**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**x****   QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For thequarterly period ended March 31, 2007**

**OR**

**o****   TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**[For thetransition period from                                                           to                                                           ]**

**CommissionFile No. 0-31157**

**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

(Exact name ofregistrant 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’stelephone number, including area code)

Indicate by check mark whether registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.                                               Yes x     Noo

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

                                               o Large accelerated filer       xAccelerated filer     o Non-accelerated filer

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

                                               Yes o            No x

Asof May 2, 2007, there were 16,881,001 shares of the Registrant’s Common Stock,with par value of $.001 per share, outstanding.

 

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**INNOVATIVE SOLUTIONS AND SUPPORT,INC.**

### **FORM 10-Q March 31, 2007**

**INDEX**
|                | ** ** | ** **                                                                                                         |   | **Page** |
|----------------|------------|--------------------------------------------------------------------------------------------------------------------|--------|----------|
| **PART I.**    | ** ** | **FINANCIAL INFORMATION**                                                                                          |   |     |
| ** **     | ** ** | ** **                                                                                                         |   |     |
| Item 1.        |       | Financial Statements  (Unaudited)                                                                                  |   |     |
|           |       |                                                                                                               |   |     |
|           |       | Condensed  Consolidated Balance Sheets – March 31, 2007 and September 30, 2006                                |   | 3        |
|           |       |                                                                                                               |   |     |
|           |       | Condensed  Consolidated Statements of Operations – Three Months and Six Months Ended  March 31, 2007 and 2006 |   | 4        |
|           |       |                                                                                                               |   |     |
|           |       | Condensed  Consolidated Statements of Cash Flows – Six Months Ended March 31, 2007 and  2006                  |   | 5        |
|           |       |                                                                                                               |   |     |
|           |       | Notes to  Condensed Consolidated Financial Statements                                                              |   | 6-10     |
|           |       |                                                                                                               |   |     |
| Item 2.        |       | Managements  Discussion and Analysis of Financial Controls and Results of Operations                               |   | 10-15    |
|           |       |                                                                                                               |   |     |
| 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** |       |                                                                                                               |

 

2

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**PART I–FINANCIAL INFORMATION**

**Item 1–FinancialStatements**

**INNOVATIVE SOLUTIONS AND SUPPORT,INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEET**

**(unaudited)**
| ** **                                                                                                                                                                                                          | ** ** | **As of**               | ** ** | **As of**                   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                          | ** ** | **March 31, 2007** | ** ** | **September 30, 2006** | ** ** |
| **ASSETS**                                                                                                                                                                                                          |       |                         |       |                             |       |
| Current Assets:                                                                                                                                                                                                     |       |                         |       |                             |       |
| Cash and cash  equivalents                                                                                                                                                                                          |       | $                            | 60,719,959 |                             | $          | 62,984,829 |   |
| Accounts  receivable, less allowance for doubtful accounts of $0 and $100,000 at March  31, 2007 and September 30, 2006                                                                                             |       | 2,322,706                    |       | 3,333,131                        |       |
| Inventories                                                                                                                                                                                                         |       | 5,553,926                    |       | 6,466,156                        |       |
| Deferred income  taxes                                                                                                                                                                                              |       | 1,327,973                    |       | 1,082,931                        |       |
| Prepaid expenses  and other current assets                                                                                                                                                                          |       | 7,194,983                    |       | 4,065,696                        |       |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Total current  assets                                                                                                                                                                                               |       | 77,119,547                   |       | 77,932,743                       |       |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Property and Equipment:                                                                                                                                                                                             |       |                         |       |                             |       |
| Computers and  test equipment                                                                                                                                                                                       |       | 4,746,175                    |       | 4,592,410                        |       |
| Corporate  airplane                                                                                                                                                                                                 |       | 3,044,871                    |       | 3,027,502                        |       |
| Furniture and  office equipment                                                                                                                                                                                     |       | 892,989                      |       | 748,827                          |       |
| Manufacturing  facility                                                                                                                                                                                             |       | 5,488,824                    |       | 5,426,761                        |       |
| Land                                                                                                                                                                                                                |       | 1,021,245                    |       | 1,021,245                        |       |
|                                                                                                                                                                                                                |       | 15,194,104                   |       | 14,816,745                       |       |
| Less-  Accumulated depreciation and amortization                                                                                                                                                                    |       | (6,235,705                   | )          | (5,846,272                       | )          |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Net property and  equipment                                                                                                                                                                                         |       | 8,958,399                    |       | 8,970,473                        |       |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Deposits and other  assets                                                                                                                                                                                          |       | 316,564                      |       | 329,664                          |       |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Total assets                                                                                                                                                                                                        |       | $                            | 86,394,510 |                             | $          | 87,232,880 |   |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                      | ** ** | ** **                   | ** ** | ** **                       | ** ** |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Current Liabilities                                                                                                                                                                                                 |       |                         |       |                             |       |
| Current portion  of capitalized lease obligations                                                                                                                                                                   |       | $                            | 8,405      |                             | $          | 7,891 |   |
| Accounts payable                                                                                                                                                                                                    |       | 2,299,895                    |       | 358,818                          |       |
| Accrued expenses                                                                                                                                                                                                    |       | 3,380,382                    |       | 3,122,542                        |       |
| Deferred revenue                                                                                                                                                                                                    |       | 211,418                      |       | 591,626                          |       |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Total current  liabilities                                                                                                                                                                                          |       | 5,900,100                    |       | 4,080,877                        |       |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Note payable                                                                                                                                                                                                        |       | 4,335,000                    |       | 4,335,000                        |       |
| Long-term  portion of capitalized lease obligations                                                                                                                                                                 |       | —                       |       | 4,587                            |       |
| Deferred revenue                                                                                                                                                                                                    |       | 85,756                       |       | 120,991                          |       |
| Deferred income  taxes                                                                                                                                                                                              |       | 367,550                      |       | 490,072                          |       |
| 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  December 31, 2006 and September 30, 2006 |       | —                       |       | —                           |       |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Common stock,  $.001 par value: 75,000,000 shares authorized, 18,147,253 and 18,088,121  shares issued at March 31, 2007 and September 30, 2006                                                                     |       | 18,147                       |       | 18,088                           |       |
| Additional  paid-in capital                                                                                                                                                                                         |       | 44,192,634                   |       | 43,230,352                       |       |
| Retained  earnings                                                                                                                                                                                                  |       | 49,581,751                   |       | 53,039,341                       |       |
| Treasury stock,  at cost, 1,272,510, shares at March 31, 2007 and September 30, 2006                                                                                                                                |       | (18,086,428                  | )          | (18,086,428                      | )          |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Total  shareholders’ equity                                                                                                                                                                                    |       | 75,706,104                   |       | 78,201,353                       |       |
|                                                                                                                                                                                                                |       |                         |       |                             |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                     |       | $                            | 86,394,510 |                             | $          | 87,232,880 |   |

 

The accompanying notesare an integral part of these statements.

