting litigation could result
in substantial costs and diversion of resources and could have a material
adverse effect on the business, operating results and financial condition. There
can be no assurance that the Companys means of protecting proprietary
rights will be adequate or that the Companys competitors will not
independently develop similar technology. Any failure by the Company to
meaningfully protect the Companys proprietary rights could have a material
adverse effect on the business, operating results and financial condition.


-3-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Management
believes that none of the Companys current products infringe upon valid
claims of patents owned by third parties. However, there have been claims and
there can be no assurance that third parties will not make further claims of
infringement with respect to our current or future products.Any such
claims, with or without merit, could be time-consuming to defend, result in
costly litigation, divert managements attention and resources, cause
product shipment delays or require us to enter into royalty or licensing
agreements. Such royalty or licensing agreements, if required, may not be
available on terms acceptable to us or at all. A successful claim of
intellectual property infringement against us and our failure or inability to
license the infringed technology or develop or license technology with
comparable functionality could have a material adverse effect on our business,
financial condition and operating results. (See Item 7A. Risk
Factors.)


In
August 1995, the Company entered into an agreement with MGH whereby MGH agreed
to conduct clinical trials on a laser treatment for hair removal/reduction
developed at MGHs Wellman Laboratories of Photomedicine. In July 1999, the
Company amended this agreement to extend its exclusive research relationship for
an additional five years. In addition to photo thermal removal or reduction of
hair, the agreement has been expanded to include research and development in the
fields of non-invasive, electromagnetic targeting of subcutaneous fat, and
treatment of sebaceous glands and related skin disorders (e.g., acne) using
infrared light except when externally applied chromophores are used (hereinafter
referred to, respectively, as hair removal, fat removal,
acne treatment, and skin rejuvenation for simplicity).


Palomar
has licensed two United States patents (and corresponding, foreign patent
applications) involving laser / light based hair removal that expire on February
1st, 2015. MGH licenses these patents exclusively to Palomar.
Palomar, in turn, has the right to sublicense these patents to others. Palomar
also has the right to exclusively license patents in the fields of hair removal,
fat removal, and acne treatment arising out of MGHs Palomar-funded
clinical trials. As consideration for this license, the Company is obligated to
pay MGH royalties on products and services covered by valid patents licensed to
the Company. Palomar has sublicensed these two MGH patents to several
competitors. Palomar also has rights to patents arising out of MGHs
Palomar funded, clinical trials in other fields and to patents jointly invented
by Palomar and MGH.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (v) |  | Seasonal
Influences
| |  | --- |  | -------------------

|There
is no significant seasonal influence on the Companys sales.
|------------------------------------------------------------------

| |  | (vi) |  | Working
Capital
| |  | ---- |  | ---------------

|There are
no special inventory requirements, return rights, or credit terms extended to
customers that would have a material adverse effect on the Companys
working capital.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (vii) |  | Dependence
on a Single Sales Agent
| |  | ----- |  | ----------------------------------

|The
Company is not dependent on a Single Sales Agent. Sales pursuant to the
Companys Sales Agency, Development and License Agreement with Coherent
accounted for approximately 60% of the Companys total revenues in fiscal
1999. The Sales Agency Agreement terminated upon the closing of the sale of Star
in April 1999.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (viii) |  | Backlog
| |  | ------ |  | -------

|The
Companys backlog of firm orders for its continuing operations at December 
31, 2001 and December 31, 2000, was approximately $275,000 and $606,000
respectively.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (ix) |  | Government
Contracts
| |  | ---- |  | --------------------

|Not
applicable.


-4-
|---------------------

|
|

| |  | (x) |  | Competition
| |  | --- |  | -----------

|The
markets in which the Company is engaged are subject to keen competition and
rapid technological change. To Palomars knowledge, at least ten other
companies have received market clearance from the FDA for laser hair removal and
another company has received FDA clearance to market a laser-like system using
filtered intense light to remove hair. The Companys former subsidiary,
Star, was sold to Coherent on April 27, 1999 then to Lumenis and competes with
Palomar in the hair removal market as well. The Company expects that other hair
removal devices will be developed and/or introduced in 2002, making laser hair
removal a competitive application within the cosmetic laser marketplace. The
Company also expects that there may be further consolidation of companies within
the laser hair removal industry via acquisitions, partnering arrangements or
joint ventures. The Companys products will also compete with other hair
removal products and methods. The Company competes primarily on the basis of
technology, product performance, price, quality, reliability, distribution and
customer service and support. To remain competitive, the Company will be
required to continue to develop new products and periodically enhance its
existing products. (See Item 7. Risk Factors.)
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (xi) |  | Research
and Development
| |  | ---- |  | ------------------------

|Palomars
research and development goals in the field of laser / light based hair removal
are to design systems that (1) permit more effective treatment and rapid
treatment of large areas, (2) have high gross margins, and (3) are
manufactured at a lower cost, thus addressing broader markets. Further, Palomar
aims to address dermatological and cosmetic procedure markets other than hair,
including the fields of acne treatment, fat removal, skin rejuvenation and
wrinkle removal.


During
fiscal 2001, 2000 and 1999, the Company incurred approximately $6,045,000,
$7,851,000, $8,022,000, respectively, on research and development programs. Due
to the intense competition and rapid technological changes in the laser
industry, the Company believes that it must continue to improve and refine its
existing products and services, and develop new applications for its technology.
(See Item 7A. Risk Factors and Note 4 to Financial Statements.)
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (xii) |  | Environmental
Protection Regulations
| |  | ----- |  | ------------------------------------

|The
Company believes that compliance with federal, state and local environmental
regulations will not have a material adverse effect on its capital expenditures,
earnings or competitive position.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (xiii) |  | Number
of Employees
| |  | ------ |  | -------------------

|As
of December 31, 2001, the Company employed 89 persons. The Company is not
subject to any collective bargaining agreements, has never experienced a work
stoppage and considers its relations with its employees to be good.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(d) |  | Financial
Information About Exports by Domestic Operations
|--- |  | ----------------------------------------------------------

|Aggregate
export sales for the Companys continuing operations were approximately
$8.4 million for 1999, $3.9 million for 2000 and $6.0 million for 2001. (See
Notes 2(i) and 3 to Consolidated Financial Statements.)





Item 2.
Properties.


The
Company occupies approximately 44,000 square feet of office, manufacturing and
research space in Burlington, Massachusetts under a lease expiring in August
2009. The Company believes that this facility is in good condition and is
suitable and adequate for its current operations.


In
the fourth quarter of 2001, the Company announced a workforce reduction and
closed its 4,000 square foot research space in Livermore, California. The lease
at the Livermore facility had expired in December 2001.



Item 3. Legal
Proceedings.


On
March 11, 1999, the United States District Court for the Southern District of
New York granted plaintiffs leave to amend their complaint in the action styled
Varljen v. H.J. Meyers, Inc., et. al. The court entered a final judgement
of dismissal with prejudice on November 6, 2000. All payments required by
Palomar under the settlement agreement have been made except for the delivery of
358,547 shares of Palomar Common stock, which is the balance of the shares owed
under the settlement agreement. These shares will be delivered upon receipt of
instruction from plaintiffs counsel.


-5-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|The
Company is involved in other legal and administrative proceedings and claims of
various types. While any litigation contains an element of uncertainty,
management, in consultation with the Companys general counsel, at present
believes that the outcome of each such other proceeding or claim which is
pending or known to be threatened, or all of them combined, will not have a
material adverse effect on the Company.


(See
Item 7A. Risk Factors.)



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


Not
applicable.

-6-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART II



Item 5. Market
for Registrants Common Equity and Related Stockholder Matters.


The
Companys common stock is currently traded on the National Association of
Securities Dealers Automated Quotation System (Nasdaq) under the symbol PMTI.
The following table sets forth the high and low bid prices quoted on Nasdaq for
the common stock for the periods indicated. Such quotations reflect inter-dealer
prices, without retail markup, markdown or commission and do not necessarily
represent actual transactions.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 | Fiscal Year EndedDecember 31, 2000
|-------------------------------- | ----------------------------------
|
|Quarter Ended March 31, 2000     |                                   
|Quarter Ended June 30, 2000      |                                   
|Quarter Ended September 30, 2000 |                                   
|Quarter Ended December 31, 2000  |                                   
|                                
|                                
|
|
|Quarter Ended March 31, 2001     |                                   
|Quarter Ended June 30, 2001      |                                   
|Quarter Ended September 30, 2001 |                                   
|Quarter Ended December 31, 2001  |                                   

|As
of February 28, 2002, the Company had 1,684 holders of record of common
stock. This does not include holdings in street or nominee names.


The
Company has not paid dividends to its common stockholders since its inception
and does not plan to pay dividends to its common stockholders in the foreseeable
future. The Company intends to retain substantially all earnings to finance the
operations of the Company. The Company may buy back shares of its common stock
on the open market from time to time.




-7-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Item 6. Selected
Financial Data.


The
following table sets forth selected consolidated financial and other information
on a historical basis for the Company and its subsidiaries as of and for each of
the fiscal years in the five-year period ended December 31, 2001. Pursuant to
Accounting Principles Board Opinion (APB) No. 30, Reporting the
Results of Operations  Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions, the consolidated financial statements of the Company have been
reclassified to reflect the dispositions of its subsidiaries that comprise the
electronics segment. This table should be read in conjunction with the
Consolidated Financial Statements of the Company and the Notes thereto included
elsewhere in this Annual Report on Form 10-K.


Selected Financial Data
(in thousands, except per share data)
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                               | Year ended December 31,
|-------------------------------------------------------------- | -----------------------
|
|Statement of Operations Data:                                  |                        
|Total Revenues                                                 |                        
|Gross Profit                                                   |                        
|Operating Expenses (Income)                                    |                        
|Income (Loss) from Operations                                  |                        
|Net Income (Loss)  from Continuing Operations                  |                        
|Cumulative effect of change in accounting method               |                        
|Net Loss from Discontinued Operations                          |                        
|Net Income (Loss)                                              |                        
|Basic Net  Income (Loss) Per Common Share:                     |                        
|Continuing Operations                                          |                        
|Cumulative effect of change in accounting method               |                        
|Discontinued Operations                                        |                        
|                                                               |                        
|Total Basic Net Income (Loss) Per Common Share                 |                        
|Basic Weighted Average Number of                               |                        
|Common Shares Outstanding                                      |                        
|                                                               |                        
|Diluted Net Income (Loss) Per Common Share:                    |                        
|Continuing Operations                                          |                        
|Cumulative effect of change in accounting method               |                        
|Discontinued Operations                                        |                        
|                                                               |                        
|Total Diluted Net Income (Loss) Per               Common Share |                        
|Diluted Weighted Average Number of                             |                        
|Common Shares Outstanding                                      |                        
|                                                               |                        
|Balance Sheet Data:                                            |                        
|Working Capital                                                |                        
|Total Assets                                                   |                        
|Long-term  Debt                                                |                        
|Stockholders Equity (Deficit)                                 |                        

|-8-
|---

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

|(a) |  | Overview
|--- |  | --------

|We
are a researcher and developer of proprietary laser / light based systems for
hair removal and other cosmetic treatments; as well as, the first company to
obtain clearance using laser systems from the FDA for permanent hair
reduction. Palomars laser / light based hair removal systems have
been installed in physician practices worldwide. Through Palomars research
partnerships including its partnership with Massachusetts General
Hospitals Wellman Laboratories, new indications are being tested to
further advance the hair removal market and other cosmetic laser / light based
applications including fat reduction, acne treatment and skin rejuvenation.


On
April 27, 1999, the Company sold all of the issued and outstanding common stock
of Palomars Star Medical Technologies, Inc. (Star) subsidiary
to Coherent, Inc. (Coherent) for $65 million, paid in cash and an
on-going 7.5% royalty on the LightSheer product line. The purchase price was
paid to the stockholders of Star in proportion to their holdings of Star capital
stock. On the date of sale, Palomar owned 82.46% of Star. Palomar received net
proceeds of $49,736,023. The Company believes the successful introduction and
marketing of new products will become critical to the Companys long-term
success. Broad market acceptance of laser / light based hair removal and
specific acceptance of the Palomar SLP1000 diode laser system, Palomar
EsteLux light based system and the Palomar Q-Yag 5 Q-Switched ND:
Yag laser system is critical to the Companys success. The three systems,
all of which have FDA clearance, cover a wide spectrum of cosmetic applications;
the Palomar SLP1000® is the first diode laser system in the marketplace
cleared for use on all skin types and has different hand pieces to be used in a
variety of cosmetic applications including hair and vascular lesion removal; the
Palomar EsteLux system is a fast, more compact and efficient light based
system for hair removal and pigmented lesion removal and the Palomar Q-Yag
5 is a laser system for tattoo and pigmented lesion removal. The Company
has traditionally spent a significant amount of its resources in developing new
technologies and products.


During
the fourth quarter of 2001, substantial cost reductions were implemented; the
Company expects these cost-cutting measures to reduce payroll costs by more than
20 percent in 2002, as well as decrease expenses throughout the organization.
Included in these cost reduction measures was the closing of the Companys
4,000 square foot research space in Livermore, California. The lease had expired
in December 2001. In addition, the Company plans to focus its efforts on
expanding its distribution network, both domestically and internationally.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(b) |  | Critical
Accounting Policies
|--- |  | ----------------------------

|The Company believes the
following represent its critical accounting policies:



Revenue Recognition


The
Company recognizes revenue in accordance with SEC Staff Accounting Bulletin No.
101, Revenue Recognition in Financial Statements (SAB 101), as amended by SAB
101A and 101B. SAB 101 requires that four basic criteria must be met before
revenue can be recognized: (1) persuasive evidence of an arrangement exists; (2)
delivery has occurred or services rendered; (3) the fee is fixed and
determinable; and (4) collectibility is reasonably assured. Determination of
criteria (3) and (4) are based on managements judgments regarding the
fixed nature of the fee charged for services rendered and products delivered and
the collectibility of those fees. Should changes in conditions cause management
to determine these criteria are not met for certain future transactions, revenue
recognized for any reporting period could be adversely affected.


Products
sold are generally covered by a warranty for a period of one year. The Company
accrues a warranty reserve for estimated costs to provide warranty services. The
Companys estimate of costs to service its warranty obligations is based on
historical experience and expectation of future conditions. To the extent the
Company experiences increased warranty claim activity or increased costs
associated with servicing those claims, its warranty accrual will increase
resulting in decreased gross profit.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(c) |  | Results
of Operations
|--- |  | ---------------------

|-9-
|---

|
|

|
|

| |  | (i) |  | REVENUES
AND GROSS PROFIT: Year ended December 31, 2001, Compared to the Year ended December 31,
2000
| |  | --- |  | -----------------------------------------------------------------------------------------------------

|For
the year ended December 31, 2001, the Companys revenues increased to $16.7
million, as compared to $13.2 million for the year ended December 31, 2000. This
increase in the Companys revenues of $3.5 million, or 26% from the year
ended December 31, 2000, was mainly due to an increase in product sales of
SLP1000® of $1.6 million, the newly introduced EsteLux pulsed light
hair removal system of $1.4 million, shipments associated with the Q-Yag 5
of $1.1 million, offset by a decrease in service revenue of $200,000 a decrease
in product sales associated with the RD1200 of $1.0 million and a decrease
in shipments associated with the E2000 of $500,000. Additionally, royalty
revenues received by the Company increased by $1.1 million. Included in this
increase was a back-owed payment of $1.2 million paid by one of the
Companys licensees, resulting from a royalty audit performed through the
period ending December 31, 1999.


