**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**
| **x**      | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES   EXCHANGE ACT OF 1934**  |
|------------|------------|-----------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                |
| ** ** | ** ** | **For the  quarterly period ended June 30, 2006**                                                    |
| ** ** | ** ** | ** **                                                                                                |
| ** ** | ** ** | **OR**                                                                                                    |
| ** ** | ** ** | ** **                                                                                                |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES   EXCHANGE ACT OF 1934** |

** **

**[For the transition period from                            to                               ]**

**Commission File No. 0-31157**

**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

(Exact name of registrant as specified in its charter)

 

| **PENNSYLVANIA**              | ** ** | **23-2507402**       |
|-------------------------------|------------|----------------------|
| (State or other  jurisdiction |       | (IRS Employer        |
| of  incorporation)            |       | Identification  No.) |

 

| **720 Pennsylvania Drive, Exton, Pennsylvania** | ** ** | **19341**  |
|-------------------------------------------------|------------|------------|
| (Address of  principal executive offices)       |       | (Zip Code) |

** **

**(610) 646-9800**

(Registrant’s telephone number, including area code)

Indicateby check mark whether registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yes x     No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition or “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act.

o Large accelerated filer     xAccelerated filer     o Non-accelerated filer

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o             No x

As of August 2, 2006, there were 16,812,269shares of the Registrant’s Common Stock, with par value of $.001 per share,outstanding.

 

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**INNOVATIVESOLUTIONS & SUPPORT, INC.**

### **FORM 10-QJune 30, 2006**

**INDEX**

|                   | ** ** | ** **                                                                                                        | ** ** | **Page No.** |
|-------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|-------------------|
| **PART I.**  | ** ** | **FINANCIAL  INFORMATION**                                                                                        |       | —            |
|              |       |                                                                                                              |       |              |
| Item  1.          |       | Financial  Statements (Unaudited)                                                                                 |       |              |
|              |       |                                                                                                              |       |              |
|              |       | Condensed Consolidated Balance Sheets — June 30, 2006  and September 30, 2005                                |       | 3                 |
|              |       |                                                                                                              |       |              |
|              |       | Condensed Consolidated Statements of Operations — Three  Months and Nine Months Ended June 30, 2006 and 2005 |       | 4                 |
|              |       |                                                                                                              |       |              |
|              |       | Condensed  Consolidated Statements of Cash Flows — Nine Months Ended June 30, 2006 and  2005                 |       | 5                 |
|              |       |                                                                                                              |       |              |
|              |       | Notes to Condensed Consolidated Financial Statements                                                              |       | 6                 |
|              |       |                                                                                                              |       |              |
| Item 2.           |       | Management’s Discussion and Analysis of Financial  Controls and Results of Operations                        |       | 10                |
|              |       |                                                                                                              |       |              |
| Item 3.           |       | Quantitative  and Qualitative Disclosures about Market Risk                                                       |       | 15                |
|              |       |                                                                                                              |       |              |
| Item 4.           |       | Controls and Procedures                                                                                           |       | 15                |
|              |       |                                                                                                              |       |              |
| **PART II.** | ** ** | **OTHER  INFORMATION**                                                                                            |       |              |
|              |       |                                                                                                              |       |              |
| Item  1.          |       | Legal  Proceedings                                                                                                |       | 17                |
|              |       |                                                                                                              |       |              |
| Item 1A           |       | Risk Factors                                                                                                      |       | 17                |
|              |       |                                                                                                              |       |              |
| Item 2.           |       | Unregistered Sales of Equity Securities and use of  Proceeds                                                      |       | 17                |
|              |       |                                                                                                              |       |              |
| Item 3.           |       | Defaults upon Senior Securities                                                                                   |       | 17                |
|              |       |                                                                                                              |       |              |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                                               |       | 17                |
|              |       |                                                                                                              |       |              |
| Item  5.          |       | Other  Information                                                                                                |       | 17                |
|              |       |                                                                                                              |       |              |
| Item 6.           |       | Exhibits                                                                                                          |       | 17                |
|              |       |                                                                                                              |       |              |
| **SIGNATURES**    |       |                                                                                                              |       | 18                |

 

 

2

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**PART I—FINANCIAL INFORMATION**

**Item 1—Financial Statements**

**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEET**

**(unaudited)**

| ASSETS                                                                                                                                                                                                           | ** ** | **As of  June 30, 2006** | ** ** | **As of  September 30, 2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------------|------------|
| Current Assets:                                                                                                                                                                                                  |       |                                    |       |                                         |       |
| Cash and cash  equivalents                                                                                                                                                                                       |       | $                                       | 66,679,719 |                                         | $          | 83,172,582 |   |
| Accounts  receivable, less allowance for doubtful accounts of   $100,000 at June 30, 2006 and September 30, 2005                                                                                                 |       | 1,651,487                               |       | 5,479,936                                    |       |
| Inventories                                                                                                                                                                                                      |       | 5,888,956                               |       | 3,911,626                                    |       |
| Deferred income  taxes                                                                                                                                                                                           |       | 1,000,604                               |       | 956,070                                      |       |
| Prepaid expenses  and other current assets                                                                                                                                                                       |       | 3,287,000                               |       | 4,028,498                                    |       |
| Total current  assets                                                                                                                                                                                            |       | 78,507,766                              |       | 97,548,712                                   |       |
| Property and  Equipment:                                                                                                                                                                                         |       |                                    |       |                                         |       |
| Computers and  test equipment                                                                                                                                                                                    |       | 4,616,382                               |       | 4,278,748                                    |       |
| Corporate  airplane                                                                                                                                                                                              |       | 3,027,502                               |       | 2,998,161                                    |       |
| Furniture and  office equipment                                                                                                                                                                                  |       | 748,827                                 |       | 734,038                                      |       |
| Manufacturing  facility                                                                                                                                                                                          |       | 5,420,741                               |       | 5,420,741                                    |       |
| Land                                                                                                                                                                                                             |       | 1,021,245                               |       | 1,021,245                                    |       |
|                                                                                                                                                                                                             |       | 14,834,697                              |       | 14,452,933                                   |       |
| Less-  Accumulated depreciation and amortization                                                                                                                                                                 |       | (5,691,721                              | )          | (5,091,881                                   | )          |
| Net property and  equipment                                                                                                                                                                                      |       | 9,142,976                               |       | 9,361,052                                    |       |
| Deposits and  other assets                                                                                                                                                                                       |       | 339,864                                 |       | 125,114                                      |       |
| Total assets                                                                                                                                                                                                     |       | $                                       | 87,990,606 |                                         | $          | 107,034,878 |   |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                    |       |                                    |       |                                         |       |
| CURRENT LIABILITIES:                                                                                                                                                                                             |       |                                    |       |                                         |       |
| Current portion  of notes payable                                                                                                                                                                                |       | $                                       | 100,000    |                                         | $          | 100,000 |   |
| Current portion  of capitalized lease obligations                                                                                                                                                                |       | 7,891                                   |       | 7,257                                        |       |
| Accounts payable                                                                                                                                                                                                 |       | 631,503                                 |       | 305,516                                      |       |
| Accrued expenses                                                                                                                                                                                                 |       | 2,798,295                               |       | 3,503,814                                    |       |
| Deferred revenue                                                                                                                                                                                                 |       | 592,288                                 |       | 176,650                                      |       |
| Total current  liabilities                                                                                                                                                                                       |       | 4,129,977                               |       | 4,093,237                                    |       |
| Note payable                                                                                                                                                                                                     |       | 4,235,000                               |       | 4,235,000                                    |       |
| Long-term portion  of capitalized lease obligations                                                                                                                                                              |       | 6,591                                   |       | 13,113                                       |       |
| Deferred revenue                                                                                                                                                                                                 |       | 138,609                                 |       | 191,463                                      |       |
| Deferred income  taxes                                                                                                                                                                                           |       | 521,388                                 |       | 635,967                                      |       |
| Commitments and  contingencies                                                                                                                                                                                   |       | —                                  |       | —                                       |       |
| Shareholders’  Equity:                                                                                                                                                                                      |       |                                    |       |                                         |       |
| Preferred stock,  10,000,000 shares authorized, $.001par value, of which 200,000 shares are  authorized as Class A Convertible stock. No shares issued and outstanding at  June 30, 2006 and September 30, 2005. |       | —--                                |       | ---                                          |       |
| Common stock,  $.001 par value: 75,000,000 shares authorized, 18,080,879 and 18,047,425  shares issued and outstanding at June 30, 2006 and September 30, 2005                                                   |       | 18,081                                  |       | 18,047                                       |       |
| Additional  paid-in capital                                                                                                                                                                                      |       | 43,038,800                              |       | 41,926,318                                   |       |
| Retained  earnings                                                                                                                                                                                               |       | 53,988,588                              |       | 55,921,733                                   |       |
| Treasury stock,  at cost, 1,272,510 and 0 shares at June 30, 2006 and September 30, 2005                                                                                                                         |       | (18,086,428                             | )          | ---                                          |       |
| Total  shareholders’ equity                                                                                                                                                                                 |       | 78,959,041                              |       | 97,866,098                                   |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                  |       | $                                       | 87,990,606 |                                         | $          | 107,034,878 |   |

