##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549




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FORM 10-Q

QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934


| |                       |  |                        
| | --------------------- |  | -----------------------
| | For the quarter ended |  | Commission File Number:
| | September 30, 2003    |  | 0-10211                

INTER-TEL, INCORPORATED

| |                                      |  |                      
| | ------------------------------------ |  | ---------------------
| | Incorporated in the State of Arizona |  | I.R.S. No. 86-0220994

1615 S. 52nd Street
Tempe, Arizona 85281

(480) 449-8900



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|                           |  |                                      |            | 
|-------------------------- |  | ------------------------------------ | ---------- | 
|Title of Class             |  | Outstanding as of September 30, 2003
|                           |  |                                     
|Common Stock, no par value |  |                                      | 25,190,276 | 

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter periods that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [   ]

Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes [X] No [   ]





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TABLE OF CONTENTS



|                              |                                                                                               |                                                      |  |  |  |  |  | 
|----------------------------- | --------------------------------------------------------------------------------------------- | ---------------------------------------------------- |  |  |  |  |  | 
|PART I. FINANCIAL INFORMATION
|                              | ITEM 1. FINANCIAL STATEMENTS                                                                 
|                              |                                                                                               | CONDENSED CONSOLIDATED BALANCE SHEETS               
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF INCOME         
|                              |                                                                                               | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                              |                                                                                               | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|                              | ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                              | ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                           
|                              | ITEM 4. CONTROLS AND PROCEDURES                                                              
|PART II. OTHER INFORMATION   
|                              | ITEM 1. LEGAL PROCEEDINGS                                                                    
|                              | ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS                                            
|                              | ITEM 3. DEFAULTS ON SENIOR SECURITIES                                                        
|                              | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                  
|                              | ITEM 5. OTHER INFORMATION                                                                    
|                              | ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K:                                                    
|SIGNATURES                   
|EX-31.1                      
|EX-31.2                      
|EX-32.1                      
|EX-32.2                      



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##### Table of Contents



INDEX

INTER-TEL, INCORPORATED AND SUBSIDIARIES

|         |                       |                                                                                                                   |  |     
|-------- | --------------------- | ----------------------------------------------------------------------------------------------------------------- |  | ----
|         |                       |                                                                                                                   |  | Page
|PART I.  | FINANCIAL INFORMATION |                                                                                                                   | 
|Item 1.  |                       | Financial Statements (unaudited)                                                                                  |  |     
|         |                       | Condensed consolidated balance sheetsSeptember 30, 2003
and December 31, 2002                                    |  | 3   
|         |                       | Condensed consolidated statements of incomethree and
nine months ended September 30, 2003 and September 30,
2002 |  | 4   
|         |                       | Condensed consolidated statements of cash flowsnine
months ended September 30, 2003 and September 30, 2002       |  | 5   
|         |                       | Notes to condensed consolidated financial
StatementsSeptember 30, 2003                                           |  | 6   
|Item 2.  |                       | Managements Discussion and Analysis of Financial
Condition and Results of Operations                             |  | 13  
|Item 3.  |                       | Quantitative and Qualitative Disclosures About Market Risk                                                        |  | 31  
|Item 4.  |                       | Controls and Procedures                                                                                           |  | 32  
|PART II. |                       | OTHER INFORMATION                                                                                                 |  |     
|Item 1.  |                       | Legal Proceedings                                                                                                 |  | 32  
|Item 2.  |                       | Changes in Securities and Use of Proceeds                                                                         |  | 32  
|Item 3.  |                       | Defaults on Senior Securities                                                                                     |  | 32  
|Item 4.  |                       | Submission of Matters to a Vote of Security Holders                                                               |  | 32  
|Item 5.  |                       | Other Information                                                                                                 |  | 33  
|Item 6.  |                       | Exhibits and Reports on Form 8-K                                                                                  |  | 33  
|         |                       | SIGNATURES                                                                                                        |  | 33  

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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
INTER-TEL, INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | ------------ |  | - | ------- | -
|                                                                                                                                                                            |  | September 30, |         | December 31,
|                                                                                                                                                                            |  | 2003          |         | 2002        
|(in thousands, except share amounts)                                                                                                                                        |  | (Unaudited)   |         | (Note A)    
|                                                                                                                                                                            |  |               |         |             
|ASSETS                                                                                                                                                                      |  |               |         |              |  |   |         |  
|CURRENT ASSETS                                                                                                                                                              |  |               |         |              |  |   |         |  
|Cash and equivalents                                                                                                                                                        |  | $             | 73,387  |              |  | $ | 84,923  |  
|Short-term investments                                                                                                                                                      |  |               | 69,076  |              |  |   | 40,916  |  
|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|Total cash and equivalents and short-term investments                                                                                                                       |  |               | 142,463 |              |  |   | 125,839 |  
|Accounts receivable, net of allowances of $11,246 in
2003 and $12,159 in 2002                                                                                               |  |               | 43,635  |              |  |   | 42,566  |  
|Inventories, net of allowances of $7,033 in 2003 and
$10,558 in 2002                                                                                                        |  |               | 12,468  |              |  |   | 11,329  |  
|Net investment in sales-leases, net of allowances of
$757 in 2003 and $516 in 2002                                                                                          |  |               | 16,318  |              |  |   | 13,344  |  
|Income taxes receivable                                                                                                                                                     |  |               | 12,805  |              |  |   | 2,604   |  
|Deferred income taxes                                                                                                                                                       |  |               | 508     |              |  |   | 2,377   |  
|Prepaid expenses and other assets                                                                                                                                           |  |               | 6,127   |              |  |   | 6,705   |  
|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|TOTAL CURRENT ASSETS                                                                                                                                                        |  |               | 234,324 |              |  |   | 204,764 |  
|PROPERTY, PLANT & EQUIPMENT                                                                                                                                                 |  |               | 24,559  |              |  |   | 24,795  |  
|GOODWILL                                                                                                                                                                    |  |               | 17,646  |              |  |   | 17,646  |  
|PURCHASED INTANGIBLE ASSETS                                                                                                                                                 |  |               | 8,640   |              |  |   | 7,416   |  
|NET INVESTMENT IN SALES-LEASES, net of allowances of
$1,828 in 2003 and $1,411 in 2002                                                                                      |  |               | 29,333  |              |  |   | 24,692  |  
|OTHER ASSETS                                                                                                                                                                |  |               | 175     |              |  |   | 2,749   |  
|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|                                                                                                                                                                            |  | $             | 314,677 |              |  | $ | 282,062 |  
|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                                                                                                                        |  |               |         |              |  |   |         |  
|CURRENT LIABILITIES                                                                                                                                                         |  |               |         |              |  |   |         |  
|Accounts payable                                                                                                                                                            |  | $             | 26,146  |              |  | $ | 23,089  |  
|Other current liabilities                                                                                                                                                   |  |               | 45,250  |              |  |   | 50,051  |  
|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|TOTAL CURRENT LIABILITIES                                                                                                                                                   |  |               | 71,396  |              |  |   | 73,140  |  
|DEFERRED TAX LIABILITY                                                                                                                                                      |  |               | 29,336  |              |  |   | 16,320  |  
|LEASE RECOURSE LIABILITY                                                                                                                                                    |  |               | 12,095  |              |  |   | 11,125  |  
|RESTRUCTURING RESERVE                                                                                                                                                       |  |               | 299     |              |  |   | 1,049   |  
|OTHER LIABILITIES                                                                                                                                                           |  |               | 6,810   |              |  |   | 6,525   |  
|SHAREHOLDERS EQUITY                                                                                                                                                        |  |               |         |              |  |   |         |  
|Common stock, no par value-authorized 100,000,000
shares; issued27,161,823 shares;
outstanding25,190,276 at September 30, 2003 and
24,908,983 shares at December 31, 2002 |  |               | 112,718 |              |  |   | 111,639 |  
|Less: Shareholder loans                                                                                                                                                     |  |               | (312    | )            |  |   | (338    | )
|Retained earnings                                                                                                                                                           |  |               | 106,077 |              |  |   | 89,643  |  
|Accumulated other comprehensive income                                                                                                                                      |  |               | 298     |              |  |   | 195     |  
|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|                                                                                                                                                                            |  |               | 218,781 |              |  |   | 201,139 |  
|Less: Treasury stock at cost  1,971,547 shares in
2003 and 2,252,840 shares in 2002                                                                                        |  |               | (24,040 | )            |  |   | (27,236 | )
|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|TOTAL SHAREHOLDERS EQUITY                                                                                                                                                  |  |               | 194,741 |              |  |   | 173,903 |  
|                                                                                                                                                                            |  |               |         |              |  |   |         |  
|                                                                                                                                                                            |  | $             | 314,677 |              |  | $ | 282,062 |  
|                                                                                                                                                                            |  |               |         |              |  |   |         |  

See accompanying notes.

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INTER-TEL, INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|----------------------------------------------------- |  | ------------------- | ------ | ------------------- |  | ---- | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                      |  | Three Months        |        | Nine Months        
|(In thousands, except                                 |  | Ended September 30, |        | Ended September 30,
|per share amounts)                                    |  | 2003                |        | 2002                |  | 2003 |        | 2002
|                                                      |  |                     |        |                     |  |      |        |     
|NET SALES                                             |  | $                   | 94,545 |                     |  | $    | 96,665 |      |  | $ | 273,816 |   |  | $ | 282,682 |  
|Cost of sales                                         |  |                     | 45,301 |                     |  |      | 47,615 |      |  |   | 130,248 |   |  |   | 140,104 |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|GROSS PROFIT                                          |  |                     | 49,244 |                     |  |      | 49,050 |      |  |   | 143,568 |   |  |   | 142,578 |  
|Research & development                                |  |                     | 5,718  |                     |  |      | 4,871  |      |  |   | 16,378  |   |  |   | 13,726  |  
|Selling, general and administrative                   |  |                     | 31,761 |                     |  |      | 32,194 |      |  |   | 96,008  |   |  |   | 95,716  |  
|Amortization of purchased intangible assets           |  |                     | 445    |                     |  |      | 269    |      |  |   | 1,359   |   |  |   | 796     |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|                                                      |  |                     | 37,924 |                     |  |      | 37,334 |      |  |   | 113,745 |   |  |   | 110,238 |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|OPERATING INCOME                                      |  |                     | 11,320 |                     |  |      | 11,716 |      |  |   | 29,823  |   |  |   | 32,340  |  
|Litigation settlement (net of costs except for taxes) |  |                     |       |                     |  |      |       |      |  |   |        |   |  |   | 15,516  |  
|Write-down of investment in Inter-Tel.NET/Vianet      |  |                     |       |                     |  |      |       |      |  |   |        |   |  |   | (1,200  | )
|Interest and other income                             |  |                     | 351    |                     |  |      | 411    |      |  |   | 1,226   |   |  |   | 1,364   |  
|Foreign currency transaction gains (losses)           |  |                     | 5      |                     |  |      | 73     |      |  |   | (9      | ) |  |   | 273     |  
|Interest expense                                      |  |                     | (34    | )                   |  |      | (34    | )    |  |   | (137    | ) |  |   | (114    | )
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|INCOME BEFORE INCOME TAXES                            |  |                     | 11,642 |                     |  |      | 12,166 |      |  |   | 30,903  |   |  |   | 48,179  |  
|Income tax provision                                  |  |                     | 4,424  |                     |  |      | 4,623  |      |  |   | 11,744  |   |  |   | 18,206  |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|NET INCOME                                            |  | $                   | 7,218  |                     |  | $    | 7,543  |      |  | $ | 19,159  |   |  | $ | 29,973  |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|NET INCOME PER SHARE                                  |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|Basic                                                 |  | $                   | 0.29   |                     |  | $    | 0.31   |      |  | $ | 0.77    |   |  | $ | 1.23    |  
|Diluted                                               |  | $                   | 0.27   |                     |  | $    | 0.29   |      |  | $ | 0.73    |   |  | $ | 1.17    |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|DIVIDENDS PER SHARE                                   |  | $                   | 0.06   |                     |  | $    | 0.03   |      |  | $ | 0.12    |   |  | $ | 0.07    |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|Weighted average basic common shares                  |  |                     | 25,107 |                     |  |      | 24,544 |      |  |   | 24,991  |   |  |   | 24,331  |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  
|Weighted average diluted common shares                |  |                     | 26,865 |                     |  |      | 26,033 |      |  |   | 26,291  |   |  |   | 25,715  |  
|                                                      |  |                     |        |                     |  |      |        |      |  |   |         |   |  |   |         |  

See accompanying notes.

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INTER-TEL, INCORPORATED AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

|                                                                                  |                                                                                |      |                     |          |   |   |         |         |  
|--------------------------------------------------------------------------------- | ------------------------------------------------------------------------------ | ---- | ------------------- | -------- | - | - | ------- | ------- | -
|                                                                                  |                                                                                |      | Nine Months        
|                                                                                  |                                                                                |      | Ended September 30,
|(In thousands)                                                                    |                                                                                | 2003 |                     | 2002    
|                                                                                  |                                                                                |      |                     |         
|OPERATING ACTIVITIES                                                              |                                                                                |      |                     |          |   |   |         |        
|Net income                                                                        |                                                                                | $    | 19,159              |          |   | $ | 29,973  |        
|Adjustments to reconcile net income to net cash provided
by operating activities: |                                                                                |      |                     |          |   |   |         |        
|                                                                                  | Depreciation of fixed assets                                                   |      |                     | 5,290    |   |   |         | 5,465   |  
|                                                                                  | Amortization of patents included in R&D expenses                               |      |                     | 166      |   |   |         | 166     |  
|                                                                                  | Amortization of purchased intangible assets                                    |      |                     | 1,359    |   |   |         | 796     |  
|                                                                                  | Provision for losses on receivables                                            |      |                     | 2,397    |   |   |         | 3,195   |  
|                                                                                  | Provision for losses on leases                                                 |      |                     | 3,831    |   |   |         | 4,736   |  
|                                                                                  | Provision for inventory valuation                                              |      |                     | 479      |   |   |         | 903     |  
|                                                                                  | Decrease in other liabilities                                                  |      |                     | (2,658   | ) |   |         | (2,299  | )
|                                                                                  | Loss on sale of property and equipment                                         |      |                     | 91       |   |   |         | 53      |  
|                                                                                  | Deferred income taxes                                                          |      |                     | 14,885   |   |   |         | 1,772   |  
|                                                                                  | Effect of exchange rate changes                                                |      |                     | 102      |   |   |         | 166     |  
|                                                                                  | Changes in operating assets and liabilities                                    |      |                     | (25,705  | ) |   |         | 11,190  |  
|                                                                                  |                                                                                |      |                     |          |   |   |         |        
|NET CASH PROVIDED BY OPERATING ACTIVITIES                                         |                                                                                |      | 19,396              |          |   |   | 56,114  |        
|INVESTING ACTIVITIES                                                              |                                                                                |      |                     |          |   |   |         |        
|                                                                                  | Purchases of short-term investments                                            |      |                     | (141,869 | ) |   |         | (18,100 | )
|                                                                                  | Maturities and sales of short-term investments                                 |      |                     | 113,710  |   |   |         | 2,000   |  
|                                                                                  | Additions to property, plant and equipment                                     |      |                     | (5,219   | ) |   |         | (5,178  | )
|                                                                                  | Proceeds from disposal of property, plant and equipment                        |      |                     | 75       |   |   |         | 289     |  
|                                                                                  | Proceeds from investment in Inter-Tel.NET/Vianet                               |      |                     | 1,450    |   |   |         | 0       |  
|                                                                                  | Cash used in acquisitions                                                      |      |                     | (267     | ) |   |         | (7,912  | )
|                                                                                  |                                                                                |      |                     |          |   |   |         |        
|NET CASH USED IN INVESTING ACTIVITIES                                             |                                                                                |      | (32,120             | )        |   |   | (28,901 | )      
|FINANCING ACTIVITIES                                                              |                                                                                |      |                     |          |   |   |         |        
|                                                                                  | Cash dividends paid                                                            |      |                     | (2,245   | ) |   |         | (1,454  | )
|                                                                                  | Treasury stock purchases                                                       |      |                     | (206     | ) |   |         | (11     | )
|                                                                                  | Payments on term debt                                                          |      |                     | (89      | ) |   |         | (412    | )
|                                                                                  | Proceeds from exercise of stock options, including
shareholder loan repayments |      |                     | 3,260    |   |   |         | 4,495   |  
|                                                                                  | Proceeds from stock issued under the ESPP                                      |      |                     | 468      |   |   |         | 475     |  
|                                                                                  |                                                                                |      |                     |          |   |   |         |        
|NET CASH PROVIDED BY FINANCING ACTIVITIES                                         |                                                                                |      | 1,188               |          |   |   | 3,093   |        
|                                                                                  |                                                                                |      |                     |          |   |   |         |        
|INCREASE (DECREASE) IN CASH AND EQUIVALENTS                                       |                                                                                |      | (11,536             | )        |   |   | 30,306  |        
|CASH AND EQUIVALENTS AT BEGINNING OF PERIOD                                       |                                                                                |      | 84,923              |          |   |   | 58,795  |        
|                                                                                  |                                                                                |      |                     |          |   |   |         |        
|CASH AND EQUIVALENTS AT END OF PERIOD                                             |                                                                                | $    | 73,387              |          |   | $ | 89,100  |        
|                                                                                  |                                                                                |      |                     |          |   |   |         |        

See accompanying notes.