Gross
profit for the year ended December 31, 2001 was $5.3 million, 32% of revenues,
as compared $2.6 million, or 20% of revenues for the year ended December 31,
2000. The increase in gross profit and gross profit percentage was mainly due to
an increase in product sales of the SLP1000, the newly introduced EsteLux,
shipments associated with the Q-Yag 5 as well as the increased royalty payments
received during the twelve-month period.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (ii) |  | OPERATING
AND OTHER EXPENSES: Year ended December 31, 2001, Compared to Year ended December 31, 2000
| |  | ---- |  | ----------------------------------------------------------------------------------------------------

|Research
and development costs decreased to $6.0 million for the year ended December 30,
2001, from $7.9 million for the year ended December 31, 2000. Research and
development expenses as a percentage of revenue totaled 36% for the year ended
December 31, 2001 and 60% for the year ended December 31, 2000. The continued
spending on research and development reflects the Companys commitment to
research and development for devices and delivery systems for cosmetic and
medical applications using a variety of lasers and light-based systems, while
continuing dermatology research utilizing the Companys platforms. The
research and development goals in the fields of laser and light-based hair
removal are to design systems that (1) permit more rapid treatment of large
areas, (2) have high gross margins, and (3) are manufactured at a lower cost,
thus addressing broader markets. Further, the Company is aiming to address
dermatology and cosmetic procedure markets other than hair, including the fields
of fat reduction, acne treatment and skin rejuvenation.


Sales
and marketing expenses increased to $3.5 million (21% of revenues) for the year
ended December 31, 2001, from $3.2 million (24% of revenues) for the year ended
December 31, 2000. The increase in selling and marketing expenses is directly
associated with the increased shipments of the SLP1000 and launch of the EsteLux
and Q-Yag 5 products.


General
and administrative expenses decreased to $2.5 million (15% of revenues) for the
year ended December 31, 2001, as compared to $3.9 million (29% of revenues) for
the year ended December 31, 2000. This decrease of $1.4 million or 36% for the
year ended December 31, 2001 is attributable to the reduction in legal expenses
of $123,000, the reduction in the legal accrual of $250,000, the reduction in
the incentive compensation accrual of $513,000, the reduction of Directors and
Officers insurance expense of approximately $200,000 and other cost
cutting measures taken by management.


During
the year ended December 31, 2000, the Company made a determination that goodwill
and equipment related to certain past generation products being phased out had
been impaired and, accordingly, wrote-off $522,000 of goodwill and $224,000 of
equipment.


Gain
from the sale of a subsidiary, Star, was $2.4 million, net of certain
commitments and contingencies related to the sale, in the year ended December
31, 2000 as the one-year escrow period had lapsed.



Interest
expense decreased to $98,000 for year ended December 31, 2001, from $155,000 for
the year ended December 31, 2000.


Interest
income decreased to $759,000 for the year ended December 31, 2001 as compared to
$1.2 million for the year ended December 31, 2000. This decrease in interest
income is attributable to the reduction in cash available for investment.


-10-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|Other
income, net decreased to $186,000 for the year ended December 31, 2001, as
compared to $380,000 for the year ended December 31, 2000.


The
Company recognized an income tax benefit of $422,000 for the year ended December
31, 2001 as compared to $226,000 for the year ended December 31, 2000.


During
the year ended December 31, 2000, the Company adopted Securities and Exchange
Commission (SEC) Staff Accounting Bulletin (SAB) No. 101, Revenue
Recognition.As a result of adopting SAB 101, the Company now records
royalty income when cash is received rather than when earned. In accordance with
SAB No. 101, the Company recorded the impact of adopting SAB No. 101 as a
cumulative catch-up adjustment, totaling $712,000, in the year ended December
31, 2000 statement of operations, effective January 1, 2000.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (iii) |  | REVENUES
AND GROSS PROFIT: Year Ended December 31, 2000 Compared to Year Ended December 31, 1999
| |  | ----- |  | ------------------------------------------------------------------------------------------------

|For
the year ended December 31, 2000, the Companys revenues decreased to $13.2
million as compared to $24.3 million for the year ended December 31, 1999. The
decrease in the Companys revenues of $11.1 million, or 46% from the year
ended December 31, 1999, was mainly due to the reduction of $14.5 million in
sales volume associated with the elimination of LightSheer sales in
connection with the sale of Star to Coherent on April 27, 1999, as discussed
above. There was an additional decrease of $1.7 million due to declining sales
of the Palomar E2000TM, offset by an increase of $3.7 million from
the Palomar SLP 1000TM introduced in June of 2000. Royalties received
by the Company increased by $1.4 million.


Gross
profit for the year ended December 31, 2000 was $2.6 million (20% of revenues)
compared to $8.7 million (36% of revenues) for the year ended December 31, 1999.
The decrease in gross profit and gross profit percentage was due to the fact
that the Company sold Star and its LightSheer laser system to Coherent on
April 27, 1999, as discussed above.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (iv) |  | OPERATING
AND OTHER EXPENSES: Year Ended December 31, 2000 Compared to Year Ended December 31, 1999
| |  | ---- |  | ---------------------------------------------------------------------------------------------------

|Research
and development costs decreased slightly to $7.9 million for the year ended
December 31, 2000 from $8.0 million for the year ended December 31, 1999.
Research and development expenses as a percentage of revenues totaled 60% for
the year ended December 31, 2000 and 33% for the year ended December 31, 1999.
The continued spending on research and development reflects the Companys
commitment to research and development of devices and delivery systems for
cosmetic and medical applications using a variety of lasers, while continuing
dermatology research utilizing the Companys ruby and diode lasers.
Palomars research and development goals in the field of laser hair removal
are to design systems that (1) permit more rapid treatment of large areas,
(2) have high gross margins, and (3) are manufactured at a lower cost,
thus addressing broader markets. Management believes that research and
development expenditures will remain constant over the next year as the Company
continues product development and clinical trials for additional applications
for its lasers and delivery systems in the cosmetic and dermatological markets.
The Company entered into an amendment to its existing Clinical Trial Agreement
with Massachusetts General Hospital, pursuant to which it will fund a minimum of
$475,000 per year for research until August 18, 2004. The funding will be in the
fields of photo thermal removal or reduction of hair, non-invasive
electromagnetic targeting of subcutaneous fat, treatment of sebaceous glands and
related skin disorders (e.g., acne) using infrared light except when externally
applied chromophores are used and other fields agreed to by the Company and
Massachusetts General Hospital. In return, the Company will obtain exclusive
license rights to patents arising from Palomar funded research in these fields
(referred to, respectively, as hair removal, fat
removal, and acne treatment, for simplicity).


Sales
and marketing expenses decreased to $3.2 million (24% of revenues) for the year
ended December 31, 2000 from $6.6 million (27% of revenues) for the year ended
December 31, 1999. The decrease in sales and marketing expenses as a percentage
of revenues is a result of the Companys sale of Star to Coherent, which
accounted for significant commission expense. New distribution channels include
direct sales by the Company and other distribution channels, and the associated
sales and marketing expenses for the SLP 1000 are less than the commission
earned by Coherent, the Companys previous distributor. The Company will
continue to expand its own direct sales force to complement these sales
channels. The Company anticipates that, in comparison to the commission
previously paid to Coherent as a percentage of revenues, its future sales and
marketing costs as a percentage of revenues will decrease.

-11-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|General
and administrative expenses decreased to $3.9 million (29% of revenues) for the
year ended December 31, 2000 as compared to $5.1 million (21% of revenues) for
the year ended December 31, 1999. This decrease for the year ended December 31,
2000 is attributable to the sale of the Companys Star subsidiary and due
to the Companys restructuring and consolidation of administrative
functions.


Costs
related to goodwill and asset write-off were the result of impaired past
generation products being phased out, and, accordingly, we wrote off $522,000 of
goodwill and $224,000 of equipment.


Costs
related to solicitation of proxies in connection with the Companys 1999
Annual Meeting of Stockholders were $625,000 for the year ended December 31,
1999 as a result of a proxy contest launched by a dissident stockholder group.


Settlement
costs were $2.5 million for the year ended December 31, 1999 and are
attributable to lawsuits and claims against the Company.


Gain
from the sale of a subsidiary was $47.1 million for the year ended December 31,
1999 due to the Company completing the sale of Star on April 27, 1999. The
Company recognized a deferred gain of $2.4 million, net of certain commitments
and contingencies related to the sale for the year ended December 31, 2000 as
the one-year escrow period had lapsed in connection with the sale of Star.


Interest
expense decreased to $155,000 for the year ended December 31, 2000 from $597,000
for the year ended December 31, 1999. As a result of the sale of Star, which
generated $49.7 million in cash, the Company used a portion of these proceeds to
pay down certain of its outstanding debt during the second quarter of 1999.



Interest
income decreased slightly to $1.2 million for the year ended December 31, 2000
as compared to $1.3 for the year ended December 31, 1999. This amount represents
interest earned on the balance of the funds received from the sale of Star,
which are invested in high-grade corporate and government notes and bonds and
will be used to fund future operations and research and development efforts.


Redemption
expense was $6.2 million for the year ended December 31, 1999. This amount
reflects a redemption expense as a result of a settlement agreement between
Palomar and certain European banks that had held 4.5% Swiss franc denominated
subordinated convertible debentures originally totaling $7.7 million and due in
2003. Under the terms of this agreement, which resolved a lawsuit, Palomar
agreed to rescind its conversion notices issued in November 1997. Through these
conversion notices, Palomar converted the subordinated debentures into 130,576
shares of the Companys common stock. Since the conversion date, the
Company had treated these shares as issued and outstanding. Under the terms of
this compromise, the Company agreed to pay a total of $6.7 million to the
European banks, of which $5.7 million has been paid as of December 31, 2000.
Accordingly, the Company has recorded a charge to operations of $6.2 million as
of December 31, 1999. This amount represents the total amount due to the
European banks less the fair market value of the redemption of the common shares
previously considered outstanding by the Company.


Other
income decreased slightly to $380,000 for the year ended December 31, 2000. This
amount compares to $411,000 for the year ended December 31, 1999.


The
Company recognized an income tax benefit of $226,000 for the year ended December
31, 2000 as compared to a $2.5 million expense for the year ended 1999 as a
result of the sale of Star.


The
Company adopted Securities and Exchange Commission (SEC) Staff Accounting Bulletin
(SAB) No. 101, Revenue Recognition in Financial Statements. As a result of adopting SAB
101, the Company now records royalty income when received rather than when earned. In
accordance with SAB No. 101, the Company recorded the impact of adopting SAB No. 101 as a
cumulative catch-up adjustment, totaling $712,000, in the year ended December 31, 2000.


The
loss from discontinued operations of $435,000 for the year ended December 31,
1999 was due to a settlement related to the operations of a former subsidiary.




-12-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|(d) |  | Liquidity
and Capital Resources
|--- |  | -------------------------------

|As
of December 31, 2001, the Company had $5.8 million in cash and cash equivalents.
The successful sales and marketing of new products and an on-going royalty
stream will be critical to future liquidity.


The
Companys operating activities used cash of $9.2 million and $11.8 million
for the years ended December 31, 2001 and 2000, respectively. Net cash provided
during the year ended December 31, 2001 consisted primarily of a net loss from
operations, offset by depreciation and amortization, an increase in accounts
receivable, an increase in inventories, a decrease in other current assets, a
decrease in accounts payable, accrued liabilities and accrued income taxes and
an increase in deferred revenue. Net cash used for operating activities during
the year ended December 31, 2000 consisted primarily of a net loss from
operations, offset by depreciation and amortization, an increase in gain from
subsidiary, goodwill, asset and inventory write-offs, warrants issued for
investment banking services, a decrease in accounts receivable, an increase in
inventories, a decrease in receivable from sale of subsidiary, a decrease in
other current assets, an increase in accounts payable and accrued liabilities, a
decrease in accrued income taxes, deferred gain from subsidiary and deferred
revenue.


Investing
activities provided cash of $5.6 million and $19.7 million during the year ended
December 31, 2001 and 2000, respectively. During the year ended December 31,
2001, the principal uses were purchases of available-for-sale investments,
increases in other assets and purchases of property and equipment, offset by
proceeds from the sale of available-for-sale investments. During the year ended
December 31, 2000, the principal uses were purchases of available-for-sale
investments, purchases of property and equipment, offset by proceeds from the
sale of available-for-sale investments, proceeds from the sale of subsidiary and
a decrease in other assets.


Financing
activities used cash of $118,000 and $1.1 million during the year ended December
31, 2001 and 2000, respectively. During the year ended December 31, 2001, the
principal uses of cash used in financing activities consisted of proceeds from
the exercise of warrants, stock options and employee stock purchase plan,
proceeds from the issuance of notes payable to related party, offset by costs
incurred to issuance of common stock and payments on Swiss Franc convertible
debentures. During the year ended December 31, 2000, the principal uses of cash
used in financing activities consisted of proceeds from the exercise of
warrants, stock options and employee stock purchase plan, offset by costs
incurred to issuance of common stock and payments on Swiss Franc convertible
debentures.


The
Company anticipates that capital expenditures for 2002 will total $200,000,
consisting primarily of machinery, equipment, computers and peripherals. The
Company expects to finance these expenditures with cash on hand and equipment
leasing.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(e) |  | Recently
Issued Accounting Standards
|--- |  | ------------------------------------

|In
August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets.This statement supercedes FASB Statement No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of, and the accounting and reporting provisions of APB
Opinion No. 30, Reporting the Results of Operations, Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions. Under this statement it is required that
one accounting model be used for long-lived assets to be disposed of by sale,
whether previously held and used or newly acquired, and it broadens the
presentation of discontinued operations to include more disposal transactions.
The provisions of this statement are effective for financial statements issued
for fiscal years beginning after December 15, 2001, and interim periods within
those fiscal years, with early adoption permitted. The Company does not expect
the adoption of this statement to have a material impact on its results of
operations or financial position.



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

| |  | (i) |  | Derivative
Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments.
| |  | --- |  | ----------------------------------------------------------------------------------------------------

|SFAS
No. 107 requires disclosure about fair value of financial instruments. Financial
instruments consist of cash equivalents, accounts receivable, accounts payable
and short-term debt obligations. The fair value of these financial instruments
approximates their carrying amount as of December 31, 2001 due to their
short-term nature. All of the Companys investments are considered cash
equivalent money market accounts and debt securities which are considered
available-for-sale investments and are carried at market value, with the
difference between cost and market value, net of related tax effects, recorded
as a separate component of stockholders (deficit) equity. Accordingly, the
Company has no quantitative information concerning the market risk of
participating in such investments.


