**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|------------------------------------------------------------------------------------------------------------------|
|                                                                                                             |   |   |
| **For the quarterly period ended  March 31, 2006**                                                          |
|                                                                                                             |   |   |
| **OR**                                                                                                           |
|                                                                                                             |   |   |
| **o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**     |

 

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

 

**Commission File No. 0-31157**

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

(Exact name of registrant as specified in itscharter)

 

| **PENNSYLVANIA**                                           | ** ** | **23-2507402**      |
|------------------------------------------------------------|------------|---------------------|
| (State or other jurisdiction                               |       | (IRS Employer       |
| of incorporation)                                          |       | Identification No.) |
|                                                       |       |                |
| **720 Pennsylvania Drive, Exton, Pennsylvania**            | ** ** | **19341**           |
| (Address of principal executive offices)                   |       | (Zip Code)          |
|                                                       |       |                |
| **(610) 646-9800**                                         |
| (Registrant’s telephone number, including  area code) |

 

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

Yesý     Noo

 

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

 

o Large accelerated filer       ýAccelerated filer     o Non-accelerated filer

 

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).

 

Yeso            No ý

 

Asof May 3, 2006, there were 17,107,533 shares of the Registrant’s Common Stock,with par value of $.001 per share, outstanding.

 

 

----

 

**INNOVATIVE SOLUTIONS & SUPPORT, INC.**

### **FORM 10-Q March 31, 2006**

 

**INDEX**

 
| **PART I.**  | **FINANCIAL INFORMATION**                                                                  |   |
|-------------------|--------------------------------------------------------------------------------------------|--------|
|              |                                                                                       |   |
| Item 1.           | Financial Statements (Unaudited)                                                           |   |
|              |                                                                                       |   |
|              | Condensed Consolidated  Balance Sheets – March 31, 2006 and September 30, 2005        | 3      |
|              |                                                                                       |   |
|              | Condensed Consolidated  Statements of Operations –                                    |   |
|              | Three Months and Six Months  Ended March 31, 2006 and 2005                                 | 4      |
|              |                                                                                       |   |
|              | Condensed Consolidated  Statements of Cash Flows –                                    |   |
|              | Six Months Ended March 31,  2006 and 2005                                                  | 5      |
|              |                                                                                       |   |
|              | Notes to Condensed  Consolidated Financial Statements                                      | 6      |
|              |                                                                                       |   |
| Item 2.           | Management’s Discussion and  Analysis of Financial Controls and Results of Operations | 9      |
|              |                                                                                       |   |
| Item 3.           | Quantitative and Qualitative  Disclosures about Market Risk                                | 14     |
|              |                                                                                       |   |
| Item 4.           | Controls and Procedures                                                                    | 14     |
|              |                                                                                       |   |
| **PART II.** | **OTHER INFORMATION**                                                                      |   |
|              |                                                                                       |   |
| Item 1.           | Legal Proceedings                                                                          | 15     |
|              |                                                                                       |   |
| Item 1A           | Risk Factors                                                                               | 15     |
|              |                                                                                       |   |
| Item 2.           | Unregistered Sales of Equity  Securities and use of Proceeds                               | 15     |
|              |                                                                                       |   |
| Item 3.           | Defaults upon Senior  Securities                                                           | 15     |
|              |                                                                                       |   |
| Item 4.           | Submission of Matters to a  Vote of Security Holders                                       | 15     |
|              |                                                                                       |   |
| Item 5.           | Other Information                                                                          | 15     |
|              |                                                                                       |   |
| Item 6.           | Exhibits                                                                                   | 16     |
|              |                                                                                       |   |
| **SIGNATURES**    |                                                                                       | **17** |

 

2

----

 

**PART I–FINANCIAL INFORMATION**

**Item 1–Financial Statements**

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED BALANCESHEET**

**(unaudited)**

 
| ** **                                                                                                                                                                                                                                    | ** ** | **As of**               | ** ** | **As of**                   | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                                                                                                    | ** ** | **March 31, 2006** | ** ** | **September 30, 2005** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                    | ** ** | ** **                   | ** ** | ** **                       | ** ** |
| Current Assets:                                                                                                                                                                                                                               |       |                         |       |                             |       |
| Cash and cash equivalents                                                                                                                                                                                                                     |       | $                            | 72,252,681 |                             | $          | 83,172,582 |   |
| Accounts receivable, less allowance for  doubtful accounts of $100,000 at March 31, 2006 and September 30, 2005                                                                                                                               |       | 2,633,800                    |       | 5,479,936                        |       |
| Inventories                                                                                                                                                                                                                                   |       | 4,307,417                    |       | 3,911,626                        |       |
| Deferred income taxes                                                                                                                                                                                                                         |       | 764,042                      |       | 956,070                          |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                     |       | 2,433,037                    |       | 4,028,498                        |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Total current assets                                                                                                                                                                                                                          |       | 82,390,977                   |       | 97,548,712                       |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Property and Equipment:                                                                                                                                                                                                                       |       |                         |       |                             |       |
| Computers and test equipment                                                                                                                                                                                                                  |       | 4,448,739                    |       | 4,278,748                        |       |
| Corporate airplane                                                                                                                                                                                                                            |       | 3,027,502                    |       | 2,998,161                        |       |
| Furniture and office equipment                                                                                                                                                                                                                |       | 742,999                      |       | 734,038                          |       |
| Manufacturing facility                                                                                                                                                                                                                        |       | 5,420,741                    |       | 5,420,741                        |       |
| Land                                                                                                                                                                                                                                          |       | 1,021,245                    |       | 1,021,245                        |       |
|                                                                                                                                                                                                                                          |       | 14,661,226                   |       | 14,452,933                       |       |
| Less- Accumulated depreciation and  amortization                                                                                                                                                                                              |       | (5,481,528                   | )          | (5,091,881                       | )          |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Net property and equipment                                                                                                                                                                                                                    |       | 9,179,698                    |       | 9,361,052                        |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Deposits and other assets                                                                                                                                                                                                                     |       | 347,114                      |       | 125,114                          |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Total assets                                                                                                                                                                                                                                  |       | $                            | 91,917,789 |                             | $          | 107,034,878 |   |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                |       |                         |       |                             |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| CURRENT LIABILITIES:                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Current portion of notes payable                                                                                                                                                                                                              |       | $                            | 100,000    |                             | $          | 100,000 |   |
| Current portion of capitalized lease  obligations                                                                                                                                                                                             |       | 7,891                        |       | 7,257                            |       |
| Accounts payable                                                                                                                                                                                                                              |       | 389,096                      |       | 305,516                          |       |
| Accrued expenses                                                                                                                                                                                                                              |       | 2,303,832                    |       | 3,503,814                        |       |
| Deferred revenue                                                                                                                                                                                                                              |       | 275,649                      |       | 176,650                          |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Total current liabilities                                                                                                                                                                                                                     |       | 3,076,468                    |       | 4,093,237                        |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Note payable                                                                                                                                                                                                                                  |       | 4,235,000                    |       | 4,235,000                        |       |
| Long-term portion of capitalized lease  obligations                                                                                                                                                                                           |       | 8,574                        |       | 13,113                           |       |
| Deferred revenue                                                                                                                                                                                                                              |       | 156,227                      |       | 191,463                          |       |
| Deferred income taxes                                                                                                                                                                                                                         |       | 532,408                      |       | 635,967                          |       |
| Commitments and contingencies                                                                                                                                                                                                                 |       | —                       |       | —                           |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Shareholders’ Equity:   Preferred stock, 10,000,000 shares authorized, $.001par value, of which 200,000  shares are authorized as Class A Convertible stock. No shares issued and  outstanding at March 31, 2006 and September 30, 2005. |       | —                       |       | —                           |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Common stock, $.001 par value: 75,000,000  shares authorized, 18,063,407 and 18,047,425 shares issued and outstanding at  March 31, 2006 and September 30, 2005                                                                               |       | 18,063                       |       | 18,047                           |       |
| Additional paid-in capital                                                                                                                                                                                                                    |       | 42,481,545                   |       | 41,926,318                       |       |
| Retained earnings                                                                                                                                                                                                                             |       | 55,150,202                   |       | 55,921,733                       |       |
| Treasury stock, at cost, 961,610 and 0  shares at March 31, 2006 and September 30, 2005                                                                                                                                                       |       | (13,740,698                  | )          | —                           |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Total shareholders’ equity                                                                                                                                                                                                               |       | 83,909,112                   |       | 97,866,098                       |       |
|                                                                                                                                                                                                                                          |       |                         |       |                             |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                                               |       | $                            | 91,917,789 |                             | $          | 107,034,878 |   |

