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** **

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

** **
| **x**                                                  | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|                                                   |                                                                                                    |
| **For the  quarterly period ended June 30, 2009** |
|                                                   |                                                                                                    |
| **OR**                                                 |
|                                                   |                                                                                                    |
| **o**                                                  | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**[For thetransition period from                to                ]**

 

**CommissionFile No. 0-31157**

 

**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

(Exact name of registrant as specified in its charter)

 

| **PENNSYLVANIA**                                 | ** ** | **23-2507402**       |
|--------------------------------------------------|------------|----------------------|
| (State or other  jurisdiction                    |       | (IRS Employer        |
| of  incorporation)                               |       | Identification  No.) |
|                                             |       |                 |
| **720  Pennsylvania Drive, Exton, Pennsylvania** | ** ** | **19341**            |
| (Address of  principal executive offices)        |       | (Zip Code)           |

 

**(610)646-9800**

(Registrant’stelephone number, including area code)

 

Indicate by check markwhether registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 day.  Yes x  No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files).  Yes o No o

 

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

 

| o Large accelerated filer                                              |   | x Accelerated filer         |
|------------------------------------------------------------------------|--------|-----------------------------|
|                                                                   |   |                        |
| o Non-accelerated filer  (Do not check if a smaller reporting company) |   | o Smaller reporting company |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes o  No x

 

As of August 3,2009, there were 16,736,329 shares of the Registrant’s Common Stock, with parvalue of $.001 per share, outstanding.

 

 

** **

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

### **FORM 10-Q June 30, 2009**

**INDEX**

 
| ** **        | ** **                                                                                                     | **Page No.** |
|-------------------|----------------------------------------------------------------------------------------------------------------|-------------------|
|              |                                                                                                           |              |
| **PART I.**  | **FINANCIAL INFORMATION**                                                                                      | —            |
|              |                                                                                                           |              |
| Item 1.           | Financial Statements (Unaudited)                                                                               |              |
|              |                                                                                                           |              |
|              | Condensed  Consolidated Balance Sheets — June 30, 2009 and September 30, 2008                   | 1                 |
|              |                                                                                                           |              |
|              | Condensed  Consolidated Statements of Operations —Three and Nine months ended June 30, 2009 and 2008 | 2                 |
|              |                                                                                                           |              |
|              | Condensed Consolidated  Statements of Cash Flows — Nine  months ended June 30, 2009 and 2008         | 3                 |
|              |                                                                                                           |              |
|              | Notes to Condensed Consolidated Financial Statements                                                           | 4 – 13       |
|              |                                                                                                           |              |
| Item 2.           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                    | 14 – 20      |
|              |                                                                                                           |              |
| Item 3.           | Quantitative  and Qualitative Disclosures about Market Risk                                                    | 20                |
|              |                                                                                                           |              |
| Item 4.           | Controls and  Procedures                                                                                       | 20                |
|              |                                                                                                           |              |
| **PART II.** | **OTHER INFORMATION**                                                                                          |              |
|              |                                                                                                           |              |
| Item 1.           | Legal Proceedings                                                                                              | 21                |
|              |                                                                                                           |              |
| Item 1A           | Risk Factors                                                                                                   | 21                |
|              |                                                                                                           |              |
| Item 2.           | Unregistered  Sales of Equity Securities and use of Proceeds                                                   | 21                |
|              |                                                                                                           |              |
| Item 3.           | Defaults upon  Senior Securities                                                                               | 22                |
|              |                                                                                                           |              |
| Item 4.           | Submission of  Matters to a Vote of Security Holders                                                           | 22                |
|              |                                                                                                           |              |
| Item 5.           | Other Information                                                                                              | 22                |
|              |                                                                                                           |              |
| Item 6.           | Exhibits                                                                                                       | 22                |
|              |                                                                                                           |              |
| **SIGNATURES**    |                                                                                                           | 23                |

 

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**PART I—FINANCIAL INFORMATION**

**Item 1—FinancialStatements**

 

**INNOVATIVESOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                                      | ** ** | **June 30,********2009** | ** ** | **September 30, 2008** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                                                                                      | ** ** | ** **                    | ** ** | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                 |       |                          |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                                                                      |       | $                             | 39,307,938 |                        | $          | 35,031,932 |   |
| Accounts receivable,  net                                                                                                                                                                                                       |       | 4,747,604                     |       | 4,218,443                   |       |
| Inventories                                                                                                                                                                                                                     |       | 5,495,720                     |       | 9,361,257                   |       |
| Deferred income taxes                                                                                                                                                                                                           |       | 326,969                       |       | 414,636                     |       |
| Prepaid expenses and  other current assets                                                                                                                                                                                      |       | 1,307,003                     |       | 1,406,260                   |       |
| Total current assets                                                                                                                                                                                                            |       | 51,185,234                    |       | 50,432,528                  |       |
| Property and equipment,  net                                                                                                                                                                                                    |       | 8,605,705                     |       | 8,958,346                   |       |
| Other assets                                                                                                                                                                                                                    |       | 477,784                       |       | 505,840                     |       |
| Total assets                                                                                                                                                                                                                    |       | $                             | 60,268,723 |                        | $          | 59,896,714 |   |
|                                                                                                                                                                                                                            |       |                          |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                                                  |       |                          |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                            |       |                          |       |                        |       |
| Current portion of  capitalized lease obligations                                                                                                                                                                               |       | $                             | 9,908      |                        | $          | 9,908 |   |
| Accounts payable                                                                                                                                                                                                                |       | 1,016,477                     |       | 2,349,981                   |       |
| Accrued expenses                                                                                                                                                                                                                |       | 2,403,137                     |       | 5,130,463                   |       |
| Deferred revenue                                                                                                                                                                                                                |       | 180,309                       |       | 450,923                     |       |
| Total current  liabilities                                                                                                                                                                                                      |       | 3,609,831                     |       | 7,941,275                   |       |
| Note payable                                                                                                                                                                                                                    |       | 4,335,000                     |       | 4,335,000                   |       |
| Long-term portion of  capitalized lease obligations                                                                                                                                                                             |       | 29,717                        |       | 37,633                      |       |
| Deferred revenue                                                                                                                                                                                                                |       | 73,818                        |       | 114,075                     |       |
| Deferred income taxes                                                                                                                                                                                                           |       | 326,969                       |       | 414,636                     |       |
| Other liabilities                                                                                                                                                                                                               |       | 226,074                       |       | 249,969                     |       |
| Total liabilities                                                                                                                                                                                                               |       | 8,601,409                     |       | 13,092,588                  |       |
|                                                                                                                                                                                                                            |       |                          |       |                        |       |
| Commitments and  contingencies                                                                                                                                                                                                  |       | —                        |       | —                      |       |
| Shareholders’ Equity:                                                                                                                                                                                                      |       |                          |       |                        |       |
| Preferred stock, 10,000,000 shares authorized, $.001  par value, of which 200,000 shares are authorized as Class A Convertible  stock. No shares issued and outstanding at June 30, 2009 and  September 30, 2008 |       | —                        |       | —                      |       |
|                                                                                                                                                                                                                            |       |                          |       |                        |       |
| Common stock, $.001 par value: 75,000,000 shares  authorized, 18,197,779 and 18,177,024 shares issued at June 30, 2009 and  September 30, 2008, respectively                                                          |       | 18,198                        |       | 18,177                      |       |
| Additional paid-in  capital                                                                                                                                                                                                     |       | 46,316,149                    |       | 45,767,960                  |       |
| Retained earnings                                                                                                                                                                                                               |       | 24,575,843                    |       | 20,152,615                  |       |
| Treasury stock, at cost,  1,470,510 and 1,445,510 shares at June 30, 2009 andSeptember 30, 2008, respectively                                                                                                         |       | (19,242,876                   | )          | (19,134,626                 | )          |
| Total shareholders’  equity                                                                                                                                                                                                |       | 51,667,314                    |       | 46,804,126                  |       |
| Total liabilities and  shareholders’ equity                                                                                                                                                                                |       | $                             | 60,268,723 |                        | $          | 59,896,714 |   |

 

The accompanying notesare an integral part of these statements.

 

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

**(unaudited)**

 
| ** **                                  | ** ** | **Three months ended June 30,** | ** ** | **Nine months ended June 30,** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                  | ** ** | **2009**                             | ** ** | **2008**                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net sales:                                  |       |                                 |       |                                |       |   |   |   |   |
| Product                                     |       | $                                    | 6,645,822  |                                | $          | 7,178,212 |   | $ | 24,900,246 |   | $ | 17,290,973 |   |
| Engineering -  modification and development |       | 1,113,478                            |       | 1,573,097                           |       | 3,900,126 |   | 3,020,343 |   |
| Total net sales                             |       | 7,759,300                            |       | 8,751,309                           |       | 28,800,372 |   | 20,311,316 |   |
| Cost of sales:                              |       |                                 |       |                                |       |   |   |   |   |
| Product                                     |       | 3,302,823                            |       | 3,850,657                           |       | 13,213,569 |   | 10,331,738 |   |
| Engineering -  modification and development |       | 318,222                              |       | 717,646                             |       | 880,262 |   | 1,686,285 |   |
| Total cost of sales                         |       | 3,621,045                            |       | 4,568,303                           |       | 14,093,831 |   | 12,018,023 |   |
|                                        |       |                                 |       |                                |       |   |   |   |   |
| Gross profit                                |       | 4,138,255                            |       | 4,183,006                           |       | 14,706,541 |   | 8,293,293 |   |
|                                        |       |                                 |       |                                |       |   |   |   |   |
| Operating expenses:                         |       |                                 |       |                                |       |   |   |   |   |
| Research and  development                   |       | 1,287,397                            |       | 3,221,698                           |       | 4,178,585 |   | 7,738,942 |   |
| Selling, general and  administrative        |       | 1,840,571                            |       | 3,282,183                           |       | 6,471,958 |   | 13,952,535 |   |
| Asset impairment                            |       | —                               |       | 2,475,000                           |       | — |   | 2,475,000 |   |
| Total operating  expenses                   |       | 3,127,968                            |       | 8,978,881                           |       | 10,650,543 |   | 24,166,477 |   |
|                                        |       |                                 |       |                                |       |   |   |   |   |
| Operating income (loss)                     |       | 1,010,287                            |       | (4,795,875                          | )          | 4,055,998 |   | (15,873,184 | ) |
|                                        |       |                                 |       |                                |       |   |   |   |   |
| Interest income                             |       | 62,594                               |       | 284,079                             |       | 360,907 |   | 1,315,219 |   |
| Interest expense                            |       | (19,798                              | )          | (33,064                             | )          | (74,513 | ) | (122,183 | ) |
| Other income                                |       | —                               |       | —                              |       | 50,073 |   | 300,000 |   |
| Income (loss) before  income taxes          |       | 1,053,083                            |       | (4,544,860                          | )          | 4,392,465 |   | (14,380,148 | ) |
| Income tax expense  (benefit)               |       | (199,228                             | )          | (255,989                            | )          | (30,762 | ) | 1,090,821 |   |
| Net income (loss)                           |       | $                                    | 1,252,311  |                                | $          | (4,288,871 | ) | $ | 4,423,227 |   | $ | (15,470,969 | ) |
|                                        |       |                                 |       |                                |       |   |   |   |   |
| Net income (loss) per  common share:        |       |                                 |       |                                |       |   |   |   |   |
| Basic                                       |       | $                                    | 0.07       |                                | $          | (0.25 | ) | $ | 0.26 |   | $ | (0.92 | ) |
| Diluted                                     |       | $                                    | 0.07       |                                | $          | (0.25 | ) | $ | 0.26 |   | $ | (0.92 | ) |
|                                        |       |                                 |       |                                |       |   |   |   |   |
| Weighted average shares  outstanding:       |       |                                 |       |                                |       |   |   |   |   |
| Basic                                       |       | 16,727,269                           |       | 16,893,499                          |       | 16,727,269 |   | 16,897,313 |   |
| Diluted                                     |       | 16,750,308                           |       | 16,893,499                          |       | 16,746,631 |   | 16,897,313 |   |

 

The accompanyingnotes are an integral part of these statements.