3

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**INNOVATIVE SOLUTIONS AND SUPPORT,INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(unaudited)**
| ** **                                   | ** ** | **Three Months** | ** ** | **Three Months** | ** ** | **Six Months** | ** ** | **Six Months** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|-----------------------|------------|---------------------|------------|---------------------|------------|
| ** **                                   | ** ** | **Ended**             | ** ** | **Ended**             | ** ** | **Ended**           | ** ** | **Ended**           | ** ** |
| ** **                                   | ** ** | **March 31,**    | ** ** | **March 31,**    | ** ** | **March 31,**  | ** ** | **March 31,**  | ** ** |
| ** **                                   | ** ** | **2007**              | ** ** | **2006**              | ** ** | **2007**            | ** ** | **2006**            | ** ** |
| Net sales:                                   |       |                  |       |                  |       |                |       |                |       |
| Product                                      |       | $                     | 3,152,791  |                  | $          | 3,437,516           |       | $                   | 6,334,819  |   | $ | 8,687,968 |   |
| Engineering - Modification & Development |       | 802,507               |       | 307,236               |       | 1,049,127           |       | 462,171             |       |
| Total net sales                              |       | 3,955,298             |       | 3,744,752             |       | 7,383,946           |       | 9,150,139           |       |
| Cost of sales                                |       |                  |       |                  |       |                |       |                |       |
| Product                                      |       | 2,294,539             |       | 2,018,067             |       | 4,041,755           |       | 4,541,784           |       |
| Engineering - Modification & Development |       | 723,489               |       | 176,651               |       | 1,010,218           |       | 354,952             |       |
| Total cost of sales                          |       | 3,018,028             |       | 2,194,718             |       | 5,051,973           |       | 4,896,736           |       |
| Gross profit                                 |       | 937,270               |       | 1,550,034             |       | 2,331,973           |       | 4,253,403           |       |
| Operating expenses:                          |       |                  |       |                  |       |                |       |                |       |
| Research and development                     |       | 1,480,741             |       | 1,916,788             |       | 2,805,095           |       | 3,451,789           |       |
| Selling, general and administrative          |       | 3,873,767             |       | 2,200,650             |       | 6,932,782           |       | 4,097,486           |       |
| Total operating expenses                     |       | 5,354,508             |       | 4,117,438             |       | 9,737,877           |       | 7,549,275           |       |
| Operating loss                               |       | (4,417,238            | )          | (2,567,404            | )          | (7,405,904          | )          | (3,295,872          | )          |
| Interest income                              |       | 790,535               |       | 819,626               |       | 1,606,808           |       | 1,601,071           |       |
| Interest expense                             |       | (49,784               | )          | (44,483               | )          | (100,544            | )          | (87,995             | )          |
| Loss before income taxes                     |       | (3,676,487            | )          | (1,792,261            | )          | (5,899,640          | )          | (1,782,796          | )          |
| Income tax  benefit                          |       | (1,317,341            | )          | (1,014,605            | )          | (2,442,050          | )          | (1,011,265          | )          |
| Net loss                                     |       | $                     | (2,359,146 | )                     | $          | (777,656            | )          | $                   | (3,457,590 | ) | $ | (771,531 | ) |
|                                         |       |                  |       |                  |       |                |       |                |       |
| Net loss per  common share:                  |       |                  |       |                  |       |                |       |                |       |
| Basic                                        |       | $                     | (0.14      | )                     | $          | (0.04               | )          | $                   | (0.21      | ) | $ | (0.04 | ) |
| Diluted                                      |       | $                     | (0.14      | )                     | $          | (0.04               | )          | $                   | (0.21      | ) | $ | (0.04 | ) |
|                                         |       |                  |       |                  |       |                |       |                |       |
| Weighted average  shares outstanding:        |       |                  |       |                  |       |                |       |                |       |
| Basic                                        |       | 16,865,098            |       | 17,674,391            |       | 16,844,795          |       | 17,866,910          |       |
| Diluted                                      |       | 16,865,098            |       | 17,674,391            |       | 16,844,795          |       | 17,866,910          |       |

 

The accompanyingnotes are an integral part of these statements.