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INTER-TEL, INCORPORATED AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
September 30, 2003

NOTE ABASIS OF PRESENTATION

The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States for interim financial information and with the
instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they
do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements. In the
opinion of management, all adjustments (consisting of normal recurring
accruals) considered necessary for a fair presentation of the results for the
interim periods presented have been included. Operating results for the three
and nine months ending September 30, 2003 are not necessarily indicative of the
results that may be expected for the year ended December 31, 2003. The balance
sheet at December 31, 2002 has been derived from the audited financial
statements at that date, but does not include all of the information and
footnotes required by accounting principles generally accepted in the United
States for complete financial statements. For further information, refer to
the consolidated financial statements and footnotes thereto included in the
Companys annual report on Form 10-K for the year ended December 31, 2002.

Certain prior year amounts have been reclassified to conform with the
current period presentation.

Stock-Based Compensation

In 2002, the Financial Accounting Standards Board (FASB) issued
Statement No. 148 Accounting for Stock-Based CompensationTransition and
Disclosure, an amendment of FASB Statement No. 123 (SFAS No. 148), which
provides alternative methods of transition for an entity that voluntarily
changes to the fair value based method of accounting for stock-based employee
compensation. It also amends the disclosure provisions of SFAS No. 123 to
require prominent disclosure about the effects on reported net income of an
entitys accounting policy decisions with respect to stock-based employee
compensation. Finally, this statement amends APB Opinion No. 28, Interim
Financial Reporting, to require disclosure about those effects in interim
financial information. We adopted SFAS No. 148 in the fourth quarter of 2002.
Since we have not changed to a fair value method of stock-based compensation,
the applicable portion of this statement only affects our disclosures.

We generally do not recognize compensation expense relating to employee
stock options because we only grant options with an exercise price equal to the
fair value of the underlying common stock on the effective date of grant. At
September 30, 2003, the Company has four stock-based employee and director
incentive plans and an employee stock purchase plan. The Company accounts for
these plans under the recognition and measurement principles of APB No. 25,
Accounting for Stock Issued to Employees, and related interpretations. If we
had elected to recognize compensation expense using a fair value approach, and
therefore determined the compensation based on the value as determined by the
modified Black-Scholes option pricing model, the pro forma net income and
earnings per share would have been as follows:

|                                                                                                                   |  |                                 |        |      |  |   |        |  
|------------------------------------------------------------------------------------------------------------------ |  | ------------------------------- | ------ | ---- |  | - | ------ | -
|                                                                                                                   |  | Nine Months Ended September 30,
|(in thousands, except per share data)                                                                              |  | 2003                            |        | 2002
|                                                                                                                   |  |                                 |        |     
|Net income, as reported                                                                                            |  | $                               | 19,159 |      |  | $ | 29,973 |  
|Deduct: total stock-based compensation expense
determined under fair value based method for all
awards, net of tax |  |                                 | (2,281 | )    |  |   | (2,176 | )
|                                                                                                                   |  |                                 |        |      |  |   |        |  
|Pro forma net income                                                                                               |  | $                               | 16,878 |      |  | $ | 27,797 |  
|                                                                                                                   |  |                                 |        |      |  |   |        |  
|Earnings per share of common stock                                                                                 |  |                                 |        |      |  |   |        |  
|Basic  as reported                                                                                                |  | $                               | 0.77   |      |  | $ | 1.23   |  
|Basic  pro forma                                                                                                  |  | $                               | 0.68   |      |  | $ | 1.14   |  
|Diluted  as reported                                                                                              |  | $                               | 0.73   |      |  | $ | 1.17   |  
|Diluted  pro forma                                                                                                |  | $                               | 0.64   |      |  | $ | 1.08   |  

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The fair value for these options was estimated at the date of grant using
a Black-Scholes option pricing model using the low end of reasonable
assumptions for input variables rather than attempting to identify a best-point
estimate. The option pricing model utilized the following weighted average
assumptions for 2003 and 2002: risk free interest rates of 2.98% for 2003 and
2.73% for 2002; dividend yields of 1.2% for 2003 and 0.75% for 2002; volatility
factors of the expected market price of our stock averaged .295 for
2003 and .576 for 2002. Employee stock options vest over four to five year periods and
director options vest at the end of six months from the grant date.

New Accounting Standards and Pronouncements

Costs Associated with Exit or Disposal Activities:In 2002, the FASB
issued Statement of Financial Accounting Standards No. 146, Accounting for
Costs Associated with Exit or Disposal Activities (SFAS No. 146). This
standard requires companies to recognize costs associated with exit or disposal
activities when they are incurred, rather than at the date of a commitment to
an exit or disposal plan. Examples of costs covered by the standard include
lease termination costs and certain employee severance costs that are
associated with a restructuring, plant closing, or other exit or disposal
activity. We adopted SFAS No. 146 effective January 1, 2003, to be applied
prospectively to exit or disposal activities initiated after December 31, 2002,
and its adoption did not have any effect on our financial position or results
of operations.

Asset Retirement Obligations:In 2001, the FASB issued Statement of
Financial Accounting Standards No. 143, Accounting for Asset Retirement
Obligations (SFAS No. 143). This statement addresses financial accounting
and reporting for obligations associated with the retirement of tangible
long-lived assets and associated asset retirement costs. We adopted SFAS No.
143 on January 1, 2003 and its adoption did not have any effect on our
financial position or results of operations.

Variable Interest Entities:In January 2003, the FASB issued
Interpretation No. 46, Consolidation of Variable Interest Entities, an
interpretation of ARB 51 (FIN 46). The primary objectives of FIN 46 are to
provide guidance on the identification of entities for which control is
achieved through means other than through voting rights (VIEs) and how to
determine when and which business enterprise should consolidate the VIE. This
new model for consolidation applies to an entity (1) in which either the equity
investors (if any) do not have a controlling financial interest or (2) where
the equity investment at risk is insufficient to finance that entitys
activities without receiving additional subordinated financial support from
other parties. The adoption of this standard did not have any impact on our
results of operations, financial position or liquidity.

Guarantees:In November 2002, the FASB issued Interpretation No. 45,
Guarantors Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others (FIN 45). This interpretation
expands the disclosure requirements of guarantee obligations and requires the
guarantor to recognize a liability for the fair value of the obligation assumed
under a guarantee. In general, FIN 45 applies to contracts or indemnification
agreements that contingently require the guarantor to make payments to the
guaranteed party based on changes in an underlying instrument that is related
to an asset, liability, or equity security of the guaranteed party. Other
guarantees are subject to the disclosure requirements of FIN 45 but not to the
recognition provisions and include, among others, a guarantee accounted for as
a derivative instrument under SFAS No. 133, Accounting for Derivatives and
Hedging(SFAS No. 133),a parents guarantee of debt owed to a third party
by its subsidiary or vice versa, and a guarantee which is based on performance.
The disclosure requirements of FIN 45 were effective as of December 31, 2002.
The recognition requirements of FIN 45 are to be applied prospectively to
guarantees issued or modified after December 31, 2002. Adoption of FIN 45 to
has not had any impact on our results of operations, financial position or
liquidity.

Financial
Instruments: In May 2003, the FASB issued Statement of
Financial Accounting Standards No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity (SFAS No.
150). SFAS 150 establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity, and is effective for financial instruments entered into or modified
after May 31, 2003 and otherwise is effective July 1, 2003. The Company
believes SFAS 150 will have no impact on its financial condition or results of
operations.

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Contingencies. We are a party to various claims and litigation in the
normal course of business. Managements current estimated range of liability
related to various claims and pending litigation is based on claims for which
our management can estimate the amount and range of loss, or can estimate a
minimum amount of a loss. Because of the uncertainties related to both the
amount and range of loss on the remaining pending claims and litigation,
management is unable to make a reasonable estimate of the liability that could
result from an unfavorable outcome. As additional information becomes
available, we will assess the potential liability related to our claims and
pending litigation, revise our estimates and accrue for any losses to the
extent that they are probable and the amount is estimable. Such revisions in
our estimates of the potential liability could materially impact our results of
operations and financial position. However, at September 30, 2003 management
does not believe that the ultimate impact of various claims and pending
litigation will have a materially adverse impact on the Company.

Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has not provided Inter-Tel with a description of the evidence on
which the investigations are based. Inter-Tel is presently unable to predict
or determine the final outcome of, or to estimate the potential range of loss
with respect to, the investigations. Based upon the information known at this
time, we do not know what, if any, impact the investigations may have on the
Companys business or financial condition. If Inter-Tel is convicted of any
crime or subjected to sanctions, or debarred from certain government contracts
or if penalties, damages or other monetary remedies are assessed against
Inter-Tel in connection with or related to these and other investigations, our
business and operating results could be materially and adversely affected. The
existence and disclosure of the investigations may have already caused
competitive harm to Inter-Tel, and any unfavorable resolution to these matters
may further harm Inter-Tels business. Nevertheless, the early nature of the
investigations makes it difficult to determine whether a material adverse
outcome is likely.

NOTE BEARNINGS PER SHARE

Diluted earnings per share assume that weighted average outstanding common
shares were increased by weighted average shares issuable upon the exercise of
all outstanding stock options for which the market price exceeds exercise
price, less shares which could have been purchased with related proceeds and
tax benefit of expenses, if the effect would be dilutive.

The following table sets forth the computation of basic and diluted earnings
per share:

|                                                                                                      |                                                                    |               |                    |               |                   |               |        |               |  |   |        |        |  |   |        |        | 
|----------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------ | ------------- | ------------------ | ------------- | ----------------- | ------------- | ------ | ------------- |  | - | ------ | ------ |  | - | ------ | ------ | 
|                                                                                                      |                                                                    |               | Three Months Ended |               | Nine Months Ended
|(In thousands, except                                                                                 |                                                                    | September 30, |                    | September 30, |                   | September 30, |        | September 30,
|per share amounts)                                                                                    |                                                                    | 2003          |                    | 2002          |                   | 2003          |        | 2002         
|                                                                                                      |                                                                    |               |                    |               |                   |               |        |              
|Numerator: Net income                                                                                 |                                                                    | $             | 7,218              |               |                   | $             | 7,543  |               |  | $ | 19,159 |        |  | $ | 29,973 |       
|                                                                                                      |                                                                    |               |                    |               |                   |               |        |               |  |   |        |        |  |   |        |       
|Denominator:                                                                                          |                                                                    |               |                    |               |                   |               |        |               |  |   |        |        |  |   |        |       
|                                                                                                      | Denominator for basic earnings per
share  weighted average shares |               |                    | 25,107        |                   |               |        | 24,544        |  |   |        | 24,991 |  |   |        | 24,331 | 
|Effect of dilutive securities:                                                                        |                                                                    |               |                    |               |                   |               |        |               |  |   |        |        |  |   |        |       
|                                                                                                      | Employee and director stock options                                |               |                    | 1,758         |                   |               |        | 1,489         |  |   |        | 1,300  |  |   |        | 1,384  | 
|                                                                                                      |                                                                    |               |                    |               |                   |               |        |               |  |   |        |        |  |   |        |       
|Denominator for diluted earnings per
share  adjusted weighted average
shares and assumed conversions |                                                                    |               | 26,865             |               |                   |               | 26,033 |               |  |   | 26,291 |        |  |   | 25,715 |       
|                                                                                                      |                                                                    |               |                    |               |                   |               |        |               |  |   |        |        |  |   |        |       
|Basic earnings per share                                                                              |                                                                    | $             | 0.29               |               |                   | $             | 0.31   |               |  | $ | 0.77   |        |  | $ | 1.23   |       
|                                                                                                      |                                                                    |               |                    |               |                   |               |        |               |  |   |        |        |  |   |        |       
|Diluted earnings per share                                                                            |                                                                    | $             | 0.27               |               |                   | $             | 0.29   |               |  | $ | 0.73   |        |  | $ | 1.17   |       
|                                                                                                      |                                                                    |               |                    |               |                   |               |        |               |  |   |        |        |  |   |        |       

At September 30, 2003 and 2002, options to purchase 227,150 and 342,150 shares,
respectively, of Inter-Tel stock were excluded from the calculation of diluted
net earnings per share for the periods presented because the exercise price of
these options was greater than the average market price of the common shares
for the respective fiscal years, and therefore the effect would have been
antidilutive.

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NOTE C  ACQUISITIONS, DISPOSITIONS AND RESTRUCTURING CHARGES

McLeod.On January 24, 2002, we acquired certain assets of McLeodUSA
Integrated Business Systems, Inc. (McLeod) for cash plus the assumption of
various liabilities and related acquisition costs. Inter-Tel acquired McLeods
voice customer base in Minnesota, Iowa and Colorado and DataNet operations in
South Dakota, which also included the related accounts receivable, inventory
and fixed assets along with assumption of scheduled specific liabilities for
warranty and maintenance obligations. The aggregate purchase price of $7.9
million was allocated to the fair value of the assets and liabilities acquired.

In connection with the McLeod acquisition, we recorded goodwill of
approximately $4.0 million and other purchased intangible assets of $0.5
million, for a total of $4.5 million. The goodwill balance is being accounted
for in accordance with SFAS 141 and 142. The balances included in other
purchased intangible assets are being amortized over periods ranging from two
to five years from the date of the acquisition. During the quarters ended
September 30, 2003 and 2002, the amortization of purchased intangible assets
from McLeod was $113,000 and $100,000, respectively.

Swan.On December 3, 2002, Inter-Tel Integrated Systems, Inc., our wholly-owned
subsidiary, acquired 100% of the capital stock of Swan Solutions Limited
(Swan) in England and Wales, for $4.0 million in cash. Of this amount, $3.0
million was paid at closing, $250,000 was paid within six months from the
closing date and $250,000 is payable one year from closing date. The remaining
$500,000 is subject to the achievement of five performance milestones
triggering the payment of $100,000 each. As of September 30, 2003, the first
two of the milestones were achieved and $200,000 in the aggregate was paid to
the Swan shareholders. Achievement of performance milestones is considered a
part of the purchase price and accordingly, for purposes of determining the
total purchase price, $500,000 was deemed to be achieved and added to the
purchase price and capitalized as purchased intangibles. These technology
assets are being amortized over a life of 5 years. The remaining three
milestones must be achieved by June 30, 2004. Accordingly, the purchase price
may be reduced if any portion of the remaining milestones is not achieved.
Through September 30, 2003, we recorded amortizable intangible technology
assets of $3.9 million in connection with this acquisition. During the first
nine months of 2003 the amortization of these technology assets from Swan was
$599,000.