 

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**INNOVATIVE SOLUTIONS AND SUPPORT, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(unaudited)**

 
| ** **                                                                                          | ** ** | **For the Nine Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2009**                                    | ** ** | **2008** | ** ** |
| **CASH  FLOWS FROM OPERATING ACTIVITIES:**                                                          |       |                                        |       |   |   |
| Net income (loss)                                                                                   |       | $                                           | 4,423,227  |   | $ | (15,470,969 | ) |
| Adjustments to reconcile net income (loss) to net cash  provided by (used in) operating activities: |       |                                        |       |   |   |
| Depreciation and  amortization                                                                      |       | 767,849                                     |       | 761,666 |   |
| Share-based  compensation expense:                                                                  |       |                                        |       |   |   |
| Stock options                                                                                       |       | 395,006                                     |       | 809,792 |   |
| Nonvested stock awards                                                                              |       | 150,110                                     |       | 149,940 |   |
| Tax benefit from  share-based arrangements:                                                         |       |                                        |       |   |   |
| Stock options                                                                                       |       | —                                      |       | 12,491 |   |
| Nonvested stock awards                                                                              |       | 3,094                                       |       | 6,286 |   |
| (Gain) loss on disposal  of property and equipment                                                  |       | 260                                         |       | (3,000 | ) |
| Excess and obsolete  inventory expense                                                              |       | 666,580                                     |       | 78,913 |   |
| Asset Impairment                                                                                    |       | —                                      |       | 2,475,000 |   |
| Deferred income taxes                                                                               |       | —                                      |       | 1,227,955 |   |
| (Increase) decrease in:                                                                             |       |                                        |       |   |   |
| Accounts receivable                                                                                 |       | (529,160                                    | )          | 1,285,003 |   |
| Inventories                                                                                         |       | 3,198,957                                   |       | (1,669,066 | ) |
| Prepaid expenses and  other current assets                                                          |       | 98,247                                      |       | 4,933,932 |   |
| Other non current  assets                                                                           |       | (74,534                                     | )          | (6,180 | ) |
| Increase (decrease) in:                                                                             |       |                                        |       |   |   |
| Accounts payable                                                                                    |       | (1,402,254                                  | )          | (1,135,941 | ) |
| Accrued expenses                                                                                    |       | (2,032,173                                  | )          | (976,452 | ) |
| Income taxes payable                                                                                |       | (718,039                                    | )          | — |   |
| Deferred revenue                                                                                    |       | (310,871                                    | )          | (218,236 | ) |
| Other non current  liabilities                                                                      |       | —                                      |       | 223,893 |   |
| Net cash provided by  (used in) operating activities                                                |       | 4,636,299                                   |       | (7,514,973 | ) |
| ** **                                                                                          |       |                                        |       |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                          |       |                                        |       |   |   |
| Purchases of property  and equipment                                                                |       | (244,127                                    | )          | (536,532 | ) |
| Proceeds on sale of  property and equipment                                                         |       | —                                      |       | 3,000 |   |
| Net cash used in  investing activities                                                              |       | (244,127                                    | )          | (533,532 | ) |
|                                                                                                |       |                                        |       |   |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                          |       |                                        |       |   |   |
| Proceeds from exercise  of stock options                                                            |       | —                                      |       | 32,873 |   |
| Purchase of treasury  shares                                                                        |       | (108,250                                    | )          | (57,178 | ) |
| Repayment of  capitalized lease obligations                                                         |       | (7,916                                      | )          | (7,372 | ) |
| Net cash (used in)  provided by financing activities                                                |       | (116,166                                    | )          | (31,677 | ) |
| Net increase (decrease)  in cash and cash equivalents                                               |       | 4,276,006                                   |       | (8,080,182 | ) |
| Cash and cash  equivalents, beginning of period                                                     |       | 35,031,932                                  |       | 49,151,078 |   |
|                                                                                                |       |                                        |       |   |   |
| Cash and cash  equivalents, end of period                                                           |       | $                                           | 39,307,938 |   | $ | 41,070,896 |   |
|                                                                                                |       |                                        |       |   |   |
| **SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION**                                               |       |                                        |       |   |   |
| Cash paid for interest                                                                              |       | $                                           | 44,488     |   | $ | 92,066 |   |
| Cash paid for income  tax                                                                           |       | $                                           | 704,486    |   | $ | 9,073 |   |
| Cash received from  income tax refunds                                                              |       | $                                           | 25,115     |   | $ | 5,107,269 |   |
| ***Noncash Investing******Activities******:***                                                      |       |                                        |       |   |   |
| Accrual for purchases  of property and equipment                                                    |       | $                                           | 68,750     |   | $ | — |   |

 

The accompanyingnotes are an integral part of these statements.

 

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**Innovative Solutions and Support Inc.Notes to Condensed Consolidated Financial Statements**

**(Unaudited)**

 

**1.****Summary of SignificantAccounting Policies**

 

***Descriptionof the Company***

 

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

 

***Basisof Presentation***

 

The accompanyingunaudited condensed consolidated financial statements are presented pursuant tothe rules and regulations of the United States Securities and ExchangeCommission in accordance with the disclosure requirements for the quarterlyreport on Form 10-Q and therefore do not include all of the informationand footnotes required by generally accepted accounting principles for completeannual financial statements. In the opinion of Company management, theunaudited condensed consolidated financial statements reflect all adjustments(consisting of normal recurring adjustments) necessary to fairly state theresults for the interim periods presented. The condensed consolidated balancesheet as of September 30, 2008 is derived from audited financialstatements. Operating results for the three and nine months ended June 30,2009 are not necessarily indicative of the results that may be expected for thefiscal year ending September 30, 2009. These unaudited condensedconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements and notes of the Company included inthe Company’s Annual Report on Form 10-K/A for the fiscal year ended September 30,2008.

 

Our condensedconsolidated financial statements include the accounts of our wholly-ownedsubsidiaries. All intercompany balances and transactions have been eliminatedin consolidation.

 

***Use of Estimates***

 

Preparation of consolidated financial statements in conformity withaccounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect reportedamounts of assets and liabilities, and disclosure of contingent assets andliabilities, as of the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ materially from those estimates.

 

***Cash and Cash Equivalents***

 

Highly liquid investments purchased with an original maturity of threemonths or less are classified as cash equivalents. Cash equivalents at June 30,2009 and September 30, 2008 consist of funds invested in money market accountswith financial institutions.

 

***Property and Equipment***

 

Property and equipment is stated at cost. Depreciation is providedusing an accelerated method over estimated useful lives of the assets (thelesser of three to seven years or over the lease term), except for the airplaneand manufacturing facility, which are depreciated using the straight-linemethod over estimated useful lives of ten years and thirty-nine years,respectively. Major additions and improvements are capitalized, whilemaintenance and repairs that do not improve or extend the life of assets arecharged to expense as incurred.

 

***Long-Lived Assets***

 

The Company assesses the impairment of long-lived assets in accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*(“SFAS 144”)*.* Thisstatement requires that long-lived assets be reviewed for impairment wheneverevents or changes in circumstances indicate the carrying amount of an asset maynot be recoverable. In addition, long-lived assets to be disposed of should bereported at the lower of the carrying amount or fair value less cost to sell.The Company considers historical performance and future estimated results inits evaluation of potential impairment and then compares the carrying amount ofthe asset to estimated future cash flows expected to result from use of theasset. If the carrying amount of the asset exceeds the estimated expectedundiscounted future cash flows, the Company measures the amount of theimpairment by comparing the carrying amount of the asset to its fair value. Theestimation of fair value is generally measured by discounting expected futurecash flows.  No impairment charges wererecorded during the nine months ended June 30, 2009.

 

During the nine months ended June 30, 2008 the Company recorded anasset impairment of $2.5 million, the full carrying value of the asset. Theimpairment was related to previously acquired engineering software which is nolonger part of the Company’s product offering and will generate no future cashflows.

 

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***Revenue Recognition***

 

The Company enters intosales arrangements with customers that, in general, provide for theCompany to design, develop, manufacture and deliver flightinformation computers, large flat-panel displays, and advanced monitoringsystems that measure and display critical flight information, including datarelative to aircraft separation, airspeed, and altitude, as well as engine andfuel data measurements.  The Company’s sales arrangements may includemultiple deliverables as defined in Emerging Issues Task Force (“EITF”) Issue No. 00-21,*Revenue Arrangements with Multiple Deliverables*(“EITF00-21”), which typically include design and engineering services and theproduction and delivery of the flat panel display and related components.

 

Multiple ElementArrangements -

 

The Company identifiesall goods and/or services that are to be delivered separately under such asales arrangement and allocates revenue to each deliverable (if more than one)based on that deliverable’s fair value.  The Company then considers theappropriate recognition method for each deliverable; deliverables undermultiple element arrangements are typically purchased engineering and designservices and product sales.  To theextent that an arrangement contains defined design and development activitiesas an identified deliverable in addition to products (resulting in a multipleelement arrangement), the Company recognizes as Engineering — Modification andDevelopment (“EMD”) revenue amounts earned during the design and developmentphase of the contract following the guidance included in the American Instituteof Certified Public Accountants (“AICPA”) Statement of Position 81-1, *Accounting for Performance of Construction-Type and CertainProduction-Type Contracts* (“SOP 81-1”). To the extent thatmultiple element arrangements include product sales, revenue is generallyrecognized once revenue recognition criteria for the product deliverable hasbeen met based on the provisions of Staff Accounting Bulletin No. 104, *Revenue Recognition* (“SAB 104”).