 

Theaccompanying notes are an integral part of these statements.

 

3

----

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(unaudited)**

 
| ** **                           | ** ** | **Three Months** | ** ** | **Three Months** | ** ** | **Six Months** | ** ** | **Six Months** | ** ** |
|--------------------------------------|------------|-----------------------|------------|-----------------------|------------|---------------------|------------|---------------------|------------|
| ** **                           | ** ** | **Ended**             | ** ** | **Ended**             | ** ** | **Ended**           | ** ** | **Ended**           | ** ** |
| ** **                           | ** ** | **March 31,**    | ** ** | **March 31,**    | ** ** | **March 31,**  | ** ** | **March 31,**  | ** ** |
| ** **                           | ** ** | **2006**              | ** ** | **2005**              | ** ** | **2006**            | ** ** | **2005**            | ** ** |
| Net sales                            |       | $                     | 3,744,752  |                  | $          | 19,001,021          |       | $                   | 9,150,139  |   | $ | 37,979,825 |   |
| Cost of sales                        |       | 2,194,718             |       | 5,777,273             |       | 4,896,736           |       | 11,959,415          |       |
| Gross profit                         |       | 1,550,034             |       | 13,223,748            |       | 4,253,403           |       | 26,020,410          |       |
| Operating expenses:                  |       |                  |       |                  |       |                |       |                |       |
| Research and development             |       | 1,916,788             |       | 1,548,468             |       | 3,451,789           |       | 2,819,999           |       |
| Selling, general and administrative  |       | 2,200,650             |       | 2,303,928             |       | 4,097,486           |       | 4,332,395           |       |
|                                 |       | 4,117,438             |       | 3,852,396             |       | 7,549,275           |       | 7,152,394           |       |
| Operating income (loss)              |       | (2,567,404            | )          | 9,371,352             |       | (3,295,872          | )          | 18,868,016          |       |
| Interest income                      |       | 819,626               |       | 428,325               |       | 1,601,071           |       | 711,575             |       |
| Interest expense                     |       | (44,483               | )          | (39,395               | )          | (87,995             | )          | (79,134             | )          |
| Income (loss) before income taxes    |       | (1,792,261            | )          | 9,760,282             |       | (1,782,796          | )          | 19,500,457          |       |
| Income tax expense (benefit)         |       | (1,014,605            | )          | 3,486,443             |       | (1,011,265          | )          | 7,033,815           |       |
| Net income (loss)                    |       | $                     | (777,656   | )                     | $          | 6,273,839           |       | $                   | (771,531   | ) | $ | 12,466,642 |   |
|                                 |       |                  |       |                  |       |                |       |                |       |
| Net Income (loss) Per Common Share:  |       |                  |       |                  |       |                |       |                |       |
| Basic                                |       | $                     | (0.04      | )                     | $          | 0.35                |       | $                   | (0.04      | ) | $ | 0.70 |   |
| Diluted                              |       | $                     | (0.04      | )                     | $          | 0.34                |       | $                   | (0.04      | ) | $ | 0.68 |   |
|                                 |       |                  |       |                  |       |                |       |                |       |
| Weighted Average Shares Outstanding: |       |                  |       |                  |       |                |       |                |       |
| Basic                                |       | 17,674,391            |       | 17,781,957            |       | 17,866,910          |       | 17,766,965          |       |
| Diluted                              |       | 17,674,391            |       | 18,316,479            |       | 17,866,910          |       | 18,293,080          |       |

 

The accompanying notes are an integral part of these statements.

 

4

----

 