Inter-Tel.NET/Comm-Services/Vianet.On July 24, 2001, Inter-Tel sold 83% of
the stock of Inter-Tel.NET, Inc. to Comm-Services Corporation for a note of
$4.95 million, collateralized by Comm-Services stock, other marketable
securities of the shareholders of Comm-Services and 100% of the net assets of
Inter-Tel.NET. In connection with the sale of 83% of Inter-Tel.NET, we
assessed the fair value of the remaining 17% investment in Inter-Tel.NET.
Pursuant to SFAS 121, we recorded a charge as of the close of the second
quarter of 2001 of $5.4 million ($3.4 million after tax) associated with the
impairment of our investment in Inter-Tel.NET. After the impairment charge,
the carrying value of our investment (the note receivable from Comm-Services
plus the 17% ownership interest in Comm-Services) totaled $3.7 million as of
December 31, 2001. The charge was primarily non-cash.

Inter-Tels management has not participated in the management of Inter-Tel.NET
since the sale in July 2001. As a result, since July 24, 2001, we have
accounted for the remaining Inter-Tel.NET/Comm-Services investment using the
cost method of accounting. On December 30, 2001, Comm-Services entered into a
merger agreement with Vianet. Inter-Tels 17% investment in Comm-Services was
converted to approximately 10% of Vianet stock and as a result, Vianet assumed
the loan for the purchase and Inter-Tel continued to hold collateral from the
former shareholders of Comm-Services until March 2003. During the first six
months of 2002, the net investment in the notes receivable and 10% interest in
Vianet (formerly Comm-Services) was written down by $1.2 million ($600,000 each
in the first and second quarters) and was recorded in other assets at a
carrying value of approximately $2.5 million as of December 31, 2002, which
approximated managements estimate of the related collateral value at that
time.

During 1999, 2000 and 2001, Inter-Tel.NET entered into operating lease
agreements totaling approximately $6.5 million from an equipment vendor for
network equipment and software. The lease agreements required Inter-Tel.NET to
purchase vendor maintenance on their products. Inter-Tel originally
guaranteed the indebtedness. In February 2003, we executed an agreement with
Vianet and this vendor releasing

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Inter-Tel from its guarantee of all of these
obligations, and Inter-Tel and Vianet released the vendor from claims arising
from the failure of the network equipment and software previously leased. As
part of this agreement, Inter-Tel also received payment from the Vianet
shareholders of $1.45 million, in exchange for the release of the remaining
collateral and as payment of the loan. The value received in this transaction
was equivalent to our remaining investment value, less accruals for potential
obligations to the vendor discussed above.

Inter-Tel retains its ownership interest in Vianet and will account for the
remaining investment interest of approximately 10% in Vianet using the cost
method of accounting.

Executone Restructuring Charge.During the second quarter of 2000, we
recognized a restructuring charge related to acquired Executone operations. We
accounted for the restructuring of the Executone operations, including
severance and related costs, the shut down and consolidation of the Milford
facility and the impairment of assets associated with the restructuring as
identified in the table below. Accrued costs associated with this plan were
estimates; the original estimates made in the second quarter of 2000 for
reserve balances have not changed significantly through September 30, 2003.

Exit costs associated with the closure of the Milford facility also included
liabilities for building, furniture and equipment lease, and other contractual
obligations. We are liable for the lease on the Milford buildings through
January 2005. Various furniture leases ran concurrently through March 2002.
Other capital leases for computer and other equipment terminated on varying
dates through September 2002. To date, we have entered into sublease
agreements with third parties to sublease portions of the facility and
equipment. The reserve for lease and other contractual obligations is
identified in the table below.

The following table summarizes details of the restructuring charge taken in the
second quarter of 2000 in connection with the Executone acquisition, including
the description of the type and amount of liabilities assumed, and activity in
the reserve balances from the date of the charge through September 30, 2003.

|                                                                                   |                                      |          |          |        |               |         |         |          |      |            |          |  |   |     |       |  |         |        |        |   | 
|---------------------------------------------------------------------------------- | ------------------------------------ | -------- | -------- | ------ | ------------- | ------- | ------- | -------- | ---- | ---------- | -------- |  | - | --- | ----- |  | ------- | ------ | ------ | - | 
|                                                                                   |                                      |          |          |        |               |         |         |          |      |            | Activity |  |   |     |       |  | Reserve
|                                                                                   |                                      |          | Cash/    |        | Restructuring |         | Through |          | 2003 |            | Balance 
|Description                                                                        |                                      | Non-Cash |          | Charge |               | 2002    |         | Activity |      | At 9/30/03
|                                                                                   |                                      |          |          |        |               |         |         |          |      |           
|Personnel Costs:                                                                   |                                      |          |          |        |               |         |         |          |      |            |          |  |   |     |       |  |         |        |        |  
|                                                                                   | Severance and termination costs      |          | Cash     |        | $             | (1,583  | )       |          | $    | 1,580      |          |  | $ | 3   |       |  | $       |       |       
|                                                                                   | Other Plant closure costs            |          | Cash     |        |               | (230    | )       |          |      | 230        |          |  |   |    |       |  |         |       |       
|Lease termination and other
contractual obligations (net of
anticipated recovery): |                                      |          |          |        |               |         |         |          |      |            |          |  |   |     |       |  |         |        |        |  
|                                                                                   | Building and equipment leases        |          | Cash     |        |               | (7,444  | )       |          |      | 5,431      |          |  |   | 720 |       |  |         | (1,293 | )     
|                                                                                   | Other contractual obligations        |          | Cash     |        |               | (1,700  | )       |          |      | 1,700      |          |  |   |    |       |  |         |       |       
|Impairment of Assets:                                                              |                                      |          |          |        |               |         |         |          |      |            |          |  |   |     |       |  |         |        |        |  
|                                                                                   | Inventories                          |          | Non-Cash |        |               | (3,454  | )       |          |      | 3,454      |          |  |   |    |       |  |         |       |       
|                                                                                   | Prepaid inventory and other
expenses |          | Non-Cash |        |               | (2,485  | )       |          |      | 2,485      |          |  |   |    |       |  |         |       |       
|                                                                                   | Accounts receivable                  |          | Non-Cash |        |               | (1,685  | )       |          |      | 854        |          |  |   | 676 |       |  |         | (155   | )     
|                                                                                   | Fixed assets                         |          | Non-Cash |        |               | (3,151  | )       |          |      | 2,995      |          |  |   | 4   |       |  |         | (152   | )     
|                                                                                   | Net intangible assets                |          | Non-Cash |        |               | (29,184 | )       |          |      | 29,184     |          |  |   |    |       |  |         |       |       
|                                                                                   |                                      |          |          |        |               |         |         |          |      |            |          |  |   |     |       |  |         |        |        |  
|Total                                                                              |                                      |          |          |        |               | $       | (50,916 | )        |      | $          | 47,913   |  |   | $   | 1,403 |  |         | $      | (1,600 | )
|                                                                                   |                                      |          |          |        |               |         |         |          |      |            |          |  |   |     |       |  |         |        |        |  

NOTE D  SEGMENT INFORMATION

Inter-Tel follows Statement of Financial Accounting Standards No. 131,
Disclosures about Segments of an Enterprise and Related Information (SFAS
131). SFAS 131 established standards for reporting information regarding
operating segments in annual financial statements and requires selected
information for those segments to be presented in interim financial reports
issued to stockholders. SFAS 131 also established standards for related
disclosures about products and services and geographic areas.

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Operating
segments are identified as components of an enterprise about which separate
discrete financial information is available for evaluation by the chief
operating decision maker, or decision making group, in making decisions as to
how to allocate resources and assess performance. The Companys chief decision
maker, as defined under SFAS 131, is the Chief Executive Officer.

We view our operations as primarily composed of two segments: (1) telephone
systems, telecommunications software and hardware, and (2) local and long
distance calling services. These services are provided through the Companys
direct sales offices and dealer network to business customers throughout the
United States, Europe, Asia, Mexico and Canada. As a result, financial
information disclosed represents substantially all of the financial information
related to the Companys two principal operating segments. Results of
operations for the local and long distance calling services segment, if the
operations were not included as part of the consolidated group, could differ
materially, as the operations are integral to the total telephony solution
offered by us to our customers.

In addition to the two primary segments discussed above, the Inter-Tel.NET
operations/investment, Inter-Tels former IP long distance subsidiary, is
separately disclosed as a business segment through June of 2002. On July 24,
2001, Inter-Tel agreed to sell 83% of Inter-Tel.NET to Comm-Services
Corporation. As a result, since July 24, 2001, we have accounted for the
remaining 17% Inter-Tel.NET/Comm-Services investment using the cost method of
accounting. On December 30, 2001, Comm-Services entered into a merger
agreement with Vianet. Inter-Tels 17% investment in
Inter-Tel.NET/Comm-Services was converted to approximately 10% of Vianet stock.
Inter-Tel assessed the value of this investment at March 31, 2002 and
wrote-down this investment by $600,000. Inter-Tel assessed the value of this
investment again at June 30, 2002 and wrote-down this investment by another
$600,000. In February 2003, we executed an agreement with Vianet (See Note C)
and the vendor releasing Inter-Tel from its guarantee of any and all of these
obligations, and Inter-Tel and Vianet released the vendor from claims arising
from the failure of the network equipment and software previously leased. As
part of this agreement, Inter-Tel also received payment from the Vianet
shareholders of $1.45 million, in exchange for the release of the remaining
collateral and as payment of the loan. Inter-Tel will account for the remaining
10% investment in Vianet (formerly Comm-Services) using the cost method of
accounting.

For the quarters and nine months ended September 30, 2003 and 2002, we
generated income from business segments, including income from a litigation
settlement and losses from our investment in Inter-Tel.NET/Vianet for 2002, as
follows:

|                                   |  |                                       |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  |           |        |  |  |   |         |  
|---------------------------------- |  | ------------------------------------- | ------- | ---------- |  | --------- | - | ------------- |  | -------- | ------- | ----- |  | - | - | ---- |  | --------- | ------ |  |  | - | ------- | -
|                                   |  | Three Months Ended September 30, 2003
|                                   |  |                                       |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  | Resale of |        |  |  |  
|                                   |  |                                       |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  | Local and |        |  |  |  
|                                   |  |                                       |         |            |  |           |   |               |  | Subtotal |         |       |  |   |   | Long |  |           |        | 
|(In thousands, except per share    |  | Principal                             |         | Litigation |  | Principal |   | Inter-Tel.NET |  | Distance |         |       |  |  
|amounts)                           |  | Segment                               |         | Settlement |  | Segment   |   | /Vianet       |  | Services |         | Total
|                                   |  |                                       |         |            |  |           |   |               |  |          |         |      
|Net sales                          |  | $                                     | 84,616  |            |  | $         |  |               |  | $        | 84,616  |       |  | $ |  |      |  | $         | 9,929  |  |  | $ | 94,545  |  
|Gross profit                       |  |                                       | 45,777  |            |  |           |  |               |  |          | 45,777  |       |  |   |  |      |  |           | 3,467  |  |  |   | 49,244  |  
|Operating income                   |  |                                       | 9,699   |            |  |           |  |               |  |          | 9,699   |       |  |   |  |      |  |           | 1,621  |  |  |   | 11,320  |  
|Interest and other income          |  |                                       | 309     |            |  |           |  |               |  |          | 309     |       |  |   |  |      |  |           | 42     |  |  |   | 351     |  
|Foreign currency transaction gains |  |                                       | 5       |            |  |           |  |               |  |          | 5       |       |  |   |  |      |  |           |       |  |  |   | 5       |  
|Interest expense                   |  |                                       | (34     | )          |  |           |  |               |  |          | (34     | )     |  |   |  |      |  |           |       |  |  |   | (34     | )
|Net income                         |  | $                                     | 6,186   |            |  | $         |  |               |  | $        | 6,186   |       |  | $ |  |      |  | $         | 1,032  |  |  | $ | 7,218   |  
|Net income per diluted share       |  | $                                     | 0.23    |            |  | $         |  |               |  | $        | 0.23    |       |  | $ |  |      |  | $         | 0.04   |  |  | $ | 0.27    |  
|Weighted average diluted shares    |  |                                       | 26,865  |            |  |           |  |               |  |          | 26,865  |       |  |   |  |      |  |           | 26,865 |  |  |   | 26,865  |  
|Total assets                       |  | $                                     | 298,087 |            |  | $         |  |               |  | $        | 298,087 |       |  | $ |  |      |  | $         | 16,590 |  |  | $ | 314,677 |  
|Depreciation and amortization      |  |                                       | 2,244   |            |  |           |  |               |  |          | 2,244   |       |  |   |  |      |  |           | 13     |  |  |   | 2,257   |  

|                                |  |                                       |        |            |  |           |   |               |  |          |        |       |  |   |   |      |  |           |       |  |  |   |        | 
|------------------------------- |  | ------------------------------------- | ------ | ---------- |  | --------- | - | ------------- |  | -------- | ------ | ----- |  | - | - | ---- |  | --------- | ----- |  |  | - | ------ | 
|                                |  | Three Months Ended September 30, 2002
|                                |  |                                       |        |            |  |           |   |               |  |          |        |       |  |   |   |      |  | Resale of |       |  |  |  
|                                |  |                                       |        |            |  |           |   |               |  |          |        |       |  |   |   |      |  | Local and |       |  |  |  
|                                |  |                                       |        |            |  |           |   |               |  | Subtotal |        |       |  |   |   | Long |  |           |       | 
|(In thousands, except per share |  | Principal                             |        | Litigation |  | Principal |   | Inter-Tel.NET |  | Distance |        |       |  |  
|amounts)                        |  | Segment                               |        | Settlement |  | Segment   |   | /Vianet       |  | Services |        | Total
|                                |  |                                       |        |            |  |           |   |               |  |          |        |      
|Net sales                       |  | $                                     | 88,842 |            |  | $         |  |               |  | $        | 88,842 |       |  | $ |  |      |  | $         | 7,823 |  |  | $ | 96,665 | 
|Gross profit                    |  |                                       | 46,802 |            |  |           |  |               |  |          | 46,802 |       |  |   |  |      |  |           | 2,248 |  |  |   | 49,050 | 
|Operating income                |  |                                       | 10,680 |            |  |           |  |               |  |          | 10,680 |       |  |   |  |      |  |           | 1,036 |  |  |   | 11,716 | 