 

Single ElementArrangements —

 

*Products -*

 

To the extent that asingle element arrangement provides for product sales and repairs, revenue isgenerally recognized once revenue recognition criteria for the productdeliverable has been met based on the provisions of SAB 104.  The Companyalso receives orders for existing equipment and parts.  Revenue from thesale of such products is generally recognized upon shipment to the customer.

 

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

 

               *Engineering Services -*

 

The Company also mayenter into service arrangements to perform specified design and developmentservices related to its products.  The Company recognizes revenue fromthese arrangements as EMD revenue, following the guidance included in SOP 81-1.The Company considers the nature of these service arrangements (including term,size of contract, level of effort) when determining the appropriate accountingtreatment for a particular contract. The Company recognizes the revenue fromthese contracts using either the percentage-of-completion method or completedcontract method of accounting.

 

The Company recordsrevenue relating to these contracts using the percentage-of-completion methodwhen the Company determines that progress toward completion is reasonable andreliably estimable and the contract is long-term in nature; the Company usesthe completed contract method for all others.

 

***Warranty***

 

Estimated cost to repair or replace products under warranty is providedwhen sales of product are recorded.

 

***Income Taxes***

 

Income taxes are recordedin accordance with SFAS No. 109,*Accounting for IncomeTaxes* (“SFAS 109”), which principally utilizes a balance sheetapproach to provide for income taxes. Under this method, the Company recognizes deferred tax assets andliabilities for temporary differences between the financial reporting basis andthe tax basis of the Company’s assets and liabilities. The impact on deferredtaxes of changes in tax rates and laws, if any, applied to the years duringwhich temporary differences are expected to be settled, are reflected in theconsolidated financial statements in the period of enactment. A valuationallowance is established when it is more likely than not that all or a portionof a deferred tax asset will not be realized. The Company files a consolidated United States federal income tax return(see Note 3).

 

Effective October 1,2007 (the first day of fiscal 2008), the Company adopted Financial AccountingStandards Board (“FASB”) Interpretation No. 48, *Accounting for Uncertainty in Income Taxes* (“FIN 48”).  FIN 48 prescribes a comprehensive model forhow a company should recognize, measure, present and disclose in its financialstatements uncertain tax positions that the company has taken 

 

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or expects to takeon a tax return. The Company has elected to record any interest or penaltiesfrom the uncertain tax position as income tax expense.

 

***Research and Development***

 

Research and development charges incurred for product design, productenhancements and future product development are expensed as incurred. Productdevelopment and design charges incurred related to a specific customeragreement that are billable are capitalized and then charged to cost of sales —engineering modification and development as the revenue related to theagreements are recognized.

 

***Comprehensive Income***

 

Pursuant to SFAS No. 130, *Reporting ComprehensiveIncome,*the Company is required to classify items of othercomprehensive income by their nature in a financial statement and display the accumulatedbalance of other comprehensive income separately from retained earnings andadditional paid-in capital in the equity section of our condensed consolidatedbalance sheets.  Through June 30,2009, comprehensive income consists of net income and there were no items ofother comprehensive income for any of the periods presented.

 

***Fair Value of FinancialInstruments***

 

The Company adopted SFAS No. 157,*Fair Value Measurements*(“SFAS 157”) inthe first quarter of fiscal 2009 for financial assets and liabilities. Thisstandard defines fair value as the price at which an asset could be exchangedin a current transaction between knowledgeable, willing parties. A liability’sfair value is defined as the amount that would be paid to transfer theliability to a new obligor, not the amount that would be paid to settle theliability with the creditor.

 

Assets and liabilitiesmeasured at fair value are categorized based upon the level of judgmentassociated with the inputs used to measure their fair value. Hierarchicallevels, defined by SFAS 157 and directly related to the amount of subjectivityassociated with the inputs to fair valuation of these assets and liabilities,are as follows:

 

Level 1 — Unadjusted quoted prices that are availablein active markets for the identical assets or liabilities at the measurementdate.

 

Level 2 — Other observable inputs available at themeasurement date, other than quoted prices included in Level 1, either directlyor indirectly, including:

·                  Quoted prices for similar assets or liabilities inactive markets;

·                  Quoted prices for identical or similar assets innon-active markets;

·                  Inputs other than quoted prices that are observablefor the asset or liability; and

·                  Inputs that are derived principally from orcorroborated by other observable market data.

 

Level 3 — Unobservableinputs that cannot be corroborated by observable market data and reflect theuse of significant management judgment.  These values are generallydetermined using pricing models for which the assumptions utilize management’sestimates of market participant assumptions.

 

The following table setsforth by level within the fair value hierarchy the Company’s financial assetsand liabilities that were accounted for at fair value on a recurring basis asof June 30, 2009, according to the valuation techniques the Company usedto determine their fair values.

 
| ** **                  | ** ** | **Fair Value Measurements on June 30, 2009** | ** ** |
|-----------------------------|------------|---------------------------------------------------|------------|
| ** **                  | ** ** | **Quoted Prices in Active**                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **Markets**                                       | ** ** | **Significant Other** | ** ** | **Significant** | ** ** |
| ** **                  | ** ** | **for Identical**                                 | ** ** | **Observable** | ** ** | **Unobservable** | ** ** |
| ** **                  | ** ** | **Assets**                                        | ** ** | **Inputs** | ** ** | **Inputs** | ** ** |
| ** **                  | ** ** | **(Level 1)**                                     | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** |
| Assets                      |       |                                              |       |   |   |   |   |
| Cash  and cash equivalents: |       |                                              |       |   |   |   |   |
| Money  market funds         |       | $                                                 | 36,214,154 |   | $ | 0 |   | $ | 0 |   |
|                             |            |                                                   |            |  |  |  |  |  |  |  |

 

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***Stock-Based Compensation***

 

The Company accounts forstock-based compensation under SFAS No. 123 (revised 2004), *Share-Based Payment*(“SFAS 123(R)”)FAS 123(R) requires the Company to measure the cost of employeeservices received in exchange for an award of equity instruments based on thegrant-date fair value of the award using an option pricing model. That cost isrecognized over the period during which an employee is required to provideservice in exchange for the award.

 

***Concentrations***

 

*Major Customers and Products*

 

For the three monthsended June 30, 2009, three of the Company’s customers, American Airlines,the United States Department of Defense and Western Aircraft, accounted for24%, 21% and 13% of net sales, respectively. During the nine months ended June 30,2009, two of the Company’s customers, American Airlines and the United StatesDepartment of Defense, accounted for 30% and 12% of net sales, respectively.

 

For the three monthsended June 30, 2008, three of the Company’s customers, Eclipse AviationCorp. (“Eclipse”), Federal Express and American Airlines accounted for 44%, 15%and 14% of net sales, respectively. For the nine months ended June 30,2008 Eclipse accounted for 52% of net sales.

 

*Major Suppliers*

 

The Company currently buys several of its components from single sourcesuppliers. Although there are a limited number of manufacturers of particularcomponents, management believes other suppliers could provide similarcomponents on comparable terms.

 

During the three and nine months ended June 30, 2009 one supplier,ABX Air Inc., accounted for 30% and 31% of the Company’s total inventoryrelated purchases, respectively.

 

*Concentration of Credit Risk*

 

Financial instruments that potentially subject the Company toconcentration of credit risk consist principally of cash balances and accountsreceivable. The Company invests its excess cash where preservation of principalis the major consideration. The Company’s customer base principally consists ofcompanies within the aviation industry. The Company routinely requests advancepayments from new customers.

 

The Company has maintained a reserve for doubtful accounts in theamount of $0 and $4.1 million, as of June 30, 2009 and September 30,2008, respectively. The large balance in the reserve for doubtful accounts at September 30,2008 was directly related to accounts receivable from Eclipse, a customer thatfiled for bankruptcy under Chapter 11 subsequent to the Company’s fiscal yearend.  During the three months ended December 31,2008 the Company wrote off the entire Eclipse receivable against the previouslyestablished reserve.

 

***                RecentAccounting Pronouncements***

 

In September 2006,the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). SFAS 157 defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles and expandsdisclosures about fair value measurements. This statement does not require anynew fair value measurements; however, the application of this Statement maychange current practice for some entities. SFAS 157 is effective for fiscalyears beginning after November 15, 2007. The adoption did not have amaterial impact on the Company’s financial statements.

 

In February 2008,the FASB issued FASB Staff Position (“FSP”) 157-2, *EffectiveDate of FASB Statement No. 157* which delays the effective dateof SFAS 157 for nonfinancial assets and nonfinancial liabilities, except thosethat are recognized or disclosed at fair value on a recurring basis, at leastannually, until fiscal years beginning after November 15, 2008, andinterim periods within those fiscal years. The Company does not expect the adoption to have any impact on theCompany’s financial statements.

 

In December 2007,the FASB issued SFAS 160, *Noncontrolling Interestsin Consolidated Financial Statements—Amendment of ARB No. 51* (“SFAS160”)*.* SFAS 160 establishes accounting andreporting standards for ownership interests in subsidiaries held by partiesother than the parent, changes in a parent’s ownership of a noncontrollinginterest, calculation and disclosure of the consolidated net incomeattributable to the parent and the noncontrolling interest, changes in a parent’sownership interest while the parent retains its controlling financial interestand fair value measurement of any retained noncontrolling equity investment.SFAS 160 is effective for financial statements issued for fiscal yearsbeginning after December 15, 2008 (the Company’s fiscal year 2010). TheCompany does not expect the adoption to have any impact on its financialstatements.

 

In May 2008, theFASB issued SFAS 162, *The Hierarchy of GenerallyAccepted Accounting Principles*(“SFAS 162”)*.*This statement identifies the sources of accounting principles and theframework for selecting the principles to be used in the preparation offinancial 

 

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statements ofnongovernmental entities that are presented in conformity with generallyaccepted accounting principles in the United States. This statement waseffective on November 15, 2008.

 

In June 2008, theFASB issued FASB Staff Position EITF 03-6-1, *DeterminingWhether Instruments Granted in Share-Based Payment Transactions areParticipating Securities* (“FSP EITF 03-6-1”). FSP EITF 03-6-1requires that unvested stock-based compensation awards that containnon-forfeitable rights to dividends or dividend equivalents (whether paid orunpaid) should be classified as participating securities and should be includedin the computation of earnings per share pursuant to the class method asdescribed by SFAS 128, *Earnings per Share*.FSP EITF 03-6-1 is effective for financial statements issued for fiscal yearsbeginning on or after December 15, 2008 and earlier adoption isprohibited. The Company will adopt FSP EITF 03-6-1 on October 1, 2010. TheCompany does not expect the adoption to have a material impact on its financialstatements.