**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(unaudited)**

 
| ** **                                                                                   | ** ** | **For the Six** | ** **  | **For the Six** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------|-------------|---------------------------|------------|
| ** **                                                                                   | ** ** | **Months Ended**     | ** **  | **Months Ended**     | ** ** |
| ** **                                                                                   | ** ** | **March 31,**        | ** **  | **March 31,**        | ** ** |
| ** **                                                                                   | ** ** | **2006**                  | ** **  | **2005**                  | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                        |       |                      |        |                      |       |
| Net income (loss)                                                                            |       | $                         | (771,531    | )                         | $          | 12,466,642 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities: |       |                      |        |                      |       |
| Depreciation and amortization                                                                |       | 413,156                   |        | 370,045                   |       |
| Stock-based compensation expense                                                             |       | 355,507                   |        | —                    |       |
| Compensation expense for stock issued to  directors                                          |       | 119,872                   |        | 101,740                   |       |
| Loss on Disposal of Fixed Assets                                                             |       | 156                       |        | —                    |       |
| Excess and obsolete inventory expense                                                        |       | —                    |        | 26,908                    |       |
| Deferred income taxes                                                                        |       | 88,469                    |        | —                    |       |
| Tax benefit from exercise of stock options                                                   |       | 23,659                    |        | 247,041                   |       |
| Excess tax benefits from share-based  payment arrangements                                   |       | (9,119                    | )           | —                    |       |
| (Increase) decrease in:                                                                      |       |                      |        |                      |       |
| Accounts receivable                                                                          |       | 2,846,136                 |        | (1,446,160                | )          |
| Inventories                                                                                  |       | (395,791                  | )           | (156,101                  | )          |
| Prepaid expenses and other current assets                                                    |       | 1,595,461                 |        | 22,436                    |       |
| Increase (decrease) in:                                                                      |       |                      |        |                      |       |
| Accounts payable                                                                             |       | 83,580                    |        | (503,925                  | )          |
| Accrued expenses                                                                             |       | (1,199,982                | )           | (746,158                  | )          |
| Deferred revenue                                                                             |       | 63,763                    |        | (4,040                    | )          |
| Net cash provided by operating activities                                                    |       | 3,213,336                 |        | 10,378,428                |       |
|                                                                                         |       |                      |        |                      |       |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                        |       |                      |        |                      |       |
| Purchases of property and equipment                                                          |       | (213,958                  | )           | (196,015                  | )          |
| Purchases of other assets                                                                    |       | (240,000                  | )           | —                    |       |
| Net cash used in investing activities                                                        |       | (453,958                  | )           | (196,015                  | )          |
|                                                                                         |       |                      |        |                      |       |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                        |       |                      |        |                      |       |
| Proceeds from exercise of stock options                                                      |       | 56,205                    |        | 304,621                   |       |
| Purchase of Treasury Stock                                                                   |       | (13,740,698               | )           | —                    |       |
| Repayment of capitalized lease obligation                                                    |       | (3,905                    | )           | (3,744                    | )          |
| Excess tax benefits from share-based  payment arrangements                                   |       | 9,119                     |        | —                    |       |
| Net cash provided by (used in) financing  activities                                         |       | (13,679,279               | )           | 300,877                   |       |
|                                                                                         |       |                      |        |                      |       |
| Net increase (decrease) in cash and cash  equivalents                                        |       | $                         | (10,919,901 | )                         | $          | 10,483,290 |   |
|                                                                                         |       |                      |        |                      |       |
| Cash and cash equivalents, beginning of  year                                                |       | $                         | 83,172,582  |                      | $          | 65,867,167 |   |
|                                                                                         |       |                      |        |                      |       |   |   |
| Cash and cash equivalents, end of period                                                     |       | $                         | 72,252,681  |                      | $          | 76,350,457 |   |
|                                                                                         |       |                      |        |                      |       |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW  INFORMATION:                                           |       |                      |        |                      |       |
| Cash paid for interest                                                                       |       | $                         | 55,170      |                      | $          | 40,303 |   |
| Cash paid for income taxes                                                                   |       | $                         | 440,000     |                      | $          | 6,969,500 |   |
| Cash received from income tax refund                                                         |       | $                         | (3,137,923  | )                         | $          | — |   |

 

The accompanying notes are an integral part of these statements.

 

5

----

 

**Innovative Solutions & Support Inc.**

**Notes toCondensed Consolidated Financial Statements**

 

**1.Basis of Presentation:**

 

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

 

Thebalance sheet as of March 31, 2006, the statement of operations for thethree months and six months ended March 31, 2006 and 2005 and the statementsof cash flows for the six months ended March 31, 2006 and 2005 have beenprepared by the Company without audit. In the opinion of management, alladjustments, consisting of normal and recurring adjustments, necessary topresent fairly the financial position, results of operations and cash flows atMarch 31, 2006 and for all periods presented have been made.

 

Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with accounting principles generally accepted in theUnited States of America have been condensed or omitted. It is suggested thatthese financial statements be read in conjunction with the financial statementsand notes thereto included in the Company’s Form 10K for the year endedSeptember 30, 2005 as filed with the Securities and Exchange Commission.The results of operations for the three months and six months endedMarch 31, 2006 are not necessarily indicative of the operating results forthe full year.

 

OnJune 13, 2005, the Company’s Board of Directors approved a three-for-twosplit of the Company’s common stock. The stock split was effected in the formof a fifty percent (50%) stock dividend that was paid on July 7, 2005 toshareholders of record on June 23, 2005. The issued and outstanding commonstock and all share and per share amounts have been retroactively restated inthis report to give effect to this three-for-two stock split.

 

**2. Netincome per Share**

 

Netincome per share (“EPS”) is calculated using the principles of SFASNo. 128, “Earnings Per Share.”

 

Areconciliation of weighted average shares outstanding appears below:

 
| ** **                                              | ** ** | **Three Months**        | ** ** | **Three Months**        | ** ** | **Six Months**          | ** ** | **Six Months**          | ** ** |
|---------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                              | ** ** | **Ended**                    | ** ** | **Ended**                    | ** ** | **Ended**                    | ** ** | **Ended**                    | ** ** |
| ** **                                              | ** ** | **March 31, 2006** | ** ** | **March 31, 2005** | ** ** | **March 31, 2006** | ** ** | **March 31, 2005** | ** ** |
| Weighted average number of shares-basic                 |       | 17,674,391                   |       | 17,781,957                   |       | 17,866,910                   |       | 17,766,965                   |       |
| Effect of dilutive securities:   Employee stock options |       | 0                            |       | 534,522                      |       | 0                            |       | 526,115                      |       |
| Weighted average number of shares-diluted               |       | 17,674,391                   |       | 18,316,479                   |       | 17,866,910                   |       | 18,293,080                   |       |

 

Forthe six-month periods ended March 31, 2006 and 2005, there were 420,987and 13,517 options outstanding that were excluded from the computation ofdiluted earnings per share as the effect would be antidilutive.

 

**3.Concentrations**

 

Forthe three months ended March 31, 2006, two customers accounted for 25% and16% of net sales or 41% of net sales on a combined basis. For the three monthsended March 31, 2005, two customers accounted for 17% and 15% of net salesor 32% of net sales on a combined basis. For the six months endedMarch 31, 2006, two customers accounted for 17% and 10% of net sales or27% of net sales on a combined basis. For the six months ended March 31,2005, one customer accounted for 14% of net sales. No other customer accountedfor 10% or more of net sales for the six months ended March 31, 2005.