4

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**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**
| ** **                                                                                 | ** ** | **For the Six** | ** ** | **For the Six** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                                                                                 | ** ** | **Months Ended**     | ** ** | **Months Ended**     | ** ** |
| ** **                                                                                 | ** ** | **March 31**         | ** ** | **March 31**         | ** ** |
| ** **                                                                                 | ** ** | **2007**                  | ** ** | **2006**                  | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                 | ** ** | ** **                | ** ** | ** **                | ** ** |
| Net loss                                                                                   |       | $                         | (3,457,590 | )                         | $          | (771,531 | ) |
| Adjustments to reconcile net loss to net cash provided  by (used in) operating activities: |       |                      |       |                      |       |
| Depreciation and amortization                                                              |       | 407,567                   |       | 413,156                   |       |
| Stock-based compensation expense                                                           |       | 223,742                   |       | 355,507                   |       |
| Compensation expense for stock issued to directors                                         |       | 99,942                    |       | 119,872                   |       |
| Loss on disposal of fixed assets                                                           |       | 551                       |       | 156                       |       |
| Excess and obsolete inventory expense                                                      |       | 100,000                   |       | —                    |       |
| Deferred income taxes                                                                      |       | (367,564                  | )          | 88,469                    |       |
| Tax benefit from exercise of stock options                                                 |       | 203,719                   |       | 23,659                    |       |
| Excess tax benefits from share-based payment  arrangements                                 |       | (135,302                  | )          | (9,119                    | )          |
| (Increase) decrease in:                                                                    |       |                      |       |                      |       |
| Accounts receivable                                                                        |       | 1,010,425                 |       | 2,846,136                 |       |
| Inventories                                                                                |       | 812,230                   |       | (395,791                  | )          |
| Prepaid expenses and other current assets                                                  |       | (3,129,287                | )          | 1,595,461                 |       |
| Increase (decrease) in:                                                                    |       |                      |       |                      |       |
| Accounts payable                                                                           |       | 1,941,077                 |       | 83,580                    |       |
| Accrued expenses                                                                           |       | 257,840                   |       | (1,199,982                | )          |
| Deferred revenue                                                                           |       | (415,443                  | )          | 63,763                    |       |
| Net cash provided by (used in) operating activities                                        |       | (2,448,093                | )          | 3,213,336                 |       |
|                                                                                       |       |                      |       |                      |       |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                 | ** ** | ** **                | ** ** | ** **                | ** ** |
| Cash paid for property and equipment                                                       |       | (380,444                  | )          | (213,958                  | )          |
| Purchases of other assets                                                                  |       | (2,500                    | )          | (240,000                  | )          |
| Net cash used in investing activities                                                      |       | (382,944                  | )          | (453,958                  | )          |
|                                                                                       |       |                      |       |                      |       |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                 | ** ** | ** **                | ** ** | ** **                | ** ** |
| Proceeds from exercise of stock options                                                    |       | 434,938                   |       | 56,205                    |       |
| Purchase of treasury stock                                                                 |       |                      |       | (13,740,698               | )          |
| Repayment of capitalized lease obligation                                                  |       | (4,073                    | )          | (3,905                    | )          |
| Excess tax benefits from share-based payment  arrangements                                 |       | 135,302                   |       | 9,119                     |       |
| Net cash provided by (used in) financing activities                                        |       | 566,167                   |       | (13,679,279               | )          |
|                                                                                       |       |                      |       |                      |       |
| Net decrease in  cash and cash equivalents                                                 |       | $                         | (2,264,870 | )                         | $          | (10,919,901 | ) |
|                                                                                       |       |                      |       |                      |       |
| Cash and cash  equivalents, beginning of year                                              |       | $                         | 62,984,829 |                      | $          | 83,172,582 |   |
|                                                                                       |       |                      |       |                      |       |
| Cash and cash  equivalents, end of period                                                  |       | $                         | 60,719,959 |                      | $          | 72,252,681 |   |
|                                                                                       |       |                      |       |                      |       |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION:**                                     | ** ** | ** **                | ** ** | ** **                | ** ** |
| Cash paid for interest                                                                     |       | $                         | 81,128     |                      | $          | 55,170 |   |
| Cash paid for income taxes                                                                 |       | $                         | —     |                      | $          | 440,000 |   |
| Cash received  from income tax refund                                                      |       | $                         | (1,801     | )                         | $          | (3,137,923 | ) |

 

The accompanying notesare an integral part of these statements.

5

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**Innovative Solutions and SupportInc.**

**Notes to Condensed Consolidated FinancialStatements**

**1. Basis of Presentation:**

Innovative Solutions andSupport, Inc. (the “Company”) was incorporated in Pennsylvania on February 12,1988. The Company’s primary business is the design, manufacture and sale offlat panel display systems, flight information computers, and advancedmonitoring systems for military, government, commercial air transport andcorporate aviation markets.

The balance sheet as ofMarch 31, 2007, the statement of operations for the three months and six monthsended March 31, 2007 and 2006 and the statements of cash flows for the sixmonths ended March 31, 2007 and 2006 have been prepared by the Company withoutaudit. In the opinion of management, all adjustments, consisting of normal andrecurring adjustments, necessary to present fairly the financial position,results of operations and cash flows at March 31, 2007 and for all periodspresented have been made.

Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America have been condensed or omitted. It is suggested that these financialstatements be read in conjunction with the financial statements and notesthereto included in the Company’s Form 10K for the year ended September 30,2006 as filed with the Securities and Exchange Commission. The results ofoperations for the three months and six months ended March 31, 2007 are notnecessarily indicative of the operating results for the full year.

The balance sheet as ofSeptember 30, 2006 presented in this quarterly report on Form 10-Q has beenreclassified to include the $100,000 optional first-year pay down on our loanagreement with the Chester County, Pennsylvania Industrial DevelopmentAuthority as long-term debt. For fiscal year 2006, the impact of thereclassification was to decrease the current portion of notes payable by$100,000 and to increase long term notes payable by $100,000. Thereclassification does not have a significant impact on working capital and hasno impact on the financial covenants associated with the notes payableagreement as the lender has waived compliance with the existing covenantsthrough the fiscal quarter ending on June 30, 2008.

**2. Net income per Share**

Net income per share (“EPS”)is calculated using the principles of SFAS No. 128, “Earnings Per Share.”

For the six month periodsended March 31, 2007 and 2006, there were 547,000 and 638,000 optionsoutstanding that were excluded from the computation of diluted earnings pershare as the effect would be antidilutive.

**3. Concentrations**

For the three monthsended March 31, 2007, three customers accounted for 35%, 18% and 12% of netsales or 65% on a combined basis.  Forthe three months ended March 31, 2006, two customers accounted for 25%, and 16%of net sales or 41% on a combined basis. For the six months ended March 31,2007, two customers accounted for 22% and 10% of net sales or 32% on a combinedbasis.  For the six months ended March31, 2006, two customers accounted for 17%, and 10% of net sales or 27% on acombined basis.

**4. Inventories**

Inventories are stated atthe lower of cost (first-in, first-out) or market and consist of the following:
|                 | ** ** | **March 31** | ** ** | **September 30** | ** ** |
|-----------------|------------|-------------------|------------|-----------------------|------------|
| ** **      | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| Raw materials   |       | $                 | 3,392,039  |                  | $          | 3,006,088 |   |
| Work-in-process |       | 1,108,508         |       | 2,237,489             |       |
| Finished goods  |       | 1,053,379         |       | 1,222,579             |       |
|            |       | $                 | 5,553,926  |                  | $          | 6,466,156 |   |

 

6

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**5.Warranty**

The Company provides forthe estimated cost of product warranties at the time revenue is recognized.Warranty cost is recorded as cost of sales and the reserve balance recorded asan accrued expense in the financial statements. While the Company engages inextensive product quality programs and processes, the Company’s warrantyobligation is affected by product failure rates and the related material, laborand delivery costs incurred in correcting a product failure. Should actual productfailure rates, material or labor costs differ from the Company’s estimates,further revisions to the estimated warranty liability would be required.