-13-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

| |  | (ii) |  | Primary
Market Risk Exposures.
| |  | ---- |  | ------------------------------

|The
Companys primary market risk exposures are in the areas of interest rate
risk. The Companys investment portfolio of cash equivalents and debt
securities is subject to interest rate fluctuations, but the Company believes
this risk is immaterial because of the short-term nature of these investments.
-14-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|
|

|Statement
under the Private Securities Litigation Reform Act


In
addition to the other information in this Form 10-K, the following cautionary
statements should be considered carefully in evaluating the Company and its
business. Statements contained in this Form 10-K that are not historical facts
and other information provided by the Company and its employees from time to
time may contain certain forward-looking information, as defined by (i) the
Private Securities Litigation Reform Act of 1995 (the Reform Act)
and (ii) releases by the SEC. Our actual results could differ materially from
those suggested in such forward-looking statements due to the risk factors
identified below and other factors including, without limitation, risks
concerning the timing of new product introductions, financing of future
operations, the Companys research partnership with MGH, manufacturing
risks, variations in our quarterly results, enforcement of intellectual property
rights by us and our competitors, the occurrence of unanticipated events and
circumstances, ability to maintain the NASDAQ minimum continued listing
requirements and general economic conditions, including stock market volatility.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which speak only as of the date hereof. The Company undertakes no
obligation to release publicly the results of any revisions to these
forward-looking statements that may be made to reflect events or circumstances
after the date hereof or to reflect the occurrence of unanticipated events. The
cautionary statements below are being made pursuant to the provisions of the
Reform Act and with the intention of obtaining the benefits of safe harbor
provisions of the Reform Act. Forward looking statements include statements
regarding our expectations, beliefs, intentions or strategies regarding the
future and can be identified by forward-looking words such as
anticipate, believe, could,
estimate, expect, intend, may,
should, will, and would or similar words.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|-15-
|----

|
|

|RISK FACTORS


Our future revenue
depends on our successfully developing and marketing new products.


We
face rapidly changing technology and continuing improvements in cosmetic laser /
light-based technology. In order to be successful, we must continue to make
significant investments in research and development in order to develop in a
timely and cost-effective manner new products that meet changing market demands,
to enhance existing products, and to achieve market acceptance for such
products. We have in the past experienced delays in developing and marketing new
products and enhancing existing products. Furthermore, some of our new products
under development are based on unproven technology and/or technology with which
the Company has no previous experience. Since the sale of Star to Coherent, our
revenues have almost entirely depended on sales of newly introduced products. In
addition, the market for hair removal laser / light-based devices may already be
saturated. At present, broad market acceptance of laser / light-based hair
removal is critical to our success. We intend to continue to diversify our
product line by developing cosmetic laser / light-based products for uses other
than hair and tattoo removal and treatment of pigmented and vascular lesions,
but there can be no assurance that we will be able to successfully implement
such strategy in a timely fashion or at all.




We face intense
competition from companies with superior financial, marketing and other
resources.


The
laser / light-based hair removal industry is highly competitive and companies
frequently introduce new products. We compete in the development, manufacture,
marketing and servicing of hair removal laser / light-based devices with
numerous other companies, some of which have substantially greater financial,
marketing and other resources than we do. As a result, some of our competitors
are able to sell hair removal laser / light-based devices at prices
significantly below the prices at which we sell our products. In addition, as a
result of the Star sale to Coherent and its subsequent re-sale to Lumenis,
Lumenis is now a stronger competitor and we have had to find new ways to
distribute our products. We currently have no significant direct or indirect
sales force in place for our new products. Our products also face competition
from alternative medical products and procedures, such as electrolysis and
waxing, among others. We may not be able to differentiate our products from the
products of our competitors, and customers may not consider our products to be
superior to competing products or medical procedures, especially if competitive
products and procedures are offered at lower prices. Our competitors may develop
products or new technologies that make our products obsolete or less
competitive.


We may need to secure
additional financing, and our auditors have expressed doubt about our ability to
continue as a going concern.


We
have a history of losses. As a result, the report of our independent public
accountants in connection with our Consolidated Balance Sheets as of
December 31, 2000 and 2001, and the related Consolidated Statements of
Operations, Stockholders Equity (Deficit) and Cash Flows for the three
years ended December 31, 2001 includes an explanatory paragraph stating that our
recurring losses, and cash flow from operations raises substantial doubts about
our ability to continue as a going concern. We may have to secure additional
financing to complete our research and development activities, commercialize our
current and proposed cosmetic laser / light-based products, and fund ongoing
operations. However, there can be no assurance that such financing will be
obtained. We may also determine, depending upon the opportunities available, to
seek additional debt or equity financing to fund the costs of operations or
expansion. Additionally, if we incur indebtedness to fund increased levels of
accounts receivable, finance the acquisition of capital equipment, or if we
issue debt securities in connection with any acquisition we will be subject to
risks associated with incurring substantial additional indebtedness.


Our quarterly operating
results have decreased as a result of the Star sale, and that may hurt the price
of our common stock.


Almost
all of our revenues in 1999 were attributable to sales of the LightSheer diode
laser system manufactured by Star. Therefore, as a result of the Star sale, our
revenues declined significantly. If our operating results fall below the
expectations of investors or public market analysts, the price of our common
stock could decline.



We could be
delisted from NASDAQ.


For
continued listing on The NASDAQ SmallCap Market, a company must maintain a
minimum bid price of $1.00 per share. A company must also maintain a minimum
requirement of net tangible assets of $2.5 million or market capitalization of
$35 million or net income (in latest fiscal year or 2 of the last 3 fiscal
years) of $500,000. In March 1999, NASDAQ held a hearing regarding our continued
listing on The NASDAQ SmallCap Market in light of the fact that our common stock
had traded below the $1.00 minimum bid price requirement for longer than 30
trading days. As a result of our reverse stock split, we regained compliance
with the minimum bid price requirement before that date, and are now in
compliance with all of NASDAQs requirements for continued listing on The
NASDAQ SmallCap Market. However, there can be no assurance that we will remain
in compliance with NASDAQs criteria for continued listing or that we will
remain listed on NASDAQ. The delisting of our common stock would likely reduce
the liquidity of our common stock and our ability to raise capital. If our
common stock is delisted from The NASDAQ SmallCap Market, it will likely be
quoted on the pink sheets maintained by the National Quotation
Bureau, Inc. or NASDAQs OTC Bulletin Board. These listings can make
trading more difficult for stockholders.


-16-
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We depend on a number of
vendors for critical components in our current and future products.


We
develop laser / light-based systems that incorporate third-party components.
Some of these items are custom made or otherwise not readily available on the
market. We purchase some of these components from small, specialized vendors
that are not well capitalized. A disruption in the delivery of these key
components could have an adverse effect on our business.


Our products are subject
to numerous medical device regulations. Compliance is expensive and
time-consuming. Our new products may not be able to obtain the necessary
clearances in order to sell them.


All
of our current products are laser / light-based medical devices which are
subject to FDA regulations for clinical testing, manufacturing, labeling, sale,
distribution and promotion. Before a new product or a new use of or claim for an
existing product can be introduced into the market, we must obtain clearance
from the FDA. Our products may also be subject to state regulations, which are,
in many instances, in a state of flux. Changes in state regulations may enhance
or impede sales. Our products are subject to similar regulations in our major
international markets. Complying with these regulations is necessary for our
strategy of expanding the markets for and sales of our products into these
countries. Compliance with the regulatory clearance process in any country is
expensive and time-consuming, and we may not be able to obtain such clearances
in a timely fashion or at all. Regulatory clearances may necessitate clinical
testing, limitations on the number of sales and limitations on the type of end
user, among other things. In certain instances, these constraints can delay
planned shipment schedules as design and engineering modifications are made in
response to regulatory concerns and requests.



We are
dependent on third-party researchers.


We
are substantially dependent upon third-party researchers over whom we do not
have absolute control to satisfactorily conduct and complete research on our
behalf. We are also substantially dependent upon 3rd party
researchers to grant us licensing terms, which may or may not be favorable for
products and technology, which they may develop. At present, our principal
research partner is the Wellman Laboratories of Photomedicine at Massachusetts
General Hospital. We provide research funding, laser technology and optics
know-how in return for licensing rights with respect to specific medical
applications and patents. Our success will be highly dependent upon the results
of this research. We cannot be sure that such research agreements will provide
us with marketable products in the future or that any of the products developed
under these agreements will be profitable for us.


Our common stock could
be further diluted as the result of outstanding, convertible securities,
warrants and options.


In
the past, we have issued convertible securities, such as debentures, preferred
stock and warrants, in order to raise money. We have also issued options and
warrants as compensation for services and incentive compensation for our
employees and directors. We have a substantial number of shares of common stock
reserved for issuance upon the conversion and exercise of these securities.
These outstanding convertible securities, options and warrants could dilute
our stockholders, and could adversely affect the market price of our
common stock.


Our proprietary
technology has only limited protections.


Our
business could be materially and adversely affected if we are not able to
adequately protect our intellectual property rights. We rely on a combination of
patent, copyright, trademark and trade secret laws, license and confidentiality
agreements to protect our proprietary rights. We generally enter into
non-disclosure agreements with our employees and third parties with which we
work, including but not limited to consultants and vendors, to restrict access
to, and distribution of, our proprietary information. Despite our efforts to
protect our proprietary rights, unauthorized parties may attempt to copy or
otherwise obtain and use our technology. Monitoring unauthorized use of our
technology is difficult and we cannot be certain that the steps we have taken
will prevent unauthorized use of our technology, particularly in foreign
countries where the laws may not protect our proprietary rights as fully as in
the United States. If competitors are able to use our technology, our ability to
compete effectively could be harmed. Costly and time consuming lawsuits may be
necessary to enforce patents issued or licensed exclusively to us, to protect
our trade secrets and/or know-how or to determine the enforceability, scope and
validity of others intellectual property rights. Our competitors also may
independently develop technologies that are substantially equivalent or superior
to our technology.


-17-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We could become subject
to claims by third parties regarding intellectual property rights.


In recent
years, there has been significant litigation in the United States involving
patents and other intellectual property rights. The medical laser / light-based
industry in particular is characterized by the large number of patents and
frequent claims and related litigation regarding patent and other intellectual
property rights. Because patent applications are maintained in secrecy for a
period of time, we can conduct only limited searches to determine whether our
technology infringes any patents or patent applications. Any claims for patent
infringement, regardless of merit, could be time-consuming, result in costly
litigation and diversion of technical and management personnel, cause shipment
delays, require us to develop non-infringing technology or to enter into royalty
or licensing agreements. Although patent and intellectual property disputes in
the laser / light-based industry have often been settled through licensing or
similar arrangements, costs associated with such arrangements may be substantial
and often require the payment of ongoing royalties, which could have a negative
impact on gross margins. There can be no assurance that necessary licenses would
be available to us on satisfactory terms, or that we could redesign our products
or processes to avoid infringement, if necessary. Accordingly, an adverse
determination in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent us from manufacturing and selling some of our
products. This could have a material adverse effect on our business, results of
operations and financial condition.


Our charter documents
and Delaware law may discourage potential takeover attempts.


Our
Second Restated Certificate of Incorporation and our By-laws contain provisions
that could discourage takeover attempts or make more difficult the acquisition
of a substantial block of our common stock. Our By-laws require a stockholder to
provide to the Secretary of the Company advance notice of director nominations
and business to be brought by such stockholder before any annual or special
meeting of stockholders, as well as certain information regarding such
nomination and/or business, the stockholder and others known to support such
proposal and any material interest they may have in the proposed business. They
also provide that a special meeting of stockholders may be called only by the
affirmative vote of a majority of the Board of Directors. These provisions could
delay any stockholder actions that are favored by the holders of a majority of
the outstanding stock of the Company until the next stockholders meeting.
In addition, the Board of Directors is authorized to issue shares of common
stock and preferred stock that, if issued, could dilute and adversely affect
various rights of the holders of common stock and, in addition, could be used to
discourage an unsolicited attempt to acquire control of the Company.


The
Company is also subject to the anti-takeover provisions of Section 203 of the
Delaware General Corporation Law, which prohibits the Company from engaging in a
business combination with an interested stockholder for
a period of three years after the date of the transaction in which the person
becomes an interested stockholder, unless the business combination is approved
in a prescribed manner. The application of Section 203 may limit the ability of
stockholders to approve a transaction that they may deem to be in their best
interests. These provisions of our Second Restated Certificate of Incorporation,
By-laws and the Delaware General Corporation Law could deter certain takeovers
or tender offers or could delay or prevent certain changes in control or
management of the Company, including transactions in which stockholders might
otherwise receive a premium for their shares over the then current market
prices.


As with any new
products, there is substantial risk that the marketplace may not accept or be
receptive to the potential benefits of our products.


Market
acceptance of our current and proposed products will depend, in large part, upon
our or any marketing partners ability to demonstrate to the marketplace
the advantages of our products over other types of products. There can be no
assurance that the marketplace will accept applications or uses for our current
and proposed products or that any of our current or proposed products will be
able to compete effectively.


-18-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|We may not be able to
successfully collect licensing royalties.


At
present, material portions of our revenues consist of royalties from licensing
patents licensed to us on an exclusive basis by Massachusetts General Hospital.
However, there can be no assurance that these royalty amounts will not decrease
or that we will be able to collect all licensing royalties owed by current
licensees or increase royalties by licensing additional third parties.


We face risks associated
with pending litigation.


We
are involved in disputes with third parties. Such disputes have resulted in
litigation with such parties. We have incurred, and likely will continue to
incur, legal expenses in connection with such matters. There can be no assurance
that such litigation will result in favorable outcomes for us. Any adverse
result in litigation could have a material adverse effect on our business,
financial condition and results of operations.


We may not be able to
retain our key executives and research and development personnel.


As
a small company with less than 100 employees, our success depends on the
services of key employees in executive and research and development positions.
The loss of the services of one or more of these employees could have a material
adverse effect on our business.


We face a risk of
financial exposure to product liability claims in the event that the use of our
products results in personal injury.


Our
products are and will continue to be designed with numerous safety features, but
it is possible that patients could be adversely affected by use of one of our
products. Further, in the event that any of our products prove to be defective,
we may be required to recall and redesign such products. Although we have not
experienced any material losses due to product liability claims to date, there
can be no assurance that we will not experience such losses in the future. We
maintain general liability insurance in the amount of $1 million per occurrence
and $2 million in the aggregate and maintain umbrella coverage in the aggregate
amount of $25 million; however, there can be no assurance that such coverage
will continue to be available on terms acceptable to us or that such coverage
will be adequate for liabilities actually incurred. In the event we are found
liable for damages in excess of the limits of our insurance coverage or if any
claim or product recall results in significant adverse publicity against us, our
business, financial condition and results of operations could be materially and
adversely affected. In addition, although our products have been and will
continue to be designed to operate in a safe manner, and although we attempt to
educate customers with respect to the proper use of our products, misuse of our
products by personnel over whom we cannot exert control may result in the filing
of product liability claims or significant adverse publicity against us.



We face risks
associated with revenues.