 

**4.Inventories**

 

Inventoriesare stated at the lower of cost (first-in, first-out) or market and consist ofthe following:

 
| ** **      | ** ** | **March 31,** | ** ** | **September 30,** | ** ** |
|-----------------|------------|--------------------|------------|------------------------|------------|
| ** **      | ** ** | **2006**           | ** ** | **2005**               | ** ** |
| Raw materials   |       | $                  | 2,404,825  |                   | $          | 1,696,050 |   |
| Work-in-process |       | 1,184,943          |       | 1,151,828              |       |
| Finished goods  |       | 717,649            |       | 1,063,748              |       |
|            |       | $                  | 4,307,417  |                   | $          | 3,911,626 |   |

 

6

----

 

**5.Warranty**

 

TheCompany provides for the estimated cost of product warranties at the timerevenue is recognized. Warranty cost is recorded as cost of sales and thereserve balance recorded as an accrued expense in the financial statements.While the Company engages in extensive product quality programs and processes, theCompany’s warranty obligation is affected by product failure rates and therelated material, labor and delivery costs incurred in correcting a productfailure. Should actual product failure rates, material or labor costs differfrom the Company’s estimates, further revisions to the estimated warrantyliability would be required.

 

Warrantycost and accrual information for the three months ended March 31, 2006 ishighlighted below:

 
| Warranty accrual at December 31, 2005                       |   | $       | 740,976 |   |
|-------------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense for the three months ended  March, 31, 2006 |   | 13,481  |    |
| Warranty costs for the three months ended  March 31, 2006   |   | (45,505 | )       |
|                                                        |   |    |    |
| Warranty accrual at March 31, 2006                          |   | $       | 708,952 |   |

 

Warrantycost and accrual information for the six months ended March 31, 2006 is highlightedbelow:

 
| Warranty accrual at September 30, 2005                    |   | $       | 770,845 |   |
|-----------------------------------------------------------|--------|---------|---------|--------|
| Accrued expense for the six months ended  March, 31, 2006 |   | 30,778  |    |
| Warranty costs for the six months ended  March 31, 2006   |   | (92,671 | )       |
|                                                      |   |    |    |
| Warranty accrual at March 31, 2006                        |   | $       | 708,952 |   |

 

**6.Stock Options**

 

TheCompany’s 1998 Stock Option Plan (the “Plan”) provides for the granting ofincentive and nonqualified stock options to employees, officers, directors andindependent contractors and consultants. Through March 31, 2006  no stock options have been granted toindependent contractors or consultants under this plan.

 

Incentivestock options granted under the Plan have exercise prices that must be at leastequal to the fair value of the common stock on the date of grant. Nonqualified stockoptions granted under the Plan have exercise prices that may be less than,equal to or greater than the fair value of the common stock on the date ofgrant. The Company has reserved 3,389,025 shares of Common Stock for awardsunder the Plan. As of March 31, 2006 there were 1,693,818 remaining andavailable for grant.

 

OnDecember 16, 2004, the FASB finalized SFAS No. 123(R) Share-BasedPayment (SFAS 123(R)). SFAS123(R) amends SFAS 123 and supersedes APB25. SFAS123(R) requires that the cost of share-based payment transactions (includingthose with employees and non-employee directors’) be recognized in thefinancial statements. SFAS 123(R) applies to all share-based paymenttransactions in which an entity acquires goods or services by issuing (or offeringto issue) its shares, share options, or other equity instruments (except forthose held by an Employee Stock Option Plan (ESOP)) or by incurring liabilities(1) in amounts based (even in part) on the price of the entity’s shares orother equity instruments, or (2) that require (or may require) settlementby the issuance of an entity’s shares or other equity instruments. Thisstatement was effective as of the first annual reporting period beginning afterJune 15, 2005, or the Company’s period ending December 31, 2005.

 

EffectiveOctober 1, 2005 the Company adopted the provisions of SFAS 123(R), usingthe modified prospective approach and now accounts for share-based compensationapplying the fair value method for expensing stock options. Accordingly, the adoptionof SFAS 123R’s fair value method resulted in compensation costs for theCompany’s 1998 Stock Option Plan. The compensation cost that has been chargedagainst income as a result of adoption of SFAS 123R for the plan was $181,498and $355,507 for the three and six month periods ended March 31, 2006respectively . The total income tax benefit recognized in the statement ofoperations for share-based compensation arrangements was $56,410 and $110,492for the three and six month periods ended March 31, 2006, respectively.

 

Share-basedcompensation costs prior to October 1, 2005 were recognized using theintrinsic value method in accordance with Accounting Principles Board Opinion(“APB”) No. 25, “Accounting for Stock Issued to Employees.” For disclosurepurposes, pro forma net income and net income per share data were provided inaccordance with SFAS No. 123, “Accounting for Stock-Based Compensation,”as if the fair value method had been applied. Under SFAS No. 123,compensation cost related to stock options 

 

7

----

 

grantedto employees was computed based on the fair value of the stock option at thedate of grant using the Black-Scholes option pricing model. Prior to theadoption of SFAS 123(R) had compensation costs been determined based on thefair market value of the stock options, consistent with the provisions of SFAS123, the Company’s net income and earnings per share for the three and sixmonths ended March 31, 2005 would have been as follows:

 
| ** **                          | ** ** | **Three Months**        | ** ** | **Three Months**        | ** ** | **Six Months**          | ** ** | **Six Months**          | ** ** |
|-------------------------------------|------------|------------------------------|------------|------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                          | ** ** | **Ended March 31** | ** ** | **Ended March 31** | ** ** | **Ended March 31** | ** ** | **Ended March 31** | ** ** |
| ** **                          | ** ** | **2006**                     | ** ** | **2005**                     | ** ** | **2006**                     | ** ** | **2005**                     | ** ** |
| Net income (loss) as reported       |       | $                            | (777,656   | )                            | $          | 6,273,839                    |       | $                            | (771,531   | ) | $ | 12,466,642 |   |
|                                |       |                         |       |                         |       |                         |       |                         |       |
| Add back fair market value expense: |       |                         |       |                         |       |                         |       |                         |       |
| Employee stock options (1)          |       | 125,088                      |       |                         |       | 245,015                      |       |                         |       |
|                                |       |                         |       |                         |       |                         |       |                         |       |
| Deduct fair market value expense:   |       |                         |       |                         |       |                         |       |                         |       |
| Employee stock options (2)          |       | (125,088                     | )          | (203,199                     | )          | (245,015                     | )          | (406,398                     | )          |
|                                |       |                         |       |                         |       |                         |       |                         |       |
| Pro forma net income (loss)         |       | $                            | (777,656   | )                            | $          | 6,070,640                    |       | $                            | (771,531   | ) | $ | 12,060,244 |   |
|                                |       |                         |       |                         |       |                         |       |                         |       |
| Basic earnings (loss) per share:    |       |                         |       |                         |       |                         |       |                         |       |
| As reported                         |       | $                            | (0.04      | )                            | $          | 0.35                         |       | $                            | (0.04      | ) | $ | 0.70 |   |
| Pro forma                           |       | $                            | (0.04      | )                            | $          | 0.34                         |       | $                            | (0.04      | ) | $ | 0.68 |   |
|                                |       |                         |       |                         |       |                         |       |                         |       |
| Diluted earnings (loss) per share : |       |                         |       |                         |       |                         |       |                         |       |
| As reported                         |       | $                            | (0.04      | )                            | $          | 0.34                         |       | $                            | (0.04      | ) | $ | 0.68 |   |
| Pro forma                           |       | $                            | (0.04      | )                            | $          | 0.33                         |       | $                            | (0.04      | ) | $ | 0.66 |   |