 

The accompanying notes are an integral part of these statements.

3

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS****(unaudited)**

|                                           | ** ** | **Three Months  Ended  June 30  2006** | ** ** | **Three Months  Ended  June 30  2005** | ** ** | **Nine Months  Ended  June 30  2006** | ** ** | **Nine Months  Ended  June 30  2005** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|
| Net sales                                 |       | $                                                | 2,991,022  |                                             | $          | 17,101,620                                      |       | $                                               | 12,141,161 |   | $ | 55,081,445 |   |
| Cost of sales                             |       | 1,667,301                                        |       | 5,846,912                                        |       | 6,564,037                                       |       | 17,806,327                                      |       |
| Gross profit                              |       | 1,323,721                                        |       | 11,254,708                                       |       | 5,577,124                                       |       | 37,275,118                                      |       |
| Operating expenses:                       |       |                                             |       |                                             |       |                                            |       |                                            |       |
|  Research and development            |       | 1,695,304                                        |       | 1,501,475                                        |       | 5,147,093                                       |       | 4,321,474                                       |       |
|  Selling, general and administrative |       | 2,543,635                                        |       | 2,489,287                                        |       | 6,641,121                                       |       | 6,821,682                                       |       |
|                                      |       | 4,238,939                                        |       | 3,990,762                                        |       | 11,788,214                                      |       | 11,143,156                                      |       |
| Operating income (loss)                   |       | (2,915,218                                       | )          | 7,263,946                                        |       | (6,211,090                                      | )          | 26,131,962                                      |       |
| Interest income                           |       | 848,601                                          |       | 543,857                                          |       | 2,449,672                                       |       | 1,255,431                                       |       |
| Interest expense                          |       | (50,068                                          | )          | (48,796                                          | )          | (138,063                                        | )          | (127,930                                        | )          |
| Income (loss)  before income taxes        |       | (2,116,685                                       | )          | 7,759,007                                        |       | (3,899,481                                      | )          | 27,259,463                                      |       |
| Income tax expense  (benefit)             |       | (955,071                                         | )          | 2,860,294                                        |       | (1,966,336                                      | )          | 9,894,108                                       |       |
| Net income (loss)                         |       | $                                                | (1,161,614 | )                                                | $          | 4,898,713                                       |       | $                                               | (1,933,145 | ) | $ | 17,365,355 |   |
| Net income  (loss) per common share:      |       |                                             |       |                                             |       |                                            |       |                                            |       |
| Basic                                     |       | $                                                | (0.07      | )                                                | $          | 0.27                                            |       | $                                               | (0.11      | ) | $ | 0.97 |   |
| Diluted                                   |       | $                                                | (0.07      | )                                                | $          | 0.27                                            |       | $                                               | (0.11      | ) | $ | 0.95 |   |
| Weighted average  shares outstanding:     |       |                                             |       |                                             |       |                                            |       |                                            |       |
| Basic                                     |       | 17,013,737                                       |       | 17,909,270                                       |       | 17,582,519                                      |       | 17,814,504                                      |       |
| Diluted                                   |       | 17,013,737                                       |       | 18,360,921                                       |       | 17,582,519                                      |       | 18,314,568                                      |       |

 

The accompanying notes are an integral part of these statements.

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**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

|                                                                                              | ** ** | **For the Nine  Months Ended  June 30  2006** | ** **  | **For the Nine  Months Ended  June 30  2005** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|-------------|-------------------------------------------------------------------|------------|
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                       |       |                                                              |        |                                                              |       |
| Net income  (loss)                                                                           |       | $                                                                 | (1,933,145  | )                                                                 | $          | 17,365,355 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                                                              |        |                                                              |       |
| Depreciation and  amortization                                                               |       | 628,750                                                           |        | 565,876                                                           |       |
| Stock-based  compensation expense                                                            |       | 539,635                                                           |        | —                                                            |       |
| Compensation  expense for stock issued to directors                                          |       | 239,919                                                           |        | 145,525                                                           |       |
| Loss (Gain) on  disposal of fixed assets                                                     |       | 156                                                               |        | (14,000                                                           | )          |
| Excess and  obsolete inventory expense                                                       |       | 47,817                                                            |        | 52,340                                                            |       |
| Deferred income  taxes                                                                       |       | (159,113                                                          | )           | —                                                            |       |
| Tax benefit from  exercise of stock options                                                  |       | 201,826                                                           |        | 1,628,562                                                         |       |
| Excess tax  benefits from share-based payment arrangements                                   |       | (12,335                                                           | )           | —                                                            |       |
| (Increase)  decrease in:                                                                     |       |                                                              |        |                                                              |       |
| Accounts  receivable                                                                         |       | 3,828,449                                                         |        | (2,493,776                                                        | )          |
| Inventories                                                                                  |       | (2,025,147                                                        | )           | 1,478,696                                                         |       |
| Prepaid expenses  and other current assets                                                   |       | 743,348                                                           |        | (679,366                                                          | )          |
| Increase  (decrease) in:                                                                     |       |                                                              |        |                                                              |       |
| Accounts payable                                                                             |       | 325,987                                                           |        | (1,286,829                                                        | )          |
| Accrued expenses                                                                             |       | (705,519                                                          | )           | (989,931                                                          | )          |
| Deferred revenue                                                                             |       | 362,784                                                           |        | 156,587                                                           |       |
| Net cash  provided by operating activities                                                   |       | 2,083,412                                                         |        | 15,929,039                                                        |       |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                       |       |                                                              |        |                                                              |       |
| Purchases of  property and equipment                                                         |       | (387,430                                                          | )           | (315,221                                                          | )          |
| Purchases of other  assets                                                                   |       | (240,000                                                          | )           | —                                                            |       |
| Net cash used in  investing activities                                                       |       | (627,430                                                          | )           | (315,221                                                          | )          |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                       |       |                                                              |        |                                                              |       |
| Proceeds from  exercise of stock options                                                     |       | 131,136                                                           |        | 1,744,370                                                         |       |
| Purchase of  treasury stock                                                                  |       | (18,086,428                                                       | )           | —                                                            |       |
| Repayment of capitalized  lease obligation                                                   |       | (5,888                                                            | )           | (5,646                                                            | )          |
| Excess tax  benefits from share-based payment arrangements                                   |       | 12,335                                                            |        | —                                                            |       |
| Net cash  provided by (used in) financing activities                                         |       | (17,948,845                                                       | )           | 1,738,724                                                         |       |
| Net increase  (decrease) in cash and cash equivalents                                        |       | $                                                                 | (16,492,863 | )                                                                 | $          | 17,352,542 |   |
| Cash and cash  equivalents, beginning of year                                                |       | $                                                                 | 83,172,582  |                                                              | $          | 65,867,167 |   |
| Cash and cash  equivalents, end of period                                                    |       | $                                                                 | 66,679,719  |                                                              | $          | 83,219,709 |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:                                           |       |                                                              |        |                                                              |       |
| Cash paid for  interest                                                                      |       | $                                                                 | 108,938     |                                                              | $          | 72,932 |   |
| Cash paid for  income taxes                                                                  |       | $                                                                 | 440,338     |                                                              | $          | 10,046,772 |   |
| Cash received from  income tax refund                                                        |       | $                                                                 | (3,267,575  | )                                                                 | $          | — |   |