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|                                   |  |                                       |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  |           |        |  |  |   |         |  
|---------------------------------- |  | ------------------------------------- | ------- | ---------- |  | --------- | - | ------------- |  | -------- | ------- | ----- |  | - | - | ---- |  | --------- | ------ |  |  | - | ------- | -
|                                   |  | Three Months Ended September 30, 2002
|                                   |  |                                       |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  | Resale of |        |  |  |  
|                                   |  |                                       |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  | Local and |        |  |  |  
|                                   |  |                                       |         |            |  |           |   |               |  | Subtotal |         |       |  |   |   | Long |  |           |        | 
|(In thousands, except per share    |  | Principal                             |         | Litigation |  | Principal |   | Inter-Tel.NET |  | Distance |         |       |  |  
|amounts)                           |  | Segment                               |         | Settlement |  | Segment   |   | /Vianet       |  | Services |         | Total
|                                   |  |                                       |         |            |  |           |   |               |  |          |         |      
|Interest and other income          |  |                                       | 369     |            |  |           |  |               |  |          | 369     |       |  |   |  |      |  |           | 42     |  |  |   | 411     |  
|Foreign currency transaction gains |  |                                       | 73      |            |  |           |  |               |  |          | 73      |       |  |   |  |      |  |           |       |  |  |   | 73      |  
|Interest expense                   |  |                                       | (34     | )          |  |           |  |               |  |          | (34     | )     |  |   |  |      |  |           |       |  |  |   | (34     | )
|Net income                         |  | $                                     | 6,875   |            |  | $         |  |               |  | $        | 6,875   |       |  | $ |  |      |  | $         | 668    |  |  | $ | 7,543   |  
|Net income per diluted share       |  | $                                     | 0.26    |            |  | $         |  |               |  | $        | 0.26    |       |  | $ |  |      |  | $         | 0.03   |  |  | $ | 0.29    |  
|Weighted average diluted shares    |  |                                       | 26,033  |            |  |           |  |               |  |          | 26,033  |       |  |   |  |      |  |           | 26,033 |  |  |   | 26,033  |  
|Total assets                       |  | $                                     | 259,720 |            |  | $         |  |               |  | $        | 259,720 |       |  | $ |  |      |  | $         | 12,200 |  |  | $ | 271,920 |  
|Depreciation and amortization      |  |                                       | 2,062   |            |  |           |  |               |  |          | 2,062   |       |  |   |   |      |  |           | 15     |  |  |   | 2,077   |  

|                                    |  |                                      |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  |           |        |  |  |   |         |  
|----------------------------------- |  | ------------------------------------ | ------- | ---------- |  | --------- | - | ------------- |  | -------- | ------- | ----- |  | - | - | ---- |  | --------- | ------ |  |  | - | ------- | -
|                                    |  | Nine Months Ended September 30, 2003
|                                    |  |                                      |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  | Resale of |        |  |  |  
|                                    |  |                                      |         |            |  |           |   |               |  |          |         |       |  |   |   |      |  | Local and |        |  |  |  
|                                    |  |                                      |         |            |  |           |   |               |  | Subtotal |         |       |  |   |   | Long |  |           |        | 
|(In thousands, except per share     |  | Principal                            |         | Litigation |  | Principal |   | Inter-Tel.NET |  | Distance |         |       |  |  
|amounts)                            |  | Segment                              |         | Settlement |  | Segment   |   | /Vianet       |  | Services |         | Total
|                                    |  |                                      |         |            |  |           |   |               |  |          |         |      
|Net sales                           |  | $                                    | 245,912 |            |  | $         |  |               |  | $        | 245,912 |       |  | $ |  |      |  | $         | 27,904 |  |  | $ | 273,816 |  
|Gross profit                        |  |                                      | 134,609 |            |  |           |  |               |  |          | 134,609 |       |  |   |  |      |  |           | 8,959  |  |  |   | 143,568 |  
|Operating income                    |  |                                      | 25,631  |            |  |           |  |               |  |          | 25,631  |       |  |   |  |      |  |           | 4,192  |  |  |   | 29,823  |  
|Interest and other income           |  |                                      | 1,115   |            |  |           |  |               |  |          | 1,115   |       |  |   |  |      |  |           | 111    |  |  |   | 1,226   |  
|Foreign currency transaction losses |  |                                      | (9      | )          |  |           |  |               |  |          | (9      | )     |  |   |  |      |  |           |       |  |  |   | (9      | )
|Interest expense                    |  |                                      | (137    | )          |  |           |  |               |  |          | (137    | )     |  |   |  |      |  |           |       |  |  |   | (137    | )
|Net income                          |  | $                                    | 16,491  |            |  | $         |  |               |  | $        | 16,491  |       |  | $ |  |      |  | $         | 2,668  |  |  | $ | 19,159  |  
|Net income per diluted share        |  | $                                    | 0.63    |            |  | $         |  |               |  | $        | 0.63    |       |  | $ |  |      |  | $         | 0.10   |  |  | $ | 0.73    |  
|Weighted average diluted shares     |  |                                      | 26,291  |            |  |           |  |               |  |          | 26,291  |       |  |   |  |      |  |           | 26,291 |  |  |   | 26,291  |  
|Total assets                        |  | $                                    | 298,087 |            |  | $         |  |               |  | $        | 298,087 |       |  | $ |  |      |  | $         | 16,590 |  |  | $ | 314,677 |  
|Depreciation and amortization       |  |                                      | 6,779   |            |  |           |  |               |  |          | 6,779   |       |  |   |  |      |  |           | 36     |  |  |   | 6,815   |  

|                                    |  |                                      |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  |           |        |  |  |   |         |  
|----------------------------------- |  | ------------------------------------ | ------- | ---------- |  | --------- | ------ | ------------- |  | -------- | ------- | ----- |  | - | ------ | ---- |  | --------- | ------ |  |  | - | ------- | -
|                                    |  | Nine Months Ended September 30, 2002
|                                    |  |                                      |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  | Resale of |        |  |  |  
|                                    |  |                                      |         |            |  |           |        |               |  |          |         |       |  |   |        |      |  | Local and |        |  |  |  
|                                    |  |                                      |         |            |  |           |        |               |  | Subtotal |         |       |  |   |        | Long |  |           |        | 
|(In thousands, except per share     |  | Principal                            |         | Litigation |  | Principal |        | Inter-Tel.NET |  | Distance |         |       |  |  
|amounts)                            |  | Segment                              |         | Settlement |  | Segment   |        | /Vianet       |  | Services |         | Total
|                                    |  |                                      |         |            |  |           |        |               |  |          |         |      
|Net sales                           |  | $                                    | 260,936 |            |  | $         |       |               |  | $        | 260,936 |       |  | $ |       |      |  | $         | 21,746 |  |  | $ | 282,682 |  
|Gross profit                        |  |                                      | 136,303 |            |  |           |       |               |  |          | 136,303 |       |  |   |       |      |  |           | 6,275  |  |  |   | 142,578 |  
|Operating income                    |  |                                      | 29,453  |            |  |           |       |               |  |          | 29,453  |       |  |   |       |      |  |           | 2,887  |  |  |   | 32,340  |  
|Interest and other income           |  |                                      | 1,254   |            |  |           | 15,516 |               |  |          | 16,770  |       |  |   | (1,200 | )    |  |           | 110    |  |  |   | 15,680  |  
|Foreign currency transaction gains  |  |                                      | 273     |            |  |           |       |               |  |          | 273     |       |  |   |       |      |  |           |       |  |  |   | 273     |  
|Interest expense                    |  |                                      | (114    | )          |  |           |       |               |  |          | (114    | )     |  |   |       |      |  |           |       |  |  |   | (114    | )
|Net income                          |  | $                                    | 19,365  |            |  | $         | 9,496  |               |  | $        | 28,861  |       |  | $ | (756   | )    |  | $         | 1,868  |  |  | $ | 29,973  |  
|Net income per diluted share (1)    |  | $                                    | 0.75    |            |  | $         | 0.37   |               |  | $        | 1.12    |       |  | $ | (0.03  | )    |  | $         | 0.07   |  |  | $ | 1.17    |  
|Weighted average diluted shares (1) |  |                                      | 25,715  |            |  |           | 25,715 |               |  |          | 25,715  |       |  |   | 24,331 |      |  |           | 25,715 |  |  |   | 25,715  |  
|Total assets                        |  | $                                    | 259,720 |            |  | $         |       |               |  | $        | 259,720 |       |  | $ |       |      |  | $         | 12,200 |  |  | $ | 271,920 |  
|Depreciation and amortization       |  |                                      | 6,362   |            |  |           |       |               |  |          | 6,362   |       |  |   |       |      |  |           | 65     |  |  |   | 6,427   |  

1) Options that are antidilutive because the exercise price was greater than
the average market price of the common shares are not included in the
computation of diluted earnings per share when a net loss is recorded.

Our revenues are generated predominantly in the United States. Total revenues
generated from U.S. customers totaled $265.6 million or 97.0% of total
revenues, and $275.3 million or 97.4% of total revenues for the nine months
ended September 30, 2003 and 2002, respectively. Total revenues generated from
U.S. customers totaled $91.8 million or 97.1% of total revenues, and $94.3
million or 97.5% of total revenues for the quarters ended September 30, 2003
and 2002, respectively. The Companys revenues from international sources were
primarily generated from customers located in the United Kingdom, Europe and
Asia. In the first nine months of 2003 and 2002, revenues from customers
located internationally accounted for 3.0% and 2.6% of total revenues,
respectively. In the quarters ended September 30, 2003 and 2002, revenues from
customers located internationally accounted for 2.9% and 2.5% of total
revenues, respectively.

NOTE E NET INVESTMENT IN SALES-LEASES

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Net investment in sales-leases represents the value of sales-leases presently
held under our Total Solution program. We currently sell the rental payments
due to us from some of the sales-leases. We maintain reserves against our
estimate of potential recourse for the balance of sales-leases and for the
balance of sold rental payments remaining unbilled. The following table
provides detail on the total net balances in sales-leases (in thousands):

|                                                                                                                                           |                                                                                                                                       |   |               |        |              |   |         |        | 
|------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------- | - | ------------- | ------ | ------------ | - | ------- | ------ | 
|                                                                                                                                           |                                                                                                                                       |   | September 30, |        | December 31,
|                                                                                                                                           |                                                                                                                                       |   | 2003          |        | 2002        
|                                                                                                                                           |                                                                                                                                       |   |               |        |             
|Lease balances included in consolidated accounts
receivable, net of allowances of $1,936 in 2003
and $2,562 in 2002                        |                                                                                                                                       | $ | 8,909         |        |              | $ | 6,470   |       
|Net investment in sales-leases:                                                                                                            |                                                                                                                                       |   |               |        |              |   |         |       
|                                                                                                                                           | Current portion, net of allowances of $757 in
2003 and $516 in 2002                                                                   |   |               | 16,318 |              |   |         | 13,344 | 
|                                                                                                                                           | Long-term portion, includes residual amounts
of $592 in 2003 and $518 in 2002, net of
allowances of $1,828 in 2003 and $1,411 in
2002 |   |               | 29,333 |              |   |         | 24,692 | 
|                                                                                                                                           |                                                                                                                                       |   |               |        |              |   |         |       
|Total investment in sales-leases, net of
allowances of $4,521 in 2003 and $4,489 in 2002                                                   |                                                                                                                                       |   | 54,560        |        |              |   | 44,506  |       
|Sold rental payments remaining unbilled (subject
to limited recourse provisions), net of
allowances of $12,095 in 2003 and $11,125 in 2002 |                                                                                                                                       |   | 194,052       |        |              |   | 194,684 |       
|                                                                                                                                           |                                                                                                                                       |   |               |        |              |   |         |       
|Total balance of sales-leases and sold rental
payments remaining unbilled, net of allowances                                               |                                                                                                                                       | $ | 248,612       |        |              | $ | 239,190 |       
|                                                                                                                                           |                                                                                                                                       |   |               |        |              |   |         |       
|Total allowances for entire lease portfolio
(including limited recourse liabilities)                                                       |                                                                                                                                       | $ | 16,616        |        |              | $ | 15,614  |       
|                                                                                                                                           |                                                                                                                                       |   |               |        |              |   |         |       

Reserve levels are established based on portfolio size, loss experience, levels
of past due accounts and periodic, detailed reviews of the portfolio. Recourse
on the sold rental payments is contractually limited to a percentage of the net
credit losses in a given annual period as compared to the beginning portfolio
balance for a specific portfolio of sold leases. While our recourse is limited,
we maintain reserves at a level that we believe is sufficient to cover all
anticipated credit losses. The aggregate reserve for uncollectible lease
payments and recourse liability represents the reserve for the entire lease
portfolio. These reserves are either netted from consolidated accounts
receivable, netted against current or long-term investment in sales-leases or
included in long-term liabilities for sold rental payments remaining unbilled.
Sales of rental payments per period:

|                                                  |  |                    |         |                   |  |   |         | 
|------------------------------------------------- |  | ------------------ | ------- | ----------------- |  | - | ------- | 
|                                                  |  | Nine Months Ended  |         | Year Ended       
|(In thousands)                                    |  | September 30, 2003 |         | December 31, 2002
|                                                  |  |                    |         |                  
|Sales of rental payments                          |  | $                  | 63,876  |                   |  | $ | 83,141  | 
|Sold payments remaining unbilled at end of period |  | $                  | 206,147 |                   |  | $ | 205,809 | 

Sales of rental payments represents the gross selling price or total present
value of the payment stream on the sale of the rental payments to third
parties. Sold payments remaining unbilled at the end of the period represents
the total balance of leases that are not included in our balance sheet. We do
not expect to incur any significant losses in excess of reserves from the
recourse provisions related to the sale of rental payments.




ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report to Shareholders on Form 10-Q (10-Q) contains
forward-looking statements that involve risks and uncertainties. The
statements contained in this 10-Q that are not purely historical are
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended, and Section 21E of the Securities Exchange Act of
1934, as amended, including without limitation

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statements regarding our
expectations, beliefs, intentions or strategies for the future. All
forward-looking statements included in this document are based on
information available to us on the date hereof, and we assume no obligation
to update any such forward-looking statements. The cautionary statements
made in this 10-Q should be read as being applicable to all related
forward-looking statements wherever they appear in this document. Our
actual results could differ materially from those anticipated in these
forward-looking statements as a result of certain factors, including those set
forth under Factors That May Affect Future Operating Results below and
elsewhere in this document.

Overview

Inter-Tel, incorporated in 1969, is a single point of contact, full service
provider of converged voice and data business communications systems,
networking applications, presence management, collaboration, and messaging
applications. We market and sell voice processing and unified messaging
software, presence management applications, audio and web conferencing
applications, call accounting software, Internet Protocol (IP) telephony
software, computer-telephone integration (CTI) applications, local and long
distance calling services through NetSolutions (our wholly-owned subsidiary),
and other communications services. Our products and services include the
Inter-Tel Axxess® and Inter-Tel Encore® business communication systems, with
integrated voice processing and unified messaging systems, and e-commerce
software. We also provide maintenance, leasing and support services for our
products. Our customers include business enterprises, government agencies and
non-profit organizations. Our common stock is quoted on the Nasdaq National
Market System under the symbol INTL.

We have developed a distribution network of direct sales offices, dealers and
value added resellers (VARs), which sell our products to organizations
throughout the United States and internationally, including to divisions of
Fortune 500 companies, large service organizations and governmental agencies.
As of September 30, 2003, we had 51 direct sales offices in the United States
and one in Japan, and a network of hundreds of dealers and VARs around the
world that purchase directly from us. We also maintain a wholesale
distribution office in the United Kingdom that supplies Inter-Tels dealers and
distributors
throughout the United Kingdom and parts of Europe. In December 2002, we
acquired Swan Solutions Limited, a research and development and software sales
office in the United Kingdom.

Sales of systems through our dealers and VARs typically generate lower gross
margins than sales through our direct sales organization, although direct sales
typically require higher levels of selling, general and administrative
expenses. In addition, our long distance services and Datanet products
typically generate lower gross margins than sales of software and system
products. Accordingly, our margins may vary from period to period depending
upon distribution channel and product mix. In the event that sales through
dealers or sales of long distance services increase as a percentage of net
sales, our overall gross margin could decline.

Our operating results depend upon a variety of factors, including the volume
and timing of orders received during a period, the mix of products sold and the
mix of distribution channels, general economic conditions, patterns of capital
spending by customers, the timing of new product announcements and releases by
us and our competitors, pricing pressures, the cost and effect of acquisitions
and the availability and cost of products and components from our suppliers.
Historically, a substantial portion of our net sales in a given quarter has
been recorded in the third month of the quarter, with a concentration of such
net sales in the last two weeks of the quarter. In addition, we are subject to
seasonal variations in our operating results, as net sales for the first and
third quarters are frequently less than those experienced during the fourth and
second quarters, respectively.