 

----

(1) Amount represents compensation expense determinedunder the fair market value method included in reported net income, net ofrelated tax effect.

 

(2) Amounts represent compensation expense if it hadbeen determined under the fair market value based method, net of related taxeffect.

 

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model and the following weighted –averageassumptions:

 
| ** **                               | ** ** | **Six Months**          | ** ** | **Six Months**          | ** ** |
|------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **Ended**                    | ** ** | **Ended**                    | ** ** |
| ** **                               | ** ** | **March 31, 2006** | ** ** | **March 31, 2005** | ** ** |
|                                     |       |                         |       |                         |       |
| Expected lives (years)                   |       | 9.1                          |       | 8.8                          |       |
| Weighted average risk-free interest rate |       | 1.9                          | %          | 1.7                          | %          |
| Expected volatility                      |       | 65.4                         | %          | 66.8                         | %          |
| Expected dividend rate                   |       | —                       | %          | —                       | %          |

 

**7.Stock Repurchase Program**

 

OnDecember 28, 2005 the Company’s Board of Directors approved a common stockrepurchase program to acquire up to 2,000,000 shares of its outstanding commonstock. Purchases of the stock may be made from time to time, subject to marketconditions and at prevailing market prices. The program will remain in effectuntil June 30, 2006, unless extended by the Board of Directors.

 

Duringthe three months ended March 31, 2006, the Company repurchased 961,610 sharesof its common stock at an average cost of $14.29 per share. As of March 31,2006, 1,038,390 shares may be repurchased under the existing plan.

 

8

----

 

**NewAccounting Pronouncements**

 

InMay 2005, the Financial Accounting Standards Board (FASB) issued Statementof Financial Accounting Standard (SFAS) No. 154, “Accounting Changes andError Corrections – a replacement of APB Opinion No. 20 and FASB StatementNo. 3.”   SFAS No. 154 requiresretrospective application to prior periods’ financial statements of changes inaccounting principle, unless it is impracticable to determine either theperiod-specific effects or the cumulative effect of the change. SFAS No. 154also requires that retrospective application of a change in accountingprinciple be limited to the direct effects of the change. Indirect effects of achange in accounting principle, such as a change in nondiscretionaryprofit-sharing payments resulting from an accounting change, should berecognized in the period of the accounting change. SFAS No. 154 alsorequires that a change in depreciation, amortization, or depletion method forlong-lived, non-financial assets be accounted for as a change in accountingestimate effected by a change in accounting principle. SFAS No. 154 iseffective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005. Early adoption is permitted foraccounting changes and corrections of errors made in fiscal years beginningafter the date this Statement is issued. The Company will adopt the provisionsof SFAS No. 154 as applicable beginning in fiscal 2007.

 

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

 

InNovember 2004, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) 151, “Inventory Costs.” ThisStatement amends the guidance in ARB No. 43, Chapter 4 “InventoryPricing,” to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material (spoilage). Paragraph 5of ARB 43, Chapter 4 previously stated that “... under some circumstances, itemssuch as idle facility expense, excessive spoilage, double freight, andrehandling costs may be so abnormal as to require treatment as current periodcharges...”. This Statement requires that those items be recognized ascurrent-period charges regardless of whether they meet the criterion of “soabnormal.” In addition, this Statement requires that allocation of fixedproduction overheads to the costs of conversion be based on the normal capacityof the production facilities. This statement is effective for inventory costsincurred during fiscal years beginning after June 15, 2005. The Companyhas adopted this statement on October 1, 2005 and it did not have a materialimpact on the Company’s financial position or results of operations.

 

**Item 2. Management’s Discussion and Analysis of Financial Controls and Resultsof Operations**

 

**Overview**

 

Wedesign, manufacture and sell flight information computers, flat panel displaysystems and advanced monitoring systems to the Department of Defense (DOD),government agencies, commercial air transport carriers and corporate/generalaviation markets.

 

Ourrevenues are derived from the sale of our products to the retrofit market and,to a lesser extent, original equipment manufacturers (OEMs). Our customersinclude government and military entities and their commercial contractors,aircraft operators, aircraft modification centers and variousOEMs. Although we occasionally sell our products directly to governmententities, we primarily sell our products to commercial customers for end use ingovernment and military programs.

 

Wecontinue to invest in and seek additional opportunities for our Flat PanelDisplay Systems (“FPDS”) product line. In October 2005, the FAA awardedthe Company a second Technical Standard Order (TSO) for the FPDS orCOCKPIT/IP®. This TSO establishes our FPDS as meeting FAA requirements thathave been put in place to ensure safe flight on a variety of aircraft typesand, additionally, it addresses the most stringent Commercial Air Transportmarket requirements as provided in Title 14 of the Code of Federal Regulation,subpart 25, Commercial Air Transport. The TSO states “It has been noted thatthis display system employs an integrity monitoring system that assuresintegrity to a catastrophic/Level A design condition with the use of commercialgraphic processors’.

 

InOctober 2005, the Company in a teaming arrangement with ABX Air, receivedFAA Supplemental Type Certification (STC) of its FPDS for use on B-767aircraft. The STC provides B-767 operators with a low cost, rapidly implementedretrofit of their cockpit avionics with a modern pilot and copilot suite ofhigh resolution multi-color LCD flat panel displays. Operators will benefitfrom 

 

9

----

 

improveddispatch 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 FPDS upgrades. The STCalso provides a foundation for incorporating the product into other airplanesas well.

 

Our“cost of sales” is comprised of material components 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.