Warranty cost and accrualinformation for the three months ended March 31, 2007 is highlighted below:

 
| Warranty accrual at December  31, 2006                      |   | $       | 572,881 |   |
|-------------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense  for the three months ended March, 31, 2007 |   | 36,784  |    |
| Warranty costs  for the three months ended March 31, 2007   |   | (58,959 | )       |
|                                                        |   |    |    |
| Warranty accrual at  March 31, 2007                         |   | $       | 550,706 |   |

 

Warranty cost andaccrual information for the six months ended March 31, 2007 is highlightedbelow:

 
| Warranty accrual at  September 30, 2006                   |   | $        | 617,116 |   |
|-----------------------------------------------------------|--------|----------|---------|--------|
| Accrued expense  for the six months ended March, 31, 2007 |   | 59,413   |    |
| Warranty costs  for the six months ended March 31, 2007   |   | (125,823 | )       |
|                                                      |   |     |    |
| Warranty accrual at  March 31, 2007                       |   | $        | 550,706 |   |

 

**6. Share-Based Compensation**

Effective October 1, 2005the Company adopted the provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123(R), Share-Based Payment (“SFAS 123(R)”), using themodified prospective approach and now accounts for share-based compensationapplying the fair value method for expensing stock options and non-vested stockawards.

Total share-based compensationexpense was $172,000 and $242,000 for the three months ended March 31, 2007 and2006 respectively. The total income tax benefit recognized in the statement ofoperations for share-based compensation arrangements was $62,000 and $137,000for the three months ended March 31, 2007 and 2006, respectively. Totalshare-based compensation expense was $334,000 and $476,000 for the six monthsended March 31, 2007 and 2006 respectively and the total income tax benefitrecognized in the statement of operations for share based compensationarrangements was $138,000 and $270,000, respectively. Compensation expenserelated to share-based awards is recorded as a component of general andadministrative expense.

The Company maintains the1998 Stock Option Plan (the “Plan”) and the 2003 Restricted Stock Plan (the “RestrictedPlan”). These plans were approved by the Company’s shareholders.

**Stock Options**

The Plan provides for thegranting of incentive and nonqualified stock options to employees, officers,directors and independent contractors and consultants. Through March 31, 2007no stock options have been granted to independent contractors or consultantsunder this plan.  Total compensationexpense was $112,000, and $182,000 for the three months ended March 31, 2007 and2006 and $224,000 and $356,000 for the six months ended March 31, 2007 and2006, respectively.

 Incentive stock options granted under the Planhave exercise prices that must be at least equal to the fair value of thecommon stock on the date of grant. Nonqualified stock options granted under thePlan have exercise prices that may be less than, equal to or greater than thefair value of the common stock on the date of grant. The Company has reserved3,389,025 shares of Common Stock for awards under the Plan. As of March 31,2007 there were 1,715,819 remaining and available for granting.

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A summary of optionactivity under the Plan as of March 31, 2007 and changes during the period thenended is as follows:
| ** **                         | ** ** | ** **  | ** ** | ** **                | ** ** | **Weighted Average** | ** ** | **Aggregate** | ** ** |
|------------------------------------|------------|-------------|------------|---------------------------|------------|---------------------------|------------|---------------|------------|
| ** **                         | ** ** | ** **  | ** ** | **Weighted Average** | ** ** | **Remaining**             | ** ** | **Intrinsic** | ** ** |
| ** **                         | ** ** | **Options** | ** ** | **Exercise Price**   | ** ** | **Contractual Life** | ** ** | **Value**     | ** ** |
| Outstanding at  September 30, 2006 |       | 701,854     |       | $                         | 9.93       |                      |       |          |       |   |
| Granted                            |       | 9,000       |       | 16.30                     |       |                      |       |          |       |
| Exercised                          |       | (52,392     | )          | 8.30                      |       |                      |       |          |       |
| Cancelled                          |       | (111,400    | )          | 14.56                     |       |                      |       |          |       |
|                               |       |        |       |                      |       |                      |       |          |       |
| Outstanding at  March 31, 2007     |       | 547,062     |       | $                         | 9.25       |                      | 6.35       |          | $          | 8,790,491 |   |
| Exercisable at March  31, 2007     |       | 364,862     |       | $                         | 6.80       |                      | 5.47       |          | $          | 6,756,981 |   |

 

The weighted-averagegrant date fair value of individual options granted during the six months endedMarch 31, 2007 and 2006 was $9.64 and $7.36, respectively. The total intrinsicvalue of options exercised during the six months ended March 31, 2007 and 2006was $534,000 and $66,000, respectively.

The followingtable summarizes information about stock options under the Plan at March 31,2007:
| **Options Outstanding**                   | ** ** | **Options Exercisable** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|
| ** **                                     | ** ** | ** **                   | ** ** | **Weighted-** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Outstanding**              | ** ** | **Average** | ** ** | **Weighted-** | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
| ** **                                     | ** ** | **As of**               | ** ** | **Remaining** | ** ** | **Average** | ** ** | **As of** | ** ** | **Average** | ** ** |
| **Range of Exercise**                | ** ** | **March 31,**           | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **March 31,** | ** ** | **Exercise** | ** ** |
| **Prices**                                     | ** ** | **2007**                     | ** ** | **Life** | ** ** | **Price** | ** ** | **2007** | ** ** | **Price** | ** ** |
| ** **                                     | ** ** | ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| $0.00  -    5.00 |       | 205,563                      |       | 5.73 |   | $ | 4.18 |   | 203,163 |   | $ | 4.18 |   |
| $5.01  -  10.00            |       | 147,199                      |       | 4.69 |   | 7.69 |   | 117,499 |   | 7.70 |   |
| $10.01 - 15.00                       |       | 112,000                      |       | 8.39 |   | 14.01 |   | 18,000 |   | 13.56 |   |
| $15.01 - 20.00                       |       | 52,600                       |       | 8.19 |   | 16.73 |   | 15,600 |   | 16.94 |   |
| $20.01 - 22.35                       |       | 29,700                       |       | 8.00 |   | 20.90 |   | 10,600 |   | 20.72 |   |
|                                           |       |                         |       |   |   |   |   |   |   |   |   |
|                                           |       | 547,062                      |       |   |   |   |   | 364,862 |   |   |   |
|                                                |            |                              |            |  |  |  |  |  |  |  |  |  |  |

 