 

The accompanying notes are an integral part of these statements.

 

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**InnovativeSolutions & Support Inc.**

**Notes to Condensed Consolidated FinancialStatements**

**1. Basisof Presentation:**

InnovativeSolutions and Support, Inc. (the “Company”) was incorporated inPennsylvania on February 12, 1988. The Company’s primary business is thedesign, manufacture and sale of flight information computers, flat paneldisplay systems and advanced monitoring systems for the military, government,commercial air transport and corporate aviation markets.

The balance sheetas of June 30, 2006, the statement of operations for the three months and ninemonths ended June 30, 2006 and 2005 and the statements of cash flows for thenine months ended June 30, 2006 and 2005 have been prepared by the Companywithout audit. In the opinion of management, all adjustments, consisting ofnormal and recurring adjustments, necessary to present fairly the financialposition, results of operations and cash flows at June 30, 2006 and for allperiods presented have been made.

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted. It is suggested thatthese financial statements be read in conjunction with the financial statementsand notes thereto included in the Company’s Form 10K for the year endedSeptember 30, 2005 as filed with the Securities and Exchange Commission.The results of operations for the three months and nine months ended June 30,2006 are not necessarily indicative of the operating results for the full year.

On June 13, 2005,the Company’s Board of Directors approved a three-for-two split of the Company’scommon stock.  The stock split waseffected in the form of a fifty (50%) stock dividend that was paid on July 7,2005 to shareholders of record on June 23, 2005.  The issued and outstanding common stock andall the share and per share amounts have been retroactively restated in thisreport to give effect to this three-for-two stock split.

**2. Netincome per Share**

Net income pershare (“EPS”) is calculated using the principles of SFAS No. 128, “EarningsPer Share.”

A reconciliationof weighted average shares outstanding appears below:

|                                           | ** ** | **Three Months  Ended June  2006** | ** ** | **Three Months  Ended June  2005** | ** ** | **Nine Months  Ended June   2006** | ** ** | **Nine Months  Ended June  2005** | ** ** |
|-------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------|------------|
| Weighted average number  of shares-basic  |       | 17,013,737                                   |       | 17,909,270                                   |       | 17,582,519                                        |       | 17,814,504                                  |       |
| Effect of dilutive  securities:           |       |                                         |       |                                         |       |                                              |       |                                        |       |
| Employee stock  options                   |       |                                         |       | 451,651                                      |       |                                              |       | 500,064                                     |       |
| Weighted average number of shares-diluted |       | 17,013,737                                   |       | 18,360,921                                   |       | 17,582,519                                        |       | 18,314,568                                  |       |

 

For the threemonth periods ended June 30, 2006 and 2005, there were 371,272 and 0 optionsoutstanding that were excluded from the computation of diluted earnings pershare as the effect would have been antidilutive. For the nine month periodsended June 30, 2006 and 2005, there were 418,559 and 16,841 options outstandingthat were excluded from the computation of diluted earnings per share as theeffect would be antidilutive.

**3.Concentrations**

For the threemonths ended June 30, 2006, two customers accounted for 16.1% and 10.4% of netsales or 26.5% of net sales on a combined basis.  For the three months ended June 30,2005, three customers accounted for 19%, 15% and 11% of net sales or 45% of netsales on a combined basis. For the nine months ended June 30, 2006, twocustomers accounted for 12.4% and 9.8% of net sales or 22.2% of net sales on acombined basis.  For the nine monthsended June 30, 2005, three customers accounted for 12%, 11% and 10% of netsales or 33% on a combined basis.

6

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**4.Inventories**

Inventories arestated at the lower of cost (first-in, first-out) or market and consist of thefollowing:

|                 | ** ** | **June 30   2006** | ** ** | **September 30  2005** | ** ** |
|-----------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw materials   |       | $                            | 3,103,347  |                        | $          | 1,696,050 |   |
| Work-in-process |       | 1,777,700                    |       | 1,151,828                   |       |
| Finished goods  |       | 1,007,909                    |       | 1,063,748                   |       |
|            |       | $                            | 5,888,956  |                        | $          | 3,911,626 |   |

** **

**5.Warranty**

The Companyprovides for the estimated cost of product warranties at the time revenue isrecognized. Warranty cost is recorded as cost of sales and the reserve balancerecorded as an accrued expense in the financial statements. While the Companyengages in extensive product quality programs and processes, the Company’swarranty obligation is affected by product failure rates and the relatedmaterial, labor and delivery costs incurred in correcting a product failure.Should actual product failure rates, material or labor costs differ from theCompany’s estimates, further revisions to the estimated warranty liabilitywould be required.

Warrantycost and accrual information for the three months ended June 30, 2006 ishighlighted below:

| Warranty accrual at March  31, 2006                       |   | $       | 708,952 |   |
|-----------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense for the  three months ended June 30, 2006 |   | 12,861  |    |
| Warranty costs for the  three months ended June 30, 2006  |   | (70,631 | )       |
| Warranty accrual at June 30, 2006                         |   | $       | 651,182 |   |

 

Warrantycost and accrual information for the nine months ended June 30, 2006 ishighlighted below:

| Warranty accrual at  September 30, 2005                  |   | $        | 770,845 |   |
|----------------------------------------------------------|--------|----------|---------|--------|
| Accrued expense for the  nine months ended June 30, 2006 |   | 43,640   |    |
| Warranty costs for the  nine months ended June 30, 2006  |   | (163,303 | )       |
| Warranty accrual at June 30, 2006                        |   | $        | 651,182 |   |

** **

**6. StockOptions**

The Company’s 1998Stock Option Plan (the “Plan”) provides for the granting of incentive andnonqualified stock options to employees, officers, directors and independentcontractors and consultants. Through June 30, 2006 no stock options have beengranted to independent contractors or consultants under this plan.