There
can be no certainty as to the severity or duration of the current economic
downturn and its impact on our future revenues.


We face risks associated
with liquidity and capital resources.


There
can be no assurance that we will not require additional financing to fund our
operations or that such additional funding, if needed, will be available on
terms acceptable to us or at all.



We may be unable to
generate sufficient revenues to achieve profitability.


-19-
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|There
can be no assurance that our revenues will increase or that we will generate
sufficient revenues to achieve or sustain profitability. While we strive to
minimize the Companys business expenses, we will continue to have large
fixed expenses and we expect to continue to incur significant sales and
marketing, product development, customer support and service, administrative and
other expenses. As a result, we need to generate significantly higher revenue to
achieve and maintain profitability.


Terrorist acts and acts
of war may seriously harm our business and revenues, costs and expenses and
financial condition.


Terrorist
acts or acts of war (wherever located around the world) may cause damage or
disruption to Palomar, our employees, facilities, partners, suppliers,
distributors, resellers, or customers, which could significantly impact our
revenues, costs and expenses and financial condition. The terrorist attacks that
took place in the United States on September 11, 2001 were unprecedented events
that have created many economic and political uncertainties, some of which may
materially harm our business and results of operations. The long-term effects on
our business of the September 11, 2001 attacks are unknown. The potential for
future terrorist attacks, the national and international responses to terrorist
attacks, and other acts of war or hostility have created many economic and
political uncertainties, which could adversely affect our business and results
of operations in ways that cannot presently be predicted.




-20-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Item 8.
Financial Statements.


PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES



INDEX TO
CONSOLIDATED FINANCIAL STATEMENTS
|---------------------------------------------------------------------------------------------------------------------------------

|Report of Independent Public Accountants                                                         |  | 22 | 
|------------------------------------------------------------------------------------------------ |  | -- | 
|                                                                                                
|Consolidated Balance Sheets as of December 31, 2000 and 2001                                     |  | 23 | 
|                                                                                                
|Consolidated Statements of Operations for the Years Ended December 31, 1999,                     | 
|2000 and 2001                                                                                    |  | 24 | 
|                                                                                                
|Consolidated Statements of Stockholders Equity (Deficit) for the Years Ended December 31, 1999, | 
|2000 and 2001                                                                                    |  | 25 | 
|                                                                                                
|Consolidated Statements of Cash Flows for the Years Ended December 31, 1999,                     | 
|2000 and 2001                                                                                    |  | 26 | 
|                                                                                                
|Notes to Consolidated Financial Statements                                                       |  | 27 | 

|-21-
|----

|REPORT OF
INDEPENDENT PUBLIC ACCOUNTANTS


To Palomar Medical Technologies, Inc:


We
have audited the accompanying consolidated balance sheets of Palomar Medical
Technologies, Inc. (a Delaware corporation) and subsidiaries as of December 31,
2000 and 2001 and the related consolidated statements of operations,
stockholders equity (deficit) and cash flows for each of the three years
in the period ended December 31, 2001. These financial statements are the
responsibility of the Companys management. Our responsibility is to
express an opinion on these financial statements based on our audits.


We
conducted our audits in accordance with auditing standards generally accepted in
the United States. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.


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


The
accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern. As discussed in Note 1 to the
consolidated financial statements, the Company has suffered recurring losses
from operations that raise substantial doubt about the Companys ability to
continue as a going concern. Managements plans in regard to these matters
are also described in Note 1 to the consolidated financial statements. The
accompanying consolidated financial statements do not include any adjustments
that might result from the outcome of this uncertainty.


As
explained in Note 2(h) to the consolidated financial statements, effective
January 1, 2000, the Company changed its method of accounting for revenue
recognition for royalties through the adoption of Staff Accounting Bulletin No.
101, Revenue Recognition in Financial Statements.


/s/ ARTHUR ANDERSEN LLP





Boston, MassachusettsJanuary 29, 2002


-22-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES



CONSOLIDATED
BALANCE SHEETS
|----------------------------------------------------------------------------------

|                                                                   | December 31,2000 | December 31,2001
|------------------------------------------------------------------ | ---------------- | ----------------
|ASSETS                                                            
|                                                                   |                  |                 
|Current Assets:                                                    |                 
|Cash and cash equivalents                                          |                  | $     9,535,694 
|Available-for-sale investments, at market value                    |                  | 5,868,213       
|Accounts receivable, net of allowance for doubtful accounts of     |                 
|approximately $306,000 and $397,000 in 2000 and 2001, respectively |                  | 1,613,150       
|Inventories                                                        |                  | 2,411,526       
|Other current assets                                               |                  | 569,898         
|                                                                   |                  |                 
|Total current assets                                               |                  | 19,998,481      
|                                                                   |                  |                 
|Property and Equipment, Net                                        |                  | 879,156         
|                                                                   |                  |                 
|Other Assets                                                       |                  | 122,024         
|                                                                   |                  |                 
|                                                                   |                  | $   20,999,661  
|                                                                   |                  |                 
|LIABILITIES AND STOCKHOLDERS EQUITY                              
|                                                                  
|Current Liabilities:                                               |                 
|Current portion of long-term debt                                  |                  | $        951,842
|Note payable to related party                                      |                  |                
|Accounts payable                                                   |                  | 2,139,150       
|Accrued liabilities                                                |                  | 5,934,232       
|Accrued income taxes                                               |                  | 1,822,146       
|Deferred revenue                                                   |                  | 286,907         
|                                                                   |                  |                 
|Total current liabilities                                          |                  | 11,134,277      
|                                                                   |                  |                 
|Long-Term Debt, Net of Current Portion                             |                  | 500,000         
|                                                                   |                  |                 
|Commitments and Contingencies (Note 9)                             |                 
|Stockholders Equity:                                              |                 
|Preferred stock, $.01 par value-                                   |                 
|Authorized - 1,500,000 shares                                      |                 
|Issued and outstanding -                                           |                 
|6,000 shares at December 31, 2000 and 2001                         |                 
|(Liquidation preference of $7,785,450 and $8,177,717 as of         |                 
|December 31, 2000 and 2001, respectively)                          |                  | 60              
|Common stock, $.01 par value-                                      |                 
|Authorized - 45,000,000 shares                                     |                 
|Issued - 11,074,393 shares                                         |                 
|at December 31, 2000 and 2001, respectively                        |                  | 110,744         
|Additional paid-in capital                                         |                  | 163,561,833     
|Accumulated deficit                                                |                  | (151,505,342    
|Unrealized loss on available-for-sale investments                  |                  | (2,836          
|Less: Treasury stock - 763,835 and 573,031 shares at cost          |                 
|at December 31, 2000 and 2001, respectively                        |                  | (2,799,075      
|                                                                   |                  |                 
|Total stockholders equity                                         |                  | 9,365,384       
|                                                                   |                  |                 
|                                                                   |                  | $   20,999,661  
|                                                                   |                  |                 

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




-23-
|------------------------------------------------------------------------------------------------

|PALOMAR MEDICAL
TECHNOLOGIES, INC. AND SUBSIDIARIES



CONSOLIDATED
STATEMENTS OF OPERATIONS
|--------------------------------------------------------------------------------------------

|                                                          | Years Ended December 31,
|--------------------------------------------------------- | ------------------------
|
|Product revenues                                          |                         
|Royalty revenues                                          |                         
|                                                          |                         
|Total Revenues                                            |                         
|                                                          |                         
|Cost of product revenues                                  |                         
|Cost of royalty revenues                                  |                         
|                                                          |                         
|Total Cost of Revenues                                    |                         
|                                                          |                         
|Gross profit                                              |                         
|                                                          |                         
|Operating Expenses (Income)                               |                         
|Research and development                                  |                         
|Sales and marketing                                       |                         
|General and administrative                                |                         
|Goodwill and asset write-off (Note 2)                     |                         
|Costs incurred for proxy contest                          |                         
|Settlement and litigation costs                           |                         
|Gain from sale of subsidiary (Note 1)                     |                         
|                                                          |                         
|Total operating (income) expenses                         |                         
|                                                          |                         
|Income (loss) from operations                             |                         
|                                                          |                         
|Interest Expense                                          |                         
|                                                          |                         
|Interest Income                                           |                         
|                                                          |                         
|Swiss Franc Redemption (Note 9)                           |                         
|                                                          |                         
|Other Income, Net                                         |                         
|                                                          |                         
|Income (Loss) from Continuing Operations                  |                         
|Before Provision (Benefit) from Income Taxes              |                         
|                                                          |                         
|Provision (Benefit) for Income Taxes                      |                         
|                                                          |                         
|Net Income (Loss) from Continuing Operations              |                         
|                                                          |                         
|Cumulative Effect of Change in Accounting Method (Note 2) |                         
|                                                          |                         
|Loss from Discontinued Operations (Note 11)               |                         
|                                                          |                         
|Net Income (Loss)                                         |                         
|                                                          |                         
|Basic Net Income (Loss) Per Share:                        |                         
|Continuing operations                                     |                         
|Cumulative effect of change in accounting method          |                         
|Discontinued operations                                   |                         
|                                                          |                         
|Total Basic Net Income (Loss) Per Share                   |                         
|                                                          |                         
|Basic Weighted Average Number of Shares Outstanding       |                         
|                                                          |                         
|Diluted Net Income (Loss) Per Share:                      |                         
|Continuing operations                                     |                         
|Cumulative effect of change in accounting method          |                         
|Discontinued operations                                   |                         
|                                                          |                         
|Total Diluted Net Income (Loss) Per Share                 |                         
|                                                          |                         
|Diluted Weighted Average Number of Shares Outstanding     |                         
|                                                          |                         

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



-24-
|-----------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES



CONSOLIDATED
STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)
|----------------------------------------------------------------------------------------------------------------

|                                                                               | Preferred Stock | Common Stock | Treasury Stock | Additional | Accumulated Other | Total      |  |         
|------------------------------------------------------------------------------ | --------------- | ------------ | -------------- | ---------- | ----------------- | ---------- |  | --------
|
|                                                                               |                 |             
|Balance, December 31, 1998                                                     |                 | 6,993        |                | $ 69       |                   | 10,074,864 |  | $100,747
|                                                                               |                
|Net income                                                                     |                 |             |                |           |                   |           |  |        
|Issuance of stock for Employee Stock Purchase Plan                             |                 |             |                |           |                   | 10,118     |  | 103     
|Issuance of common stock for 1998 employer 401(k       matching contribution   |                 |             |                |           |                   | 32,561     |  | 326     
|Conversion of preferred stock                                                  |                 | (340         | )              | (3         | )                 | 74,905     |  | 749     
|Conversion of convertible debentures                                           |                 |             |                |           |                   | 377,760    |  | 3,778   
|Redemption of preferred stock                                                  |                 | (653         | )              | (6         | )                 |           |  |        
|Redemption of common stock related to Swiss Franc       convertible debentures |                 |             |                |           |                   |           |  |        
|Purchase of stock for treasury                                                 |                 |             |                |           |                   |           |  |        
|Issuance of escrow shares to treasury                                          |                 |             |                |           |                   | 464,285    |  | 4,642   
|Costs incurred related to the issuance of common stock                         |                 |             |                |           |                   |           |  |        
|Unrealized loss on available-for-sale investments                              |                 |             |                |           |                   |           |  |        
|                                                                               |                
|Comprehensive Income                                                           |                 |              | $ 24,997,947   |           
|                                                                               |                
|Preferred stock dividends                                                      |                 |             |                |           |                   |           |  |        
|                                                                               |                 |             
|Balance, December 31, 1999                                                     |                 | 6,000        |                | 60         |                   | 11,034,493 |  | 110,345 
|                                                                               |                
|Net loss                                                                       |                 |             |                |           |                   |           |  |        
|Issuance of stock for Employee Stock Purchase Plan                             |                 |             |                |           |                   |           |  |        
|Issuance of stock for 1999 employer 401(k) matching contribution               |                 |             |                |           |                   |           |  |        
|Exercise of stock options                                                      |                 |             |                |           |                   | 39,900     |  | 399     
|Fair value of warrants issued for investment banking services                  |                 |             |                |           |                   |           |  |        
|Costs incurred from issuance of treasury stock for settlement                  |                 |             |                |           |                   |           |  |        
|Costs incurred related to the issuance of common stock                         |                 |             |                |           |                   |           |  |        
|Unrealized gain on available-for-sale investments                              |                 |             |                |           |                   |           |  |        
|                                                                               |                
|Comprehensive Income                                                           |                 |              | $(9,521,827    | )         
|                                                                               |                
|Preferred stock dividends                                                      |                 |             |                |           |                   |           |  |        
|                                                                               |                 |             
|Balance, December 31, 2000                                                     |                 | 6,000        |                | 60         |                   | 11,074,393 |  | 110,744 
|                                                                               |                
|Net loss                                                                       |                 |             |                |           |                   |           |  |        
|Issuance of stock for Employee Stock Purchase Plan                             |                 |             |                |           |                   |           |  |        
|Issuance of stock for 2000 employer 401(k) matching contribution               |                 |             |                |           |                   |           |  |        
|Costs incurred related to the issuance of common stock                         |                 |             |                |           |                   |           |  |        
|Unrealized gain on available-for-sale investments                              |                 |             |                |           |                   |           |  |        
|                                                                               |                
|Comprehensive Income                                                           |                 |              | $(5,467,733    | )         
|                                                                               |                
|Preferred stock dividends                                                      |                 |             |                |           |                   |           |  |        
|                                                                               |                 |              |                |           
|Balance, December 31, 2001                                                     |                 | 6,000        |                | $ 60       |                   | 11,074,393 |  | $110,744
|                                                                               |                 |              |                |           