The markets we serve have been characterized by rapid technological changes and
increasing customer requirements. We have sought to address these changes and
requirements through the development of software enhancements and
improvements to existing systems and the introduction of new systems,
products and applications. Inter-Tels research and development efforts over
the last several years have been focused primarily on the development of and
enhancements to our Axxessand Eclipse 2systems, including adding new
applications, incorporating IP convergence applications and IP telephones into
our product lines, developing Unified Messaging Software applications,
developing speech recognition and text-to-speech applications, developing and
enhancing call center applications, developing Unified Communications Software
applications, and expanding the telecommunications networking package to

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include networking over IP and frame relay networks. We are currently focused
on developing and enhancing the convergence applications for our Axxesssystem,
enhancing our server-PBX offering, enhancing our unified communications
applications, developing new IP endpoint technology and enhancing our call
center applications.

We offer to our customers a package of lease financing and other services under
the name Total Solution (formerly, Totalease). Total Solution provides our
customers lease financing, maintenance and support services, fixed price
upgrades and other benefits. We finance this program through the periodic
resale of lease rental streams to financial institutions. Refer to Note E of
Notes to Consolidated Financial Statements for additional information regarding
our program.

Results of Operations

The following table sets forth certain statement of operations data
expressed as a percentage of net sales for the periods indicated:

|                                                      |  |                    |       |                   |  |      |       |      |  |  |       |   |  |  |       |  
|----------------------------------------------------- |  | ------------------ | ----- | ----------------- |  | ---- | ----- | ---- |  |  | ----- | - |  |  | ----- | -
|                                                      |  | Three Months Ended |       | Nine Months Ended
|                                                      |  | September 30,      |       | September 30,    
|                                                      |  | 2003               |       | 2002              |  | 2003 |       | 2002
|                                                      |  |                    |       |                   |  |      |       |     
|NET SALES                                             |  |                    | 100.0 | %                 |  |      | 100.0 | %    |  |  | 100.0 | % |  |  | 100.0 | %
|Cost of sales                                         |  |                    | 47.9  |                   |  |      | 49.3  |      |  |  | 47.6  |   |  |  | 49.6  |  
|                                                      |  |                    |       |                   |  |      |       |      |  |  |       |   |  |  |       |  
|GROSS PROFIT                                          |  |                    | 52.1  |                   |  |      | 50.7  |      |  |  | 52.4  |   |  |  | 50.4  |  
|Research and development                              |  |                    | 6.0   |                   |  |      | 5.0   |      |  |  | 6.0   |   |  |  | 4.9   |  
|Selling, general and administrative                   |  |                    | 33.6  |                   |  |      | 33.3  |      |  |  | 35.1  |   |  |  | 33.9  |  
|Amortization of purchased intangible assets           |  |                    | 0.5   |                   |  |      | 0.3   |      |  |  | 0.5   |   |  |  | 0.3   |  
|                                                      |  |                    |       |                   |  |      |       |      |  |  |       |   |  |  |       |  
|OPERATING INCOME                                      |  |                    | 12.0  |                   |  |      | 12.1  |      |  |  | 10.9  |   |  |  | 11.4  |  
|Litigation settlement (net of costs except
for taxes) |  |                    |      |                   |  |      |      |      |  |  |      |   |  |  | 5.5   |  
|Interest and other income                             |  |                    | 0.4   |                   |  |      | 0.4   |      |  |  | 0.4   |   |  |  | 0.5   |  
|Write-down of investment in Inter-Tel.NET
/ Vianet    |  |                    |      |                   |  |      |      |      |  |  |      |   |  |  | (0.4  | )
|Foreign currency transaction gains (losses)           |  |                    | 0.0   |                   |  |      | 0.1   |      |  |  | (0.0  | ) |  |  | 0.1   |  
|Interest expense                                      |  |                    | (0.0  | )                 |  |      | (0.0  | )    |  |  | (0.1  | ) |  |  | (0.0  | )
|                                                      |  |                    |       |                   |  |      |       |      |  |  |       |   |  |  |       |  
|Income before income taxes                            |  |                    | 12.3  |                   |  |      | 12.6  |      |  |  | 11.3  |   |  |  | 17.0  |  
|Income taxes                                          |  |                    | 4.7   |                   |  |      | 4.8   |      |  |  | 4.3   |   |  |  | 6.4   |  
|                                                      |  |                    |       |                   |  |      |       |      |  |  |       |   |  |  |       |  
|Net income                                            |  |                    | 7.6   | %                 |  |      | 7.8   | %    |  |  | 7.0   | % |  |  | 10.6  | %
|                                                      |  |                    |       |                   |  |      |       |      |  |  |       |   |  |  |       |  

Net Sales.Net sales decreased 2.2% to $94.5 million in the third quarter
of 2003 from $96.7 million in the third quarter of 2002, representing a
decrease of $2.1 million. Sales from our direct sales offices decreased $3.8
million in the third quarter of 2003 compared to the third quarter of 2002.
Sales from our DataNet, leasing and network services divisions decreased $2.2
million in the aggregate in the third quarter of 2003 compared to the third
quarter of 2002. Sales from these divisions are closely linked to the sales of
telephony products and services. These decreases were offset in part by
increases of $2.1 million in sales from our long distance resale division,
$873,000 in sales to our dealer network, and $529,000 in sales from our
government and national accounts division, and $333,000 in sales from
international sources in the third quarter of 2003, each as compared to the
third quarter of 2002.

The decrease in overall net sales for the third quarter of 2003 compared
to the third quarter of 2002 was primarily attributable to lower volumes of
systems sold as a result of economic conditions and increased competitive
pressures. In some instances, to generate sales we decreased the prices of
some telecommunications systems, products or applications, and we offered
discounts and other competitive promotions which resulted in lower revenues
from both our direct and indirect sales channels. Sales of communications
systems were also adversely impacted by delayed buying decisions, particularly
in our direct sales offices, resulting from relatively weak economic conditions
affecting our industry. Sales to new customers declined during the third
quarter of 2003, as recurring revenues to existing customers increased as a
percentage of total sales.

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Sales from NetSolutions, our long distance resale division, represented
our largest percentage sales increases in the third quarter of 2003 as compared
to the third quarter of 2002. Sales from NetSolutions increased in the third
quarter of 2003 by 26.9% compared to the third quarter of 2002, despite
downward pricing pressure and significant competition. Increased sales volume
allowed NetSolutions to offer more competitive pricing, which improved sales to
our existing customer base. Revenues from our network services agency division
decreased 36.3% in the third quarter of 2003 compared to the third quarter of
2002, on lower sales volume and commissions on local and network services such
as T-1 access, frame relay and other voice and data circuit services, due
primarily to changes to terms and contract provisions in our agency agreement
with a regional bell operating company. See Note D of Notes to Condensed
Consolidated Financial Statements for additional segment reporting information.

Gross Profit. Gross profit for the third quarter of 2003 increased 0.4%
to $49.2 million, or 52.1% of net sales, from $49.1 million, or 50.7% of net
sales, in the third quarter of 2002. Gross profit increased 0.7% to $143.6
million, or 52.4% of net sales, in the first nine months of 2003 compared to
$142.6 million, or 50.4% of net sales, in the first nine months of 2002. The
increases in gross profit dollars and as a percentage of net sales (or gross
margin), resulted from several different factors, including a higher proportion
of recurring revenues from existing customers (including increased maintenance
and services revenues as a percentage of total sales), higher software content
in our products, continued cost containment efforts, product design
improvements, component price reductions, efficiencies achieved in our
installations in our direct sales offices, and efficiencies achieved with our
manufacturing vendors, as well as efficiencies achieved from a higher
percentage of orders placed through our website. These increases were offset
in part by greater competitive pricing pressures and by pricing discounts or
special promotions on telephone system and software sales and related
equipment.

During the third quarter of 2003, recurring revenues from existing
customers in our direct sales and national and government accounts channels
increased as a percentage of total sales from these same channels in the third
quarter of 2002. Existing customers accounted for a significant portion of our
net sales from maintenance and other services, software additions and/or
upgrades, support and hardware products during the third quarter of 2003. Our
business communications platforms allow for system migration without the
complete change-out of hardware, which enable us to offer enhancements and new
solutions through software-only upgrades to our existing customers, which
generally result in higher gross margins. In addition, our gross margins are
generally higher with recurring revenues because we incur less materials costs
relative to new installations. Accordingly, our gross margins improved in the
third quarter of 2003 as a result of increased recurring revenues from existing
customers.

Sales from NetSolutions, our long distance resale subsidiary, increased by
26.9%, or $2.1 million, in the third quarter of 2003 as compared to the third
quarter of 2002. Gross margins are generally lower in this division as
compared to our consolidated margins. However, NetSolutions margins improved
in the third quarter of 2003 relative to the third quarter of 2002, based in
part on our ability to negotiate more favorable pricing with vendors on higher
resale volumes. Sales from our network services division decreased 36.3% in
the third quarter of 2003 compared to the third quarter of 2002. This division
generally receives commissions on network services we sell as an agent for
regional bell operating companies. Sales from this division carry little to no
equipment costs and generated margins of 88.2% during the third quarter of
2003; therefore, the decrease in sales from this division partially offset the
overall improvement of our consolidated gross margins. We cannot accurately
predict future gross margins based on a number of factors, including
competitive pricing pressures, sales of systems, software and services through
different distribution channels, and the mix of systems, software and services
we sell, as well as macroeconomic conditions.

Research and Development. Research and development expenses for the third
quarter of 2003 increased 17.4% to $5.7 million, or 6.0% of net sales, from
$4.9 million, or 5.0% of net sales, for the third quarter of 2002. Research and
development expenses increased 19.3% to $16.4 million, or 6.0% of net sales, in
the first nine months of 2003 compared to $13.7 million, or 4.9% of net sales,
in the first nine months of 2002. Included in research and development
expenses in both the third quarter of 2003 and the third quarter of 2002 was
amortization of patents totaling $55,000 in each period. The increase in
research and development expenses was primarily attributable to our development
of new convergence, presence, and collaboration applications, our development of new IP and digital
endpoint technology, and the increase in engineering personnel following our
acquisition of Swan in December 2002. In the third quarter

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of 2003, research
and development expenses were directed principally toward the continued
development of the AXXESSsoftware and systems (including version 8.1), unified
messaging and voice processing software, speech recognition and text-to-speech
applications, call center applications, unified communications applications,
presence management and collaboration applications, IP endpoint development,
and CTI and IVR applications. We expect that research and development expenses
will increase in absolute dollars as we continue to develop and enhance
existing and new technologies and products. These expenses may vary, however,
as a percentage of net sales.

Selling, general and administrative. In the third quarter of 2003,
selling, general and administrative expenses, including amortization (see
amortization of goodwill and purchased intangible assets below), decreased
0.8% to $32.2 million, or 34.1% of net sales, from $32.5 million, or 33.6% of
net sales, in the third quarter of 2002. In the third quarter of 2003,
selling, general and administrative expenses, excluding amortization, decreased
1.3% to $31.8 million, or 33.6% of net sales, from $32.2 million, or 33.3% of
net sales, in the third quarter of 2002. Selling, general and administrative
expenses decreased slightly in absolute dollars, but increased as a percentage
of net sales. The decrease in absolute dollars in selling, general and
administrative expenses during the third quarter of 2003 was due primarily to
the lower volume of total net sales. The slight increase as a percentage of
net sales was due in part to higher costs associated with selling expenses
relative to 2002, higher insurance costs and professional fees, partially
offset by lower expenses attributable to bad debts. In addition, higher
relative sales through the Swan acquisition and sales in our long distance
division led to higher selling expenses and commission costs in the first nine
months of 2003 relative to total sales in the first nine months of 2002. We
expect that for the foreseeable future selling, general and administrative
expenses may vary in absolute dollars and as a percentage of net sales.

Amortization of goodwill and purchased intangible assets. We adopted
Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets (SFAS 142) effective in the beginning of our fiscal year
ended December 31, 2002. In accordance with SFAS 142, we ceased amortizing
goodwill. We are required to perform goodwill impairment tests on an annual
basis and between annual tests in certain circumstances. As of September 30,
2003, no impairment of goodwill has been recognized. We face the risk that
future goodwill impairment tests may result in charges to earnings.

Amortization of purchased intangible assets included in operating expenses
was $445,000 in the third quarter of 2003, compared to $269,000 in the third
quarter of 2002. In addition, $55,000 of amortization was included in research
and development expenses for the third quarter of 2003 and the third quarter of
2002. Amortization of purchased intangible assets included in operating
expenses was $1.4 million for the nine months ended September 30, 2003,
compared to $796,000 for the nine months ended September 30, 2002. An
additional $166,000 of amortization was included in research and development
expenses for the nine months ended September 30, 2003 and September 30, 2002.
The increase in the amortization of purchased intangible assets for the third
quarter and nine months ended September 30, 2003 compared to the same periods
in 2002 was primarily related to the additional amortization from recent
acquisitions. For additional information regarding purchased intangible assets,
see Note C Acquisitions, Dispositions and Restructuring Charges  to the
Condensed Consolidated Financial Statements.

Litigation Settlement, Net of Costs Except Taxes. In May 2001, Inter-Tel
entered into an agreement to submit to binding arbitration a lawsuit we filed
in 1996. The arbitration was completed in January 2002 and, as a result of the
arbitration, Inter-Tel received a one-time gross cash award of $20 million in
February 2002. Direct costs for attorneys fees, expert witness costs,
arbitration costs and estimated additional payments and expenses, totaled
approximately $4.5 million in the first nine months of 2002, excluding income
taxes, for a net award of approximately $15.5 million. The estimated net
proceeds from this arbitration settlement were approximately $9.5 million after
taxes, or $0.37 per diluted share for the nine months ended September 30, 2002.

Interest and Other Income. Interest and other income in 2003 and 2002
consisted primarily of interest income and foreign currency transaction gains
or losses, with the exception of an expense of $1.2 million related to the
write-down of Inter-Tels investment in Inter-Tel.NET/Vianet in the first nine
months of 2002. Income from interest and short-term investments in the first
nine months of 2003 was down slightly compared to 2002 despite higher level of invested funds, due to lower
yields on investments. Other changes in other income primarily reflected
slightly lower net foreign currency transaction gains and losses

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of
approximately $282,000 in the first nine months of 2003 compared to the first
nine months of 2002. Interest expense in the first nine months of 2003
increased $23,000 compared to the first nine months of 2002.

Income Taxes. Inter-Tels income tax rate was 38.0% for both the third
quarter of 2003 and the third quarter of 2002. Inter-Tel currently expects
the full-year 2003 tax rate to be comparable to the tax rate effective for the
third quarter of 2003.

Net Income. Net income for the third quarter of 2003 was $7.2 million
($0.27 per diluted share), compared to net income of $7.5 million ($.29 per
diluted share) in the third quarter of 2002. Net income for the nine months
ended September 30, 2003 was $19.2 million ($0.73 per diluted share), compared
to net income of $30.0 million ($1.17 per diluted share) for the nine months
ended September 30, 2002, including the 2002 litigation settlement. Excluding
the 2002 litigation settlement, we reported net income of $20.5 million ($0.80
per diluted share) in the first nine months of 2002.

Net income decreased 4.3% for the quarter ended September 30, 2003
compared to same period in 2002, primarily attributable to lower sales and
higher research and development costs. The decrease in net income for the nine
months ended September 30, 2003 as compared to the same period in 2002 was
primarily attributable to the litigation settlement award received in 2002,
lower net sales and higher research and development costs.

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Inflation/Currency Fluctuation

Inflation and currency fluctuations have not previously had a material
impact on Inter-Tels operations. International procurement agreements have
traditionally been denominated in U.S. currency. The potential expansion of
international operations in the United Kingdom and Europe and increased sales,
if any, in Japan and other parts of Asia could result in higher international
sales as a percentage of total revenues; however, international revenues do not
currently represent a significant portion of our total revenues.

Liquidity and Capital Resources

At September 30, 2003, cash and equivalents and short-term investments
totaled $142.5 million, an increase of approximately $16.6 million from
December 31, 2002. We maintain a $10 million unsecured, revolving line of
credit with Bank One, NA that is available through June 1, 2004. Under the
credit facility, we have the option to borrow at a prime rate or adjusted LIBOR
interest rate. During 2003, we used part of the credit facility primarily for
a standby letter of credit relating to a facility lease, and at September 30,
2003, $9.5 million was available on this line. Our cash balances may be used
for acquisitions, strategic alliances, working capital, dividends and other
general corporate purposes.