 

Weintend to continue investing in the development of new products and theenhancement of our existing product line. We expense research and developmentcosts related to future product development as they are incurred.

 

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

 

**ThreeMonths Ended March 31, 2006 Compared to the Three Months Ended March 31,2005**

 

*Netsales.* Net sales decreased$15.3 million, or 80%, to $3.7 million for the three months ended March 31, 2006from $19.0 million in the three months ended March 31, 2005. This decrease innet sales was mainly due to a decrease in demand for RVSM systems. Sales forthe three months ended March 31, 2005 reflected an industry wide response to aFederal Aviation Administration (FAA) mandate that required the installation ofRVSM equipment on aircraft flying between 29,000 and 41,000 feet by January 20,2005. The peak demand for the RVSM system declined soon after this date.

 

*Cost ofsales.* Cost of sales decreased$3.6 million or 62%, to $2.2 million, or 59% of net sales in the three monthsended March 31, 2006 from $5.8 million, or 30 % of net sales in the threemonths ended March 31, 2005. The absolute dollar decrease in cost of sales wasrelated to our decrease in net sales. As a percentage, the increase was theresult of fixed operating costs being absorbed over lower net sales in thecurrent period.

 

*Researchand development.*Research and development expenses increased $0.4 million or 24% to $1.9 millionor 51% of net sales in the three months ended March 31, 2006 from $1.5 millionor 8% of net sales in the three months ended March 31, 2005. The increase indollar spending reflects our sustained new product development effort. Thepercent increase was due to lower sales in the period.

 

*Selling,general, and administrative.* Selling, general, and administrative expenses decreased $0.1 million,or 4%, to $2.2 million, or 59% of net sales in the three months ended March 31,2006 from $2.3 million or 12% of net sales in the three months ended March 31,2005. The decrease in the dollar amount was primarily the result of lowercommissions offset by the recognition of expenses related to stock options. Theincrease as a percent of net sales was the result of lower net sales in theperiod.

 

*Interestincome.* Interestincome was $820,000 in the three months ended March 31, 2006 as compared tointerest income of $428,000 in the three months ended March 31, 2005. The increasein interest income in the three months ended March 31, 2006 was primarily theresult of higher interest rates in the current period.

 

*Interestexpense.* Interestexpense was $44,000 in the three months ended March 31, 2006 as compared tointerest expense of $39,000 in the three months ended March 31, 2005. Theincrease in interest expense in the three months ended March 31, 2006 wasprimarily the result of higher interest rates in the period.

 

*Incometax expense.* Incometax benefit for the three months ended March 31, 2006 was $1.0 million. Theincome tax expense for the three months ending March 31, 2005 was $3.5 million.The decrease in tax expense was primarily due to the loss for the periodgenerating a tax benefit and the recognition of additional refunds related to changesin previous income tax estimates.

 

Theeffective tax rate in the March 31, 2006 quarter was 31%. In the March 31, 2005quarter the effective tax rate was 36%. In each quarter, the effective tax ratediffers from the statutory rate due to the utilization of research anddevelopment tax credits.

 

 *Net income (loss).*As result of the factors described above, our net loss in the three monthsended March 31, 2006 was $778,000, a 112% decrease from the $6.3 million netincome in the three months ended March 31, 2005.

 

**Six MonthsEnded March 31, 2006 Compared to the Six Months Ended March 31, 2005**

 

*Netsales.* Net salesdecreased $28.8 million, or 76%, to $9.2 million for the six months ended March31, 2006 from $38.0 million in the six months ended March 31, 2005. Thisdecrease in net sales was mainly due to a decrease in demand for RVSM systems.Sales for the six months ended March 31, 2005 reflected an industry wideresponse to a Federal Aviation Administration (FAA) mandate that required theinstallation of RVSM equipment on aircraft flying between 29,000 and 41,000 feetby January 20, 2005. The peak demand for the RVSM system declined soonafter this date.

 

10

----

 

*Cost ofsales.* Cost of salesdecreased $7.1 million or 59%, to $4.9 million, or 54% of net sales in the sixmonths ended March 31, 2006 from $12.0 million, or 31 % of net sales in the sixmonths ended March 31, 2005. The absolute dollar decrease in cost of sales wasrelated to our decrease in net sales. As a percentage, the increase was theresult of fixed operating costs being absorbed over lower net sales in thecurrent period.

 

*Researchand development.*Research and development expenses increased $0.6 million or 22% to $3.4 millionor 38% of net sales in the six months ended March 31, 2006 from $2.8 million or7% of net sales in the six months ended March 31, 2005. The increase in dollarspending reflects our sustained new product development effort. The percentincrease was mostly due to lower sales in the period.

 

*Selling,general, and administrative.* Selling, general, and administrative expenses decreased $0.2 million,or 5%, to $4.1 million, or 45% of net sales in the six months ended March 31, 2006from $4.3 million or 11% of net sales in the six months ended March 31, 2005. Thedecrease in the dollar amount was primarily the result of lower commissionsoffset by the recognition of expenses related to stock options. The increase asa percent of net sales was the result of lower net sales in the period.

 

*Interestincome.* Interestincome was $1.6 million in the six months ended March 31, 2006 as compared tointerest income of $700,000 in the six months ended March 31, 2005. Theincrease in interest income in the six months ended March 31, 2006 wasprimarily the result of higher interest rates in the current period and anincrease in our cash balance over the prior period.

 

*Interestexpense.* Interestexpense was $88,000 in the six months ended March 31, 2006 as compared tointerest expense of $79,000 in the six months ended March 31, 2005. Theincrease in interest expense in the six months ended March 31, 2006 wasprimarily the result of higher interest rates in the period.

 

*Incometax expense.* Incometax benefit for the six months ended March 31, 2006 was $1.0 million. Theincome tax expense for the six months ending March 31, 2005 was $7.0 million.The decrease in tax expense was primarily due to the loss for the periodgenerating a tax benefit and the recognition of additional refunds related to changesin previous income tax estimates.

 

Theeffective tax rate for the six months ended March 31, 2006 was 31%. For the sixmonths ended March 31, 2005 the effective tax rate was 36%. In each period, theeffective tax rate differs from the statutory rate due to the utilization ofresearch and development tax credits.

 

*Net income(loss).* As a resultof the factors described above, our net loss in the six months ended March 31, 2006was $771,531, a 106% decrease from the $12.5 million net income in the sixmonths ended March 31, 2005.

 

**Liquidityand Capital Resources**

 

Ourmain source of liquidity has been cash flows from operations. We require cashprincipally to finance inventory, accounts receivable and payroll.