Incentive stockoptions granted under the Plan have exercise prices that must be at least equalto the fair value of the common stock on the date of grant. Nonqualified stockoptions granted under the Plan have exercise prices that may be less than,equal to or greater than the fair value of the common stock on the date ofgrant. The Company has reserved 3,389,025 shares of Common Stock for awardsunder the Plan. As of June 30, 2006 there were 1,696,518 remaining andavailable for grant.

OnDecember 16, 2004, the FASB finalized SFAS No. 123(R) Share-BasedPayment (SFAS 123(R)). SFAS123(R) amends SFAS 123 and supersedes APB25. SFAS123(R) requires that the cost of share-based payment transactions (includingthose with employees and non-employee directors) be recognized in the financialstatements. SFAS 123(R) applies to all share-based payment transactions inwhich an entity acquires goods or services by issuing (or offering to issue)its shares, share options, or other equity instruments (except for those heldby an Employee Stock Option Plan (ESOP)) or by incurring liabilities(1) in amounts based (even in part) on the price of the entity’s shares orother equity instruments, or (2) that require (or may require) settlementby the issuance of an entity’s shares or other equity instruments. Thisstatement was effective as of the first annual reporting period beginning afterJune 15, 2005, which is the Company’s period beginning October 1, 2005.

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EffectiveOctober 1, 2005 the Company adopted the provisions of SFAS 123(R), usingthe modified prospective approach and now accounts for share-based compensationapplying the fair value method for expensing stock options. Accordingly, theadoption of SFAS 123R’s fair value method resulted in compensation costs forthe Company’s 1998 Stock Option Plan. The compensation cost that has beencharged against income as a result of adoption of SFAS 123(R) for the plan was$184,128 and $539,635 for the three and nine month periods ended June 30, 2006,respectively . The total income tax benefit recognized in the statement ofoperations for share-based compensation arrangements was $74,498 and $218,336for the three and nine month periods ended June 30, 2006, respectively.

Share-basedcompensation costs prior to October 1, 2005 were recognized using theintrinsic value method in accordance with Accounting Principles Board Opinion (“APB”)No. 25, “Accounting for Stock Issued to Employees.” For disclosure purposes,pro forma net income and net income per share data were provided in accordancewith SFAS No. 123, “Accounting for Stock-Based Compensation,” as if thefair value method had been applied. Under SFAS No. 123, compensation costrelated to stock options granted to employees was computed based on the fairvalue of the stock option at the date of grant using the Black-Scholes optionpricing model. Prior to the adoption of SFAS 123(R) had compensation costs beendetermined based on the fair market value of the stock options, consistent withthe provisions of SFAS 123, the Company’s net income and earnings per share forthe three and nine months ended June 30, 2005 would have been as follows:

|                                      | ** ** | **Three Months  Ended June 30  2006** | ** ** | **Three Months  Ended June 30  2005** | ** ** | **Nine Months  Ended June 30  2006** | ** ** | **Nine Months  Ended June 30  2005** | ** ** |
|--------------------------------------|------------|------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net income (loss) as  reported       |       | $                                                    | (1,161,614 | )                                                    | $          | 4,898,713                                           |       | $                                                   | (1,933,145 | ) | $ | 17,365,355 |   |
| Add back fair  market value expense: |       |                                                 |       |                                                 |       |                                                |       |                                                |       |
| Employee stock  options (1)          |       | 109,630                                              |       |                                                 |       | 321,299                                             |       |                                                |       |
| Deduct fair  market value expense:   |       |                                                 |       |                                                 |       |                                                |       |                                                |       |
| Employee stock  options (2)          |       | (109,630                                             | )          | (201,483                                             | )          | (321,299                                            | )          | (607,881                                            | )          |
| Pro forma net  income (loss)         |       | $                                                    | (1,161,614 | )                                                    | $          | 4,697,230                                           |       | $                                                   | (1,933,145 | ) | $ | 16,757,474 |   |
| Basic earnings  (loss) per share     |       |                                                 |       |                                                 |       |                                                |       |                                                |       |
| As reported                          |       | $                                                    | (0.07      | )                                                    | $          | 0.27                                                |       | $                                                   | (0.11      | ) | $ | 0.97 |   |
| Pro forma                            |       | $                                                    | (0.07      | )                                                    | $          | 0.26                                                |       | $                                                   | (0.11      | ) | $ | 0.94 |   |
| Diluted earnings  (loss) per share : |       |                                                 |       |                                                 |       |                                                |       |                                                |       |
| As reported                          |       | $                                                    | (0.07      | )                                                    | $          | 0.27                                                |       | $                                                   | (0.11      | ) | $ | 0.95 |   |
| Pro forma                            |       | $                                                    | (0.07      | )                                                    | $          | 0.26                                                |       | $                                                   | (0.11      | ) | $ | 0.91 |   |

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(1)             Amountrepresents compensation expense determined under the fair market value methodincluded in reported net income, net of related tax effect.

(2)             Amountsrepresent compensation expense if it had been determined under the fair marketvalue based method, net of related tax effect.

The fair value ofeach option grant is estimated on the date of grant using the Black-Scholesoption pricing model and the following weighted —average assumptions:

|                                           | ** ** | **Nine Months   Ended June 30   2006** | ** ** | **Nine Months   Ended June 30  2005** | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Expected lives (years)                    |       | 9.0                                                             |       | 8.8                                                       |       |
| Weighted average  risk-free interest rate |       | 1.9                                                             | %          | 1.7                                                       | %          |
| Expected volatility                       |       | 65.3                                                            | %          | 66.8                                                      | %          |
| Expected dividend rate                    |       | —                                                          | %          | —                                                    | %          |

** **

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**7. StockRepurchase Program**

On December 28,2005 the Company’s Board of Directors approved a common stock repurchaseprogram to acquire up to 2,000,000 shares of its outstanding common stock.Purchases of the stock may be made from time to time, subject to marketconditions and at prevailing market prices. The program was in effect untilJune 30, 2006.

During the threemonths ended June 30, 2006, the Company repurchased 310,900 shares of itscommon stock at an average cost of $13.98 per share. Over the course of theprogram the Company repurchased 1,272,510 shares of its common stock at anaverage cost of $14.21 per share.

**8. NotesPayable**

The Companyentered into a $4,335,000 loan agreement dated August 1, 2000 with the ChesterCounty, Pennsylvania Industrial Development Authority.  The purpose of the loan was to fund theconstruction of the Company’s new office and manufacturing facility.  The loan matures in 2015 and carries aninterest rate set by the remarketing agent that is consistent with 30-daytax-exempt commercial paper.

The loan agreementrequires the Company to maintain certain financial covenants including a ratioof liabilities to earnings before interest, taxes and depreciation andamortization (EBITDA), fixed charge ratio and a minimum tangible net worth.

As of June 30,2006, the Company was in violation of these financial covenants.  The defaults were subsequently waived and anamendment to the agreement was entered into with the lender whereby theexisting covenants were suspended until the fiscal quarter ending on June 30,2007.

**NewAccounting Pronouncements**

In July 2006, theFASB issued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes— an interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, “Accounting for Income Taxes”.  This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  This Interpretation alsoprovides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  TheCompany is currently evaluating the impact of this pronouncement.