Net cash provided by operating activities totaled $19.4 million for the
nine months ended September 30, 2003, compared to $56.1 million for the same
period in 2002. Cash provided by operating activities in the first nine months
of 2003 was primarily the result of cash generated from profitable operations,
including non-cash depreciation, provisions for losses and amortization
charges. Cash provided by operating activities in the first nine months of
2002 was primarily the result of cash generated from operations, as well as the
receipt of a gross cash award of $20 million (net award of $15.5 million before
income taxes) in settlement of a dispute submitted to binding arbitration.
Cash used for changes in operating assets and liabilities in the first nine
months of 2003 was $25.7 million primarily from higher income taxes receivable,
accounts receivable and increased investment in sales-leases, as well as
reduced accrued expenses, compared to cash provided by operating assets and
liabilities of $11.2 million for the same period in 2002. In the future, we
may need to expend additional working capital for increased accounts receivable
and inventories to expand sales through our direct sales offices, dealer
network and government and national accounts divisions.

Net cash used in investing activities totaled $32.1 million for the nine
months ended September 30, 2003 compared to $28.9 million for the nine months
ended September 30, 2002. In 2003, we have invested higher levels of cash in
short-term investments; accordingly, net cash used in the purchase of
investments during the nine months ended September 30, 2003 and September 30,
2002 was $141.9 million and $18.1 million, respectively, offset in part during
each period by maturities and sales of short-term investments of $113.7 million
and $2.0 million, respectively. During the first nine months of 2003, we
expended $267,000 for acquisitions compared to the first nine months of 2002,
when net cash used in acquisitions totaled approximately $7.9 million. In the
first quarter of 2003, Inter-Tel also received payment from the Vianet
shareholders of $1.45 million, as payment of a loan in connection with the sale
of 83% of our interest in Inter-Tel.NET, and in exchange for the full release
of our guarantee of vendor obligations. During the first nine months of 2003,
approximately $5.2 million was used to acquire additional property and
equipment, compared to $5.1 million for the same period in 2002. We anticipate
incurring additional capital expenditures during the remainder of 2003,
principally relating to expenditures for equipment and management information
systems used in our operations.

Net cash provided by financing activities totaled approximately $1.2
million in the nine months ended September 30, 2003, compared to cash provided
by financing activities of $3.1 million for the same period in 2002. Net cash
provided by the exercise of stock options and from stock issued under the
companys employee stock purchase plan totaled $3.7 million and $5.0 million
during the first nine months of 2003 and 2002, respectively, which was
partially offset in each period by net cash used for dividends totaling
approximately $2.2 million and $1.5 million, respectively. During the first
nine months of 2003 and 2002, we reissued treasury shares through stock option
exercises and issuances. In the nine-month period ending September 30, 2003,
the proceeds received from these reissued treasury shares totaled more than the
cost basis of the treasury stock reissued. Accordingly, the difference was
recorded as an increase to retained earnings. In the nine-month period ending
September 30, 2002, the proceeds received from these

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reissued treasury shares totaled less than the cost basis of the treasury
stock reissued. Accordingly, the difference was recorded as a reduction to
retained earnings.

We offer to our customers lease financing and other services, including
our Total Solution (formerly Totalease) program, through our Inter-Tel Leasing,
Inc. subsidiary. We fund our Total Solution program in part through the sale
to financial institutions of rental payment streams under the leases. Sold
lease rentals unbilled at September 30, 2003 and December 31, 2002 totaled
$206.1 million and $205.8 million, respectively. We are obligated to
repurchase such income streams in the event of defaults by lease customers and,
accordingly, maintain reserves based on loss experience and past due accounts.
Although, to date, we have been able to resell the rental streams from leases
under the Total Solution program profitably and on a substantially current
basis, the timing and profitability of lease resales could impact our business
and operating results, particularly in an environment of fluctuating interest
rates and economic uncertainty. If we are required to repurchase rental
streams and realize losses thereon in amounts exceeding our reserves, our
operating results will be adversely affected.

We believe that our working capital and credit facilities, together with
cash generated from operations, will be sufficient to develop and expand our
business operations, to finance acquisitions of additional resellers of
telephony products and other strategic acquisitions or corporate alliances, and
to provide adequate working capital for at least the next eighteen months.
However, to the extent that additional funds are required in the future to
address working capital needs and to provide funding for capital expenditures,
expansion of the business or additional acquisitions, we will seek additional
financing. There can be no assurance that additional financing will be
available when required or on acceptable terms.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The methods, estimates and judgments we use in applying our most critical
accounting policies have a significant impact on the results we report in our
consolidated financial statements. We evaluate our estimates and judgments on
an on-going basis. We base our estimates on historical experience and on
assumptions that we believe to be reasonable under the circumstances. Our
experience and assumptions form the basis for our judgments about the carrying
value of assets and liabilities that are not readily apparent from other
sources. Actual results may vary from what we anticipate and different
assumptions or estimates about the future could change our reported results. We
believe the following accounting policies are the most critical to us, in that
they are important to the portrayal of our financial statements and they
require our most difficult, subjective or complex judgments in the preparation
of our consolidated financial statements:

Revenue Recognition. We recognize revenue pursuant to Staff Accounting
Bulletin No. 101 Revenue Recognition in Financial Statements. Accordingly,
revenue is recognized when all four of the following criteria are met: (i)
persuasive evidence that an arrangement exists; (ii) delivery of the products
and/or services has occurred; (iii) the selling price is both fixed and
determinable and; (iv) collectibility is reasonably probable. Revenue derived
from sales of systems and services to end-user customers is recognized upon
installation of the systems and performance of the services, respectively,
allowing for use by our customers of these systems. Pre-payments for
communications services are deferred and recognized as revenue as the
communications services are provided.

For shipments to dealers and other distributors, our revenues are recorded
as products are shipped and services are rendered, because the sales process is
complete. These shipments are primarily to third-party dealers and
distributors, and title passes when goods are shipped (free-on-board shipping
point). Long distance services revenues are recognized as service is provided.

Sales-Leases. For our sales-type lease accounting, we follow the guidance
provided by FASB Statement No. 13, Accounting for Leases and FASB Statement No.
140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities  A Replacement of FASB Statement No. 125. We
record the discounted present values of minimum rental payments under
sales-type leases as sales, net of provisions for continuing administration and
other expenses over the lease period. We record the lease sales at the time of
system sale and installation pursuant to Staff Accounting Bulletin No. 101, as

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discussed above for sales to end user customers, and upon receipt of the
executed lease documents. The costs of systems installed under these
sales-leases, net of residual values at the end of the lease periods, are
recorded as costs of sales. The net rental streams are sold to funding sources
on a regular basis with the income streams discounted by prevailing like-term
rates at the time of sale. Gains or losses resulting from the sale of net
rental payments from such leases are recorded as net sales. We establish and
maintain reserves against potential recourse following the resales based upon
historical loss experience, past due accounts and specific account analysis.
The allowance for uncollectible minimum lease payments and recourse liability
at the end of the year represent reserves against the entire lease portfolio.
Management reviews the adequacy of the allowance on a regular basis and adjusts
the allowance as required. These reserves are either netted in the accounts
receivable, current and long-term components of Net investments in
Sales-Leases on the balance sheet, or included in long-term liabilities on our
balance sheet for off-balance sheet leases.

Goodwill and Other Intangible Assets. We assess the impairment of
goodwill and other identifiable intangibles whenever events or changes in
circumstances indicate that the carrying value may not be recoverable. Some
factors we consider important which could trigger an impairment review include
the following:



| |  |  | Significant under-performance relative to historical, expected or
projected future operating results;        
| | - |  | -------------------------------------------------------------------------------------------------------------
|
| |  |  | Significant changes in the manner of our use of the acquired assets or
the strategy for our overall business;
|
| |  |  | Our market capitalization relative to net book value, and                                                    
|
| |  |  | Significant negative industry or economic trends.                                                            

When we determine that the carrying value of goodwill and other identified
intangibles may not be recoverable, we measure any impairment based on a
projected discounted cash flow method using a discount rate determined by our
management to be commensurate with the risk inherent in our current business
model. In accordance with SFAS No. 142, Goodwill and Other Intangible
Assets, on January 1, 2002, we ceased amortizing goodwill. Inter-Tel has
tested goodwill for impairment using the two-step process prescribed in SFAS
142. The first step is a screen for potential impairment, while the second step
measures the amount of the impairment, if any. Inter-Tel performed the first
of the required impairment tests for goodwill as of October 1, 2002 and
determined that the carrying amount of goodwill was not impaired. Inter-Tel
will perform the tests on an annual basis.

Allowance for Doubtful Accounts. We maintain allowances for doubtful
accounts for estimated losses resulting from the inability of our customers to
make required payments. Additional reserves or allowances for doubtful
accounts are recorded for our sales-type leases, discussed above in
Sales-Leases. We establish and maintain reserves against estimated losses
based upon historical loss experience, past due accounts and specific account
analysis. Management reviews the level of the allowances for doubtful
accounts on a regular basis and adjusts the level of the allowances as needed.
At September 30, 2003, our allowance for doubtful accounts for accounts
receivable was $11.2 million of our $54.9 million in gross accounts receivable.
If the financial condition of our customers or channel partners were to
deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required.

Inventories. We value our inventories at the lower of cost (principally
on a standard cost basis, which approximates the first-in, first-out (FIFO)
method) or market. Significant management judgment is required to determine
the reserve for obsolete or excess inventory. Inventory on hand may exceed
future demand either because the product is outdated or obsolete, or because
the amount on hand is more than can be used to meet estimated future needs. We
consider criteria such as customer demand, product life-cycles, changing
technologies, slow moving inventory and market conditions. We write down our
excess and obsolete inventory equal to the difference between the cost of
inventory and the estimated market value. At September 30, 2003, our inventory
reserves were $7.0 million of our $19.5 million gross inventories. In the nine
months ended September 30, 2003, our inventory reserve levels decreased
compared to the reserve levels as of December 31, 2002 primarily as a result of
scrapping inventory which had been previously fully reserved. Most of the
scrapped inventory was either purchased in the Executone, McLeod or Convergent
acquisitions, or consisted of other inventory identified as slow moving or
obsolete, generally from older or refurbished legacy systems. If actual
customer demand, product life cycles, changing

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technologies and market conditions are less favorable than those projected
by management, additional inventory write-downs may be required.

Contingencies. We are a party to various claims and litigation in the
normal course of business. Managements current estimated range of liability
related to various claims and pending litigation is based on claims for which
our management can estimate the amount and range of loss, or can estimate a
minimum amount of a loss. Because of the uncertainties related to both the
amount and range of loss on the remaining pending claims and litigation,
management is unable to make a reasonable estimate of the liability that could
result from an unfavorable outcome. As additional information becomes
available, we will assess the potential liability related to our claims and
pending litigation, revise our estimates and accrue for any losses to the
extent that they are probable and the amount is estimable. Such revisions in
our estimates of the potential liability could materially impact our results of
operations and financial position. However, at September 30, 2003 management
does not believe that the ultimate impact of various claims and pending
litigation will have a materially adverse impact on the Company.

Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has not provided Inter-Tel with a description of the evidence on
which the investigations are based. Inter-Tel is presently unable to predict
or determine the final outcome of, or to estimate the potential range of loss
with respect to, the investigations. Based upon the information known at this
time, we do not know what, if any, impact the investigations may have on the
Companys business or financial condition. If Inter-Tel is convicted of any
crime or subjected to sanctions, or debarred from certain government contracts
or if penalties, damages or other monetary remedies are assessed against
Inter-Tel in connection with or related to these and other investigations, our
business and operating results could be materially and adversely affected. The
existence and disclosure of the investigations may have already caused
competitive harm to Inter-Tel, and any unfavorable resolution to these matters
may further harm Inter-Tels business. Nevertheless, the early nature of the
investigations makes it difficult to determine whether a material adverse
outcome is likely.

Factors That May Affect Future Operating Results

This Report on Form 10-Q contains forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended and Section
21E of the Securities Exchange Act of 1934, as amended. Actual results could
differ materially from those projected in the forward-looking statements as a
result of many risk factors including, without limitation, those set forth
under Factors That May Affect Future Results Of Operations below. In
evaluating Inter-Tels business, shareholders and prospective investors should
consider carefully the following factors in addition to the other
information set forth in this document.

Risks Related to Our Business

Our operating results have historically depended on a number of factors, and
these factors may cause our operating results to fluctuate in the future.

Our quarterly operating results have historically depended on, and may
fluctuate in the future as a result of, many factors including:



| |  |  | volume and timing of orders received during the quarter;                            
| | - |  | ------------------------------------------------------------------------------------
|
| |  |  | gross margin fluctuations associated with the mix of products sold;                 
|
| |  |  | the mix of distribution channels;                                                   
|
| |  |  | general economic conditions and the condition of the markets our business addresses;
|
| |  |  | patterns of capital spending by customers;                                          
|
| |  |  | the timing of new product announcements and releases by us and our competitors;     
|
| |  |  | pricing pressures;                                                                  
|
| |  |  | the cost and effect of acquisitions;                                                
|
| |  |  | the availability and cost of products and components from our suppliers; and        
|
| |  |  | national and regional weather patterns.                                             

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In addition, we have historically operated with a relatively small
backlog, with sales and operating results in any quarter depending principally
on orders booked and shipped in that quarter. In the past, we have recorded a
substantial portion of our net sales for a given quarter in the third month of
that quarter, with a concentration of such net sales in the last two weeks of
the quarter. Market demand for investment in capital equipment such as
business communications systems and associated call processing and voice
processing software applications depends largely on general economic
conditions, and can vary significantly as a result of changing conditions in
the economy as a whole. We cannot assure you that we can continue to be
successful operating with a small backlog or whether historical backlog trends
will continue in the future.

Our expense levels are based in part on expectations of future sales and,
if sales levels do not meet expectations, our operating results could be
harmed. In addition, because sales of business communications systems through
our dealers typically produce lower gross margins than sales through our direct
sales organization, operating results have varied, and will continue to vary
based upon the mix of sales through direct and indirect channels. In addition,
in the past we have derived a significant part of our revenue from recurring
revenue streams, which typically produce higher gross margins. If we do not
maintain recurring revenue streams at current or historic levels, our operating
results will suffer if we do not significantly increase sales to new customers.
For example, in the most recent quarter ended September 30, 2003, sales to new
customers through our direct sales offices, Datanet division, network services
and leasing divisions declined as a percentage of total sales, resulting in
decreased net sales and operating income compared to the quarter ended
September 30, 2002. Moreover, particularly in an environment of fluctuating
interest rates, the timing and profitability of lease resales from quarter to
quarter could impact operating results. Long distance and Datanet sales, which
typically have lower gross margins than our core business, have grown in recent
periods at a faster rate than our overall net sales. Consolidated gross
margins could be harmed if long distance calling services continue to increase
as a percentage of net sales. We also experience seasonal fluctuations in our
operating results, as net sales for the first quarter is frequently less than
the fourth quarter and the third quarter is frequently less than the second
quarter. As a result of these and other factors, we have historically
experienced, and could continue to experience in the future, fluctuations in
sales and operating results on a quarterly basis.

Our market is subject to rapid technological change and to compete
successfully, we must continually introduce new and enhanced products and
services that achieve broad market acceptance.

The market for our products and services is characterized by rapid
technological change, evolving industry standards and vigorous customer demand
for new products, applications and services. To compete successfully, we must
continually enhance our existing telecommunications products, related software
and customer services, and develop new technologies and applications in a
timely and cost-effective manner. If we fail to introduce new products and
services that achieve broad market acceptance, or if we do not adapt our
existing products and services to customer demands or evolving industry
standards, our business could be significantly harmed. Problems and delays
associated with new product development have in the past contributed to lost
sales. In addition, current competitors or new market entrants may offer
products, applications or services that are better adapted to changing
technology or customer demands and that could render our products and services
unmarketable or obsolete.