 

Ourcash flow from operating activities was $3.2 million for the six months ended March31, 2006, as compared to $10.4 million for the six months ended March 31, 2005.The decrease was due primarily to lower net income ($13.2 million) and reducedaccrued expenses ($0.5 million) which were partially offset by reduced accountsreceivable ($4.3 million) and a decrease in prepaid expenses ($1.6 million).

 

Ourcash used in investing activities was $500,000 for the six months ended March31, 2006. This primarily consisted of spending for product certification, productionequipment and laboratory test equipment. Cash used in investing activities was$196,000 for the six months ended March 31, 2005 and primarily consisted ofspending for production equipment, laboratory test equipment, computerequipment and office furniture.

 

Netcash used in financing activities was $13.7 million for the six months ended March31, 2006 as compared to net cash provided by financing activities of $301,000in the six months ended March 31, 2005. The primary use of cash for financingactivities was attributable to the Company purchasing 961,610 shares of ourstock at a total cost of $13.7 million. In both periods the primary source ofcash was from proceeds from the exercise of stock options.

 

Ourfuture capital requirements depend on numerous factors, including marketacceptance of our products, the timing and rate of expansion of our business,acquisitions, joint ventures and other factors. We have experienced increasesin our expenditures since our inception consistent with growth in ouroperations, personnel and product line, and we anticipate that our expenditureswill continue to increase in the foreseeable future. We believe that our cashand cash equivalents will provide sufficient capital to fund our operations forat least the next twelve months. However, we may need to raise additional fundsthrough public or private financings or other arrangements in order to supportmore rapid expansion of our business than we now anticipate either throughacquisitions or organic growth. Further, we may need to develop and introducenew or enhanced products, respond to competitive pressures, invest in oracquire businesses or technologies or respond to unanticipated requirements ordevelopments. 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

 

11

----

 

introducenew products or compete effectively in any of our markets, which could hurt ourbusiness.

 

**Backlog**

 

As of March 31, 2006 and 2005, our backlog was $28.3million and $29.4 million, respectively. The components of the backlog fromperiod-to-period have shown a distinct transformation. Flat Panel DisplaySystems (FPDS) comprise $16.3 million, or 59% of the March 31, 2006 backlog, anincrease of $10.9 million from the March 31, 2005 FPDS backlog of $5.4 million.

 

Bookingsof FPDS for the six months ended March 31, 2006 increased $10.4 million or 248%to $14.6 million from $4.2 million for the six months ended March 31, 2005.

 

**CriticalAccounting Policies**

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets and liabilities,disclosure of contingent assets and liabilities at the date of the financialstatements and the reported amount of revenues and expenses during thereporting period. The Company’s most critical accounting policies are revenuerecognition, income taxes, allowance for doubtful accounts, inventory valuation,share-based compensation and warranty reserves.

 

TheCompany recognizes sales for products when the following revenue recognitioncriteria are met: persuasive evidence of an arrangement exists, productdelivery and acceptance has occurred, pricing is fixed or determinable andcollection is reasonably assured. The Company recognizes sales upon shipment ofproducts to customers.

 

Salesrelated to certain long-term contracts requiring development and delivery ofproducts over several accounting periods are accounted for under the AmericanInstitute of Certified Public Accountants (AICPA) Statement of Position (SOP) 81-1,*Accounting for Performance of Construction-Type andCertain Production-Type Contracts.*We consider the nature of thesecontracts as well as the types of products and services provided whendetermining the appropriate accounting treatment for a particular contract.Certain long-term contracts are recorded on a percentage of completion basisusing cost-to-cost methodology to measure progress towards completion.

 

TheCompany offers its customers extended warranties for additional fees. Thesewarranty sales are recorded as deferred revenue and recognized as sales on astraight-line basis over the warranty period.

 

TheCompany enters into certain sales arrangements that include multipledeliverables as defined in Emerging Issues Task Force (EITF) Issue No. 00-21,*Accounting for Revenue Arrangements with MultipleDeliverables*. Effective July 1, 2003, the Company identifiesall goods and/or services that are to be delivered separately under a salesarrangement and allocates revenue to each deliverable based on fair value thatis established with the customer during contract negotiations. In general,revenues are separated between product sales and non-recurring engineeringservices. The allocated revenue for each deliverable is then recognized usingappropriate revenue recognition methods. Effective for transactions enteredinto after October 1, 2003, the Company accounts for transactions withsoftware and non-software components under EITF Issue 03-5, “Applicability ofAICPA Statement of Position 97-2, Software Revenue Recognition, to Non-SoftwareDeliverables in an Arrangement Containing More-Than-Incidental Software.”

 

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

 

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

 

Inventoriesare written 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.

 

Weoffer warranties on some products of various lengths. At the time of shipment,we establish 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.

 

12

----

 

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

 

**BusinessSegments**

 

Weoperate in one principal business segment which designs, manufactures and sellsflight information computers, flat panel display systems and advancedmonitoring systems to the Department of Defense, government agencies,commercial air transport carriers and corporate/general aviation markets. Wecurrently derive virtually all our net sales from the sale of this equipment.Almost all of the net sales, operating results and identifiable assets are inthe United States.

 

**NewAccounting Pronouncements**

 

InMay 2005, the Financial Accounting Standards Board (FASB) issued Statementof Financial Accounting Standard (SFAS) No. 154, “Accounting Changes andError Corrections – a replacement of APB Opinion No. 20 and FASB StatementNo. 3.”   SFAS No. 154 requiresretrospective application to prior periods’ financial statements of changes inaccounting principle, unless it is impracticable to determine either theperiod-specific effects or the cumulative effect of the change. SFAS No. 154also requires that retrospective application of a change in accounting principlebe limited to the direct effects of the change. Indirect effects of a change inaccounting principle, such as a change in nondiscretionary profit-sharingpayments resulting from an accounting change, should be recognized in theperiod of the accounting change. SFAS No. 154 also requires that a changein depreciation, amortization, or depletion method for long-lived,non-financial assets be accounted for as a change in accounting estimateeffected by a change in accounting principle. SFAS No. 154 is effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. Early adoption is permitted for accountingchanges and corrections of errors made in fiscal years beginning after the datethis Statement is issued. The Company will adopt the provisions of SFAS No. 154as applicable beginning in fiscal 2007.