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



-25-
|-----------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES




CONSOLIDATED
STATEMENTS OF CASH FLOWS
|---------------------------------------------------------------------------------------------

|                                                                       | Year Ended December 31,
|---------------------------------------------------------------------- | -----------------------
|                                                                      
|
|Cash Flows from Operating Activities:                                  |                        
|Net income (loss)                                                      |                        
|Less:  Net loss from discontinued operations                           |                        
|                                                                       |                        
|Net income (loss) from continuing operations                           |                        
|                                                                       |                        
|Adjustments to reconcile net income (loss) to net cash used            |                        
|in operating activities-                                               |                        
|Depreciation and amortization                                          |                        
|Gain from sale of subsidiary                                           |                        
|Goodwill and asset write-off                                           |                        
|Inventory write-off                                                    |                        
|Unrealized foreign currency exchange loss on foreign debt              |                        
|Redemption of common stock held by Swiss Franc debenture holders       |                        
|Fair value of warrants issued for investment banking services          |                        
|Changes in assets and liabilities                                      |                        
|Accounts receivable                                                    |                        
|Inventories                                                            |                        
|Receivable from sale of subsidiary                                     |                        
|Other current assets                                                   |                        
|Accounts payable                                                       |                        
|Accrued liabilities                                                    |                        
|Accrued income taxes                                                   |                        
|Deferred gain from sale of subsidiary                                  |                        
|Deferred revenue                                                       |                        
|                                                                       |                        
|Net cash used in operating activities                                  |                        
|                                                                       |                        
|Cash Flows from Investing Activities:                                  |                        
|Purchases of property and equipment                                    |                        
|Purchases of available-for-sale investments                            |                        
|Proceeds from sale of available-for-sale investments                   |                        
|Proceeds from the sale of subsidiary, net of cash on hand $288,000     |                        
|Proceeds from the sale of building                                     |                        
|Decrease (increase) in other assets                                    |                        
|                                                                       |                        
|Net cash provided by investing activities                              |                        
|                                                                       |                        
|Cash Flows from Financing Activities:                                  |                        
|Proceeds from notes payable and advances from distributor              |                        
|Proceeds from the exercise of warrants, stock options                  |                        
|and Employee Stock Purchase Plan                                       |                        
|Costs incurred related to issuance of common stock                     |                        
|Proceeds on line of credit                                             |                        
|Payments on line of credit                                             |                        
|Purchase of treasury stock                                             |                        
|Payment on note payable                                                |                        
|Proceeds from the issuance of notes payable to related party           |                        
|Redemption of preferred stock                                          |                        
|Payments on Swiss Franc convertible debentures                         |                        
|                                                                       |                        
|Net cash used in financing activities                                  |                        
|                                                                       |                        
|Net increase (decrease) in cash and cash equivalents                   |                        
|Net cash used in discontinued operations                               |                        
|Cash and cash equivalents, beginning of the period                     |                        
|                                                                       |                        
|Cash and cash equivalents, end of the period                           |                        
|                                                                       |                        
|Supplemental Disclosure of Cash Flow Information:                      |                        
|Cash paid for interest                                                 |                        
|                                                                       |                        
|Supplemental Disclosure of Noncash Financing and Investing Activities: |                        
|Conversion of convertible debentures and related accrued               |                        
|interest , net of financing fees                                       |                        
|                                                                       |                        
|Conversion of preferred stock                                          |                        
|                                                                       |                        
|Issuance of stock for 1998, 1999 and 2000 employer 401 (k)             |                        
|matching contribution                                                  |                        
|                                                                       |                        
|Unrealized (gain) loss on available-for-sale investments               |                        
|                                                                       |                        
|Accrued dividends and interest on preferred stock                      |                        
|                                                                       |                        
|Costs incurred from the issuance of treasury stock for settlement      |                        
|                                                                       |                        

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



-26-
|-----------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES




NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS


(1)
Organization and Operations


Palomar
Medical Technologies, Inc. and subsidiaries (Palomar or the
Company) are engaged in the commercial sale and development of cosmetic
and medical laser / light-based systems and services. The Companys medical
laser products are in various stages of development; accordingly, the success of
future operations is subject to a number of risks similar to companies in
similar stages of development. Principal among these risks are the need for
successful development and marketing of the Companys products, the need
for regulatory approval, the need to achieve profitable operations, competition
from substitute products and larger companies, the need for successful funding
of future operations, and dependence on key individuals.


On
December 7, 1998, the Company entered into an Agreement and Plan of
Reorganization (the Agreement) with Coherent / Lumenis
(Coherent) to sell all of the issued and outstanding common stock of
Star, Palomars majority-owned subsidiary, to Coherent. When all of the
outstanding options under Stars Stock Option Plan were exercised, the
Company owned 82.46% of Stars common stock and the employees of Star,
collectively, owned 17.54%. This sale was approved by a majority of the
stockholders of Palomar on April 21, 1999. On April 27, 1999, the Company
completed the sale of Star to Coherent and received net proceeds of $49,736,023.
Additionally, $3,254,907 was held in escrow until April 27, 2000 as security for
any claims that Coherent may have had under the Agreement. During 2000, in
connection with the lapse of the escrow period, the Company recognized a
deferred gain of $2,439,556, net of certain commitments and contingencies
related to the sale.


The
gain on the sale of Star for 1999 is calculated as follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                 | 
|---------------------------------------------------------------- | 
|Cash Received, Net of $965,000 of Bonuses Paid to Star Employees | 
|Plus:  Net Liabilities Divested                                  | 
|                                                                 | 
|Gain on Sale Before Expenses                                     | 
|Less:  Expenses                                                  | 
|                                                                 | 
|Net Gain on Sale of Subsidiary                                   | 
|                                                                 | 

|Under
the terms of the Agreement, the Company will receive an ongoing royalty of 7.5%
from Coherent on the sale of any products by Coherent that incorporate certain
patented technology or use certain patented methods currently licensed by the
Company on an exclusive basis from Massachusetts General Hospital
(MGH). Portions of these royalty proceeds are remitted to MGH. For
the years ended December 31, 1999, 2000, the Company recognized royalty revenue
from Coherent of $1,837,250, $3,836,875, respectively, and for the year ended
December 31, 2001, the Company recognized royalty revenue from Coherent of
$3,398,253 (of which $1,221,859 was from back owed royalties) and $1,533,315
from ESC Medical who acquired Coherent Medical Group and formed Lumenis, Inc.
The Company recognized a cost of royalty to MGH of $734,900, $1,534,750 and
$1,972,627, respectively. The Company will receive an on-going royalty rate of
7.5% from Lumenis for the sale of the LightSheer.


The
Company has incurred significant losses since inception. The Company continues
to seek additional financing from issuances of common stock and / or other
potential sources in order to fund its operations over the next twelve months.
The Company has financed current operations primarily through the private sale
of debt and equity securities of the Company. Net cash used in financing
activities totaled $9.6 million, $1.1 million and $118,000 for the years ended
December 31, 1999, 2000 and 2001, respectively. Net cash used in operating
activities totaled $14.2 million, $11.8 million and $9.2 million for the years
ended December 31, 1999, 2000 and 2001, respectively. The Company believes that
it will require additional financing during the next twelve-month period to
continue to fund operations and growth. This additional financing could be in
the form of sales of securities to private investors, which are generally sold
at a discount to the publicly quoted market price for similar securities. It has
been the Companys experience that private investors require that the
Company make its best effort to register these securities for re-sale to the
public at some future time.


(2) Summary of
Significant Accounting Policies


The
accompanying consolidated financial statements reflect the application of
certain accounting policies described below and elsewhere in the Notes to
Consolidated Financial Statements.


-27-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES



NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|------------------------------------------------------------------------------------------------------------

| |  | (a) |  | Principles
of Consolidation
| |  | --- |  | ---------------------------

|The
accompanying consolidated financial statements reflect the consolidated
financial position, results of operations and cash flows of the Company and all
wholly owned and majority-owned subsidiaries. All investments of which the
Company owns less than 20% of the common stock are accounted for using the cost
method. All intercompany transactions have been eliminated in consolidation.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (b) |  | Management
Estimates
| |  | --- |  | --------------------

|The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (c) |  | Investments
| |  | --- |  | -----------

|The
Company accounts for marketable debt securities in accordance with Statement of
Financial Accounting Standards (SFAS) No. 115, Accounting for
Certain Investments in Debt and Equity Securities. The Companys
marketable debt securities, all of which have maturities within one year, are
considered available-for-sale investments in the accompanying balance sheets and
are carried at market value, with the difference between cost and market value,
net of related tax effects, recorded as a separate component of
stockholders equity. The aggregate market value, cost basis, and gross
unrealized losses of available-for-sale investments are as follows:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     
|---------------------
|
|Market Value         
|                     
|Cost Basis           
|                     
|Gross Unrealized Loss
|                     

|Available-for-sale
investments in the accompanying balance sheet at December 31, 2000 include debt
securities of $5,868,213. Actual maturities may differ from contractual
maturities as a result of the Companys intent to sell these securities
prior to maturity and as a result of call features of the securities that enable
either the Company, the issuer, or both to redeem these securities at an earlier
date. Unrealized holding gains totaling $65,107 and $2,836 on such debt
securities were recorded in stockholders equity during the twelve months
ended December 31, 2000 and 2001, respectively.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (d) |  | Inventories
| |  | --- |  | -----------

|Inventories
are stated at the lower of cost (first-in, first-out) or market. At December 31,
2000 and 2001, inventories consist of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------

|               
|---------------
|
|
|Raw materials  
|Work-in-process
|Finished goods 
|               
|               
|               

|-28-
|----

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES



NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|------------------------------------------------------------------------------------------------------------

| |  | (e) |  | Depreciation
and Amortization
| |  | --- |  | -----------------------------

|The
Company provides for depreciation and amortization on property and equipment
using the straight-line method by charging to operations amounts that allocate
the cost of assets over their estimated useful lives.


At
December 31, 2000 and 2001, property and equipment consist of the following:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                               
|-------------------------------
|
|
|Machinery and equipment        
|Furniture and fixtures         
|Leasehold improvements         
|                               
|                               
|Less:  Accumulated depreciation
|and amortization               
|                               
|                               
|                               

|During
2000, the Company determined that the carrying value of certain equipment
related to past generation products being phased out had been impaired and,
accordingly, wrote-off $223,715 of such equipment.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (f) |  | Cost
in Excess of Net Assets Acquired
| |  | --- |  | -------------------------------------

|The
costs in excess of net assets for acquired businesses were being amortized on a
straight-line basis over five to seven years. Amortization expense for the years
ended December 31, 1999, 2000 and 2001 amounted to approximately $252,000, $0
and $0 respectively, and is included in general and administrative expenses in
the consolidated statements of operations.


The
Company assesses the realizability of intangible assets in accordance with SFAS
No. 121, Accounting for the Impairment Of Long-Lived Assets And For
Long-Lived Assets To Be DisposedOf. Under SFAS No. 121, the Company is
required to assess the valuation of its long-lived assets, including intangible
assets, based on the estimated undiscounted cash flows to be generated by such
assets. During the year ended December 31, 2000, the Company made a
determination that goodwill related to certain past generation products being
phased out had been impaired and, accordingly, wrote-off $522,089 of such
goodwill.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (g) |  | Deferred
Financing Costs
| |  | --- |  | ------------------------

|The
Company incurred financing costs related to several issuances of convertible
debentures. Deferred financing costs are amortized by a charge to interest
expense over the period that the debt is outstanding. Any remaining unamortized
deferred financing costs are charged to additional paid-in-capital upon
conversion (see Note 10(a)).


-29-
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES



NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|------------------------------------------------------------------------------------------------------------

| |  | (h) |  | Revenue
Recognition
| |  | --- |  | -------------------

|The
Company recognizes product revenues upon shipment and acceptance. Provisions are
made at the time of revenue recognition for any applicable warranty costs
expected to be incurred. Revenues from services are recognized in the period the
services are provided.


During
the quarter ended June 30, 2000, the Company adopted Securities and Exchange
Commission (SEC) Staff Accounting Bulletin (SAB) No. 101, Revenue
Recognition in Financial Statements.As a result of adopting SAB No. 101,
the Company now recognizes royalty revenues when received rather than when
earned. In accordance with SAB No. 101, the Company recorded the impact of
adopting SAB No. 101 as a cumulative catch-up adjustment to income, effective
January 1, 2000. The impact of adopting SAB No. 101 for the twelve months ended
December 31, 2000 was to increase net income before the cumulative effect of
change in accounting method by approximately $140,000 ($0.01 per share).


If
SAB 101 had been adopted effective January 1, 1999, the Company would have
reported the following pro forma results:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                 
|---------------------------------
|
|
|Revenues                         
|Income from continuing operations
|Net income                       
|Net income per share - basic     
|Net income per share - diluted   

| |  | (i) |  | Significant
Sales Agent
| |  | --- |  | -----------------------

|For
the year ended December 31, 1999, Coherent acted as the sales agent for products
sold to the Companys customers that represented 60% of product revenues.
At December 31, 1999, Coherent accounted for 60% of accounts receivable.
Coherent was the Companys exclusive worldwide distributor of laser systems
until the sale of Star in April 1999. International sales (including sales for
which Coherent was the sales agent) for the year ended December 31, 1999 were
approximately 35% of total revenues.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (j) |  | Research
and Development Expenses
| |  | --- |  | ---------------------------------

|The
Company charges research and development expenses to operations as incurred.
|--------------------------------------------------------------------------------

| |  | (k) |  | Net
Income (Loss) per Common Share
| |  | --- |  | ----------------------------------

|Basic
net income (loss) per share is determined by dividing net income (loss),
adjusted for preferred stock dividends, by the weighted average common shares
outstanding during the period. Diluted net income (loss) per share is determined
by dividing net income (loss), adjusted for preferred stock dividends, by the
diluted weighted average shares outstanding during the period. Diluted weighted
average shares reflect the dilutive effect, if any, of common stock options and
warrants based on the treasury stock method and the assumed conversion of all
convertible debt obligations and convertible preferred stock. The reconciliation
of basic and diluted weighted average shares outstanding is as follows:


-30-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES



NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|------------------------------------------------------------------------------------------------------------

|                                     | Years Ended December 31,
|------------------------------------ | ------------------------
|
|Basic weighted average common        |                         
|shares outstanding                   |                         
|Potential common shares pursuant to: |                         
|Stock options and warrants           |                         
|Convertible preferred stock          |                         
|Convertible debentures               |                         
|                                     |                         
|Diluted weighted average common      |                         
|Shares outstanding                   |                         
|                                     |                         

|The
Companys basic adjusted net income (loss) per share from continuing
operations for the years ended 1999, 2000 and 2001 is as follows:
|------------------------------------------------------------------------------------------------------------------------------------------

|                                | Years Ended December 31,
|------------------------------- | ------------------------
|
|Net income (loss) from          |                         
|continuing operations           |                         
|Preferred stock dividends       |                         
|                                |                         
|Adjusted net income (loss) from |                         
|continuing operations           |                         
|                                |                         

|For
the years ended 1999, 2000 and 2001, potential common shares, respectively,
related to 3,687,262, 4,796,329 and 5,879,711 of outstanding stock options,
stock warrants and convertible debt and equity securities, were not included in
diluted weighted average shares outstanding as they were antidilutive.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (l) |  | Concentration
of Credit Risk
| |  | --- |  | ----------------------------

|SFAS
No. 105, Disclosure of Information about Financial Instruments with
Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit
Risk, requires disclosure of any significant off-balance-sheet and credit
risk concentrations. Financial instruments that subject the Company to credit
risk consist primarily of cash, cash equivalents, available-for-sale
investments, and accounts receivable. The Company places its cash, cash
equivalents and available-for-sale investments in established financial
institutions. The Company has no significant off-balance-sheet risk or
concentration of credit risk, such as foreign exchange contracts, options
contracts or other foreign hedging arrangements. The Company maintains an
allowance for potential credit losses. The Companys accounts receivable
credit risk is not concentrated within any one geographic area. The Company has
not experienced significant losses related to receivables from any individual
customers or groups of customers in any specific industry or by geographic area.
Due to these factors, no additional credit risk beyond amounts provided for
collection losses is believed by management to be inherent in the Companys
accounts receivable.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (m) |  | Disclosures
About Fair Value of Financial Instruments
| |  | --- |  | -----------------------------------------------------

|SFAS
No. 107,Disclosure About Fair Value of Financial Instruments, requires
disclosure of an estimate of the fair value of certain financial instruments. At
December 31, 2000 and 2001, financial instruments consisted principally of cash,
cash equivalents, available-for-sale investments, accounts receivable, accounts
payable and long-term debt. The fair value of financial instruments pursuant to
SFAS No. 107 approximated their carrying values at December 31, 2000 and 2001.
Fair values have been determined through information obtained from market
sources and management estimates.