In addition, if the markets for computer-telephony applications, Internet
Protocol network products, or related products fail to develop or continue to
develop more slowly than we anticipate, or if we are unable for any reason to
capitalize on any of these emerging market opportunities, our business,
financial condition and operating results could be significantly harmed.

Our future success largely depends on increased commercial acceptance of our
Axxesssystem, Encore product, speech recognition, Interactive Voice Response,
presence management, collaboration, and messaging products, and related
computer-telephony products.

Over the past 18 months, we introduced Unified Communicator, a web-based,
speech-recognition, wireless PDA, and Wireless Application Protocol (WAP)
software application for controlling and managing your calls, contacts and
presence status; Inter-Tel Application Platform, a highly flexible
speech-recognition, text-to-speech and CTI application generation platform;
enhanced convergence features on the Axxesssystem, including support of
standard Session Initiation Protocol (SIP) endpoints and trunk gateways; and
several other telephony-related products. During the past 12 months, sales of
our Axxessbusiness communications systems and related software have comprised
a substantial portion of our net

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sales. Our future success depends, in large part, upon increased
commercial acceptance and adoption of the Application Platform, the Unified
Communicator and related computer-telephony products, the Axxesssystem, Encore
products, SIP standards-based applications and devices, new speech recognition
and Interactive Voice Response products, as well as future upgrades and
enhancements to these products and networking platforms. We cannot assure you
that these products or platforms will achieve commercial acceptance in the
future.

Our products are complex and may contain errors or defects that are detected
only after their release, which may cause us to incur significant unexpected
expenses and lost sales.

Our telecommunications products and software are highly complex. Although
our new products and upgrades are examined and tested prior to release, they
can only be fully tested when used by a large customer base. Consequently, our
customers have in the past and may in the future discover program errors, or
bugs, or other defects after new products and upgrades have been released.
Some of these bugs may result from defects contained in component parts or
software from our suppliers or other third parties that are intended to be
compatible with our products and over which we have little or no control.
Although we have test procedures and quality control standards in place
designed to minimize the number of errors and defects in our products, we
cannot assure you that our new products and upgrades will be free of bugs when
released. If we are unable to quickly or successfully correct bugs identified
after release, we could experience the following, any of which would harm our
business:



| |  |  | costs associated with the remediation of any problems;       
| | - |  | -------------------------------------------------------------
|
| |  |  | costs associated with design modifications;                  
|
| |  |  | loss of or delay in revenues;                                
|
| |  |  | loss of customers;                                           
|
| |  |  | failure to achieve market acceptance or loss of market share;
|
| |  |  | increased service and warranty costs;                        
|
| |  |  | liabilities to our customers; and                            
|
| |  |  | increased insurance costs.                                   

The complexity of our products could cause delays in the development and
release of new products and services. As a result, customer demand for our
products could decline, which could harm our business.

Due to the complexity of our products and software, we have in the past
experienced and expect in the future to experience delays in the development
and release of new products or product enhancements. If we fail to introduce
new software, products or services in a timely manner, or fail to release
upgrades to our existing systems or products and software on a regular and
timely basis, customer demand for our products and software could decline,
which would harm our business.

Business acquisitions, new business ventures, dispositions or joint ventures
entail numerous risks and may disrupt our business, dilute shareholder value
and distract management attention.

As part of our business strategy, we consider acquisitions of, or
significant investments in, businesses that offer products, services and
technologies complementary to ours. Such acquisitions could materially
adversely affect our operating results and/or the price of our common stock.
Acquisitions also entail numerous risks, some of which we have experienced and
may continue to experience, including:



| |  |  | unanticipated costs and liabilities;                                                                                                                                                  
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | difficulty of assimilating the operations, products and personnel of the acquired business;                                                                                           
|
| |  |  | difficulties in managing the financial and strategic position of acquired or developed products, services and technologies;                                                           
|
| |  |  | difficulties in maintaining customer relationships;                                                                                                                                   
|
| |  |  | difficulties in servicing and maintaining acquired products, in particular where a substantial portion of the targets
sales were derived from our competitors products and services;
|
| |  |  | difficulty of assimilating the vendors and independent contractors of the acquired business;                                                                                          
|
| |  |  | the diversion of managements attention from the core business;                                                                                                                       
|
| |  |  | inability to maintain uniform standards, controls, policies and procedures; and                                                                                                       
|
| |  |  | impairment of relationships with acquired employees and customers occurring as a result of integration of the acquired
business.                                                      

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In particular, in recent years our operating results were materially
adversely affected by several of the factors described above, including
substantial acquisition-related charges, operating losses or impairment losses
from the Executone acquisition, Cirilium Corporation joint venture and
Inter-Tel.NET operations. Refer to Managements Discussion and Analysis and
notes to the consolidated financial statements for additional information
regarding these transactions.

We completed four acquisitions during 2001 and 2002. During 2001, we
acquired certain assets and assumed certain liabilities of Convergent
Communication Services and Mastermind Technologies. During 2002, we acquired
certain assets and assumed certain liabilities of McLeodUSA Integrated Business
Systems and we acquired 100% of the stock of Swan Solutions Limited in the
United Kingdom. These acquisitions are subject to risks and uncertainties
including those indicated above.

Finally, to the extent that shares of our stock or the rights to purchase
stock are issued in connection with any future acquisitions, dilution to our
existing shareholders will result and our earnings per share may suffer. Any
future acquisitions may not generate additional revenue or provide any benefit
to our business, and we may not achieve a satisfactory return on our investment
in any acquired businesses.

We may not be able to adequately protect our proprietary technology and may be
infringing upon third-party intellectual property rights.

Our success depends upon our proprietary technology. We currently hold
patents for twenty-two (22) telecommunication and unified messaging products
and have also applied to the U.S. Patent and Trademark Office for fourteen (14)
additional patents. We also rely on copyright and trade secret law and
contractual provisions to protect our intellectual property. Despite these
precautions, third parties could copy or otherwise obtain and use our
technology without authorization, or develop similar technology independently.

Any patent, trademark or copyright that we own or have applied to own is
subject to being invalidated, circumvented or challenged by a third party.
Effective protection of intellectual property rights may be unavailable or
limited in foreign countries. We cannot assure that the protection of our
proprietary rights will be adequate or that competitors will not independently
develop similar technology, duplicate our services or design around any patents
or other intellectual property rights we hold. Litigation may be necessary in
the future to enforce our intellectual property rights, to protect our trade
secrets, to determine the validity and scope of the proprietary rights of
others, or to defend against claims of infringement or invalidity. Litigation
could be costly, absorb significant management time and harm our business.

We are also subject to third party claims that our current or future
products or services infringe upon the rights of others. For example, we are
subject to proceedings alleging that certain of our key products infringe upon
third party intellectual property rights, including patents, trademarks,
copyrights or other intellectual property rights. We have viewed presentations
from Avaya, one of our primary competitors, alleging that our Axxessbusiness
communications system and associated applications utilize inventions covered by
certain of their patents. We are continuing the process of investigating this
matter and we have made claims against Avaya for infringement of our patents.
While we do not believe these matters, collectively, would have a material
adverse impact on our financial position and future results of operations, the
ultimate outcomes by their nature are uncertain.

When any such claims are asserted against us, among other means to resolve
the dispute, we may seek to license the third partys intellectual property
rights. Purchasing such licenses can be expensive, and we cannot assure you
that a license will be available on prices or other terms acceptable to us, if
at all. Alternatively, we could resort to litigation to challenge such a
claim. Litigation could require us to expend significant sums of cash and
divert our managements attention. In the event that a court renders an
enforceable decision with respect to our intellectual property, we may be
required to pay significant damages, develop non-infringing technology or
acquire licenses to the technology subject to the alleged infringement. Any of
these actions or outcomes could harm our business. If we are unable or choose
not to license technology, or decide not to challenge a third partys rights,
we could encounter substantial and costly delays in product introductions.
These delays could result from efforts to design around asserted third party
rights or our discovery that the development, manufacture or sale of products
requiring these licenses could be foreclosed.

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Our IP network products may be vulnerable to viruses, other system failure
risks and security concerns, which may result in lost customers or slow
commercial acceptance of our IP network products.

Inter-Tels IP telephony and network products may be vulnerable to
computer viruses or similar disruptive problems. Computer viruses or problems
caused by third parties could lead to interruptions, delays or cessation of
service that could harm our operations and revenues. In addition, we may lose
customers if inappropriate use of the Internet or other IP networks by third
parties jeopardizes the security of confidential information, such as credit
card or bank account information or the content of conversations over the IP
network. In addition, user concerns about privacy and security may cause IP
networks in general to grow more slowly, and impair market acceptance of our IP
network products in particular, until more comprehensive security technologies
are developed.

We have many competitors and expect new competitors to enter our market, which
could increase price competition and spending on research and development and
which may impair our ability to compete successfully.

The markets for our products and services are extremely competitive and we
expect competition to increase in the future. Our current and potential
competitors in our primary business segments include:



| |  |  | PABX and converged systems providers, distributors, or resellers such as Alcatel, Avaya, Cisco Systems, Comdial, 3Com,
Iwatsu, Mitel, NEC, NextiraOne, Nortel, Panasonic, Shoreline, Siemens, Toshiba, Vertical Networks and Vodavi;
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | large data routing and convergence companies such as 3Com and Cisco Systems;                                                                                                                                                        
|
| |  |  | voice processing applications providers such as ADC, InterVoice-Brite, Active Voice (a subsidiary of NEC America), Avaya,
and Captaris (formerly AVT);                                                                              
|
| |  |  | long distance services providers such as AT&T, MCI, Qwest and Sprint;                                                                                                                                                               
|
| |  |  | large computer and software corporations such as IBM, HP, Intel and Microsoft;                                                                                                                                                      
|
| |  |  | regional Bell operating companies, or RBOCs, cable television companies, IP Centrex service providers, and satellite and
other wireless broadband service providers; and                                                            
|
| |  |  | Independent leasing companies that provide telecom equipment financing.                                                                                                                                                             

These and other companies may form strategic relationships with each other
to compete with us. These relationships may take the form of strategic
investments, joint-marketing agreements, licenses or other contractual
arrangements. Strategic relationships and business combinations could increase
our competitors ability to address customer needs with their product and
service offerings.

Many of our competitors and potential competitors have substantially
greater financial, customer support, technical and marketing resources, larger
customer bases, longer operating histories, greater name recognition and more
established relationships in the industry than we do. We cannot be sure that
we will have the resources or expertise to compete successfully. Compared to
us, our competitors may be able to:



| |  |  | develop and expand their product and service offerings more quickly;     
| | - |  | -------------------------------------------------------------------------
|
| |  |  | offer greater price discounts or make substantial product promotions;    
|
| |  |  | adapt to new or emerging technologies and changing customer needs faster;
|
| |  |  | take advantage of acquisitions and other opportunities more readily;     
|
| |  |  | negotiate more favorable licensing agreements with vendors;              
|
| |  |  | devote greater resources to the marketing and sale of their products; and
|
| |  |  | address customers service-related issues more adequately.               

Some of our competitors may also be able to provide customers with
additional benefits at lower overall costs or to reduce their gross margins
aggressively in an effort to increase market share. We cannot be sure that we
will be able to match cost reductions by our competitors. In recent periods,
due to competitive pressures we have discounted pricing on our telephone
systems and offered promotions. In addition, we believe that there is likely
to be further consolidation in our markets, which could lead to having even
larger and more formidable competition and other forms of competition that
could cause our business to suffer.

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Our reliance on a limited number of suppliers for key components and our
dependence on contract manufacturers could impair our ability to manufacture
and deliver our products and services in a timely and cost-effective manner.

We currently obtain certain key components for our digital communication
platforms, including certain microprocessors, integrated circuits, power
supplies, voice processing interface cards and IP telephony cards, from a
limited number of suppliers and manufacturers. Our reliance on these limited
suppliers and contract manufacturers involves risks and uncertainties,
including the possibility of a shortage or delivery delay for some key
components. We currently manufacture our products through third-party
subcontractors located in the United States, the Peoples Republic of China,
the United Kingdom and Mexico. Varian, Inc. currently manufactures a
significant portion of our products at Varians Tempe, Arizona facility,
including substantially all of the printed circuit boards used in the Axxess
systems. Foreign manufacturing facilities are subject to changes in
governmental policies, imposition of tariffs and import restrictions and other
factors beyond our control. We have experienced occasional delays in the supply
of components and finished goods that have harmed our business. If inventory
levels are not adequately maintained and managed we are at risk of not having
the appropriate inventory quantities on hand to meet sales demand. We may
experience similar delays in the future.

Our reliance on third party manufacturers and OEM partners involves a
number of additional risks, including reduced control over delivery schedules,
quality assurance and costs. Our business may be harmed by any delay in
delivery or any shortage of supply of components or finished goods from a
supplier. Our business may also be harmed if we are unable to develop
alternative or additional supply sources as necessary. To date, we have been
able to obtain supplies of components and products in a timely manner even
though we do not have long-term supply contracts with any of our contract
manufacturers. However, we cannot assure you that we will be able to continue
to obtain components or finished goods in sufficient quantities or quality or
on favorable pricing or delivery terms in the future.

We derive a substantial portion of our net sales from our dealer network and if
these dealers do not effectively promote and sell our products, our business
and operating results could be harmed.

We derive a substantial portion of our net sales through our network of
independent dealers. We face intense competition from other telephone, voice
processing, and voice and data router system manufacturers for these dealers
business, as most of our dealers carry other products that compete with our
products. Our dealers may choose to promote the products of our competitors to
our detriment. We have developed programs and expended capital as incentives
to our dealers to promote our products, and we cannot assure you that these
techniques will continue to be successful. The loss of any significant dealer
or group of dealers, or any event or condition harming our dealer network,
could harm our business, financial condition and operating results.

Managing our international sales efforts may expose us to additional business
risks, which may result in reduced sales or profitability in our international
markets.

We are currently expending resources to maintain and expand our
international dealer network in the countries in which we already have a
presence and in new countries and regions. International sales are subject to
a number of risks, including changes in foreign government regulations and
telecommunication standards, export license requirements, tariffs and taxes,
other trade barriers, difficulties in protecting our intellectual property,
fluctuations in currency exchange rates, difficulty in collecting receivables,
difficulty in staffing and managing foreign operations, and political and
economic instability. In particular, the terrorist acts of September 11, 2001,
the war in Iraq and continued turmoil in the Middle East and North Korea, have
created an uncertain international economic environment and we cannot predict
the impact of these acts, any future terrorist acts or any related military
action on our efforts to expand our international sales. Fluctuations in
currency exchange rates could cause our products to become relatively more
expensive to customers in a particular country, leading to a reduction in sales
or profitability in that country. In addition, the costs associated with
developing international sales may not be offset by increased sales in the
short term, or at all. Any of these risks could cause our products to become
relatively more expensive to customers in a particular country, leading to
reduced sales or profitability in that country. In addition, the costs
associated with developing an international dealer network may not be offset by
increased sales in the short term, if at all.

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If we lose key personnel or are unable to hire additional qualified personnel
as necessary, we may not be able to achieve our objectives.

We depend on the continued service of, and our ability to attract and
retain, qualified technical, marketing, sales and managerial personnel, many of
whom would be difficult to replace. Competition for qualified personnel is
intense, and we have historically had difficulty in hiring employees in the
timeframe that we desire, particularly skilled engineers or sales personnel.
The loss of any of our key personnel or our failure to effectively recruit
additional key personnel could make it difficult for us to manage our business,
complete timely product introductions or meet other critical business
objectives. In addition, our operating results could be impaired if we lose a
substantial number of key employees from acquisitions, as was the case in our
acquisition of Executone. Moreover, our operating results could be impaired if
we lose a substantial number of key employees from recent acquisitions,
including personnel from McLeod, Swan, Mastermind and Convergent. We cannot
assure you that we will be able to continue to attract and retain the qualified
personnel necessary for the development of our business.