 

In May 2009, theFASB issued SFAS No. 165, *Subsequent Events*(“SFAS 165”). SFAS 165 establishes general accounting for and disclosure ofevents that occur after the balance sheet date but before financial statementsare issued or available to be issued. This statement also outlines thecircumstances under which an entity would need to record transactions occurringafter the balance sheet date in the financial statements. These new disclosuresidentify the date through which the entity has evaluated subsequent events.SFAS 165 is effective for interim or annual financial periods ending after June 15,2009.  The Company adopted SFAS 165 andthe adoption had no impact on the consolidated financial statements.

 

In June 2009, theFASB issued SFAS No. 168, *The FASB AccountingStandards Codification and the Hierarchy of Generally Accepted AccountingPrinciples* (“SFAS 168”). SFAS 168 replaces SFAS 162, *The Hierarchy of Generally Accepted Accounting Principles*and establishes the FASB Accounting Standards Codification as the source ofauthoritative accounting principles recognized by the FASB to be applied bynongovernmental entities in the preparation of financial statements inconformity with Generally Accepted Accounting Principles. SFAS 168 is effectivefor interim and annual periods ending after September 15, 2009. TheCompany adopted FAS 168 effective July 1, 2009, and will make the requireddisclosures beginning with the Company’s annual report on Form 10-K forthe fiscal period ending September 30, 2009.

 

**2.****Detail of CertainBalance Sheet Accounts**

 

***Inventories***

 

Inventories are stated at the lower of cost (first-in, first-out) ormarket, net of reserve for excess and obsolete, and consist of the following:

** **
| ** **      | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-----------------|------------|-------------------|------------|------------------------|------------|
| ** **      | ** ** | **2009**          | ** ** | **2008**               | ** ** |
| Raw materials   |       | $                 | 3,389,403  |                   | $          | 4,705,134 |   |
| Work-in-process |       | 965,066           |       | 3,046,451              |       |
| Finished goods  |       | 1,141,251         |       | 1,609,672              |       |
|            |       | $                 | 5,495,720  |                   | $          | 9,361,257 |   |

 

***Prepaid expenses and othercurrent assets***

 

Prepaid expenses and other current assets consist ofthe following:

 
| ** **                           | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|--------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                           | ** ** | **2009**          | ** ** | **2008**               | ** ** |
| Revenue recognized not  yet invoiced |       | $                 | 741,115    |                   | $          | 747,789 |   |
| Prepaid insurance                    |       | 172,827           |       | 248,799                |       |
| Deferred engineering  costs          |       | 105,517           |       | —                 |       |
| Other                                |       | 287,544           |       | 409,672                |       |
|                                 |       | $                 | 1,307,003  |                   | $          | 1,406,260 |   |

 

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***Property and equipment***

 

Property and equipment, net consists of the followingbalances:

 
| ** **                                       | ** ** | **June 30,********2009** | ** ** | **September 30,  2008** | ** ** |
|--------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|
|                                             | ** ** |                          |       |                         |       |
| Computer equipment                               |       | $                             | 2,012,793  |                         | $          | 1,960,664 |   |
| Corporate airplane                               |       | 3,082,186                     |       | 3,076,400                    |       |
| Furniture and office  equipment                  |       | 1,074,029                     |       | 1,074,029                    |       |
| Manufacturing facility                           |       | 5,579,486                     |       | 5,576,536                    |       |
| Test equipment                                   |       | 4,105,229                     |       | 3,918,698                    |       |
| Land                                             |       | 1,021,245                     |       | 1,021,245                    |       |
|                                             |       | 16,874,968                    |       | 16,627,572                   |       |
| Less- Accumulated  depreciation and amortization |       | (8,269,263                    | )          | (7,669,226                   | )          |
|                                             |       | $                             | 8,605,705  |                         | $          | 8,958,346 |   |

 

Depreciation andamortization related to property and equipment was approximately $227,000 and$241,000 for the three months ended June 30, 2009 and 2008, respectively.

 

Depreciation andamortization related to property and equipment was approximately $665,000 and$728,000 for the nine months ended June 30, 2009 and 2008, respectively.

 

***                Other assets***

Other assets consist ofthe following:

 
| ** **                                                                                                                                  | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2009**          | ** ** | **2008**               | ** ** |
| Intangible assets, net  of accumulated amortization of $192,540and $89,950 at June 30, 2009 and  September 30, 2008, respectively |       | $                 | 186,460    |                   | $          | 289,050 |   |
| Installation kits                                                                                                                           |       | 118,660           |       | 118,660                |       |
| Other                                                                                                                                       |       | 172,664           |       | 98,130                 |       |
|                                                                                                                                        |       | $                 | 477,784    |                   | $          | 505,840 |   |

 

Intangible assets consist of licensing and certification rights whichare amortized over a defined number of units. No impairment charge was recorded in the nine months ended June 30,2009.

 

Total intangible amortization expense was approximately $19,300 and$10,100 for the three months ended June 30, 2009 and 2008, respectively.Total amortization expense for the nine months ended June 30, 2009 and2008 was $102,600 and $22,100, respectively. Because the intangible assets arebeing amortized over a defined number of units, the future amortization expenseover the next five years cannot be determined at this time.

 

***Accruedexpenses***

 

Accrued expenses consistof the following:

 
| ** **                              | ** ** | **June 30,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------|------------|-------------------|------------|------------------------|------------|
| ** **                              | ** ** | **2009**          | ** ** | **2008**               | ** ** |
| Warranty (a)                            |       | $                 | 704,559    |                   | $          | 736,815 |   |
| Salary, benefits and  payroll taxes     |       | 500,118           |       | 904,904                |       |
| Reduction in workforce  / Severance (b) |       | 256,218           |       | 904,163                |       |
| Professional fees                       |       | 302,959           |       | 474,730                |       |
| Income taxes payable                    |       | 96,774            |       | 798,801                |       |
| Materials on order                      |       | 92,778            |       | 467,759                |       |
| Other                                   |       | 449,731           |       | 843,291                |       |
|                                    |       | $                 | 2,403,137  |                   | $          | 5,130,463 |   |

 

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

 

Warranty cost and accrual information for the threemonths ended June 30, 2009 is highlighted below:

 
| Warranty  accrual at March 31, 2009                       |   | $       | 706,834 |   |
|----------------------------------------------------------------|--------|---------|---------|--------|
| Accrued  expense for the three months ended June 30, 2009 |   | 46,887  |    |
| Warranty  costs for the three months ended June 30, 2009  |   | (49,162 | )       |
| Warranty  accrual at June 30, 2009                        |   | $       | 704,559 |   |

 

Warranty cost and accrual information for the ninemonths ended June 30, 2009 is highlighted below:

 
| Warranty  accrual at September 30, 2008                  |   | $        | 736,815 |   |
|---------------------------------------------------------------|--------|----------|---------|--------|
| Accrued  expense for the nine months ended June 30, 2009 |   | 194,186  |    |
| Warranty  costs for the nine months ended June 30, 2009  |   | (226,442 | )       |
| Warranty  accrual at June 30, 2009                       |   | $        | 704,559 |   |

 

(b)         The amountincluded in Reduction in workforce / Severance as of June 30, 2009 isseverance relating to the former Chief Executive Officer which is payable underthe terms of the Release Agreement dated November 10, 2008.

 

***Notespayable***

 

The Company entered into a $4,335,000 loan agreement dated August 1,2000 with the Chester County, Pennsylvania Industrial Development Authority.The purpose of the loan was to fund the construction of the Company’s newoffice and manufacturing facility. The loan matures in 2015 and carries aninterest rate set by the remarketing agent that is consistent with 30-daytax-exempt commercial paper. The loan agreement includes an optional redemptionschedule allowing the Company the option of forgoing any principal pay-downuntil such time the bonds expire in 2015. The Company has exercised its optionnot to pay-down the outstanding balance and accordingly, the balance of thenotes payable will be due in 2015. As of June 30, 2009 the fair value ofthe Company’s notes payable approximates its carrying value.

 

Effective November 30, 2007 the loan covenants require the Companyto maintain at all times unencumbered cash and marketable securities having amarket value of at least $20.0 million and a minimum tangible net worth of$65.0 million.  The lender, however,agreed on January 10, 2008 to discontinue the tangible net worth covenantso that the only remaining requirement is that the Company maintain at alltimes unencumbered cash and marketable securities having a value of at least$20.0 million.

 

The interest cost related to this debt for three months ended June 30,2009 and 2008 was $9,000 and $22,000 respectively. The interest cost related tothis debt for nine months ended June 30, 2009 and 2008 was $42,000 and$89,000 respectively. The interest rate on this debt was 0.8% at June 30,2009. The Company is also required to maintain a letter of credit in the amountof $4.4 million covering the debt.

 

The Company repaid this loan in full on August 3, 2009 for anaggregate payment of $4,335,000.

 

**3.Income Taxes**

 

The income tax benefitfor the three and nine months ended June 30, 2009 was $199,000 and$31,000, respectively, as compared to an income tax benefit of $256,000 and anincome tax expense of $1.1 million for the three and nine months ended June 30,2008. The decrease in the income tax benefit for the three months ended June 30,2009 and 2008 is due to a decrease in the FIN 48 liability upon the expirationof certain state statutes of limitations in the three months ended June 30,2008.  The decrease in the income taxexpense for the nine months ended June 30, 2009 is primarily due to theestablishment of a full valuation allowance on net deferred tax assets as ofthe period ended March 31, 2008.  The establishment of the allowanceas of March 31, 2008 caused the Company to recognize income tax expense inthat period relating to net deferred tax assets that are not likely to berealized.  The Company continues to maintain a full valuation allowance onnet deferred tax assets as of the period ended June 30, 2009 that are inexcess of the amounts expected to be utilized in the current fiscal year. Inaccordance with SFAS 109 the Company will continue to evaluate the need for afull or partial valuation allowance on a quarterly basis.

 

The effective tax ratesfor the three months ended June 30, 2009 and 2008 were (19%) and 6%,respectively.  The effective tax rate differs from the statutory rate forthe three months ended June 30, 2009 due to:  1) the reversal ofcertain deductible temporary differences which at September 30, 2008 wereoffset by a valuation allowance; such items will be deductible for income taxpurposes 

 

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in the current fiscalyear based on forecasted earnings, and 2) the utilization of research andexperimentation tax credits. The effective tax rate differs from the statutoryrate for the three months ended June 30, 2008 due to the establishment ofa full valuation allowance on net deferred tax assets during the precedingquarter.

 

The effective tax ratesfor the nine months ended June 30, 2009 and 2008 were (1%) and (8%),respectively.  The effective tax rate differs from the statutory rate forthe nine months ended June 30, 2009 due to:  1) the reversal ofcertain deductible temporary differences which at September 30, 2008 wereoffset by a valuation allowance; such items will be deductible for income taxpurposes in the current fiscal year based on forecasted earnings, and 2) theutilization of research and experimentation tax credits.  The effectivetax rate differs from the statutory rate for the nine months ended June 30,2008 due to the establishment of a full valuation allowance on net deferred taxassets during the quarter ended March 31, 2008.