-31-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|-----------------------------------------------------------------------------------------------------------

| |  | (n) |  | Recent
Accounting Pronouncements
| |  | --- |  | --------------------------------

|In
August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets.This statement supercedes FASB Statement No.
121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of, and the accounting and reporting provisions of APB
Opinion No. 30, Reporting the Results of Operations, Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently
Occurring Events and Transactions. Under this statement it is required that
one accounting model be used for long-lived assets to be disposed of by sale,
whether previously held and used or newly acquired, and it broadens the
presentation of discontinued operations to include more disposal transactions.
The provisions of this statement are effective for financial statements issued
for fiscal years beginning after December 15, 2001, and interim periods within
those fiscal years, with early adoption permitted. The Company does not expect
the adoption of this statement to have a material impact on its results of
operations or financial position.


(3) Segment
and Geographic Information


The
Company has adopted SFAS No. 131, Disclosures about Segments of an Enterprise
and Related Information. SFAS No. 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 No. 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, or decision making group, in making decisions
how to allocate resources and assess performance. The Companys chief
decision-maker, as defined under SFAS No. 131, is a combination of the Chief
Executive Officer and the Chief Financial Officer. To date, the Company has
viewed its operations and manages its business as principally one segment,
cosmetic laser sales, and the Companys long-lived assets are located in
facilities in the United States. Associated services are not significant. As a
result, the financial information disclosed herein represents all of the
material financial information related to the Companys principal operating
segment.


The
following table represents percentage of product revenue by geographic
destination for 1999, 2000 and 2001:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|             
|-------------
|
|
|United States
|Japan        
|Europe       
|Asia/Pacific 
|Canada       
|Latin America
|Australia    
|             
|Total        
|             

|(4) Research
and Development


In
August 1995, the Company entered into an agreement with MGH whereby MGH agreed
to conduct clinical trials on a laser treatment for hair removal/reduction
developed at MGHs Wellman Laboratories of Photomedicine. Effective
February 14, 1997, the Company amended the 1995 agreement with MGH. Under the
terms of this amendment, the Company agreed to provide MGH with a grant of
approximately $204,000 to perform research and evaluation in the field of hair
removal. In July 1999, the Company further amended this agreement to extend its
exclusive research agreement for an additional five years. In addition to laser
hair removal, the agreement has been expanded to include research and
development in the fields of fat removal and acne treatment. Palomar has the
right to exclusively license, on royalty terms to be negotiated, Palomar-funded
inventions in the relevant fields. Under the terms of this agreement, the
Company will pay MGH $475,000 on an annual basis for clinical research through
August 2004.


-32-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(5) Income
Taxes


The
Company provides for income taxes under the liability method in accordance with
the provisions of SFAS No. 109, Accounting for Income Taxes. At December 31,
2001, the Company had available, subject to review and possible adjustment by
the Internal Revenue Service, federal net operating loss carryforwards of
approximately $110.0 million to be used to offset future taxable income.
This net operating loss carryforward will expire through 2021. The Internal
Revenue Code contains provisions that limit the net operating loss carryforwards
due to changes in ownership, as defined by the Internal Revenue Code. During
1999, the Company completed an analysis of its availability to utilize its net
operating loss carryforwards in connection with the sale of Star to Coherent
(See Note 1). The Company estimates that it has net operating losses of
approximately $51.0 million that are not subject to limitation under the
Internal Revenue Code after the sale of Star. The Company has a net deferred tax
asset of approximately $44.0 million, comprised mainly of the net operating tax
carryforwards discussed above, and the tax effect of certain expenses and
reserves not currently deductible. However, the Company has placed a full
valuation allowance against the deferred tax asset, due to uncertainty relating
to the Companys ability to realize the asset.


A reconciliation of the
federal statutory rate to the Companys effective tax rate is as follows:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                         | December 31,
|-------------------------------------------------------- | ------------
|
|Income tax provision (benefit) at federal statutory rate |             
|Decrease in tax resulting from-                          |             
|Net operating loss utilization                           |             
|Other                                                    |             
|Increase in valuation allowance                          |             
|                                                         |             
|Provision (benefit) for income taxes                     |             
|                                                         |             

|(6) 401(k) Plan


The
Company has a 401(k) Plan, which covers substantially all employees who have
attained the age of 18 and are employed for at least two hundred and fifty hours during a three month period.
Employees may contribute up to the maximum amount allowed by the Internal Revenue Service, subject to restrictions defined by the
Internal Revenue Service. At the Companys discretion, the Company may make
a matching contribution in cash or the Companys common stock up to 50% of
all employee contributions in each plan year. The Company contributions vest
over a three-year period from date of hire.


During
1999, 2000 and 2001, the Company matched in Company stock 50% of all employee
contributions by issuing 32,561 shares of common stock, 99,843 and 119,948
shares of treasury stock, respectively, to the 401(k) Plan in satisfaction of
its employer match for the 1998 and 1999 employee contributions. For the year
ended December 31, 2001, the Company has accrued $178,000 for the 2001 match.
The number of shares of common stock reserved for issuance under the 401(k) Plan
is 1,000,000 shares. As of December 31, 2001, 684,049 shares of common stock
remained available for issuance thereunder.


-33-
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(7) Accrued
Liabilities


At
December 31, 2000 and 2001,accrued liabilities consisted of the
following:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                             
|-----------------------------
|
|
|Payroll and employee benefits
|Royalties                    
|Settlement costs             
|Warranty                     
|Professional Fees            
|Other                        
|                             
|Total                        
|                             

|In
the fourth quarter of 2001, the Company recorded the reduction in the legal
accrual of $250,000 and the reduction in the incentive compensation accrual of
$513,000.


(8) Long-Term
Debt


At
December 31, 2000 and 2001, long-term debt consisted of the following:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                               | December 31,
|---------------------------------------------- | ------------
|
|Dollar-denominated convertible debentures      |             
|Swiss franc-denominated convertible debentures |             
|                                               |             
|                                               |             
|Less - Current maturities                      |             
|                                               |             
|                                               |             
|                                               |             

| |  | (a) |  | Convertible
Debentures
| |  | --- |  | ----------------------

|On March
13, 1997, the Company issued $500,000 of 6% convertible debentures due March 13,
2002. The convertible debentures have a conversion price of $11.00. The
debentureholder may convert no more than one-third of the debenture in any
30-day period. The Company has accounted for these debentures at face value.


On
September 30, 1997, the Company issued $7 million of convertible debentures due
September 30, 2002. The debentures bare interest at a rate of 6% for the first
179 days, 7% for days 180 through 269 and 8% thereafter. During the year ended
December 31, 1998, the Company redeemed $2,196,667 of these convertible
debentures, including accrued interest of $196,667. During the year ended
December 31, 1999, the debentureholders converted the remaining $1,650,000 of
principal plus $176,483 of accrued interest, into 377,760 shares of the
Companys common stock.


During
the year ended December 31, 1999, the Company recorded a redemption expense of
$6,167,369 as a result of a compromise agreement between Palomar and certain
European banks that had held the Swiss franc debentures. Under the terms of this
April 21, 1999 agreement, which resolved a lawsuit, Palomar agreed to rescind
its conversion notices issued in November 1997. Under the terms of the
agreement, the Company agreed to pay a total of approximately $6,742,717 to the
European banks, all of which had been paid as of December 31, 2001. Accordingly,
the Company has recorded a charge to operations of $6,167,369 during the year
ended December 31, 1999. This amount represents the total amount due to the
European banks less the fair market value of the redeemed common shares
($575,348) previously considered outstanding by the Company.


-34-
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|-----------------------------------------------------------------------------------------------------------

| |  | (b) |  | Revolving
Line of Credit with a Bank
| |  | --- |  | ------------------------------------

|In
1998, the Company secured a $10 million revolving line of credit with a bank.
This line of credit was to mature on March 31, 2000 and bore interest at
the banks prime rate. Borrowings under this line of credit were secured by
substantially all assets of the Company and were limited to 80% of qualified
accounts receivable. A director of Palomar had guaranteed all borrowings under
this line of credit. In connection with this guarantee, the Company issued this
director warrants to purchase 28,571 shares of common stock at $10.50 per share.
These warrants were valued at approximately $69,000. This amount was amortized
to interest expense over the term of the revolving line of credit. The Company
repaid all amounts outstanding under this line of credit on April 27, 1999, and
cancelled the line of credit.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (c) |  | Notes
Payable to Coherent
| |  | --- |  | -------------------------

|In
May and June 1998 and February 1999, the Company borrowed $3,000,000, $1,000,000
and $750,000, respectively, from the Companys then worldwide distributor,
Coherent. These notes accrued interest at 8.5% per annum and were collateralized
by Stars inventory. Coherent assumed this debt in connection with its
purchase of all of the issued and outstanding common stock of Star on April 27,
1999.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (d) |  | Notes
Payable to a Director
| |  | --- |  | ---------------------------

|On
September 28, 2001, the Company issued a promissory note to a Director for
$1,000,000. This note bares interest at a rate of 5.5% per annum and is due upon
demand.


(9)
Commitments and Contingencies
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (a) |  | Operating
Leases
| |  | --- |  | ----------------

|The
Company has entered into an operating lease for its corporate office, research
facility, and manufacturing operation. This lease has a monthly rent associated
with it of approximately $75,000 per month, which is adjusted annually, for
certain, other costs, such as inflation, taxes and utilities, and expires
through August 2009.


Future
minimum payments under the Companys operating leases at December 31, 2001
are approximately as follows:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Year EndedDecember 31, |           
| | ---------------------- | ----------
| |                        | 2002      
| |                        | 2003      
| |                        | 2004      
| |                        | 2005      
| |                        | Thereafter
| |                        |           
| |                        |           
| |                        |           

| |  | (b) |  | Royalties
| |  | --- |  | ---------

|-35-
|----

|                                                                                                           
|-----------------------------------------------------------------------------------------------------------
|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)

|The
Company is required to pay a royalty under a license agreement with MGH (see
Note 4). For the years ended December 31, 1999, 2000 and 2001, approximately
$2,085,000, $2,078,000 and $2,572,000 of royalty expense, respectively, was
incurred under this agreement. These amounts are included in cost of royalty
revenues in the accompanying consolidated statements of operations.


A
former employee and previous owner of one of the Companys subsidiaries was
paid a 1% commission on the net sales of certain lasers, as defined in his
severance agreement, through March 31, 2000. Accordingly, the company paid
commissions for the years ended December 31, 1999 and 2000 of $218,000 and
$10,000, respectively.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (c) |  | Litigation
| |  | --- |  | ----------

|In
July 1999, Palomar and certain European banks entered into a settlement agreement whereby
Palomar agreed to rescind its conversion notices issued in November 1997. Under the terms
of this compromise, the Company agreed to pay a total of approximately $6.7 million to
the European banks, of which $5.7 million has been paid as of December 31, 2000. The
balance of $1.0 million was paid in 2001.


On
March 11, 1999, the United States District Court for the Southern District of
New York granted plaintiffs leave to amend their complaint in the action styled
Varljen v. H.J. Meyers, Inc., et. al. The court entered a final judgement
of dismissal with prejudice on November 6, 2000. All payments required by
Palomar under the settlement agreement have been made except for the delivery of
358,547 shares of Palomar Common stock, which is the balance of the shares owed
under the settlement agreement. These shares will be delivered upon receipt of
instruction from plaintiffs counsel.


The
Company is involved in other legal and administrative proceedings and claims of
various types. While any litigation contains an element of uncertainty,
management, in consultation with the Companys general counsel, presently
believes that the outcome of each such other proceedings or claims which are
pending or known to be threatened, or all of them combined, will not have a
material adverse effect on the Company.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (d) |  | Distribution
Agreement
| |  | --- |  | ----------------------

|On
November 17, 1997, the Company entered into an exclusive distribution, sales and
service agreement with Coherent, an established, worldwide laser company. Under
this agreement, Coherent had the exclusive right to sell the EpiLaser® and
the LightSheer diode laser system and future generation products
worldwide. The Company paid Coherent a per unit commission, adjusted for certain
events, as defined. During 1999, the Company incurred approximately $4,702,000
of commission expense related to this agreement, which is included in sales and
marketing expense in the accompanying consolidated statement of operations. Upon
execution of this agreement, Coherent made a lump sum payment of $3.5 million
and received a warrant to purchase 142,857 shares of the Companys common
stock at a price per share of $36.75. The valuation of the warrant using the
Black-Scholes option-pricing model was approximately $380,000. The value was
credited to additional paid-in capital during the year ended December 31, 1997.
The remaining amount of $3,120,000, was included in deferred revenue, and
originally amortized to revenue over the three-year life of the agreement. On
April 27, 1999, in connection with the Companys completion of the sale of
Star to Coherent, as discussed in Note 1, the distribution agreement was
terminated and replaced with a one year non-exclusive distribution agreement
that enabled Coherent to sell the Companys ruby-based laser products. The
Company amortized the remaining amounts in deferred revenue related to Coherent
over the one-year non-exclusive period endingApril 27, 2000.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (e) |  | Employment
Agreements
| |  | --- |  | ---------------------

|The
Company has two-year employment agreements with certain officers. These
employment agreements automatically renew for successive two-year periods absent
of non-renewal by either party. These employment agreements provide for 24
months severance upon termination of employment without cause and 36 months
severance upon change of control.


-36-
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)


(10)
Stockholders Equity
|---------------------------------------------------------------------------------------------------------------------------------------

| |  | (a) |  | Common
Stock
| |  | --- |  | ------------

|During
1998, the Company sold 1,457,142 shares of common stock to a group of investors
for $10,200,000. In addition, the Company issued callable warrants with a
three-year term to these investors to purchase 1,457,142 shares of common stock
at an exercise price of $21.00 per share. The callable warrants are not
exercisable for the first six months after issuance and thereafter are callable
by the Company if the closing price of the Companys common stock equals or
exceeds $35.00 for 10 consecutive trading days. Under the terms of this private
placement, the Company is obligated to pay the investors a fee of 5% per annum
(payable quarterly) of the dollar value invested in the Company as long as the
investors continue to hold their common stock in their name at the
Companys transfer agent. During 1999, 2000 and 2001, the Company paid
$382,948, $287,777 and $251,875, respectively, related to this fee. These
amounts have been charged to additional paid-in capital. During 1998, the
Company also paid $360,000 for investment banking fees related to the issuance
of these common shares. The Company netted this amount against the proceeds
through a reduction to additional paid-in capital.