In May 2005,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standard (SFAS) No. 154, “Accounting Changes and Error Corrections— a replacement of APB Opinion No. 20 and FASB Statement No. 3.”   SFAS No. 154 requires retrospectiveapplication to prior periods’ financial statements of changes in accountingprinciple, unless it is impracticable to determine either the period-specificeffects or the cumulative effect of the change. SFAS No. 154 also requires that retrospective application of achange in accounting principle be limited to the direct effects of the change.  Indirect effects of a change in accounting principle,such as a change in nondiscretionary profit-sharing payments resulting from anaccounting change, should be recognized in the period of the accountingchange.  SFAS No. 154 also requiresthat a change in depreciation, amortization, or depletion method for long-lived,non-financial assets be accounted for as a change in accounting estimateeffected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections oferrors made in fiscal years beginning after December 15, 2005.  Early adoption is permitted for accountingchanges and corrections of errors made in fiscal years beginning after the datethis Statement is issued.  The Companywill adopt the provisions of SFAS No. 154 as applicable beginning infiscal 2007.

In December 2004,the FASB issued FASB Staff Position (FSP) FAS 109-1, “Application of FASBStatement No. 109, Accounting for Income Taxes, to the Tax Deduction onQualified Production Activities Provided by the American Jobs Creation Act of2004”. This FSP provides guidance on the application of Statement 109 to theprovisions within the American Jobs Creation Act of 2005 (the Act), whichprovides tax relief to U.S. domestic manufacturers. The FSP states that amanufacturer’s deduction provided for under the Act should be accounted for asa special deduction in accordance with Statement 109 and not as a tax ratereduction. The FSP also reminds preparers that the special deduction should beconsidered by an enterprise in (a) measuring deferred taxes when the enterpriseis subjected to graduated tax rates, and (b) assessing whether a valuationallowance is necessary as required by Statement 109. This statement iseffective immediately. The Company has adopted this statement during fiscalyear 2005 and it did not have a material impact on the Company’s financialposition or results of operations.

InNovember 2004, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) 151, “Inventory Costs.” ThisStatement amends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing,”to clarify the accounting for abnormal amounts of idle facility expense,freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43,Chapter 4 previously stated that “... under some circumstances, items such asidle facility expense, excessive spoilage, double freight, and rehandling costsmay be so abnormal as to require treatment as current period charges...”. ThisStatement requires that those items be 

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recognized ascurrent-period charges regardless of whether they meet the criterion of “soabnormal.” In addition, this Statement requires that allocation of fixedproduction overheads to the costs of conversion be based on the normal capacityof the production facilities. This statement is effective for inventory costsincurred during fiscal years beginning after June 15, 2005. The Companyhas adopted this statement on October 1, 2005 and it did not have a materialimpact on the Company’s financial position or results of operations.

**Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations**

**Overview**

We design,manufacture and sell flight information computers, flat panel display systemsand advanced monitoring systems to the Department of Defense (DOD), governmentagencies, commercial air transport carriers and corporate/general aviationmarkets.

Our revenues arederived from the sale of our products to the retrofit market and, to a lesserextent, original equipment manufacturers (OEMs). Our customers includegovernment and military entities and their commercial contractors, aircraftoperators, aircraft modification centers and various OEMs. Although weoccasionally sell our products directly to government entities, we primarilysell our products to commercial customers for end use in government andmilitary programs.

We continue toinvest in and seek additional opportunities for our Flat Panel Display Systems(“FPDS”) product line. In October 2005, the FAA awarded the Company asecond Technical Standard Order (TSO) for the FPDS or COCKPIT/IP®. This TSOestablishes our FPDS as meeting FAA requirements that have been put in place toensure safe flight on a variety of aircraft types and, additionally, itaddresses the most stringent Commercial Air Transport market requirements asprovided in Title 14 of the Code of Federal Regulation, subpart 25, CommercialAir Transport. The TSO states “It has been noted that this display systememploys an integrity monitoring system that assures integrity to a catastrophic/LevelA design condition with the use of commercial graphic processors”.

InOctober 2005, the Company in a teaming arrangement with ABX Air, receivedFAA Supplemental Type Certification (STC) of its FPDS for use on B-767aircraft. The STC provides B-767 operators with a low cost, rapidly implementedretrofit of their cockpit avionics with a modern pilot and copilot suite ofhigh resolution multi-color LCD flat panel displays. Operators will benefitfrom improved dispatch reliability, logistics savings and adaptability tofuture requirements. The receipt of the STC positions the Company to pursuemore than 1,700 B-757 and B-767 aircraft with similar needs for FPDS upgrades.The STC also provides a foundation for incorporating the product into otherairplanes as well.

In April 2006, theCompany announced that the Federal Aviation Administration (FAA) granted aSupplemental Type Certificate (STC) for its Flat Panel PrimaryFlight/Navigation Display System for use on the Pilatus PC-12 Airplane.

Our “cost of sales”is comprised of material components purchased through our supplier base anddirect in-house assembly labor and overhead costs. Many of the components weuse in assembling our products are standard, although certain parts aremanufactured to meet our specifications. The overhead portion of cost of salesis primarily comprised of salaries and benefits, building occupancy, supplies,and outside service costs related to our production, purchasing, customerservice, material control and quality departments as well as warranty costs.

We intend tocontinue investing in the development of new products and the enhancement ofour existing product line. We expense research and development costs related tofuture product development as they are incurred.

Our selling,general, and administrative expenses consist of marketing and businessdevelopment expenses, professional expenses, salaries and benefits forexecutive and administrative personnel, facility costs, recruiting, legal,accounting, and other general corporate expenses.

**ThreeMonths Ended June 30, 2006 Compared to the Three Months Ended June 30,2005**

*Netsales.* Net sales decreased $14.1 million, or 83%, to $3.0million for the three months ended June 30, 2006 from $17.1 million in thethree months ended June 30, 2005. This decrease in net sales was mainly due toa decrease in demand for RVSM systems. Sales for the three months ended June30, 2005 reflected an industry wide response to a Federal AviationAdministration (FAA) mandate that required the installation of RVSM equipmenton aircraft flying between 29,000 and 41,000 feet by January 20, 2005. Thepeak demand for the RVSM system declined soon after this date.

*Cost ofsales.* Cost of sales decreased $4.1 million or 71%, to $1.7million, or 56% of net sales in the three months ended June 30, 2006 from $5.8million, or 34 % of net sales in the three months ended June 30, 2005. Theabsolute dollar decrease in cost of sales was related to our decrease in netsales. As a percentage, the increase was the result of fixed operating costsbeing absorbed over lower net sales in the current period.

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*Researchand development.* Research and development expenses increased$0.2 million or 13% to $1.7 million or 57% of net sales in the three monthsended June 30, 2006 from $1.5 million or 9% of net sales in the three monthsended June 30, 2005.  The increase indollar spending reflects our sustained new product development effort. Thepercent increase was due to lower sales in the period.

*Selling,general, and administrative.* Selling, general, andadministrative expenses increased $54,000, or 2%, to $2.5 million, or 85% ofnet sales in the three months ended June 30, 2006 from $2.5 million or 15% ofnet sales in the three months ended June 30, 2005. The increase in the dollar amountwas primarily the result of legal and other fees relating to intellectualproperty matters and recognition of expenses related to stock options offset bylower commissions. The increase as a percent of net sales was the result oflower net sales in the period.