 

**4. Capital Stock**

 

At June 30, 2009,our Articles of Incorporation provide us the authority to issue 75,000,000shares of common stock and 10,000,000 shares of blank check preferred stock.

 

***Share-basedcompensation***

 

Effective October 1,2005, the Company adopted the provisions of SFAS No.123(R), using the modifiedprospective approach and now accounts for share-based compensation applying thefair value method for expensing stock options and non-vested stock awards.

 

Total share-basedcompensation expense was $168,000 and $400,000 for the three months ended June 30,2009 and 2008, respectively. The tax impact for the three months ended June 30,2009 and 2008 was a decrease in excess tax benefits, which are recorded topaid-in capital, of $1,000 and $0, respectively.

 

Total share-basedcompensation expense was $545,000 and $960,000 for the nine months ended June 30,2009 and 2008, respectively. The excess tax benefits recorded in additionalpaid-in capital for share-based compensation arrangements were $3,000 and $0for the nine months ended June 30, 2009 and 2008, respectively.Compensation expense related to share-based awards is recorded as a componentof general and administrative expense.

 

The Company maintains the 1998 Stock Option Plan (the “1998 Plan”) andthe 2003 Restricted Stock Plan (the “Restricted Plan”). These plans wereapproved by the Company’s shareholders. The 1998 Plan expired on November 13,2008 and no additional shares may be granted under the Plan after thatdate.   In addition, at the AnnualMeeting of Shareholders of Innovative Solutions and Support, Inc. held on March 12,2009, the shareholders of the Company approved the Company’s 2009 Stock-BasedIncentive Compensation Plan (the “2009 Plan”), which is discussed below.

 

***Stock options***

 

The 1998 Plan provides for the granting of incentiveand nonqualified stock options to employees, officers, directors, andindependent contractors and consultants. Through June 30, 2009, no stockoptions have been granted to independent contractors or consultants under thisPlan.  Total compensation expense was$118,000 and $350,000 for the three months ended June 30, 2009 and 2008,respectively. Total compensation expense was $395,000 and $810,000 for the ninemonths ended June 30, 2009 and 2008, respectively.

 

Total compensation expense under the Restricted Planwas $50,000 for both the three months ended June 30, 2009 and 2008. Totalcompensation expense was $150,000 for both the nine months ended June 30,2009 and 2008. The expense relates to shares that are issued to non-employeemembers of the Board of Directors on a quarterly basis as part of theircompensation.

 

Incentive stock optionsgranted under the 1998 Plan have exercise prices that must be at least equal tothe fair value of the common stock on the date of grant. Nonqualified stockoptions granted under the 1998 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 had reserved 3,389,000 shares of Common Stock for awardsunder the plan.

 

Incentive stock optionsgranted under the 2009 Plan have exercise prices that must be at least equal tothe fair value of the common stock on the date of grant. Nonqualified stockoptions granted under the 2009 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 1,200,000 shares of Common Stock for awardsunder the plan. The 2009 Plan expires on March 12, 2019.

 

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***2009 Stock-Based Incentive Compensation Plan***

 

The 2009 Plan authorizesthe grant of Stock Appreciation Rights, Restricted Stock, Options and otherequity-based awards under the 2009 Plan (collectively referred to as “Awards”).Options granted under the 2009 Plan may be either incentive stock ornonqualified stock options, as determined by the Compensation Committee of theCompany’s Board of Directors (the “Committee”).

 

Subject to an adjustmentnecessary upon a stock dividend, recapitalization, forward split or reversesplit, reorganization, merger, consolidation, spin-off, combination, repurchaseor share exchange, extraordinary or unusual cash distribution or other similarcorporate transaction or event, the maximum number of shares of common stockavailable for awards under the 2009 Plan are 1,200,000, all of which may beissued pursuant to awards of incentive stock options. In addition, the Planprovides that no more than 300,000 shares may be awarded to any employee as aperformance-based award under Section 162(m) of the Internal RevenueCode.

 

The 2009 Plan willterminate on the tenth anniversary of the 2009 Plan’s adoption by the Board,unless earlier terminated by the Board. Termination will not affect awardsoutstanding at the time of termination. The Board may amend, alter, suspend,discontinue or terminate the 2009 Plan without shareholder approval, providedthat shareholder approval is required for any amendment which (i) wouldincrease the number of shares subject to the 2009 Plan; (ii) woulddecrease the price at which Awards may be granted, or (iii) would requireshareholder approval by law, regulation, or the rules of any stockexchange or automated quotation system.

 

No options were grantedunder the 2009 Plan during the nine months ended June 30, 2009.

 

***Stockrepurchase program***

 

On February 21, 2008, the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of theCompany’s outstanding common stock. Purchases of the stock were to be made fromtime to time, subject to market conditions and at prevailing market prices. Theprogram expired on February 21, 2009. During the current fiscal year no shares were purchased under the planprior to its expiration date.

 

On February 22, 2009 the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of theCompany’s outstanding common stock. Under the repurchase program, the Companymay purchase shares of its common stock through open market transactions or inprivately negotiated block purchases or other private transactions (eithersolicited or unsolicited). The timing and amount of repurchase transactionsunder this program will depend on market conditions and corporate andregulatory considerations. The plan will expire on February 22, 2010,unless extended by the Board of Directors; however, the program may bediscontinued or suspended at any time. During the nine months ended June 30,2009 the Company purchased 25,000 shares of common stock under the program at acost of $108,250, or an average market price of $4.33 per share. The Companyfinanced these purchases through available cash.  The following table sets forth the purchasesmade under this new plan for each month since its inception through June 30,2009:

 

| **Period**         | ** ** | **Total  Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total  Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum  Number of  Shares that May  Yet Be  Purchased  Under the  Program** | ** ** |
|--------------------|------------|-----------------------------------------|------------|------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                           |       |
| January 2009  |       |                                    |       |                               |       |                                                                                           |       |                                                                           | (a)        |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                           |       |
| February 2009 |       | —                                  |       |                               |       | —                                                                                         |       | 1,000,000                                                                      |       |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                           |       |
| March 2009    |       | 25,000                                  |       | $                                  | 4.33       |                                                                                           | 25,000     |                                                                           | 975,000    |   |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                           |       |
| April 2009    |       | —                                  |       |                               |       | —                                                                                         |       | 975,000                                                                        |       |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                           |       |
| May 2009      |       | —                                  |       |                               |       | —                                                                                         |       | 975,000                                                                        |       |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                           |       |
| June 2009     |       | —                                  |       |                               |       | —                                                                                         |       | 975,000                                                                        |       |
|               |       | 25,000                                  |       | $                                  | 4.33       |                                                                                           | 25,000     |                                                                           |       |   |

 

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**5. Income(Loss) per Share**

 

Income (loss) per share (“EPS”)is calculated using the principles of SFAS No. 128, *Earnings PerShare.*

 

For the three and ninemonth periods ended June 30, 2009, there were 425,000 and 426,000 optionsto purchase common stock outstanding, respectively, excluded from thecomputations of diluted earnings per share as the effect would beanti-dilutive.

 

For both the three andnine month periods ended June 30, 2008, there were 928,000 options topurchase common stock outstanding excluded from the computations of dilutedearnings per share as the effect would be anti-dilutive.

 

**6.Subsequent Event**

 

The Company has evaluatedsubsequent events and transactions for potential recognition or disclosure inthe financial statements through August 7, 2009.

 

OnAugust 3, 2009 the Company repaid in full its loan from the ChesterCounty, Pennsylvania Industrial Development Authority for an aggregate paymentof $4,335,000.

 

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** **

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

 

**CAUTIONARYSTATEMENT REGARDING****FORWARD-LOOKING STATEMENTS**

 

*This report contains forward looking statementswithin the meaning of Section 21E of the Securities Exchange Act of 1934.We have based these forward looking statements largely on our currentexpectations and projections about future events and trends affecting ourbusiness. In this report, the words “believe,” “may,” “will,” “estimate,” “continue,”“anticipate,” “intend,” “forecast,” “expect,” “plan,” “should,” “is likely” andsimilar expressions, as they relate to our business or our management, areintended to identify forward looking statements, but they are not exclusivemeans of identifying them.*

 

*The forward looking statements in this report areonly predictions and actual events or results may differ materially. Inevaluating such statements, a number of risks, uncertainties and other factorscould cause our actual results, performance, financial condition, cash flows,prospects, and opportunities to differ materially from those expressed in, orimplied by, the forward looking statements. These risks, uncertainties andother factors include the following:*

 

·                  *market acceptance of our flat paneldisplay systems, or COCKPIT/IPTM system or other planned products or productenhancements;*

 

·                  *difficulties in developing andproducing our COCKPIT/IPTM system or other planned products or productenhancements;*

 

·                  *continued market acceptance of ourair data systems and products;*

 

·                  *the availability of governmentfunding;*

 

·                  *our ability to gain regulatoryapproval of our products in a timely manner;*

 

·                  *delays in receiving components fromthird party suppliers;*

 

·                  *the competitive environment;*

 

·                  *the impact of general economictrends on our business;*

 

·                  *the bankruptcy or insolvency of oneor more key customers;*

 

·                  *the deferral or termination ofprograms or contracts for convenience by customers;*

 

·                  *failure to retain key personnel;*

 

·                  *new product offerings fromcompetitors;*

 

·                  *potential future acquisitions;*

 

·                  *protection of intellectual propertyrights;*

 

·                  *our ability to service theinternational market; and*

 

·                  *other factors disclosed from time totime in our filings with the Securities and Exchange Commission.*

 

*Except as expressly required by the federalsecurities laws, we undertake no obligation to publicly update or revise anyforward looking statements, whether as a result of new information, futureevents or otherwise after the date of this report. Our results of operations inany past period should not be considered indicative of the results to beexpected for future periods. Fluctuations in operating results may also resultin fluctuations in the price of our common stock.*

 

*Readers are cautioned not toplace undue reliance on these forward-looking statements, which speak only asof the date of this Form 10-Q. The Company does not undertake anyobligation to publicly release any revisions to these forward-lookingstatements to reflect events, circumstances or changes in expectations afterthe date of this Form 10-Q, or to reflect the occurrence of unanticipatedevents. The forward-looking statements in this document are intended to besubject to the safe harbor protection provided by Sections 27A of theSecurities Act and 21E of the Exchange Act. For a discussion identifying someimportant factors that could cause actual results to vary materially from thoseanticipated in the forward-looking statements, see the Company’s Securities andExchange Commission filings including, but not limited to, the discussions of “RiskFactors” contained in the Company’s Annual Report on Form 10-K for thefiscal year ended September 30, 2008.*

 

*Investors should also be aware that while we do, fromtime to time, communicate with securities analysts, it is against our policy todisclose any material non-public information or other confidential commercialinformation. Accordingly, shareholders should not assume that we agree with anystatement or report issued by any analyst irrespective of the content of thestatement or report. Furthermore, we have a policy against issuing orconfirming financial forecasts or projections issued by others. Thus, to theextent that reports issued by securities analysts contain any projections,forecasts or opinions, such reports are **not**theresponsibility of Innovative Solutions and Support, Inc.*

 

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** **

**Company Overview**

 

Innovative Solutions and Support was founded in 1988. The Companydesigns, develops, manufactures and sells flight information computers, largeflat-panel displays, and advanced monitoring systems that measure and displaycritical flight information, including data relative to aircraft separation,airspeed, altitude as well as engine and fuel data measurements.