The fair value ofeach option grant is estimated on the date of grant using the Black-Scholesoption pricing model. Options are exercised over a maximum term of ten yearsfrom the date of grant and typically vest over periods of five years from thegrant date. The expected term of options represents the period of time that theoptions granted are expected to be outstanding and is based on historical experience.Expected volatility is based on historical volatility of the Company’s stock.The risk free interest rate is based on U.S. Treasuries with constantmaturities in effect at the time of the grant. Compensation expense foremployee stock options also includes an estimate for forfeitures and isrecognized ratably over the vesting term. The table below sets forth the fairvalue assumptions used to record compensation expense for the periodidentified:
|                                           | ** ** | **Six Months**          | ** ** | **Six Months**          | ** ** |
|-------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | **Ended**                    | ** ** | **Ended**                    | ** ** |
| ** **                                | ** ** | **March 31, 2007** | ** ** | **March 31, 2006** | ** ** |
|                                      |       |                         |       |                         |       |
| Expected lives  (years)                   |       | 5.72                         |       | 5.00                         |       |
| Weighted average  risk-free interest rate |       | 5.03                         | %          | 4.10                         | %          |
| Expected  volatility                      |       | 59.56                        | %          | 55.17                        | %          |
| Expected dividend rate                    |       | —                       | %          | —                       | %          |

 

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As of March 31,2007, there was approximately $1.3 million of unrecognized compensation cost,net of forfeitures, related to non-vested stock options, which is expected tobe recognized over a period of approximately 5 years.

**Non-vestedStock**

The Restricted Plan fornon-employee directors was approved by shareholders at the Company’sFebruary 26, 2004 Annual Meeting of Shareholders. The Plan calls for anannual award of non-vested stock having a fair market value of $40,000 as ofthe close of business on October 1 of the current fiscal year for alleligible non-employee directors. The stock is awarded in four quarterlyinstallments during the fiscal year provided the director is still serving onthe board on the quarterly issue date. Total expense was $60,000 for the threemonths ended March 31, 2007 and 2006 and $110,000 and $120,000 for the sixmonths ended March 31, 2007 and 2006, respectively. As of March 31, 2007, thereis an estimated $120,000 of unrecognized compensation expense related tononvested stock awards under the Company’s Restricted Plan. That cost isexpected to be recognized over the balance of the fiscal year or 6 months. Thefollowing table outlines restricted stock awards for the six months ended March31, 2007:
|                                | ** ** | **Non-vested**        | ** ** | **Weighted Average** | ** ** |
|--------------------------------|------------|-----------------------|------------|---------------------------|------------|
| ** **                     | ** ** | **Stock Awards** | ** ** | **Share Price**      | ** ** |
| Balance at  September 30, 2006 |       | 3,275                 |       | $                         | 15.25      |   |
| Granted                        |       | 15,939                |       | 14.43                     |       |
| Issued                         |       | (6,740                | )          | 14.83                     |       |
| Cancelled                      |       |                  |       |                      |       |
| Balance at March 31,  2007     |       | 12,474                |       | $                         | 14.43      |   |

 

**7. Stock Repurchase 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. Theprogram was in effect until June 30, 2006. Over the course of the program theCompany repurchased 1,272,510 shares of its common stock at an average 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 loanwas to fund the construction of the Company’s new office and manufacturingfacility. The loan matures in 2015 and carries an interest rate set by theremarketing agent that is consistent with 30-day tax-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), a 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 an amendment to the agreement wasentered into with the lender whereby the existing covenants were suspendeduntil the fiscal quarter ending on June 30, 2008.

**9. NewAccounting Pronouncements**

In September 2006,the Financial Accounting Standards Board (FASB) issued SFAS No. 157, “FairValue Measurements” (“SFAS 157”).  SFAS157 defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles, and expands disclosures about fairvalue measurements.  This statement doesnot require any new fair value measurements; however, the application of thisStatement may change current practice for some entities.  SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007.  TheCompany is currently evaluating the impact of this pronouncement.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”).   SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thecurrent year’s financial statements are materially misstated.  SAB 108 is effective for the first fiscalyear ending after November 15, 2006.  TheCompany is in the process of evaluating the impact of the adoption of thisinterpretation and does not believe that the adoption of the SAB 108 will havea material impact on the Company’s financial position or results of operations.

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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.

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

**Overview**

We design, manufactureand sell flat panel display systems, flight information computers, and advancedmonitoring systems to the Department of Defense (DOD), government agencies,commercial air transport carriers and corporate/general aviation markets.

Our revenues are derivedfrom the sale of our products to the retrofit market and, to a lesser extent,original equipment manufacturers (OEMs). Our customers include government andmilitary entities and their commercial contractors, aircraft operators,aircraft modification centers and various OEMs. Although we occasionally sellour products directly to government entities, we primarily sell our products tocommercial customers for end use in government and military programs.

We continue to invest inand seek additional opportunities for our Flat Panel Display System productline. In October 2005, the FAA awarded the Company a second Technical StandardOrder (TSO) for our flat panel display system COCKPIT/IPTM. This TSO establishes ourflat panel display system as meeting FAA requirements that have been put inplace to ensure safe flight on a variety of aircraft types and, additionally,it addresses 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 acatastrophic/Level A design condition with the use of commercial graphicprocessors.”

In October 2005, theCompany in a teaming arrangement with ABX Air, received FAA Supplemental TypeCertification (STC) of its Flat Panel Display System for use on B-767 aircraft.The STC provides B-767 operators with a low cost, rapidly implemented retrofitof their cockpit avionics with a modern pilot and copilot suite of highresolution multi-color LCD flat panel displays. Operators will benefit fromimproved dispatch reliability, logistics savings and adaptability to futurerequirements. The receipt of the STC positions the Company to pursue more than1,700 B-757 and B-767 aircraft with similar needs for Flat Panel Display Systemupgrades. The STC also provides a foundation for incorporating the product intoother airplanes as well.

In January 2007, theCompany in a teaming arrangement with ABX Air received another STC from the FAAon its Flat Panel Display System for use on B-757 aircraft. Similar to theprior STC awarded by the FAA, this one provides B-757 operators with the samelow cost, rapidly implemented retrofit of their cockpit avionics with a modernpilot and copilot suite of high resolution multi-color LCD flat panel displays.