*Interestincome.* Interest income was $849,000 in the three monthsended June 30, 2006 as compared to interest income of $544,000 in the threemonths ended June 30, 2005. The increase in interest income in the three monthsended June 30, 2006 was primarily the result of higher interest rates in thecurrent period.

*Interestexpense.* Interest expense was $50,000 in the three monthsended June 30, 2006 as compared to interest expense of $49,000 in the threemonths ended June 30, 2005. The increase in interest expense in the threemonths ended June 30, 2006 was primarily the result of higher interest rates inthe period.

*Incometax expense.* Income tax benefit for the three months endedJune 30, 2006 was $1.0 million. The income tax expense for the three monthsending June 30, 2005 was $2.9 million. The decrease in tax expense wasprimarily due to the loss for the current period generating a tax benefit.

The effective taxrate in the June 30, 2006 quarter was a benefit of 45.12%. In the June 30, 2005quarter the effective tax rate was 36%. For the June 30, 2006 quarter, the effective tax rate differs from the statutoryrate due to the benefit for state income taxes partially offset by the loss of benefit from the deduction for domesticproduction activities and the exclusion for extraterritorial income due to theanticipated taxable loss for the year. For the June 30, 2005 quarter, the effective tax rate differs from thestatutory rate due to state tax expense, partially offset by the utilization ofresearch and development tax credits.

 *Net income (loss).*As result of the factors described above, our net loss in the three monthsended June 30, 2006 was $1.2 million, a 124% decrease from the $4.9 million netincome in the three months ended June 30, 2005.

**Ninemonths Ended June 30, 2006 Compared to the Nine months Ended June 30, 2005**

*Netsales.* Net sales decreased $43.0 million, or 78%, to $12.1million for the nine months ended June 30, 2006 from $55.1 million in the ninemonths ended June 30, 2005. This decrease in net sales was mainly due to adecrease in demand for RVSM systems. Sales for the nine months ended June 30,2005 reflected an industry wide response to a Federal Aviation Administration(FAA) mandate that required the installation of RVSM equipment on aircraftflying between 29,000 and 41,000 feet by January 20, 2005. The peak demandfor the RVSM system declined soon after this date.

*Cost ofsales.* Cost of sales decreased $11.2 million or 63%, to $6.6million, or 54% of net sales in the nine months ended June 30, 2006 from $17.8million, or 32 % of net sales in the nine months ended June 30, 2005. Theabsolute dollar decrease in cost of sales was related to our decrease in netsales. As a percentage, the increase was the result of fixed operating costsbeing absorbed over lower net sales in the current period.

*Researchand development.* Research and development expenses increased$0.8 million or 19% to $5.1 million or 42% of net sales in the nine monthsended June 30, 2006 from $4.3 million or 8% of net sales in the nine monthsended June 30, 2005.  The increase indollar spending reflects our sustained new product development effort. Thepercent increase was mostly due to lower sales in the period.

*Selling,general, and administrative.* Selling, general, andadministrative expenses decreased $0.2 million, or 3%, to $6.6 million, or 55%of net sales in the nine months ended June 30, 2006 from $6.8 million or 12% ofnet sales in the nine months ended June 30, 2005. The decrease in the dollaramount was primarily the result of lower commissions offset by the recognitionof expenses related to stock options. The increase as a percent of net saleswas the result of lower net sales in the period.

*Interestincome.* Interest income was $2.4 million in the nine monthsended June 30, 2006 as compared to interest income of $1.3 million in the ninemonths ended June 30, 2005. The increase in interest income in the nine monthsended June 30, 2006 was primarily the result of higher interest rates in thecurrent period.

*Interestexpense.* Interest expense was $138,000 in the nine monthsended June 30, 2006 as compared to interest expense of $128,000 in the ninemonths ended June 30, 2005. The increase in interest expense in the nine monthsended June 30, 2006 was primarily the result of higher interest rates in theperiod.

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*Incometax expense.* Income tax benefit for the nine months endedJune 30, 2006 was $2.0 million. The income tax expense for the nine monthsending June 30, 2005 was $9.9 million. The decrease in tax expense wasprimarily due to the loss for the current period generating a tax benefit.

The effective taxrate for the nine months ended June 30, 2006 was a benefit of 50.43%. For thenine months ended June 30, 2005 the effective tax rate was 36.3%. For the ninemonths ended June 30, 2006, the effective tax rate differs from the statutoryrate due to the benefit for state income taxes and an adjustment to the taxpayable accounts, partially offset by the loss of benefit from the deductionfor domestic production activities and the exclusion for extraterritorialincome due to the anticipated taxable loss for the year.  For the June 30, 2005 quarter, the effectivetax rate differs from the statutory rate due to state tax expense, partiallyoffset by the utilization of research and development tax credits.

*Netincome (loss).* As a result of the factors described above,our net loss in the nine months ended June 30, 2006 was $1.9 million, a 111%decrease from the $17.4 million net income in the nine months ended June 30,2005.

**Liquidityand Capital Resources**

Our main source ofliquidity has been cash flows from operations. We require cash principally tofinance inventory, accounts receivable and payroll.

Our cash flow fromoperating activities was $2.1 million for the nine months ended June 30, 2006,as compared to $15.9 million for the nine months ended June 30, 2005. Thedecrease was due primarily to lower net income ($19.3 million) and increasedinventories ($3.5 million) which were partially offset by reduced accountsreceivable ($6.3 million) and a decrease in prepaid expenses ($1.4 million).

Our cash used ininvesting activities was $627,000 for the nine months ended June 30, 2006. Thisprimarily consisted of spending for product certification, production equipmentand laboratory test equipment. Cash used in investing activities was $315,000for the nine months ended June 30, 2005 and primarily consisted of spending forproduction equipment, laboratory test equipment, computer equipment and officefurniture.

Net cash used infinancing activities was $17.9 million for the nine months ended June 30, 2006as compared to net cash provided by financing activities of $1.7 million in thenine months ended June 30, 2005. The primary use of cash for financingactivities was attributable to the Company purchasing 1,272,510 shares of ourstock at a total cost of $18.1 million. In both periods the primary source ofcash was from proceeds from the exercise of stock options.

The Companyentered into a $4,335,000 loan agreement dated August 1, 2000 with the ChesterCounty, Pennsylvania Industrial Development Authority.  The purpose of the loan was to fund theconstruction of the Company’s new office and manufacturing facility.  The loan matures in 2015 and carries aninterest rate set by the remarketing agent that is consistent with 30-daytax-exempt commercial paper.

The loan agreementrequires the Company to maintain certain financial covenants including a ratioof liabilities to earnings before interest, taxes and depreciation andamortization (EBITDA), fixed charge ratio and a minimum tangible net worth.

As of June 30,2006, the Company was in violation of these financial covenants.  The defaults were subsequently waived and anamendment to the agreement was entered into with the lender whereby theexisting covenants were suspended until the fiscal quarter ending on June 30,2007.

Our future capitalrequirements depend on numerous factors, including market acceptance of ourproducts, the timing and rate of expansion of our business, acquisitions, jointventures and other factors. We have experienced increases in our expendituressince our inception consistent with growth in our operations, personnel andproduct line, and we anticipate that our expenditures will continue to increasein the foreseeable future. We believe that our cash and cash equivalents willprovide sufficient capital to fund our operations for at least the next twelvemonths. However, we may need to raise additional funds through public orprivate financings or other arrangements in order to support more rapidexpansion of our business than we now anticipate either through acquisitions ororganic growth. Further, we may need to develop and introduce new or enhancedproducts, respond to competitive pressures, invest in or acquire businesses ortechnologies or respond to unanticipated requirements or developments. Ifadditional funds are raised through the issuance of equity securities, dilutionto existing shareholders may result. If insufficient funds are available, wemay not be able to introduce new products or compete effectively in any of ourmarkets, which could hurt our business.