On
April 21, 1999, a majority of the Companys stockholders approved an
amendment to the Companys Certificate of Incorporation to effect a plan of
recapitalization that resulted in a one-for-seven reverse split of the
Companys common stock. The Companys authorized capital stock was
also reduced to 45,000,000 shares of common stock and 1,500,000 shares of
preferred stock. All shares and per share amounts of common stock for all
periods presented have been retroactively adjusted to reflect the reverse stock
split.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (b) |  | Preferred
Stock
| |  | --- |  | ---------------

|The
Series F redeemable convertible preferred stock (Series F
Preferred), together with any accrued but unpaid dividends, may be
converted into common stock at 80% of the average closing bid price for the 10
trading days preceding the conversion date, but in no event less than $21.00 or
more than $112.00. This conversion floor was decreased by the two parties from
the original price to $49.00. The conversion price for the Series F Preferred is
adjustable for certain dilutive events, as defined. The Series F Preferred may
be redeemed at the Companys option, with no less than 10 days and no
more than 30 days notice or when the stock price exceeds $117.60 per share
for 60 consecutive trading days, at an amount equal to the amount of liquidation
preference determined as of the applicable redemption date. The Series F
Preferred has a liquidation preference equal to $1,000 per share of redeemable
convertible preferred stock, plus accrued but unpaid dividends and accrued but
unpaid interest. The Series F Preferred stockholders do not have any voting
rights except on matters affecting the Series F Preferred. Dividends are payable
quarterly at 8% per annum in arrears on March 31, June 30, September 30 and
December 31. Dividends not paid on the payment date, whether or not such
dividends have been declared, will bear interest at the rate of 10% per annum
until paid. As of December 31, 2001, there is $2,177,717 of unpaid accrued
dividends and interest.


During
the third quarter of 1996, the Company issued 10,000 shares of Series G
redeemable convertible preferred stock (Series G Preferred) for $10
million, less associated financing costs. The Series G Preferred together with
any accrued but unpaid dividends, was convertible into common stock at 85% of
the average closing bid price for the five trading days preceding the conversion
date, but in no event less than $.07. The Series G Preferred was redeemable at
the Companys option at any time, with no less than 15 days and no
more than 20 days notice, at an amount equal to the sum of (a) the amount
of liquidation preference determined as of the applicable redemption date plus
(b) $176.50. Dividends were payable quarterly at 7% per annum in arrears on
January 1, April 1, July 1 and October 1. As of December 31, 1999, all of the
Series G Preferred had been redeemed or converted.


-37-
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)


In
1999, in addition to the 74,905 shares of common stock issued related to the
Series G Preferred conversion, the Company redeemed 403 shares of Series G
Preferred and 250 shares of Series H Preferred for $902,396, which included
accrued dividends and interest of $121,009.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | (c) |  | Stock
Option Plans and Warrants
| |  | --- |  | -------------------------------

| |  |  |  | (i) |  | Stock
Options
| |  |  |  | --- |  | -------------

|The
Company has several Stock Option Plans (the Plans) that provide for
the issuance of a maximum of 4,778,571 shares of common stock, which may be
issued as incentive stock options (ISOs) or nonqualified options.
Under the terms of the Plans, ISOs may not be granted at less than the fair
market value on the date of grant (and in no event less than par value); in
addition, ISO grants to holders of 10% of the combined voting power of all
classes of Company stock must be granted at an exercise price of not less than
110% of the fair market value at the date of grant. Pursuant to the Plans,
options are exercisable at varying dates, as determined by the Board of
Directors, and have terms not to exceed 10 years (five years for 10% or greater
stockholders). The Board of Directors, at its discretion, may convert the
optionees ISOs into nonqualified options at any time prior to the
expiration of such ISOs.


The
following table summarizes all stock option activity of the Company for the
years ended December 31, 1999, 2000 and 2001:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                               | Number ofShares |           | ExercisePrice |               | Weighted AverageExercise Price |        
|---------------------------------------------- | --------------- | --------- | ------------- | ------------- | ------------------------------ | -------
|Outstanding, December 31, 1998                 |                 | 336,046   |               | $10.50-$17.50 |                                | $10.57 
|Granted                                        |                 | 1,039,327 |               | 1.63-10.50    |                                | 3.10   
|Canceled                                       |                 | (153,040  | )             | 3.19-10.50    |                                | 8.24   
|                                               |                 |           |               |               |                                |        
|Outstanding, December 31, 1999                 |                 | 1,222,333 |               | 1.63-17.50    |                                | 4.55   
|Granted                                        |                 | 1,011,200 |               | 1.38-5.06     |                                | 2.11   
|Exercised                                      |                 | (58,900   | )             | 3.19          |                                | 3.19   
|Canceled                                       |                 | (379,248  | )             | 1.97-17.50    |                                | 7.44   
|                                               |                 |           |               |               |                                |        
|Outstanding, December 31, 2000                 |                 | 1,795,385 |               | 1.38-10.50    |                                | 2.57   
|Granted                                        |                 | 1,996,100 |               | 1.00-2.68     |                                | 1.04   
|Canceled                                       |                 | (232,087  | )             | 1.00-10.50    |                                | 2.09   
|                                               |                 |           |               |               |                                |        
|Outstanding, December 31, 2001                 |                 | 3,524,798 |               | $1.00-$10.50  |                                | $  1.74
|                                               |                 |           |               |               |                                |        
|Exercisable, December 31, 1999                 |                 | 796,487   |               | $3.19-$17.50  |                                | $  5.21
|                                               |                 |           |               |               |                                |        
|Exercisable, December 31, 2000                 |                 | 629,580   |               | $1.63-$10.50  |                                | $  3.21
|                                               |                 |           |               |               |                                |        
|Exercisable, December 31, 2001                 |                 | 955,929   |               | $1.38-$10.50  |                                | $  2.84
|                                               |                 |           |               |               |                                |        
|Available for future issuances under the Plans |                
|as of December 31, 2001                        |                 | 1,087,451 |               |               |                                |        
|                                               |                 |           |               |              

|The ranges of exercise
prices for options outstanding and options exercisable at December 31, 2001 are
as follows:
|------------------------------------------------------------------------------------------------------------------

|Options Outstanding | Options Exercisable
|------------------- | -------------------
|                    |                    
|
|                    |                    
|$       1.00        |                    
|1.12-1.63           |                    
|1.97                |                    
|2.02-2.88           |                    
|3.19                |                    
|4.88-5.06           |                    
|10.50               |                    
|                    |                    
|                    |                    
|$1.00-$10.50        |                    
|                    |                    

|-38-
|----

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)


The
Company accounts for its stock-based compensation plans under APB Opinion No.
25, Accounting for Stock Issued to Employees. In October 1995, the FASB
issued SFAS No. 123, Accounting for Stock-Based Compensation, which is
effective for fiscal years beginning after December 15, 1995. SFAS No. 123
established a fair-value-based method of accounting for stock-based compensation
plans. The Company has adopted the disclosure-only alternative under SFAS No.
123, which requires disclosure of the pro forma effects on earnings per share as
if SFAS No. 123 had been adopted, as well as certain other information. Under
Emerging Issues Task Force (EITF) 96-18, the fair value of the non-employee
equity issuances will be marked to market over the vesting term of the stock
options and warrants.


The
Company has computed the pro forma disclosures required under SFAS No. 123 for
all stock options granted to employees of the Company in the years ended
December 31, 1999, 2000 and 2001 using theBlack-Scholes option pricing model
prescribed by SFAS No. 123.


The
weighted average assumptions used to calculate the SFAS No. 123 pro forma
disclosure and the resulting grant date fair values for the years ended December
31, 1999, 2000 and 2001 for the Company are as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                          
|----------------------------------------------------------
|
|
|Risk-free interest rate                                   
|Expected dividend yield                                   
|Expected lives                                            
|Expected volatility                                       
|Grant date fair value of options granted during the period
|                                                          

|The
weighted average fair-value and weighted average exercise price of options
granted by the Company for the years ended December 31, 1999, 2000 and 2001 are
as follows:
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                    |  | December 31, | 
|--------------------------------------------------- |  | ------------ | 
|
|Weighted average exercise price for options:        |  |              | 
|Whose exercise price exceeded fair market value at  | 
|the date of grant                                   |  | $5.05        | 
|Whose exercise price was equal to fair value at the | 
|date of grant                                       |  | $3.08        | 
|Weighted average fair market value for options:     | 
|Whose exercise price exceeded fair market value at  | 
|the date of grant                                   |  | $1.93        | 
|Whose exercise price was equal to fair market value | 
|at the date of grant                                |  | $2.04        | 

| |  |  |  | (ii) |  | Warrants
| |  |  |  | ---- |  | --------

|-39-
|----

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|-----------------------------------------------------------------------------------------------------------

|The
following table summarizes all warrant activity of the Company for the years
ended December 31, 1999, 2000 and 2001:
|------------------------------------------------------------------------------------------------------------------------

|                               | Number ofShares |           | ExercisePrice |                | WeightedAverageExercise Price |       
|------------------------------ | --------------- | --------- | ------------- | -------------- | ----------------------------- | ------
|Outstanding, December 31, 1998 |                 | 2,797,018 |               | $10.50-$105.00 |                               | $30.66
|Granted                        |                 | 113,000   |               | 3.19           |                               | 3.19  
|Canceled                       |                 | (260,327  | )             | 14.00-72.63    |                               | 32.53 
|                               |                 |           |               |                |                               |       
|Outstanding, December 31, 1999 |                 | 2,649,691 |               | 3.19-105.00    |                               | 29.51 
|Granted                        |                 | 330,000   |               | 1.97-3.50      |                               | 3.18  
|Canceled                       |                 | (408,132  | )             | 10.50-105.00   |                               | 35.16 
|                               |                 |           |               |                |                               |       
|Outstanding, December 31, 2000 |                 | 2,571,559 |               | 1.97-105.00    |                               | 25.23 
|Canceled                       |                 | (612,868  | )             | 10.50-105.00   |                               | 51.75 
|                               |                 |           |               |                |                               |       
|Outstanding, December 31, 2001 |                 | 1,958,691 |               | $1.97-$21.00   |                               | $16.93
|                               |                 |           |               |                |                               |       
|Exercisable, December 31, 1999 |                 | 2,649,691 |               | $3.19-$105.00  |                               | $29.51
|                               |                 |           |               |                |                               |       
|Exercisable, December 31, 2000 |                 | 2,491,559 |               | $3.19-$105.00  |                               | $25.97
|                               |                 |           |               |                |                               |       
|Exercisable, December 31, 2001 |                 | 1,905,359 |               | $1.97-$21.00   |                               | $17.34
|                               |                 |           |               |                |                               |       

|The
ranges of exercise prices for warrants outstanding and exercisable at December
31, 2001 are as follows:
|-----------------------------------------------------------------------------------------------------------

|Warrants Outstanding |  | Warrants Exercisable | 
|-------------------- |  | -------------------- | 
|
|$1.97                |  | 60,000               | 
|2.81                 |  | 20,000               | 
|3.19                 |  | 113,000              | 
|3.50                 |  | 250,000              | 
|10.50                |  | 7,141                | 
|21.00                |  | 1,508,550            | 
|                     |  |                      | 
|$1.97-$21.00         |  | 1,958,691            | 
|                     |  |                      | 

|The
Company has computed the pro forma disclosures required under SFAS No. 123 for
all warrants granted in the years ended December 31, 1999 and 2000 using the
Black-Scholes option-pricing model prescribed by SFAS No. 123. There were no
warrants granted in the year ended December 31, 2001.


The
weighted average assumptions used to calculate the SFAS No. 123 pro forma
disclosure for the years ended December 31, 1999, 2000 and 2001 for the Company are as
follows:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                 |            | December 31, |  
|------------------------------------------------ | ---------- | ------------ | -
|
|Risk-free interest rate                          | 5.81%      | 6.06%        | 
|Expected dividend yield                          |           |             | 
|Expected lives                                   | 4.00 years | 1.73 years   | 
|Expected volatility                              | 94%        | 111%         | 
|Grant date fair value of warrants granted during
|the period                                       | $2.20      | $1.07        | 

|-40-
|----

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)


The
weighted average fair value and weighted average exercise price of warrants
granted by the Company for the years ended December 31, 1999, 2000 and 2001 are
as follows:
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                        |       | December 31, |    
|------------------------------------------------------- | ----- | ------------ | ---
|
|Weighted average exercise price for warrants:           |       |              |    
|Whose exercise price exceeded fair market value at date
|of grant                                                | $    | $3.50        | $ 
|Whose exercise price was less than fair market value at
|date of grant                                           | $    | $           | $ 
|Whose exercise price was equal to fair market value at 
|date of grant                                           | $3.19 | $2.18        | $ 
|Weighted average fair value for warrants:              
|Whose exercise price exceeded fair market value at date
|of grant                                                | $    | $0.86        | $ 
|Whose exercise price was less than fair market value at
|date of grant                                           | $    | $           | $ 
|Whose exercise price was equal to fair market value at 
|date of grant                                           | $2.20 | $1.70        | $ 

| |  |  |  | (iii) |  | Pro
Forma Disclosure
| |  |  |  | ----- |  | --------------------

|The pro
forma effect on the Company of applying SFAS No. 123 for all options and
warrants to purchase common stock of the Company would be as follows:
|------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                       |  | December 31,          | 
|------------------------------------------------------ |  | --------------------- | 
|
|Pro forma net income (loss) from continuing operations |  | $     23,289,114      | 
|Pro forma basic net income (loss) per share from       | 
|continuing operations                                  |  | $                2.29 | 
|Pro forma diluted net income (loss) per share from     | 
|continuing operations                                  |  | $                2.22 | 

| |  | (d) |  | Reserved
Shares
| |  | --- |  | ---------------

|At
December 31, 2001, the Company has reserved shares of its common stock for the
following:
|--------------------------------------------------------------------------------------------

|                            
|----------------------------
|Warrants                    
|Stock option plans          
|Convertible debentures      
|Convertible preferred stock 
|Employee stock purchase plan
|Employee 401(k) plan        
|                            
|Total                       
|                            

|-41-
|----

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|-----------------------------------------------------------------------------------------------------------

| |  | (e) |  | Employee
Stock Purchase Plan
| |  | --- |  | ----------------------------

|In
June 1996, the Board of Directors established the Palomar Medical Technologies,
Inc. 1996 Employee Stock Purchase Plan (the Purchase Plan). Under
the Purchase Plan, all employees are eligible to purchase the Companys
common stock at an exercise price equal to 85% of the fair market value of the
common stock with a lookback provision of three months. During the years ended
December 31, 1999, 2000 and 2001, employees purchased 14,199, 30,937 and 70,856
shares, respectively, of the Companys common stock for approximately
$46,000, $53,000 and $86,000, respectively, pursuant to the Purchase Plan.


(11)
Discontinued Operations


During
the fourth quarter of 1997, the Companys Board of Directors approved a
plan to dispose of the Companys electronics business segment. The
electronics segment focused on of the manufacture and sale of personal
computers, high-density flexible electronics circuitry and memory modules. The
Company substantially completed this plan in May 1998.


The Company paid and settled a
lawsuit related to the operations of this electronics segment for $435,000, which
represents the net loss from discontinued operations in the accompanying statement of
operations for the year ended December 31, 1999.