Our “cost of sales”related to product is comprised of product material purchased through oursupplier base and direct in-house assembly labor and overhead costs. Many ofthe components we use in assembling our products are standard, although certainparts are manufactured to meet our specifications. The overhead portion of costof sales is primarily comprised of salaries and benefits, building occupancy,supplies, and outside service costs related to our production, purchasing,customer service, material control and quality departments as well as warrantycosts.

Our “cost of sales”related to Engineering-Modification & Development is comprised ofengineering labor, consulting services and other cost associated with specificdesign and development projects.

We continue to invest inthe development of new products and the enhancement of our existing productline. We expense research and development costs related to future productdevelopment as they are incurred.

Our selling, general, andadministrative expenses consist of marketing and business development expenses,professional expenses, salaries and benefits for executive and administrativepersonnel, facility costs, recruiting, legal, accounting, and other generalcorporate expenses.

**Reclassification**

The balance sheet as ofSeptember 30, 2006 presented has been reclassified to include the $100,000optional first-year pay down as long-term debt. For fiscal year 2006, theimpact of the reclassification was a decrease to current portion of notespayable of $100,000 and a corresponding increase to long term notes payable of$100,000. The reclassification does not have a significant impact on

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working capital and hasno impact on the financial covenants associated with the notes payableagreement as the lender suspended the existing covenants through the fiscalquarter ending on June 30, 2008.

**Three Months Ended March 31, 2007Compared to the Three Months Ended March 31, 2006**

*Net sales.* Netsales increased $0.2 million, or 6%, to $3.9 million for the three months endedMarch 31, 2007 from $3.7 million in the three months ended March 31, 2006. Thedecrease of $0.3 million in product sales was off set by the increase inEngineering-Modification and Development (EMD) sales of $0.5 million. Theminimal overall increase in sales reflects the slower than expected start up ofFlat Panel Display System deliveries.

*Cost of sales.*Cost of sales increased $0.8 million or 38%, to $3.0 million, or 76% of net salesin the three months ended March 31, 2007 from $2.2 million, or 59 % of netsales in the three months ended March 31, 2006. The increase of $0.3 million incost of sales related to product sales was primarily related to unabsorbedoverhead expenses. The increase of $0.5 million related to EMD was primarilydue to increased sales and to the recognition of an additional $0.2 million incost to complete a specific military program.

*Research and development.*Research and development expense decreased $0.4 million or 23% to $1.5 millionor 37% of net sales in the three months ended March 31, 2007 from $1.9 millionor 51% of net sales in the three months ended March 31, 2006. The decrease inresearch and development expense in the quarter was mainly due to allocating$0.7 million of EMD cost, to cost of sales. The allocation was necessary tomatch non recurring engineering cost with non recurring engineering sales inthe period.

*Selling, general, andadministrative.* Selling, general, and administrative expensesincreased $1.7 million, or 76%, to $3.9 million, or 98% of net sales in thethree months ended March 31, 2007 from $2.2 million or 59% of net sales in thethree months ended March 31, 2006. The increase in the dollar amount wasprimarily the result of $1.8 million of legal fees in the quarter that theCompany incurred in connection with litigation related to its IntellectualProperty.

*Interest income.*Interest income was $791,000 in the three months ended March 31, 2007 ascompared $820,000 in the three months ended March 31, 2006. The decrease ininterest income was primarily the result of our reduced average cash balance inthe current quarter as opposed to the prior year. Last year, in the quarterended March 31, 2006 the Company purchased 961,610 shares of its stock at acost of $13.7 million.

*Interest expense.*Interest expense was $50,000 in the three months ended March 31, 2007 ascompared to $44,000 in the three months ended March 31, 2006. The increase ininterest expense in the three months ended March 31, 2007 was primarily theresult of higher interest rates in the period.

*Income tax expense.*The income tax benefit for the three months ended March 31, 2007 was $1.3million as compared to $1.0 million for the three months ended March 31, 2006.The increase in the amount of tax benefit was due to recording a larger lossbefore taxes for the three months ended March 31, 2007 as compared to March 31,2006.

The effective tax ratefor the three months ended March 31, 2007 was a benefit of 36 %. The effectivetax rate for the three months ended March 31, 2006 was a benefit of 57%. Ineach quarter the effective tax rate differs from the statutory rate due to theutilization of research and experimentation tax credits.

*Net income (loss).*As a result of the factors described above, our net loss in the three monthsended March 31, 2007 was $2.4 million an increase of $1.6 million from net lossof $0.8 million for the three months ended March 31, 2006.

**Six Months Ended March 31, 2007Compared to the Six Months Ended March 31, 2006**

*Net sales.* Netsales decreased $1.8 million, or 19%, to $7.4 million for the six months endedMarch 31, 2007 from $9.2 million in the six months ended March 31, 2006. Thedecrease of $2.3 million in product sales was off set by the increase in EMDsales of $0.6 million. The decrease in net sales was primarily the result of aslower than expected start up of Flat Panel Display System deliveries.

*Cost of sales.*Cost of sales increased $0.2 million or 3%, to $5.1 million, or 68% of net salesin the six months ended March 31, 2007 from $4.9 million, or 54 % of net salesin the six months ended March 31, 2006. The decrease of $0.5 million in cost ofsales related to product sales was primarily related to lower sales and wasoffset by the increase of $0.7 million related to EMD which was primarily dueto increased EMD sales and to the recognition of an additional $0.2 million ofcost to complete a specific military program.

*Research and development.*Research and development expenses decreased $0.6 million or 19% to $2.8 millionor 38% of net sales in the six months ended March 31, 2007 from $3.4 million or38% of net sales in the six months ended March 31, 2006.  The decrease in research and development expensein the period was mainly due to allocating $0.7 million of non recurringengineering cost, to cost of sales. The allocation was necessary to match nonrecurring engineering cost with EMD sales in the period.

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*Selling, general, andadministrative.* Selling, general, and administrative expensesincreased $2.8 million, or 69%, to $6.9 million, or 94% of net sales in the sixmonths ended March 31, 2007 from $4.1 million or 45% of net sales in the sixmonths ended March 31, 2006. The increase in the dollar amount was primarilythe result of $2.8 million of legal fees in the six months ended March 31, 2007that the Company incurred in connection with litigation relating to itsIntellectual Property.

*Interest income.*Interest income was $1.6 million in both six month periods ended March 31, 2007and 2006. Higher interest rates have offset our reduced cash position andenabled us to maintain consistent interest income in the current period.