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**Backlog**

As of June 30, 2006 and 2005, our backlog was $34.3million and $13.7 million, respectively. The components of the backlog fromperiod-to-period have shown a distinct transformation. Flat Panel DisplaySystems (FPDS) comprise $22.1 million, or 64% of the June 30, 2006 backlog, anincrease of $17.0 million from the June 30, 2005 FPDS backlog of $5.1 million.

Bookings of FPDSfor the nine months ended June 30, 2006 increased $17.3 million or 400% to$21.6 million from $4.3 million for the nine months ended June 30, 2005.

**CriticalAccounting Policies**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities,disclosure of contingent assets and liabilities at the date of the financialstatements and the reported amount of revenues and expenses during thereporting period. The Company’s most critical accounting policies are revenuerecognition, income taxes, allowance for doubtful accounts, inventoryvaluation, share-based compensation and warranty reserves.

The Companyrecognizes sales for products when the following revenue recognition criteriaare met: persuasive evidence of an arrangement exists, product delivery andacceptance has occurred, pricing is fixed or determinable and collection isreasonably assured. The Company recognizes sales upon shipment of products tocustomers.

Sales related tocertain long-term contracts requiring development and delivery of products overseveral accounting periods are accounted for under the American Institute of CertifiedPublic Accountants (AICPA) Statement of Position (SOP) 81-1, *Accounting for Performance of Construction-Type and CertainProduction-Type Contracts.*We consider the nature of these contractsas well as the types of products and services provided when determining theappropriate accounting treatment for a particular contract. Certain long-termcontracts are recorded on a percentage of completion basis using cost-to-costmethodology to measure progress towards completion.

The Company offersits customers extended warranties for additional fees. These warranty sales arerecorded as deferred revenue and recognized as sales on a straight-line basisover the warranty period.

The Company entersinto certain sales arrangements that include multiple deliverables as definedin Emerging Issues Task Force (EITF) Issue No. 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables*. EffectiveJuly 1, 2003, the Company identifies all goods and/or services that are tobe delivered separately under a sales arrangement and allocates revenue to eachdeliverable based on fair value that is established with the customer duringcontract negotiations. In general, revenues are separated between product salesand non-recurring engineering services. The allocated revenue for eachdeliverable is then recognized using appropriate revenue recognition methods.Effective for transactions entered into after October 1, 2003, the Companyaccounts for transactions with software and non-software components under EITFIssue 03-5, “Applicability of AICPA Statement of Position 97-2, SoftwareRevenue Recognition, to Non-Software Deliverables in an Arrangement ContainingMore-Than-Incidental Software.”

Income taxes arerecorded in accordance with SFAS No. 109, Accounting for Income Taxes.Provisions for federal and state income taxes are calculated on reportedfinancial statement pre-tax income based on current tax law. The Companyrecognizes deferred tax assets and liabilities for temporary differencesbetween the financial reporting basis and the tax basis of the Company’s assetsand liabilities and expected benefits of utilizing net operating losscarryforwards. The impact on deferred taxes of changes in tax rates and laws,if any, applied to the years during which temporary differences are expected tobe settled, are reflected in the consolidated financial statements in theperiod of enactment.

We maintain anallowance for doubtful accounts for estimated losses resulting from theinability of our customers to make required payments. These allowances aredetermined by analyzing historical data and trends. If actual losses aregreater than estimated amounts or if the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, future results from operations could be adversely affected.

Inventories arewritten down for estimated obsolescence equal to the difference between thecost of inventory and the estimated net realizable value based upon assumptionsabout future market conditions. If actual future demand or market conditionsare less favorable than those projected by management, additional inventorywrite-downs may be required.

We offerwarranties on some products of various lengths. At the time of shipment, weestablish a reserve for the estimated cost of warranties based on our bestestimate of the amounts necessary to settle future and existing claims usinghistorical data on products sold as of the balance sheet date. The length ofthe warranty period, the product’s failure rates and the customer’s usageaffects warranty cost. If the actual cost of warranties differs from ourestimated amounts, future results of operations could be adversely affected.

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EffectiveOctober 1, 2005 the Company adopted the provisions of SFAS 123R, using themodified prospective approach and now accounts for share-based compensationapplying the fair value method for expensing stock options. Accordingly, theadoption of SFAS 123R’s fair value method results in compensation costs for theCompany’s 1998 Stock Option Plan.

**BusinessSegments**

We operate in oneprincipal business segment which designs, manufactures and sells flightinformation computers, flat panel display systems and advanced monitoringsystems to the Department of Defense, government agencies, commercial airtransport carriers and corporate/general aviation markets. We currently derivevirtually all our net sales from the sale of this equipment. Almost all of thenet sales, operating results and identifiable assets are in the United States.  Net sales, operating results, andidentifiable assets outside of the U.S. are not significant.

**NewAccounting Pronouncements**

In July 2006, theFASB issued FASB Interpretation 48, “Accounting for Uncertainty in Income Taxes— an interpretation of FASB Statement No. 109” (“FIN 48”).  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with FASB Statement No. 109, “Accounting for Income Taxes”.  This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a taxreturn.  This Interpretation alsoprovides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition.  FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.  TheCompany is currently evaluating the impact of this pronouncement.

In May 2005,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standard (SFAS) No. 154, “Accounting Changes and ErrorCorrections — a replacement of APB Opinion No. 20 and FASB StatementNo. 3.”   SFAS No. 154 requiresretrospective application to prior periods’ financial statements of changes inaccounting principle, unless it is impracticable to determine either theperiod-specific effects or the cumulative effect of the change.  SFAS No. 154 also requires that retrospectiveapplication of a change in accounting principle be limited to the directeffects of the change.  Indirect effectsof a change in accounting principle, such as a change in nondiscretionaryprofit-sharing payments resulting from an accounting change, should berecognized in the period of the accounting change.  SFAS No. 154 also requires that a changein depreciation, amortization, or depletion method for long-lived,non-financial assets be accounted for as a change in accounting estimate effectedby a change in accounting principle.  SFASNo. 154 is effective for accounting changes and corrections of errors madein fiscal years beginning after December 15, 2005.  Early adoption is permitted for accountingchanges and corrections of errors made in fiscal years beginning after the datethis Statement is issued.  The Companywill adopt the provisions of SFAS No. 154 as applicable beginning infiscal 2007.

InDecember 2004, the FASB issued FASB Staff Position (FSP) FAS 109-1, “Applicationof FASB Statement No. 109, Accounting for Income Taxes, to the TaxDeduction on Qualified Production Activities Provided by the American JobsCreation Act of 2004.” This FSP provides guidance on the application ofStatement 109 to the provisions within the American Jobs Creation Act of 2005(the Act), which provides tax relief to U.S. domestic manufacturers. The FSPstates that a manufacturer’s deduction provided for under the Act should beaccounted for as a special deduction in accordance with Statement 109 and notas a tax rate reduction. The FSP also reminds preparers that the specialdeduction should be considered by an enterprise in (a) measuring deferredtaxes when the enterprise is subjected to graduated tax rates, and(b) assessing whether a valuation allowance is necessary as required by Statement109. This statement is effective immediately. The Company has adopted thisstatement during fiscal year 2005 and it did not have a material impact on theCompany’s financial position or results of operations.