 

Our sales are derived from the sale of our products to the retrofitmarket and, to a lesser extent, original equipment manufacturers (“OEMs”). Ourcustomers include the United States Department of Defense (“DoD”) and theircommercial contractors, aircraft operators, aircraft modification centers andvarious OEMs. Although we occasionally sell our products directly to theDoD, we primarily have sold our products to commercial customers for end use inDoD programs. Sales to defense contractors are on commercial terms, althoughsome of the termination and other provisions of government contracts areapplicable to these contracts.

 

Our cost of sales related to product sales is comprised of material andcomponents purchased through our supplier base and direct in-house assemblylabor and overhead costs. Many of the components we use in assembling ourproducts are standard, although certain parts are manufactured to meet ourspecifications. The overhead portion of cost of sales is primarily comprised ofsalaries and benefits, building occupancy, supplies, and outside service costsrelated to our production, purchasing, material control and qualitydepartments, and warranty costs.

 

Our cost of sales related to Engineering—modification and development (“EMD”)is comprised of engineering labor, consulting services, and other costassociated with specific design and development projects that are billableunder specific customer agreements.

 

We intend to continue investing in the development of new products thatcomplement our current product offerings and will expense associated researchand development costs as they are incurred.

 

Our selling, general and administrative expenses consist of sales,marketing, business development, professional services, and salaries andbenefits for executive and administrative personnel as well as facility costs,recruiting, legal, accounting, and other general corporate expenses.

 

We sell our products toagencies of the United States and foreign governments, aircraft operators,aircraft modification centers and original equipment manufacturers.  Ourcustomers have been and may continue to be affected by the ongoing adverseeconomic conditions that currently exist both in the United States andabroad.  Such conditions may cause our customers to curtail or delaytheir spending on both new and existing aircraft.  Factors that canimpact general economic conditions and the level of spending by our customersinclude but are not limited to general levels of consumer spending,increases in fuel and energy costs, conditions in the real estate and mortgagemarkets, labor and healthcare costs, access to credit, consumer confidence andother macroeconomic factors affecting spending behavior.  In addition,spending by government agencies may in the future be further reduced due todeclining tax revenues associated with this economic downturn.  If our customerscurtail or delay their spending or are forced to declare bankruptcy orliquidate their operations due to continuing adverse economic conditions, ourrevenues and results of operations will be adversely affected.  However,we believe that in a declining economic environment a customer that may haveotherwise elected to purchase newly manufactured aircraft will instead beinterested in retrofitting existing aircraft as a cost effective alternative,which will create a market opportunity for our products.

 

**CriticalAccounting Policies and Estimates**

 

Our discussion andanalysis of our financial condition and consolidated results of operations arebased upon our condensed consolidated financial statements, which have beenprepared in accordance with generally accepted accounting principles in theUnited States. The preparation of our condensed consolidated financialstatements requires us to make estimates and assumptions that affect thereported amounts of assets, liabilities, revenue and expenses and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates based upon historical experience and various otherassumptions that we believe to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources. Ouractual results may differ from these estimates.

 

We believe that ourcritical accounting policies affect our more significant estimates andjudgments used in the preparation of our consolidated financial statements. OurAnnual Report on Form 10-K for the year ended September 30, 2008contains a discussion of these critical accounting policies. There have been nosignificant changes in our critical accounting policies since September 30,2008. See also Note 1 to our unaudited condensed consolidated financialstatements for the three and nine month periods ended June 30, 2009 as setforth herein.

 

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**RESULTSOF OPERATIONS FOR THE THREE AND NINE MONTHS ENDED**

**JUNE30, 2009 AND 2008**

 

The following table setsforth statement of operations data expressed as a percentage of total net salesfor the periods indicated (some items may not add due to rounding):

 
| ** **                                  | ** ** | **Three Months Ending June 30,** | ** ** | **Nine Months Ending June 30,** | ** ** |
|---------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                  | ** ** | **2009**                                             | ** ** | **2008**                                            | ** ** | **2009** | ** ** | **2008** | ** ** |
| Net sales:                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                     |       | 85.6                                                 | %          | 82.0                                                | %          | 86.5 | % | 85.1 | % |
| Engineering -  modification and development |       | 14.4                                                 | %          | 18.0                                                | %          | 13.5 | % | 14.9 | % |
| Total net sales                             |       | 100.0                                                | %          | 100.0                                               | %          | 100.0 | % | 100.0 | % |
|                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Cost of sales                               |       |                                                 |       |                                                |       |   |   |   |   |
| Product                                     |       | 42.6                                                 | %          | 44.0                                                | %          | 45.9 | % | 50.9 | % |
| Engineering -  modification and development |       | 4.1                                                  | %          | 8.2                                                 | %          | 3.1 | % | 8.3 | % |
| Total cost of sales                         |       | 46.7                                                 | %          | 52.2                                                | %          | 48.9 | % | 59.2 | % |
|                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Gross profit                                |       | 53.3                                                 | %          | 47.8                                                | %          | 51.1 | % | 40.8 | % |
|                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Operating expenses:                         |       |                                                 |       |                                                |       |   |   |   |   |
| Research and  development                   |       | 16.6                                                 | %          | 36.8                                                | %          | 14.5 | % | 38.1 | % |
| Selling, general and  administrative        |       | 23.7                                                 | %          | 37.5                                                | %          | 22.5 | % | 68.7 | % |
| Asset impairment                            |       | 0.0                                                  | %          | 28.3                                                | %          | 0.0 | % | 12.2 | % |
| Total operating  expenses                   |       | 40.3                                                 | %          | 102.6                                               | %          | 37.0 | % | 119.0 | % |
|                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Operating income (loss)                     |       | 13.0                                                 | %          | (54.8                                               | )%         | 14.1 | % | (78.1 | )% |
|                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Interest income                             |       | 0.8                                                  | %          | 3.2                                                 | %          | 1.3 | % | 6.5 | % |
| Interest expense                            |       | (0.3                                                 | )%         | (0.4                                                | )%         | (0.3 | )% | (0.6 | )% |
| Other income                                |       | 0.0                                                  | %          | 0.0                                                 | %          | 0.2 | % | 1.5 | % |
| Income (loss) before  income taxes          |       | 13.6                                                 | %          | (51.9                                               | )%         | 15.3 | % | (70.8 | )% |
|                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax expense  (benefit)               |       | (2.6                                                 | )%         | (2.9                                                | )%         | (0.1 | )% | 5.4 | % |
|                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss)                           |       | 16.1                                                 | %          | (49.0                                               | )%         | 15.4 | % | (76.2 | )% |

 

**Three Months Ended June 30,2009 Compared to the Three Months Ended June 30, 2008**

 

*Net sales.* Net sales decreased $1.0 million, or11.3%, to $7.8 million for the three months ended June 30, 2009 from $8.8million in the three months ended June 30, 2008. For the three monthsended June 30, 2009, product sales decreased approximately $0.6 millionand EMD sales decreased approximately $0.4 million from the same period in theprior year. The decrease in product sales was primarily the result of theimpact of a demand of a large customer that we defer a portion of a delivery offlat panel displays that had originally scheduled for the third quarter. Wehave been informed that the customer plans to accelerate modification rates by2010, consuming the balance of fifty ship-sets already delivered and restoringour delivery schedule. We are currently in discussions with the customer todetermine all future delivery dates. The decrease in EMD sales was primarily aresult of the timing of completion of several projects.

 

*Cost of sales.* Cost of sales decreased $0.9 million or20.7%, to $3.6 million, or 46.7% of net sales in the three months ended June 30,2009 from $4.6 million, or 52.2% of net sales in the three months ended June 30,2008. The decrease was primarily the result of the decrease in product salesduring the quarter which accounted for $0.5 million of the decrease, as well asby a $0.4 million decrease in EMD related costs.

 

*Research and development.* Research and development expense decreased$1.9 million or 60.0% to $1.3 million or 16.6% of net sales in the three monthsended June 30, 2009 from $3.2 million or 36.8% of net sales in the threemonths ended June 30, 2008.  Thedecrease in research and development expense in the quarter was primarily dueto a reduction in headcount related costs and a decrease in cost fromthird-party subcontractors of $1.0 million and $1.1 million, respectively.  This was offset by an increase in deferredEMD related direct costs of $0.4 million. The significant research anddevelopment costs in the prior period primarily related to the Eclipse programthat ended during the fourth quarter of fiscal year 2008. Since the terminationof the Eclipse program the Company has reduced the total number of employees inthe research and development department and has streamlined its research anddevelopment functions. However, the Company continues to invest in on-goingresearch and development of our core products.

 

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*Selling, general, andadministrative.*Selling, general and administrative expenses decreased $1.4 million, or 43.9%,to $1.8 million, or 23.7% of net sales in the three months ended June 30,2009 from $3.2 million or 37.5% of net sales in the three months ended June 30,2008. The decrease was primarily due to a reduction in professional fees,specifically legal costs, as well as a decrease in headcount related costs of$0.5 million and $0.5 million respectively. During the three months ended June 30,2008 the Company incurred $0.5 million of legal fees in connection withlitigation related to protecting its Intellectual Property.

 

*Interest income.* Interest income was $63,000 in the threemonths ended June 30, 2009 as compared to $284,000 in the three monthsended June 30, 2008. The decrease in interest income was primarily theresult of our reduced average cash balance in the current quarter as comparedto the same period in the prior year as well as lower interest rates in thequarter as compared to the same period in the prior year.

 

*Interest expense.* Interest expense was $20,000 in thethree months ended June 30, 2009 as compared to $33,000 in the threemonths ended June 30, 2008. The reduction was primarily due to lowerinterest rates in effect during the period compared to the same period in theprior year.

 

*Incometax expense (benefit).* The income tax benefit for the three months ended June 30, 2009was $199,000 as compared to $256,000 for the three months ended June 30,2008.  The decrease in the income taxbenefit for the three months ended June 30, 2009 is due to a decrease inthe FIN 48 liability upon the expiration of certain state statutes oflimitations in the three months ended June 30, 2008.  The Companycontinues to maintain a full valuation allowance as of the period ended June 30,2009 on its net deferred tax assets. In accordance with FAS 109 the Companywill continue to evaluate the need for a full or partial valuation allowance ona quarterly basis.