Pursuant to Accounting
Principles Board (APB) Opinion No. 30, Reporting the Results of
Operations  Reporting the Effects of Disposal of a Segment of a Business,
and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions, (APB 30) the consolidated financial statements of
the Company have been presented to reflect the dispositions of the subsidiaries
that comprise the aforementioned electronics segment in accordance with APB 30.
Accordingly, revenues, expenses, and cash flows of the electronics segment have
been excluded from the respective captions in the accompanying consolidated
statements of operations and consolidated statements of cash flows. The net
operating losses of these entities have been reported as Net Loss from
Discontinued Operations in the accompanying consolidated statements of
operations; and the net cash flows of these entities have been reported as
Net Cash Used in Discontinued Operations in the accompanying
consolidated statements of cash flows.



(12) Valuation
and Qualifying Accounts


The
roll forward of the Allowance for Doubtful Accounts is as follows:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                  | Balance,Beginning ofPeriod |          | Additions |          | Write - offs |           | Balance, Endof Period |         
|----------------- | -------------------------- | -------- | --------- | -------- | ------------ | --------- | --------------------- | --------
|December 31, 1999 |                            | $364,000 |           | $       |              | $(157,000 | )                     | $207,000
|                  |                            |          |           |          |              |           |                       |         
|December 31, 2000 |                            | $207,000 |           | $159,958 |              | $(60,958  | )                     | $306,000
|                  |                            |          |           |          |              |           |                       |         
|December 31, 2001 |                            | $306,000 |           | $252,332 |              | $(160,894 | )                     | $397,438
|                  |                            |          |           |          |              |           |                       |         

|The roll forward of the
Restructuring Accrual is as follows:


-42-
|-------------------------------------------------------------------

|PALOMAR
MEDICAL TECHNOLOGIES, INC. AND SUBSIDIARIES


NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS(Continued)
|-----------------------------------------------------------------------------------------------------------

|                  | Balance,Beginning ofPeriod |          | Additions |          | Payments |           | Balance, Endof Period |         
|----------------- | -------------------------- | -------- | --------- | -------- | -------- | --------- | --------------------- | --------
|December 31, 1999 |                            | $279,000 |           | $       |          | $(279,000 | )                     | $      
|                  |                            |          |           |          |          |           |                       |         
|December 31, 2000 |                            | $       |           | $       |          | $        |                       | $      
|                  |                            |          |           |          |          |           |                       |         
|December 31, 2001 |                            | $       |           | $       |          | $        |                       | $      
|                  |                            |          |           |          |          |           |                       |         

|(13) Quarterly
Results of Operations (Unaudited)


The
following table presents a condensed summary of quarterly results of operations
for the years ended December 31, 2001 and 2000 (in thousands, except per share
data).
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                     | Year Ended December 31, 2001
|-------------------- | ----------------------------
|
|Total revenues       |                             
|Gross profit         |                             
|Loss from operations |                             
|Net loss per share:  |                             
|Basic and Diluted    |                             

|                     | Year Ended December 31, 2000
|-------------------- | ----------------------------
|
|
|Total revenues       |                             
|Gross profit         |                             
|Loss from operations |                             
|Net loss per share:  |                             
|Basic and Diluted    |                             

|-43-
|----

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


Not
applicable.



PART III



Item 10. Directors and Executive Officers of the Registrant.


The
information concerning directors required under this item is incorporated herein
by reference from the material contained under the heading Election of
Directors in the Registrants definitive proxy statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A, not
later than 120 days after the close of the fiscal year. The information
concerning delinquent filers pursuant to Item 405 of Regulation S-K is
incorporated herein by reference from the material contained under the heading
Section 16(a) Beneficial Ownership Reporting Compliance in the
Registrants definitive proxy statement to be filed with the Securities and
Exchange Commission pursuant to Regulation 14A, not later than 120 days after
the close of the fiscal year.



Item 11. Executive Compensation.


The
information required under this item is incorporated herein by reference from
the material contained under the heading Executive Compensation in
the Registrants definitive proxy statement to be filed with the Securities
and Exchange Commission pursuant to Regulation 14A, not later than 120 days
after the close of the fiscal year.



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


The
information required under this item is incorporated herein by reference from
the material contained under the heading Stock Ownership in the
Registrants definitive proxy statement to be filed with the Securities and
Exchange Commission pursuant to Regulation 14A, not later than 120 days after
the close of the fiscal year.



Item 13. Certain Relationships and Related
Transactions.


The
information required under this item is incorporated herein by reference from
the material contained under the heading Relationship with
Affiliates in the Registrants definitive proxy statement to be filed
with the Securities and Exchange Commission pursuant to Regulation 14A, not
later than 120 days after the close of the fiscal year.


-44-
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|PART IV



Item 14.
Exhibits, Financial Statement Schedules and Reports on Form 8-K.
|------------------------------------------------------------------------------------

|(a) |  | Index
to Consolidated Financial Statements.
|--- |  | -------------------------------------------

| | Page
| | ----

| | The
following Consolidated Financial Statements of the Company and its subsidiaries arefiled
as part of this report on Form 10-K:
| | ---------------------------------------------------------------------------------------------------------------------------------

| |  | Reports of Independent Public Accountants                              |  | 22 | 
| |  | ---------------------------------------------------------------------- |  | -- | 
|
| |  | Consolidated Balance Sheets -                                          | 
| |  | December 31, 2001 and December 31, 2000                                |  | 23 | 
|
| |  | Consolidated Statements of Operations -                                | 
| |  | Years ended December 31, 2001, December 31, 2000 and December 31, 1999 |  | 24 | 
|
| |  | Consolidated Statements of Stockholders Equity (Deficit) -            | 
| |  | Years ended December 31, 2001, December 31, 2000 and December 31, 1999 |  | 25 | 
|
| |  | Consolidated Statements of Cash Flows -                                | 
| |  | Years ended December 31, 2001, December 31, 2000 and December 31, 1999 |  | 26 | 
|
| |  | Notes to Consolidated Financial Statements                             |  | 27 | 

|(b) |  | Reports
on Form 8-K.
|--- |  | --------------------

| | Not
applicable.
| | ---------------

|(c) |  | Exhibits.
|--- |  | ---------

| | The
following exhibits required to be filed herewith are incorporated by reference to the
filings previously made by the Company where so indicated below.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------

|ExhibitNo. |  | Title
|---------- |  | -----

|^^^3(i).1 |  | Certificate
of Designation, as filed with the Delaware Secretary of State on April 21, 1999.
|--------- |  | --------------------------------------------------------------------------------------------

|^3(i).2 |  | Second
Restated Certificate of Incorporation, as filed with the Delaware Secretary of State on
January 8, 1999.
|------- |  | ---------------------------------------------------------------------------------------------------------------

|^^^^3(ii) |  | Bylaws,
as amended.
|--------- |  | -------------------

|^4.1 |  | Common
Stock Certificate.
|---- |  | -------------------------

|^^4.2. |  | Rights
Agreement Between Palomar Medical Technologies, Inc. and American Stock Transfer & Trust
Company, dated as of April 20, 1999
|------ |  | -----------------------------------------------------------------------------------------------------------------------------------

|##4.3 |  | Form
of 4.5% Convertible Debenture (denominated in Swiss Francs) due July 3, 2003.
|----- |  | ----------------------------------------------------------------------------------

|####4.4 |  | First
Allonge and Amendment to 4.5% Subordinated Convertible Debenture
|------- |  | ----------------------------------------------------------------------

|-45-
|----

|
|

|##4.5 |  | Form
of 6% Convertible Debenture due March 13, 2002.
|----- |  | ----------------------------------------------------

|<4.6 |  | Second Amended
1991 Stock Option Plan.
|---- |  | --------------------------------------

|<4.7 |  | Second Amended
1993 Stock Option Plan.
|---- |  | --------------------------------------

|<4.8 |  | Second Amended
1995 Stock Option Plan.
|---- |  | --------------------------------------

|<4.9 |  | Second  Amended
1996 Stock Option Plan.
|---- |  | ---------------------------------------

|<4.10 |  | Third Amended
1996 Employee Stock Purchase Plan.
|----- |  | ------------------------------------------------

|*4.11 |  | Form
of Stock Option Grant under the 1991, 1993 and 1995 Amended Stock Option Plans.
|----- |  | ------------------------------------------------------------------------------------

|##4.12 |  | Form
of Stock Option Agreement under the 1996 Amended Stock Option Plan.
|------ |  | ------------------------------------------------------------------------

|#4.13 |  | Form
of Company Warrant to Purchase Common Stock.
|----- |  | -------------------------------------------------

|###10.1 |  | Employment
Agreement, dated as of May 15, 1997, between the Company and Louis P. Valente.
|------- |  | -----------------------------------------------------------------------------------------

|<10.2 |  | Amendment No.
1 to Key Employment Agreement between the Company and Louis P. Valente dated May 15, 1999.
|----- |  | --------------------------------------------------------------------------------------------------------

|####10.3 |  | Amendment
No. 2 to Key Employment Agreement between the Company and Louis P. Valente dated February
1, 2000
|-------- |  | -----------------------------------------------------------------------------------------------------------

|<10.4 |  | Amended and Restated Employment Agreement between
the Company and Joseph P. Caruso dated June 30, 1999.
|----- |  | -------------------------------------------------------------------------------------------------------

|####10.5 |  | Amendment
No. 1 to Amended and Restated Employment Agreement between the Company and Joseph P.
Caruso dated February 1, 2000.
|-------- |  | -----------------------------------------------------------------------------------------------------------------------------

|<10.6 |  | Lease for premises at 82 Cambridge Street, Burlington, Massachusetts,
dated June 17, 1999.
|----- |  | ------------------------------------------------------------------------------------------

|###10.7 |  | License
Agreement between the Company and Massachusetts General Hospital, dated August 18, 1995.
|------- |  | ------------------------------------------------------------------------------------------------

|###10.8 |  | First
Amendment to License Agreement between the Company and Massachusetts General Hospital
dated August 18, 1995.
|------- |  | ------------------------------------------------------------------------------------------------------------------

|###10.9 |  | Second
Amendment to License Agreement between the Company and Massachusetts General Hospital
dated August 18, 1995.
|------- |  | -------------------------------------------------------------------------------------------------------------------

|-10.10 |  | The
Companys 401(k) Plan.
|------ |  | --------------------------

|**10.11 |  | Agreement
and Plan of Reorganization by and among Coherent, Inc., Medical Technologies,
Acquisition, Inc., Palomar Medical Technologies, Inc., Star Medical Technologies, Inc.,
Robert E. Grove, James Z. Holtz and David C. Mundinger, dated as of December 7, 1998.
|------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|<<10.12 |  | Amendment No. 1 to Key Employment
Agreement between the Company and Joseph P. Caruso dated June 8, 2000
|------- |  | -------------------------------------------------------------------------------------------------------

|21 |  | List
of Subsidiaries.
|-- |  | ---------------------

|23 |  | Consent
of Arthur Andersen LLP.
|-- |  | -------------------------------

|-46-
|----

|
|

|99 |  | Letter
to commission pursuant to temporary note 3T
|-- |  | --------------------------------------------------

|^ |  | Previously
filed as an exhibit to Form 8-K, filed on April 21, 1999 and incorporated herein by
reference.
|- |  | ---------------------------------------------------------------------------------------------------------

|^^ |  | Previously
filed as an exhibit to Form 10-K for the period ended December 31, 1998, filed on March
30, 1999 and incorporated herein by reference.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------

|^^^ |  | Previously
filed as an exhibit to Form 10-Q for the period ended March 31, 1999, filed on May 17,
1999 and incorporated herein by reference.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------

|^^^^ |  | Previously
filed as an exhibit to Form 8-K, filed on December 16, 1999 and incorporated herein by
reference.
|---- |  | ------------------------------------------------------------------------------------------------------------

|* |  | Previously
filed as an exhibit to Amendment No. 4 to Form S-1 Registration Statement No. 33-47479
filed on October 5, 1992, and incorporated herein by reference.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------

|** |  | Previously
filed as an exhibit to the Companys Definitive Proxy Statement for the period ended
December 31, 1998 filed on March 12, 1999, and incorporated herein by reference.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|# |  | Previously
filed as an exhibit to the Companys Annual Report on Form 10-KSB for the year ended
December 31, 1995, and incorporated herein by reference.
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

|## |  | Previously
filed as an exhibit to the Companys Annual Report on Form 10-KSB for the year ended
December 31, 1996, and incorporated herein by reference.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------

|### |  | Previously
filed as an exhibit to the Companys Annual Report on Form 10-K for the year ended
December 31, 1998, and incorporated herein by reference.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

|#### |  | Previously
filed as an exhibit to the Companys Annual Report on Form 10-K for the year ended
December 31, 1999, and incorporated herein by reference.
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | Previously
filed as an exhibit to Form S-8 Registration Statement No. 33-97710 filed on October 4,
1995, and incorporated herein by reference.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

|< |  | Previously
filed as an exhibit Form 10-Q for the period ended June 30, 1999, and incorporated herein
by reference.
|- |  | ------------------------------------------------------------------------------------------------------------------

|<< |  | Previously
filed as an exhibit Form 10-Q for the period ended June 30, 2000, and incorporated herein
by reference.
|-- |  | ------------------------------------------------------------------------------------------------------------------

|-47-
|----

|SIGNATURES


Pursuant
to the requirements of the Securities Act of 1934, the Registrant certifies that
it has caused this Report to be signed on its behalf by the undersigned,
thereunto duly authorized, in the Town of Burlington in the Commonwealth of
Massachusetts on March 26, 2002.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | PALOMAR MEDICAL TECHNOLOGIES, INC.By: /s/ Louis P. Valente          
       Louis P. Valente       Chief Executive Officer
| |  | ----------------------------------------------------------------------------------------------------------------------------------------

|Pursuant
to the requirements of the Securities Act of 1934, this Report has been signed
by the following persons on behalf of the Registrant in the capacities and on
the dates indicated.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Name | Capacity | Date
|---- | -------- | ----

|/s/ Louis P. Valente
Louis P. Valente | Chief Executive Officerand Chairman | March 26, 2002
|------------------------------------------------- | ----------------------------------- | --------------

|/s/ Joseph P. Caruso
Joseph P. Caruso | President and Chief Operating Officer and Director(Principal Financial Officer andPrincipal Accounting Officer) | March 26, 2002
|------------------------------------------------- | --------------------------------------------------------------------------------------------------------------- | --------------

|/s/ Nicholas P. Economou
Nicholas P. Economou | Director | March 26, 2002
|--------------------------------------------------------- | -------- | --------------

|/s/ A. Neil Pappalardo
A. Neil Pappalardo | Director | March 26, 2002
|----------------------------------------------------- | -------- | --------------

|/s/ James G. Martin
James G. Martin | Director | March 26, 2002
|----------------------------------------------- | -------- | --------------

|/s/ Jeanne Cohane
Jeanne Cohane | Director | March 26, 2002
|------------------------------------------- | -------- | --------------

|/s/ Jay Delahanty
Jay Delahanty | Director | March 26, 2002
|------------------------------------------- | -------- | --------------

|-48-
|----