 

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

 

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

 

**FORWARD-LOOKING STATEMENTS**

 

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

 

•      continued market acceptance of our air datasystems products;

 

•      the ability to obtain future contracts and awards;

 

•      the availability of government funding andcustomer requirements;

 

13

----

 

•      difficulties in developing and producing ourflat panel display systems (CIP) or other planned products or productenhancements;

 

•      market acceptance of our CIP system or otherplanned products or product enhancements;

 

•      our ability to gain regulatory approval ofour products in a timely manner;

 

•      delays in receiving components from thirdparty suppliers;

 

•      the competitive environment;

 

•      the termination of programs or contracts forconvenience by customers;

 

•      failure to retain key personnel;

 

•      new product offerings from competitors;

 

•      potential future acquisitions;

 

•      protection of intellectual property rights;

 

•      our ability to service the internationalmarket, and

 

•      other factors disclosed from time to time inour filings with the Securities and Exchange Commission.

 

Readersare cautioned not to place undue reliance on these forward-looking statements,which speak only as of the date of this Form 10-Q. The Company does notundertake any obligation to publicly release any revisions to theseforward-looking statements to reflect events, circumstances or changes inexpectations after the date of this Form 10-Q, or to reflect theoccurrence of unanticipated events. The forward-looking statements in thisdocument are intended to be subject to the safe harbor protection provided bySections 27A of the Securities Act and 21E of the Exchange Act.

 

Fora discussion identifying some important factors that could cause actual resultsto vary materially from those anticipated in the forward-looking statements,see the Company’s Securities and Exchange Commission filings including, but notlimited to, the discussions of “Risk Factors” contained in the Company’s AnnualReport on Form 10-K for the fiscal year ended September 30, 2005.

 

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

 

TheCompany’s operations are exposed to market risks primarily as a result ofchanges in interest rates. The Company does not use derivative financialinstruments for speculative or trading purposes. The Company’s exposure tomarket risk for changes in interest rates relates to its cash equivalents andan industrial revenue bond. The Company’s cash equivalents consist of fundsinvested in money market accounts, which bear interest at a variable rate,while the industrial revenue bond carries an interest rate that is consistentwith 30-day, tax-exempt commercial paper. As the interest rates are variable,and we do not engage in hedging activities, a change in interest rates earnedon the cash equivalents or paid on the industrial revenue bond would impactinterest income and expense along with cash flows, but would not impact thefair market value of the related underlying instruments.

 

**Item 4. Controls and Procedures**

 

(a)   An evaluation was performed under thesupervision and with the participation of the Company’s management, includingits Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, ofthe effectiveness of the Company’s disclosure controls and procedures, as suchterm is defined under Rule 13a-15e under the Securities Exchange Act of1934, as amended (the “Exchange Act”) as of March 31, 2006. Based on thatevaluation, the Company’s management, including the CEO and CFO, concluded thatthe Company’s disclosure controls and procedures are effective to providereasonable assurance that information required to be disclosed by the Companyin reports that it files or submits under the Exchange Act, is recorded,processed, summarized and reported as specified in Securities and ExchangeCommission rules and forms.

 

(b)   There were no changes in the Company’sinternal control over financial reporting identified in connection with theevaluation of such controls that occurred during the Company’s most recentfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

14

----

 

**PART II–OTHER INFORMATION**

 

| **Item 1.** | **Legal Proceedings** |
|-------------|-----------------------|

 

Inthe ordinary course of our business, we are at times subject to various legalproceedings. We do not believe that any current legal proceedings will have amaterial adverse effect on our results of operations or financial position.

 

**Item 1A.Risk Factors**

 

Thereare no material changes to the risk factors described under Item 1A of our Form10-K for the year ended September 30, 2005.

 
| I**tem 2.** | **Unregistered Sales of Equity Securities and Use  of Proceeds** |
|-------------|------------------------------------------------------------------|

 
| ** **             | ** ** | ** **                        | ** ** | ** **                   | ** ** | **Total Number of**  | ** ** | **Approximate Dollar**        | ** ** |
|------------------------|------------|-----------------------------------|------------|------------------------------|------------|--------------------------------|------------|------------------------------------|------------|
| ** **             | ** ** | ** **                        | ** ** | ** **                   | ** ** | **Shares Purchased**      | ** ** | **Value of Shares**      | ** ** |
| ** **             | ** ** | ** **                        | ** ** | ** **                   | ** ** | **as**                         | ** ** | **that May Yet Be** | ** ** |
| ** **             | ** ** | ** **                        | ** ** | ** **                   | ** ** | **Part of Publicly** | ** ** | **Purchased Under**           | ** ** |
| ** **             | ** ** | **Total Number**             | ** ** | **Average Price**       | ** ** | **Announced Plans**       | ** ** | **the Plans or**         | ** ** |
| **Period**             | ** ** | **of Shares Purchased** | ** ** | **Paid per Share** | ** ** | **or Programs (1)**  | ** ** | **Programs (1) (2)**     | ** ** |
| January 1 to 31, 2006  |       | —                            |       | —                       |       | —                         |       | $                                  | 32,000,000 |   |
| February 1 to 28, 2006 |       | 519,810                           |       | $                            | 14.61      |                           | 519,810    |                               | $          | 24,404,510 |   |
| March 1 to 31, 2006    |       | 441,800                           |       | $                            | 13.91      |                           | 441,800    |                               | $          | 18,259,302 |   |

 
| **Item 3.** | **Defaults upon Senior Securities** |
|-------------|-------------------------------------|

 

None

 
| **Item 4.** | **Submission of Matters to a Vote of Security  Holders** |
|-------------|----------------------------------------------------------|

 

OnMarch 8, 2006, the Company held its Annual Meeting of Stockholders. At this meetingthe stockholders voted in favor of the following item listed and described inthe Company’s Proxy Statement dated February 3, 2006.

 

1)     Election of Directors

 
| ** **             | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|------------------------|------------|------------|------------|--------------|------------|
| Geoffrey S. M. Hedrick |       | 12,660,395 |       | 356,040      |       |
| Winston J. Churchill   |       | 12,661,570 |       | 354,865      |       |
| Benjamin A. Cosgrove   |       | 12,658,459 |       | 357,976      |       |

 

Thefollowing directors’ term of office as directors continued after this meeting

 

Ivan M. Marks

Robert H. Rau

Glenn R. Bressner

Robert E. Mittelstaedt, Jr.

 
| **Item 5.** | **Other Information** |
|-------------|-----------------------|

 

None

 

15

----

 

**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 |

 

16

----

 

**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
| ** **         | **INNOVATIVE  SOLUTIONS AND SUPPORT, INC.** |
|--------------------|---------------------------------------------|
|               |                                        |
|               |                                        |
| Date:  May 5, 2006 | By:                                         | /s/  JAMES J. REILLY |   |
| ** **         | ** **                                  | **James  J. Reilly Chief Financial Officer** |

 

17

----