 

The effective tax ratesfor the three months ended June 30, 2009 and 2008 were (19%) and 6%,respectively.  The effective tax rate differs from the statutory rate forthe three months ended June 30, 2009 due to:  1) the reversal ofcertain deductible temporary differences which at September 30, 2008 wereoffset by a valuation allowance; such items will be deductible for income taxpurposes in the current fiscal year based on forecasted earnings, and 2) theutilization of research and experimentation tax credits. The effective tax ratediffers from the statutory rate for the three months ended June 30, 2008due to the establishment of a full valuation allowance on net deferred taxassets during the preceding quarter.

 

**Nine months ended June 30,2009 Compared to the Nine months ended June 30, 2008**

 

*Net sales.* Net sales increased $8.5 million, or41.8%, to $28.8 million for the nine months ended June 30, 2009 from $20.3million in the nine months ended June 30, 2008. For the nine months ended June 30,2009, product sales increased $7.6 million and EMD sales increased $0.9 millionfrom the same period in the prior year. The increase in product sales wasprimarily related to growth in flat panel display sales to various customers.The increase in EMD sales was primarily a result of several projects for majorcustomers that were completed during the nine months ended June 30,2009.  During the nine months ended June 30,2008 $10.6 million or 52% of net sales pertained to one OEM customer, whichdeclared bankruptcy.  Excluding these OEMsales the Company’s net sales would have increased $19.1 million or 197%.

 

*Cost of sales.* Cost of sales increased $2.1 million or17.3%, to $14.1 million, or 48.9% of net sales in the nine months ended June 30,2009 from $12.0 million, or 59.2% of net sales in the nine months ended June 30,2008. The increase was primarily the result of the additional product salesduring the nine months ended June 30, 2009, which accounted for $2.9 millionof the increase and was offset by a $0.8 million decrease in EMD related costs.

 

*Research and development.* Research and development expensedecreased $3.6 million or 46.0% to $4.2 million or 14.5% of net sales in thenine months ended June 30, 2009 from $7.7 million or 38.1% of net sales inthe nine months ended June 30, 2008. The decrease in research and development expense in the nine monthsended June 30, 2009 was primarily due to a reduction in headcount relatedcosts and a decrease in costs from third-party subcontractors of $2.3 millionand $2.0 million, respectively, offset by an increase in deferred EMD costs of$1.1 million.

 

*Selling, general, andadministrative.*Selling, general and administrative expenses decreased $7.5 million, or 53.6%,to $6.5 million, or 22.5% of net sales in the nine months ended June 30,2009 from $14.0 million or 68.7% of net sales in the nine months ended June 30,2008. The decrease was primarily due to a reduction in professional fees,specifically legal costs, as well as a decrease in headcount related costs of$5.3 million and $1.0 million respectively. During the nine months ended June 30,2008 the Company incurred $5.4 million of legal fees in connection withlitigation related to protecting its intellectual property.

 

*Interest income.* Interest income was $361,000 in the ninemonths ended June 30, 2009 as compared to $1.3 million in the nine monthsended June 30, 2008. The decrease in interest income was primarily theresult of our reduced average cash balance during the nine months ended June 30,2009 as compared to the same period in the prior year as well as lower interestrates during the nine months ended June 30, 2009 as compared to the sameperiod in the prior year.

 

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*Interest expense.* Interest expense was $75,000 in the ninemonths ended June 30, 2009 as compared to $122,000 in the nine monthsended June 30, 2008. The reduction was primarily due to lower interestrates in effect during the period compared to the same period in the prioryear.

 

*Other income.*In March 2008, the Company receiveda payment of $300,000 in settlement of a claim against a shareholder for shortswing profit liability to the Company pursuant to Section 16(b) ofthe Securities Exchange Act of 1934, as amended.

 

*Incometax expense (benefit).* The income tax expense (benefit) for the nine months ended June 30,2009 was ($31,000) as compared to $1.1 million for the nine months ended June 30,2008. The decrease in the income tax expense is primarily due to theestablishment of a full valuation allowance on deferred tax assets as of theperiod ended March 31, 2008.  The establishment of the valuation allowanceas of March 31, 2008 caused the Company to recognize income tax expensefor the nine months ended June 30, 2008 relating to net deferred taxassets that are not likely to be realized.  The Company continues tomaintain a full valuation allowance as of the period ended June 30, 2009on its net deferred tax assets. In accordance with FAS 109 the Company willcontinue to evaluate the need for a full or partial valuation allowance on aquarterly basis.

 

The effective tax ratesfor the nine months ended June 30, 2009 and 2008 were (1%) and (8%),respectively.  The effective tax rate differs from the statutory rate forthe nine months ended June 30, 2009 due to:  1) the reversal ofcertain deductible temporary differences which at September 30, 2008 were offsetby a valuation allowance; such items will be deductible for income tax purposesin the current fiscal year based on forecasted earnings, and 2) the utilizationof research and experimentation tax credits.  The effective tax ratediffers from the statutory rate for the nine months ended June 30, 2008due to the establishment of a full valuation allowance on net deferred taxassets during the quarter ended March 31, 2008.

 

**Liquidity and Capital Resources**

 

The following tablehighlights key financial measurements of the Company:

 
| ** **                                    | ** ** | **June 30,  2009** | ** ** | **September 30,  2008** | ** ** |
|-----------------------------------------------|------------|-------------------------|------------|------------------------------|------------|
| Cash and cash  equivalents                    |       | $                       | 39,307,938 |                         | $          | 35,031,932 |   |
| Accounts receivable,  net                     |       | $                       | 4,747,604  |                         | $          | 4,218,443 |   |
| Working capital                               |       | $                       | 47,575,403 |                         | $          | 42,491,253 |   |
| Deferred revenue                              |       | $                       | 254,127    |                         | $          | 564,998 |   |
| Total debt and other  non-current liabilities |       | $                       | 4,927,668  |                         | $          | 5,047,146 |   |
| Quick ratio                                   |       | 12.20                   |       | 4.94                         |       |
| Current ratio                                 |       | 14.18                   |       | 6.35                         |       |

 
| ** **                                          | ** ** | **Nine Months Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                          | ** ** | **2009**                                           | ** ** | **2008** | ** ** |
| **Cash  flow activites:**                           |       |                                               |       |   |   |
| Net cash provided by  (used in) operating activites |       | $                                                  | 4,636,299  |   | $ | (7,514,973 | ) |
| Net cash used in  investing activites               |       | (244,127                                           | )          | (533,532 | ) |
| Net cash used in  financing activites               |       | (116,166                                           | )          | (31,677 | ) |
|                                                     |            |                                                    |            |  |  |  |  |

 

Our main source ofliquidity has been cash flow from operating activities. We require cashprincipally to finance inventory, accounts receivable and payroll.

 

***Operatingactivities***

 

Cash provided byoperating activities was $4.6 million for the nine months ended June 30,2009 as compared to cash used in operating activities of $7.5 million for thenine months ended June 30, 2008. The improvement was primarily due to netincome of $4.4 million for the nine months ended June 30, 2009 versus anet loss of $15.5 million in the prior year period. Additionally, the cashprovided by operating activities during the nine months ended June 30,2009 was impacted by decreases in inventories and prepaid expenses of $3.2million and $0.1 million, respectively. This was offset by increases inaccounts receivable and decreases in accounts payable, accrued expenses, incometaxes payable and deferred revenues of $0.5 million, $1.4 million, $2.0million, $0.7 million, and $0.3 million, respectively.

 

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***Investing activities***

 

Cash used in investing activities was $244,000 for the nine monthsended June 30, 2009 and $534,000 for the nine months ended June 30,2008, which primarily consisted of the purchase of production and laboratorytest equipment.

 

***Financing activities***

 

Net cash used in financing activities was $116,000 for the nine monthsended June 30, 2009 which consisted of $108,000 for the repurchase ofcommon stock and $8,000 for the repayment of capitalized lease obligations. Netcash used in financing activities of $32,000 for the nine months ended June 30,2008 primarily consisted of $57,000 for the repurchase of common stock and a$7,000 repayment for capitalized lease obligations, offset by proceeds from theexercise of stock options of $33,000.

 

The Company entered into a $4,335,000 loan agreement dated August 1,2000 with the Chester County, Pennsylvania Industrial Development Authority.The purpose of the loan was to fund the construction of the Company’s newoffice and manufacturing facility. The loan matures in 2015 and carries aninterest rate set by the remarketing agent that is consistent with 30-daytax-exempt commercial paper. The loan agreement includes an optional redemptionschedule allowing the Company the option of forgoing any principal pay-downuntil such time the bonds expire in 2015. The Company has exercised its optionnot to pay-down the outstanding balance and accordingly, the balance of thenotes payable will be due in 2015.

 

Effective November 30, 2007 the loan covenants require the Companyto maintain at all times unencumbered cash and marketable securities having amarket value of at least $20.0 million and a minimum tangible net worth of$65.0 million.  On January 10, 2008the lender agreed to discontinue the tangible net worth covenant. As of June 30,2009 the Company was in compliance with the remaining loan covenant.

 

The Company repaid this loan in full on August 3, 2009 for anaggregate payment of $4,335,000.

 

Our future capitalrequirements depend on numerous factors, including market acceptance of ourproducts, the timing and rate of expansion of our business, acquisitions, jointventures and other factors. We have experienced increases in our expendituressince our inception consistent with growth in our operations, personnel andproduct line, and we anticipate that our expenditures will continue to increasein the foreseeable future. We believe that our cash and cash equivalents willprovide sufficient capital to fund our operations for at least the next twelvemonths. However, we may need to raise additional funds through public orprivate financings or other arrangements to support more rapid expansion of ourbusiness than we now anticipate either through acquisitions or organic growth.Further, we may need to develop and introduce new or enhanced products, respondto competitive pressures, invest in or acquire businesses or technologies orrespond to unanticipated requirements or developments. If additional funds areraised through the issuance of equity securities, dilution to existingshareholders may result. If insufficient funds are available, we may not beable to introduce new products or compete effectively in any of our markets,which could hurt our business.

 

**Backlog**

 

As of June 30, 2009and September 30, 2008, our backlog was $39.0 million and $57.3 million,respectively. The subsequent decrease in backlog reflects steps taken bymanagement during the nine months ended June 30, 2009 to re-evaluatecertain customer bookings in light of the current economic environment andlikelihood that these bookings would result in actual revenues. Although we hadno customer cancellations, we have de-booked approximately $6.5 million duringthe nine months ended June 30, 2009. As noted earlier, a large customerdeferred delivery of flat panel displays that had originally been scheduled fordelivery in the third and fourth quarter of fiscal year 2009. The backlogassociated with this customer has not been changed. In consideration of thecontinually changing economic environment the Company’s management willcontinue to evaluate the realizability of the backlog.