 *Interest expense.*Interest expense was $101,000 in the six months ended March 31, 2007 ascompared to $88,000 in the six months ended March 31, 2006. The increase ininterest expense was primarily the result of higher interest rates in theperiod.

*Income tax expense.*The income tax benefit for the six months ended March 31, 2007 was $2.4 millionas compared to a $1.0 million benefit for the six months ended March 31, 2006.The increase in the amount of tax benefit was due to recording a larger lossbefore taxes for the six months ended March 31, 2007 as compared to March 31,2006.

The effective tax ratefor the six months ended March 31, 2007 was a benefit of 41%. The effective taxrate for the six months ended March 31, 2006 was 57%. In each quarter theeffective tax rate differs from the statutory rate due to the utilization ofresearch and experimentation tax credits.

In December of 2006, anadditional two-year extension of the Research and Experimentation (R&E) TaxCredit was enacted into law. This retroactive extension is for amounts paid orincurred after March 31, 2005, and before January 1, 2008.  The entire impactof this retroactive extension has been recognized in the six months ended March31, 2007, as required by SFAS 109, “Accounting for Income Taxes”.

*Net income (loss).*As a result of the factors described above, our net loss in the six monthsended March 31, 2007 was $3.5 million, an increase of $2.7 million from netloss of $771,000 for the six months ended March 31, 2006.

**Liquidity and Capital Resources**

Our main source ofliquidity has been cash flows from prior operations. We require cashprincipally to finance inventory, accounts receivable and payroll.

Our cash used inoperating activities was $2.4 million for the six months ended March 31, 2007as compared to cash provided from operating activities of $3.2 million for thesix months ended March 31, 2006. The decrease was due primarily to higher netloss ($2.7 million) and increased prepaid expenses ($4.7 million) which werepartially offset by increased accounts payable ($1.9 million) and increasedaccrued expense ($1.5 million).

Our cash used in investingactivities was $383,000 for the six months ended March 31, 2007. This primarilyconsisted of spending for production and laboratory test equipment. Cash usedin investing activities was $500,000 for the six months ended March 31, 2006and primarily consisted of production certification, production equipment and,laboratory test equipment.

Net cash flow providedfrom financing activities was $566,000, for the six months ended March 31, 2007as compared to cash used in financing activities of $13.7 million in the sixmonths ended March 31, 2006. In both periods the primary source of cash wasfrom proceeds from the exercise of stock options. The primary use of cash forfinancing activities for the six months ended March 31, 2006 was attributableto the Company purchasing 961,610 shares of our stock at as total cost of $13.7million.

The Companyentered into a $4,335,000 loan agreement dated August 1, 2000 with the ChesterCounty, Pennsylvania Industrial Development Authority. The purpose of the loanwas to fund the construction of the Company’s new office and manufacturingfacility. The loan matures in 2015 and carries an interest rate set by theremarketing agent that is consistent with 30-day tax-exempt commercial paper.The loan agreement requires the Company to maintain certain financial covenantsincluding a ratio of liabilities to earnings before interest, taxes anddepreciation and amortization (EBITDA), a fixed charge ratio and a minimumtangible net worth.

As of June 30,2006, the Company was in violation of these financial covenants. The defaultswere subsequently waived and an amendment to the agreement was entered intowith the lender whereby the existing covenants were suspended until the fiscalquarter ending on June 30, 2008.

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

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arrangements in order tosupport more rapid expansion of our business than we now anticipate eitherthrough acquisitions or organic growth. Further, we may need to develop andintroduce new or enhanced products, respond to competitive pressures, invest inor acquire businesses or technologies or respond to unanticipated requirementsor developments. If additional funds are raised through the issuance of equitysecurities, dilution to existing shareholders may result. If insufficient fundsare available, we may not be able to introduce new products or competeeffectively in any of our markets, which could hurt our business.

**Backlog**

As of March 31, 2007 and 2006, our backlog was $42.8million and $28.3 million, respectively. The period over period increase inbacklog principally reflects the increase in Flat Panel Display System orders.The Flat Panel Display System component as of March 31, 2007 is $33.5 million,an increase of $17.2 million over the March 31, 2006 balance of $16.3 million.

**Critical Accounting 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, inventory valuation, share-based compensation andwarranty reserves.

*Revenuerecognition*

The Companyrecognizes revenue under the provisions of Staff Accounting Bulletin (SAB)No. 104, “Revenue Recognition” (SAB104).

The Company entersinto certain sales arrangements that include multiple deliverables as definedin EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.”The Company identifies all goods and/or services that are to be deliveredseparately under a sales arrangement and allocates revenue to each deliverablebased on fair value. In general, revenues are separated between product salesand EDM sales. The allocated revenue for each deliverable is then recognizedusing appropriate revenue recognition methods.

The Companyaccounts for transactions with software that is more than incidental to theproducts under SOP 97-2. “Software Revenue Recognition” and EITF Issue 03-5, “Applicabilityof AICPA Statement of Position 97-2, Software Revenue Recognition, toNon-Software Deliverables in an Arrangement Containing More-Than-IncidentalSoftware.”  Accordingly, revenue isrecognized when all of the following criteria are met: 1) there is persuasiveevidence that an arrangement exists; 2) delivery has occurred or services havebeen rendered; 3) the seller’s price to the buyer is fixed or determinable; and4) collectibility is reasonably assured.

Sales related tocertain long-term contracts requiring development and delivery of products overseveral accounting periods are accounted for under the American Institute ofCertified Public Accountants (AICPA) Statement of Position (SOP) 81-1, “Accountingfor Performance of Construction-Type and Certain Production-Type Contracts.” Weconsider the nature of these contracts as well as the types of products andservices provided when determining the appropriate accounting treatment for aparticular contract. Certain long-term contracts are recorded on a percentageof completion basis using cost-to-cost methodology to measure progress towardscompletion.

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.

*Incometaxes*

Income taxes arerecorded in accordance with SFAS No. 109, Accounting for Income Taxes.Provisions for federal and state income taxes are calculated on reported financialstatement pre-tax income based on current tax law. The Company recognizesdeferred tax assets and liabilities for temporary differences between thefinancial reporting basis and the tax basis of the Company’s assets andliabilities 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.

*Inventories*

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.

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*Share-basedcompensation*

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.

*Warrantyreserves*

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.