InNovember 2004, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) 151, “Inventory Costs.” ThisStatement amends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing,”to clarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter4 previously stated that “... under some circumstances, items such as idlefacility expense, excessive spoilage, double freight, and rehandling costs maybe so abnormal as to require treatment as current period charges...” ThisStatement requires that those items be recognized as current-period chargesregardless of whether they meet the criterion of “so abnormal.” In addition,this Statement requires that allocation of fixed production overheads to thecosts of conversion be based on the normal capacity of the productionfacilities. This statement is effective for inventory costs incurred duringfiscal years beginning after June 15, 2005. The Company has adopted thisstatement on October 1, 2005 and it did not have a material impact on theCompany’s financial position or results of operations.

**FORWARD-LOOKING STATEMENTS**

ThisForm 10-Q contains statements, which, to the extent that they are notrecitations of historical fact, constitute forward-looking statements withinthe meaning of the Securities Act of 1933 and the Securities Exchange Act of1934. The words “believe,” “estimate,” “anticipate,” “project,” “intend,” “expect,”“plan,” “outlook,” “forecast” and similar expressions are intended to identifyforward-looking statements. Numerous factors, including potentially thefollowing factors, could affect the Company’s forward-looking statements andactual performance:

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•                    continuedmarket acceptance of our air data systems products;

•                    our ability toobtain future contracts and awards;

•                    availabilityof government funding and customer requirements;

•                    difficultiesin developing and producing our flat panel display systems (CIP) or otherplanned products or product enhancements;

•                    marketacceptance of our CIP system or other planned products or product enhancements;

•                    our ability togain regulatory approval of our products in a timely manner;

•                    delays inreceiving components from third party suppliers;

•                    thecompetitive environment;

•                    termination ofprograms or contracts for convenience by customers;

•                    failure toretain key personnel;

•                    new productofferings from competitors;

•                    potentialfuture acquisitions;

•                    protection ofintellectual property rights;

•                    our ability toservice the international market, and

•                    other factorsdisclosed from time to time in our filings with the Securities and ExchangeCommission.

Readers arecautioned not to place undue reliance on these forward-looking statements,which speak only as of the date of this Form 10-Q. The Company does notundertake any obligation to publicly release any revisions to theseforward-looking statements to reflect events, circumstances or changes inexpectations after the date of this Form 10-Q, or to reflect the occurrenceof unanticipated events. The forward-looking statements in this document areintended to be subject to the safe harbor protection provided by Sections 27Aof the Securities Act and 21E of the Exchange Act.

For a discussionidentifying some important factors that could cause actual results to varymaterially from those anticipated in the forward-looking statements, see theCompany’s Securities and Exchange Commission filings including, but not limitedto, the discussions of “Risk Factors” contained in the Company’s Annual Reporton Form 10-K for the fiscal year ended September 30, 2005.

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

The Company’soperations are exposed to market risks primarily as a result of changes ininterest rates. The Company does not use derivative financial instruments forspeculative or trading purposes. The Company’s exposure to market risk forchanges in interest rates relates to its cash equivalents and an industrialrevenue bond. The Company’s cash equivalents consist of funds invested in moneymarket accounts, which bear interest at a variable rate, while the industrialrevenue bond carries an interest rate that is consistent with 30-day,tax-exempt commercial paper. As the interest rates are variable, and we do notengage in hedging activities, a change in interest rates earned on the cashequivalents or paid on the industrial revenue bond would impact interest incomeand expense along with cash flows, but would not impact the fair market valueof the related underlying instruments.

**Item 4.Controls and Procedures**

(a)          An evaluation wasperformed under the supervision and with the participation of the Company’smanagement, including its Chief Executive Officer, or CEO, and Chief FinancialOfficer, or CFO, of the effectiveness of the Company’s disclosure controls andprocedures, as such term is defined under Rule 13a-15e under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”) as of June 30,2006. Based on that evaluation, the Company’s management, including the CEO andCFO, concluded that the Company’s disclosure controls and procedures areeffective to provide reasonable assurance that information required to bedisclosed by the Company in reports that it files or submits under the ExchangeAct, is recorded, processed, summarized and reported as specified in Securitiesand Exchange Commission rules and forms.

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(b)         There were no changes inthe Company’s internal control over financial reporting identified inconnection with the evaluation of such controls that occurred during theCompany’s most recent fiscal quarter that has materially affected, or isreasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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**PART II—OTHER INFORMATION**

**Item 1.    Legal Proceedings**

In the ordinary course ofour business, we are at times subject to various legal proceedings. We do notbelieve that any current legal proceedings will have a material adverse effecton our results of operations or financial position.

**Item1A.Risk Factors**

There are no materialchanges to the risk factors described under Item 1A of our Form 10-K for theyear ended September 30, 2005.

I**tem 2.    Unregistered Sales ofEquity Securities and Use of Proceeds**

(a) The Company’s purchases of its common stock during thethird quarter of Fiscal 2006 were as follows:

| Period              | ** ** | **Total Number  of Shares Purchased** | ** ** | **Average Price  Paid per Share** | ** ** | **Total Number of   Shares Purchased  as  Part of Publicly  Announced Plans  or Programs (1)** | ** ** | **Approximate Dollar  Value of Shares  that May Yet Be  Purchased Under  the Plans or  Programs (1) (2)** | ** ** |
|---------------------|------------|------------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| April 1 to 30, 2006 |       | —                                               |       | —                                           |       | —                                                                                                                                      |       | $                                                                                                                                                                | 18,259,302 |   |
| May 1 to 31, 2006   |       | —                                               |       | —                                           |       | —                                                                                                                                      |       | $                                                                                                                                                                | 18,259,302 |   |
| June 1 to 30, 2006  |       | 310,900                                              |       | $                                                | 13.98      |                                                                                                                                        | 310,900    |                                                                                                                                                             | $          | 0 |   |
|                     |            |                                                      |            |                                                  |            |                                                                                                                                             |            |                                                                                                                                                                  |            |  |  |

 

(1)             EffectiveDecember 28, 2005, the Company announced that the Board of Directors approved a$32 million share repurchase program, authorizing therepurchase of shares ofits common stock. The Company was authorized to make repurchases through June30, 2006.

(2)             Includesbrokerage commissions paid by the Company.

**Item 3.    Defaults upon Senior Securities**

None

**Item 4.****    Submissionof Matters to a Vote of Security Holders**

No matters were submitted to a vote of ourshareholders during the three months ended June 30, 2006.

**Item 5.    Other Information**

None

**Item 6.Exhibits**

(a)           Exhibits

| 31.1   |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a)                                                      |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                           |
| 31.2   |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a)                                                      |
|   |   |                                                                                                                           |
| 32.1   |   | Certification Pursuant to U.S.C. Section 1350,  as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

|                      | ** ** | **INNOVATIVE SOLUTIONS AND SUPPORT, INC.** |
|----------------------|------------|--------------------------------------------|
|                 |       |                                       |   |   |
|                 |       |                                       |   |   |
| Date: August 4, 2006 |       | By:                                        |   | /s/ JAMES J. REILLY |
|                 | ** ** | ** **                                 |   | **James J. Reilly Chief Financial Officer** |

 

 

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