 

Backlog activity for thenine months ended June 30, 2009 (in thousands):

 
| **Balance at  September   30, 2008** | ** **   | **Additional  Bookings** | ** ** | **Recognized  in Revenue** | ** ** | **Adjustments** | ** ** | **Balance  at  June 30,  2009** | ** ** |
|-------------------------------------------|--------------|--------------------------|------------|----------------------------|------------|-----------------|------------|--------------------------------------|------------|
|                                      |         |                     |       |                       |       |            |       |                                 |       |
| $                                         |  57,373 |                     | $          | 16,490                     |       | $               | (28,800    | )                                    | $          | (6,475 | ) | $ | 38,588 |   |
|                                           |              |                          |            |                            |            |                 |            |                                      |            |  |  |  |  |  |

 

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Backlog activity for the three months ended June 30,2009 (in thousands):

** **
| **Balance at  March 31,  2009** | ** **   | **Additional  Bookings** | ** ** | **Recognized  in Revenue** | ** ** | **Adjustments** | ** ** | **Balance  at  June 30,  2009** | ** ** |
|-------------------------------------------|--------------|--------------------------|------------|----------------------------|------------|-----------------|------------|--------------------------------------|------------|
|                                      |         |                     |       |                       |       |            |       |                                 |       |
| $                                         |  39,423 |                     | $          | 6,929                      |       | $               | (7,759     | )                                    | $          | (5 | ) | $ | 38,588 |   |
|                                           |              |                          |            |                            |            |                 |            |                                      |            |  |  |  |  |  |

 

**Off-BalanceSheet Arrangements**

 

We do not participate intransactions that generate relationships with unconsolidated entities orfinancial partnerships, such as special purpose entities (“SPEs”) or variableinterest entities (“VIEs”), which would have been established for the purposeof facilitating off-balance sheet arrangements or other limited purposes. As ofJune 30, 2009 and September 30, 2008, we were not involved with anyunconsolidated SPEs or VIEs.

 

As of June 30, 2009,we had a standby letter of credit of $4.4 million with PNC Bank, N.A. The standby letter of credit is one of the requirements of the loan agreement withChester County, Pennsylvania Industrial Development Authority (“PIDA”).  Upon the repayment of the PIDA bond (see Note6 to the condensed consolidated financial statements) we will no longer need tomaintain this letter of credit.

 

**Item 3. Quantitative and Qualitative DisclosuresAbout Market Risk**

 

The Company’s operations are exposed to market risks primarily as aresult of changes in interest rates. The Company does not use derivativefinancial instruments for speculative or trading purposes. The Company’sexposure to market risk for changes in interest rates relates to its cashequivalents and an industrial revenue bond. The Company’s cash equivalentsconsist of funds invested in money market accounts, which bear interest at avariable rate, while the industrial revenue bond carries an interest rate thatis consistent with 30-day tax-exempt commercial paper. Assuming that thebalances during the three and nine months ending June 30, 2009 were toremain constant and no actions were taken to alter the existing interest ratesensitivity, a hypothetical 1% increase in our variable interest rates wouldhave affected interest income by approximately $97,000 and $182,000,respectively, and interest expense by approximately $70,000 and $85,000,respectively. This would result in a net impact on cash flows of approximately$27,000 and $97,000 for the three and nine months ended June 30, 2009,respectively.

 

As the interest rates arevariable, a change in interest rates earned on the cash equivalents or paid onthe industrial revenue bond would impact interest income and expense along withcash flows, but would not impact the fair market value of the relatedunderlying 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 June 30, 2009. 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 and that such information is accumulated andcommunicated to the Company’s management, including the CEO and CFO, or personsperforming similar functions, as appropriate to allow timely decisionsregarding required disclosure.

 

(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.

 

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**PART II—OTHER INFORMATION**

 

**Item 1.    Legal Proceedings**

 

In the ordinary course ofbusiness, we are at times subject to various legal proceedings. Except withrespect to the fees incurred in connection with the matters described below, wedo not believe any current legal proceedings will have a material adverseeffect on our results of operations or financial position.

 

On September 13,2005 the Company filed a lawsuit in the United States District Court for theWestern District of Tennessee against J2, Inc., a company founded andjointly owned by Joseph Cesar, a former employee of the Company, and JamesZachary, a former sales consultant for the Company. The complaint alleged thatthe J2/Kollsman Air Data Computer then being marketed by J2 and manufactured byKollsman, Inc. infringed a patent assigned to IS&S.

 

On November 7, 2007the Company received a favorable jury verdict in its trade secretmisappropriation case against Kollsman, Inc. (a subsidiary of ElbitSystems Ltd.), J2 Inc., Joseph Caesar, James Zachary and ZacharyTechnologies, Inc. in the United States District Court for the WesternDistrict of Tennessee. The jury unanimously found that each of the defendantshad misappropriated IS&S’s air data computer technology. The jury foundthat IS&S had suffered damages of just over $4.4 million in lostprofits and $1.6 million in defendants’ net profits, for a total of over$6 million. The jury also found in favor of IS&S’s claims for breachof duty and contract, and unfair competition against J2 Inc., JosephCaesar, James Zachary and Zachary Technologies, Inc.

 

On December 18,2007, the court entered a temporary injunction aimed at preventing further useof the Company’s trade secret and proprietary information. On March 14,2008, the judge presiding over the case heard the Company’s claims for apermanent injunction as well as punitive and exemplary damages and attorneys’fees against Kollsman and the other defendants.

 

On July 7, 2008, thecourt issued several rulings in the case. In the rulings, the court awardeddamages, interest and fees in addition to the more than $6 million incompensatory damages awarded by the jury when it rendered its verdict in thecase in November 2007. The additional awards brought the damages assessedagainst Kollsman, Inc. to more than $23 million. The court alsoentered an order granting the Company’s request for permanent injunctiverelief.

 

On August 27, 2008,the Company entered into a Settlement Agreement (the Settlement Agreement) withKollsman, Inc. On August 29, 2008, the settlement became effectivewith respect to all claims filed by the Company and Kollsman against each otherin the United States District Court for the Western District of Tennessee and aConsent Order was entered. Under the Settlement Agreement, all claims betweenthe Company and Kollsman have been dismissed with prejudice, a final agreedinjunction has been entered and the matter has been fully and finally mutuallysettled without any admission of guilt by either party. In addition, an agreedsettlement payment of $17 million has been made by Kollsman to theCompany.

 

On October 9, 2008,Zachary and ZTI consented to the entry of judgment against and to a permanentinjunction, which resulted in the conclusion of all claims with respect tothose parties. On November 17, 2008, the court granted the Company’smotion to dismiss its patent infringement claims against Caesar and J2, anddismissed Caesar and J2’s counterclaims for noninfringement, invalidity andunenforceability because there was no longer a justifiable claim or controversywith respect to those counterclaims.

 

On January 17, 2007the Company filed suit in the Court of Common Pleas for Delaware County,Pennsylvania against Strathman Associates, a former software consultant forIS&S, alleging that Strathman had improperly used IS&S trade secret andproprietary information in assisting J2 and Kollsman in developing theJ2/Kollsman Air Data Computer. The case is ongoing.

 

**Item1A.  Risk Factors**

 

There are no materialchanges to the risk factors described under Item 1A of our Form 10-K forthe year ended September 30, 2008.

 

I**tem 2.    Unregistered Sales of Equity Securities andUse of Proceeds**

 

***Stockrepurchase program***

 

On February 21, 2008, the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of theCompany’s outstanding common stock. Purchases of the stock were to be made fromtime to time, subject to market conditions and at prevailing market prices.There were no shares purchased under this plan during the three months ended June 30,2008. The program expired on February 21, 2009.

 

On February 22, 2009, the Company’s Board of Directors approved acommon stock repurchase program to acquire up to 1,000,000 shares of theCompany’s outstanding common stock. Under the repurchase program, the Companymay purchase shares of its 

 

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common stock through open market transactions or in privatelynegotiated block purchases or other private transactions (either solicited orunsolicited). The timing and amount of repurchase transactions under thisprogram will depend on market conditions and corporate and regulatoryconsiderations. The plan will expire on February 22, 2010, unless extendedby the Board of Directors; however, the program may be discontinued orsuspended at any time. During the nine months ending June 30, 2009, theCompany purchased 25,000 shares of common stock under the program at a cost of$108,250, or an average market price of $4.33 per share. We financed thesepurchases through available cash.  Thefollowing table sets forth the purchases made under this new plan for eachmonth since adoption ended June 30, 2009:

 
| **Period**         | ** ** | **Total  Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total  Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum  Number  of Shares that May  Yet Be Purchased  Under the Program** | ** ** |
|--------------------|------------|-----------------------------------------|------------|------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                         |       |
| January 2009  |       |                                    |       |                               |       |                                                                                           |       |                                                                         | (a)        |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                         |       |
| February 2009 |       | —                                  |       |                               |       | —                                                                                         |       | 1,000,000                                                                    |       |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                         |       |
| March 2009    |       | 25,000                                  |       | $                                  | 4.33       |                                                                                           | 25,000     |                                                                         | 975,000    |   |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                         |       |
| April 2009    |       | —                                  |       |                               |       | —                                                                                         |       | 975,000                                                                      |       |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                         |       |
| May 2009      |       | —                                  |       |                               |       | —                                                                                         |       | 975,000                                                                      |       |
|               |       |                                    |       |                               |       |                                                                                           |       |                                                                         |       |
| June 2009     |       | —                                  |       |                               |       | —                                                                                         |       | 975,000                                                                      |       |
|               |       | 25,000                                  |       | $                                  | 4.33       |                                                                                           | 25,000     |                                                                         |       |   |

 

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(a) The plan was not approved untilFebruary 2009.

 

**Item 3.    Defaults upon Senior Securities**

 

None

 

**Item 4. Submission of Matters to a Vote ofSecurity Holders**

 

None

 

**Item 5.    OtherInformation**

 

None

 

**Item 6.Exhibits**

 

(a)   Exhibits

 

31.1*       Certification of Chief Executive OfficerPursuant to Rule 13a-14(a)

 

31.2*       Certification of Chief Financial OfficerPursuant to Rule 13a-14(a)

 

32.1†       Certification Pursuant to U.S.C. Section 1350,as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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*   Filed herewith

 

†   Furnished herewith

 

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**SIGNATURE**

 

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

 
|                       | **INNOVATIVE SOLUTIONS AND  SUPPORT, INC.** |
|----------------------------|---------------------------------------------|
|                       |                                        |   |
|                       |                                        |   |
| Date: August 7,  2009 | By:                                         | /s/ JOHN C. LONG |
|                       |                                        | JOHN C. LONG |
|                       |                                        | CHIEF FINANCIAL OFFICER |

 

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