**Business Segments**

We operate in oneprincipal business segment which designs, manufactures and sells flightinformation computers, flat panel displays and advanced monitoring systems tothe Department of Defense, government agencies, commercial air transportcarriers and corporate/general aviation markets. We currently derive virtuallyall our net sales from the sale of this equipment. Almost all of the net sales,operating results and identifiable assets are in the United States.

**New Accounting Pronouncements**

In September 2006,the Financial Accounting Standards Board (FASB) issued SFAS No. 157, “FairValue Measurements” (“SFAS 157”).  SFAS157 defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles, and expands disclosures about fairvalue measurements.  This statement doesnot require any new fair value measurements; however, the application of thisStatement may change current practice for some entities.  SFAS 157 is effective for fiscal yearsbeginning after November 15, 2007.  TheCompany is currently evaluating the impact of this pronouncement.

In September 2006,the Securities and Exchange Commission issued Staff Accounting Bulletin 108, “Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements” (“SAB 108”).   SAB 108 provides guidance on how prior yearmisstatements should be taken into consideration when quantifying misstatementsin current year financial statements for purposes of determining whether thecurrent year’s financial statements are materially misstated.  SAB 108 is effective for the first fiscalyear ending after November 15, 2006.  TheCompany is in the process of evaluating the impact of the adoption of thisinterpretation and does not believe that the adoption of the SAB 108 will havea material impact on the Company’s financial position or results of operations.

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 tax return.  This Interpretation also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition.  FIN48 is effective for fiscal years beginning after December 15, 2006.  The Company is currently evaluating theimpact of this pronouncement.

**FORWARD-LOOKINGSTATEMENTS**

This Form 10-Q containsstatements, which, to the extent that they are not recitations of historicalfact, constitute forward-looking statements within the meaning of theSecurities Act of 1933 and the Securities Exchange Act of 1934. The words “anticipate”“believe,” “estimate,” “expect,” “intend,” “may,” “plan,” “outlook,” “would,” “should,”“guidance,” “potential,” “continue,” “project,” “forecast” and similar expressions are intended to identifyforward-looking statements. Forward-looking statements are not guarantees offuture performance and involve risks, uncertainties and assumptions, which aredifficult to predict. Therefore, actual outcomes and results may differmaterially from what is expressed or implied by these statements.  Numerous factors, including potentially thefollowing factors, could affect the Company’s forward-looking statements andactual performance:

·                  continued marketacceptance of our air data systems products;

·                  the ability toobtain future contracts and awards;

·                  the availabilityof government funding and customer requirements;

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·                  difficulties indeveloping and producing our flat panel display systems , or COCKPIT/IPTM, or other planned products or product enhancements;

·                  marketacceptance of our COCKPIT/IPTM system or other planned products or productenhancements;

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

·                  delays inreceiving components from third party suppliers;

·                  the competitiveenvironment;

·                  the terminationof programs or contracts for convenience by customers;

·                  failure toretain key personnel;

·                  new productofferings from competitors;

·                  potential futureacquisitions;

·                  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 are cautioned notto place undue reliance on these forward-looking statements, which speak onlyas of the date of this Form 10-Q. The Company does not undertake any obligationto publicly release any revisions to these forward-looking statements toreflect events, circumstances or changes in expectations after the date of thisForm 10-Q, or to reflect the occurrence of unanticipated events. Theforward-looking statements in this document are intended to be subject to thesafe harbor protection provided by Sections 27A of the Securities Act and 21Eof the Exchange Act.

For a discussionidentifying some important factors that could cause actual results to varymaterially from those anticipated in the forward­looking 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, 2006.

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

The Company’s operationsare exposed to market risks primarily as a result of changes in interest rates.The Company does not use derivative financial instruments for speculative ortrading purposes. The Company’s exposure to market risk for changes in interestrates relates to its cash equivalents and an industrial revenue bond. TheCompany’s cash equivalents consist of funds invested in money market accounts,which bear interest at a variable rate, while the industrial revenue bondcarries an interest rate that is consistent with 30-day, tax-exempt commercialpaper. As the interest rates are variable, and we do not engage in hedgingactivities, a change in interest rates earned on the cash equivalents or paidon the industrial revenue bond would impact interest income and expense alongwith cash flows, but would not impact the fair market value of the relatedunderlying 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 the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”) as of March 31, 2007.Based on that evaluation, the Company’s management, including the CEO and CFO,concluded that the Company’s disclosure controls and procedures are effectiveto provide reasonable assurance that information required to be disclosed bythe Company in reports that it files or submits under the Exchange Act, isrecorded, processed, summarized and reported as specified in Securities andExchange Commission rules and forms and that such information is accumulatedand communicated to the Company’s management, including the CEO and CFO, orpersons performing similar functions, as appropriate to allow timely decisionsregarding required disclosure.

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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 of our business, we are attimes subject to various legal proceedings. We do not believe that any currentlegal proceedings will have a material adverse effect on our results ofoperations or financial position.

**Item 1A. RiskFactors**

There are no material changes to the risk factors described under Item1A of our Form 10-K for the year ended September 30, 2006.

I**tem 2.****     UnregisteredSales of Equity Securities and Use of Proceeds**

None

**Item 3.****        Defaults upon SeniorSecurities**

None

**Item 4.****        Submission of Matters to aVote of Security Holders**

On March 15, 2007, the Company held its Annual Meeting of Stockholders.At this meeting the stockholders voted in favor of the following item listedand described in the Company’s Proxy Statement dated February 9, 2007.

1)                    Election ofDirectors
|               | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|---------------|------------|------------|------------|--------------|------------|
| Ivan M. Marks |       | 11,293,109 |       | 137,384      |       |
| Robert H. Rau |       | 11,039,480 |       | 391,013      |       |

 

The following directors’ term of office as directorscontinued after this meeting:
| Geoffrey S.M. Hedrick        |   |   |   |   |   |
|------------------------------|--------|--------|--------|--------|--------|
| Winston J. Churchill         |   |   |   |   |   |
| Glenn R. Bressner            |   |   |   |   |   |
| Robert E. Mittelstaedt,  Jr. |   |   |   |   |   |
| Raymond J. Wilson            |   |   |   |   |   |

 

**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 & SUPPORT, INC.** |
|---------------------|--------|----------------------------------------------|
| ** **          |   |                                         |   |   |
| ** **          |   |                                         |   |   |
| Date: May 10,  2007 |   | By:                                          |   | /s/ JAMES J. REILLY |
| ** **          |   |                                         |   | **James J. Reilly Chief Financial Officer** |

 

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