We may be unable to achieve or manage our growth effectively, which may harm
our business.

The ability to operate our business in an evolving market requires an
effective planning and management process. Our efforts to achieve growth in
our business has placed, and is expected to continue to place, a significant
strain on our personnel, management systems, infrastructure and other
resources. In addition, our ability to manage any potential future growth
effectively will require us to successfully attract, train, motivate and manage
new employees, to integrate new employees into our overall operations and to
continue to improve our operational, financial and management controls and
procedures. Furthermore, we expect that we will be required to manage an
increasing number of relationships with suppliers, manufacturers, customers and
other third parties. If we are unable to implement adequate controls or
integrate new employees into our business in an efficient and timely manner,
our operations could be adversely affected and our growth could be impaired.

The introduction of new products and services has lengthened our sales cycles,
which may result in significant sales and marketing expenses.

In the past few years, we introduced the AxxessATM business
communications system and multiple versions of our IP networking software,
which are typically sold to larger customers at a higher average selling price
and often represent a significant expenditure in communications infrastructure
by the prospective enterprise customer. Accordingly, the purchase of our
products typically involves numerous internal approvals relating to the
evaluation, testing, implementation and acceptance of new technologies. This
evaluation process frequently results in a lengthy sales process, which can
range from a few months to more than 12 months, thereby subjecting our sales
cycle to a number of significant uncertainties concerning budgetary constraints
and internal acceptance reviews. The length of our sales cycle also may vary
substantially from customer to customer and along product lines. While our
customers are evaluating our products before placing an order with us, we may
incur substantial sales and marketing expenses and expend significant
management effort. In addition, installation of multiple systems for large,
multi-site customers may occur over an extended period of time, and depending
on the contract terms with these customers, revenues may be recognized over
more than one quarter, as systems are completed in separate phases and accepted
by the customers. Consequently, if sales forecasted from a specific customer
for a particular quarter are not realized in that quarter, our operating
results could be materially adversely affected.

We rely heavily upon third-party packaged software systems to manage and run
our business processes and to produce our financial statements. From time to
time we upgrade these systems to ensure continuation of support and to expand
the functionality of the systems to meet our business needs. The risks
associated with the upgrade process include disruption of our business
processes, which could harm our business.

We currently run third-party applications for data processing in our
distribution center operations, shipping, materials movement, customer service,
invoicing, financial record keeping and reporting, and for other operations and
administrative functions. The nature of the software industry is to upgrade
software systems to make architectural changes, increase functionality and
address software bugs. Over time, older versions of the software become less
supported by our vendors for financial and other reasons and eventually become
obsolete. Oracle, the primary supplier of our third-party applications,
provides notice of the dates that Oracle will de-support the software and
companies are expected to either make plans to

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upgrade to newer versions or operate without Oracle support. While Oracle
and other third-party vendors may provide advanced notice of product upgrade
schedules and take other steps to make the upgrade process as straight-forward
as possible, we are subject to risks associated with the process. Our software
systems could become unstable following an upgrade process and impact our
ability to process data properly in these systems, including timely and
accurate shipment of products, invoicing our customers properly and the
production of accurate and timely financial statements. We also cannot assure
you that these software upgrades or enhancements will operate as intended or be
free from bugs. We upgraded our Oracle applications during the fourth quarter
of 2002 and expect to affect similar software upgrades in the future. If we
are unable to successfully integrate the new software into our information
systems, our operations, customer service and financial reporting could be
adversely affected and could harm our business.

Our stock price has been and may continue to be volatile, impairing your
ability to sell your shares at or above purchase price.

The market price for our common stock has been highly volatile. The
volatility of our stock could be subject to continued wide fluctuations in
response to many risk factors listed in this section, and others beyond our
control, including:



| |  |  | announcements of developments relating to our business;                                                         
| | - |  | ----------------------------------------------------------------------------------------------------------------
|
| |  |  | fluctuations in our operating results;                                                                          
|
| |  |  | shortfalls in revenue or earnings relative to securities analysts expectations;                                
|
| |  |  | announcements of technological innovations or new products or enhancements by us or our competitors;            
|
| |  |  | announcements of acquisitions or planned acquisitions of other companies or businesses;                         
|
| |  |  | investors reactions to acquisition announcements or our forecasts of future results;                           
|
| |  |  | general economic conditions in the telecommunications industry;                                                 
|
| |  |  | the market for Internet-related voice and data products and services;                                           
|
| |  |  | changes in the national or worldwide economy;                                                                   
|
| |  |  | changes in legislation or regulation affecting the telecommunications industry;                                 
|
| |  |  | threats of or outbreaks of war, hostilities or terrorist acts;                                                  
|
| |  |  | developments relating to our intellectual property rights and the intellectual property rights or third parties;
|
| |  |  | litigation or governmental investigations of our business practices;                                            
|
| |  |  | changes in our relationships with our customers and suppliers; and                                              
|
| |  |  | national and regional weather patterns.                                                                         

In addition, stock prices of technology companies in general, and for
voice and data communications companies in particular, have experienced extreme
price fluctuations in recent years which have often been unrelated to the
operating performance of affected companies. We cannot assure you that the
market price of our common stock will not experience significant fluctuations
in the future, including fluctuations that are unrelated to our performance.

We are currently the target of government investigations and in the future we
may be subject to litigation, which if they result in any convictions,
sanctions or penalties against us, could harm our business.

Divisions of the United States Department of Justice are investigating
other companies and Inter-Tels participation in a federally funded E-Rate
program to connect schools and libraries to the Internet. The Justice
Department has not provided Inter-Tel with a description of the evidence on
which the investigations are based.

Inter-Tel is presently unable to predict or determine the final outcome
of, or to estimate the potential range of loss with respect to, the
investigations. If Inter-Tel is convicted of any crime or subjected to
sanctions, or debarred from certain government contracts or if penalties,
damages or other monetary remedies are assessed against Inter-Tel in connection
with these and other investigations, our business and operating results could
be materially and adversely affected. The existence and disclosure of the

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investigations may have already caused competitive harm to Inter-Tel, and
any unfavorable resolution to these matters may further harm Inter-Tels
business.

Inter-Tel is also subject to litigation in the ordinary course of
business. We cannot assure you that any adverse outcome in connection with
such litigation would not impair our business or financial condition.

The Chairman of our Board of Directors, CEO and President controls 20.4% of our
Common Stock as of November 3, 2003 and is able to significantly influence
matters requiring shareholder approval.

As of November 3, 2003, Steven G. Mihaylo, Inter-Tels Chairman of the
Board of Directors, Chief Executive Officer and President, beneficially owned
approximately 20.4% of the existing outstanding shares of the common stock. As
a result, he has the ability to exercise significant influence over all matters
requiring shareholder approval. In addition, the concentration of ownership
could have the effect of delaying or preventing a change in control of
Inter-Tel.

Risks Related to Our Industry

Reductions in spending on enterprise communications equipment may materially
and adversely affect our business.

The overall economic slowdown has had and continues to have a harmful
effect on the market for enterprise communications equipment. Our customers
have reduced significantly their capital spending on communications equipment
in an effort to reduce their own costs. The market for enterprise
communications equipment may only grow at a modest rate or possibly not grow at
all, and our financial performance has been and may continue to be materially
and adversely affected by the reductions in spending on enterprise
communications equipment.

The emerging market for IP network telephony is subject to market risks and
uncertainties that could cause significant delays and expenses.

The market for IP network voice communications products is evolving
rapidly and is characterized by an increasing number of market entrants who
have introduced or developed products and services for Internet or other IP
network voice communications. As is typical of a new and rapidly evolving
industry, the demand for and market acceptance of recently introduced IP
network products and services are highly uncertain. We cannot assure you that
IP voice networks will become widespread. Even if IP voice networks become
more widespread in the future, we cannot assure that our products, including
the IP telephony features of the Axxesssystems and our IP endpoints and
related applications, will successfully compete against other market players
and attain broad market acceptance.

Moreover, the adoption of IP voice networks and importance of development
of products using industry standards such as MGCP and SIP, generally require
the acceptance of a new way of exchanging information. In particular,
enterprises that have already invested substantial resources in other means of
communicating information may be reluctant or slow to adopt a new approach to
communications. If the market for IP network voice communications fails to
develop or develops more slowly than we anticipate, our IP network telephony
products could fail to achieve market acceptance, which in turn could
significantly harm our business, financial condition and operating results.
This growth may be inhibited by a number of factors, such as quality of
infrastructure; security concerns; equipment, software or other technology
failures; regulatory encroachments; inconsistent quality of service; poor voice
quality over IP networks as compared to circuit-switched networks; and lack of
availability of cost-effective, high-speed network capacity. Moreover, as
IP-based data communications and telephony usage grow, the infrastructure used
to support these IP networks, whether public or private, may not be able to
support the demands placed on them and their performance or reliability may
decline. The technology that allows voice and facsimile communications over
the Internet and other data networks, and the delivery of other value-added
services, is still in the early stages of development.

Government regulation of third party long distance and network service entities
on which we rely may harm our business.

Our supply of telecommunications services and information depends on
several long distance carriers, RBOCs, local exchange carriers, or LECs, and
competitive local exchange carriers, or CLECs.

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We rely on these carriers to provide network services to our customers and
to provide us with billing information. Long distance services are subject to
extensive and uncertain governmental regulation on both the federal and state
level. We cannot assure that the increase in regulations will not harm our
business. Our current contracts for the resale of services through long
distance carriers include multi-year periods during which we have minimum use
requirements and/or costs. The market for long distance services is
experiencing, and is expected to continue to experience significant price
competition, and this may cause a decrease in end-user rates. We cannot assure
you that we will meet minimum use commitments, that we will be able to
negotiate lower rates with carriers if end-user rates decrease or that we will
be able to extend our contracts with carriers at favorable prices. If we are
unable to secure reliable long distance and network services from certain long
distance carriers, RBOCs, LECs and CLECs, or if these entities are unwilling or
unable to provide telecommunications services and billing information to us on
favorable terms, our ability to expand our own long distance and network
services will be harmed. Carriers that provide telecommunications services to
us may also experience financial difficulties, up to and including
bankruptcies, which could harm our ability to offer telecommunications
services.

Consolidation within the telecommunications industry could increase competition
and reduce our customer base.

There has been a trend in the telecommunications industry towards
consolidation and we expect this trend to continue as the industry evolves. As
a result of this consolidation trend, new stronger companies may emerge that
have improved financial resources, enhanced research and development
capabilities and a larger and more diverse customer base. The changes within
the telecommunications industry may adversely affect our business, operating
results and financial condition.

Terrorist activities and resulting military and other actions could harm our
business.

Terrorist attacks in New York and Washington, D.C. in September of 2001
disrupted commerce throughout the world. The continued threat of terrorism, the
conflict in Iraq and the potential for additional military action and
heightened security measures in response to these threats may continue to cause
significant disruption to commerce throughout the world. To the extent that
disruptions result in a general decrease in corporate spending on information
technology or advertising, our business and results of operations could be
harmed. We are unable to predict whether the conflict in Iraq and its
aftermath, the threat of terrorism or the responses thereto will result in any
long-term commercial disruptions or if such activities or responses will have a
long-term adverse effect on our business, results of operations or financial
condition. Additionally, if any future terrorist attacks were to affect the
operation of the Internet or key data centers, our business could be harmed.
These and other developments arising out of the potential attacks may make the
occurrence of one or more of the factors discussed herein more likely to occur.




ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion about our market risk disclosures involves
forward-looking statements. Actual results could differ materially from those
projected in the forward-looking statements. We are exposed to market risk
related to changes in interest rates and foreign currency exchange rates. We do
not use derivative financial instruments.

INVESTMENT PORTFOLIO. We do not use derivative financial instruments in our
non-trading investment portfolio. Inter-Tel maintains a portfolio of highly
liquid cash equivalents typically maturing in three months or less as of the
date of purchase. Inter-Tel places its investments in instruments that meet
high credit quality standards, as specified in our investment policy
guidelines.

The Company also maintains short-term investments, which are all
classified as available for sale, and have been recorded at fair value, which
approximates cost. Short-term investments include certificates of deposit,
auction rate certificates, auction rate preferred securities, municipal
preferred securities and money market mutual funds. The auction rate
securities are adjustable-rate securities with dividend rates that are reset
periodically by bidders through periodic Dutch auctions generally conducted
every 7 to 49 days by a trust company or broker/dealer on behalf of the issuer.
The Company believes these securities are highly liquid investments through
the related auctions; however, the collateralizing securities have stated terms
of up to thirty (30) years. These instruments are rated A or higher by
Standard & Poors

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Ratings Group, or equivalent. The Companys short-term investments are
intended to establish a high-quality portfolio that preserves principal, meets
liquidity needs, avoids inappropriate concentrations and delivers an
appropriate yield in relationship to the Companys investment guidelines and
market conditions. Given the short-term nature of these investments, and that
we have no borrowings outstanding other than short-term letters of credit, we
are not subject to significant interest rate risk.

LEASE PORTFOLIO. We offer to our customers lease financing and other services,
including our Total Solutions program, through our Inter-Tel Leasing
subsidiary. We fund these programs in part through the sale to financial
institutions of rental payment streams under the leases. Upon the sale of the
rental payment streams, we continue to service the leases and maintain limited
recourse on the leases. We maintain reserves for loan losses on all leases
based on historical loss experience, past due accounts and specific account
analysis. Although to date we have been able to resell the rental streams from
leases under our lease programs profitably and on a substantially current
basis, the timing and profitability of lease resales could impact our business
and operating results, particularly in an environment of fluctuating interest
rates and economic uncertainty. If we were required to repurchase rental
streams and realize losses thereon in amounts exceeding our reserves, our
operating results could be materially adversely affected. See Liquidity and
Capital Resources and Critical Accounting Policies and Estimates in
Managements Discussion and Analysis for more information regarding our lease
portfolio and financing.

IMPACT OF FOREIGN CURRENCY RATE CHANGES. We invoice the customers of our
international subsidiaries primarily in the local currencies of our
subsidiaries for product and service revenues. Inter-Tel is exposed to foreign
exchange rate fluctuations as the financial results of foreign subsidiaries are
translated into U.S. dollars in consolidation. The impact of foreign currency
rate changes have historically been insignificant.




ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures. Our management
evaluated, with the participation of our Chief Executive Officer and our Chief
Financial Officer, the effectiveness of our disclosure controls and procedures
(as defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act
of 1934, as amended) as of the end of the period covered by this Quarterly
Report on Form 10-Q. Based on this evaluation, our Chief Executive Officer and
Chief Financial Officer have concluded that our disclosure controls and
procedures were effective to ensure that material information we are required
to disclose in reports that we file or submit under the Securities Exchange Act
of 1934, as amended, is recorded, processed, summarized and reported within the
time periods specified in Securities and Exchange Commission rules and forms.

Changes in internal controls over financial reporting. There were no
changes in our internal controls over financial reporting that occurred during
the period covered by this Quarterly Report on Form 10-Q that have materially
affected, or are reasonably likely to materially affect, our internal controls
over financial reporting.




INTER-TEL, INCORPORATED AND
SUBSIDIARIES
PART II. OTHER INFORMATION




ITEM 1. LEGAL PROCEEDINGS

We are involved from time to time in litigation incidental to our business. We
believe that the outcome of current litigation will not have a material adverse
effect upon our business, financial condition or results of operations and will
not disrupt our normal operations.




ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDSNot Applicable




ITEM 3. DEFAULTS ON SENIOR SECURITIESNot Applicable




ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSNot Applicable

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##### Table of Contents






ITEM 5. OTHER INFORMATION

Pursuant to Rule 14a-4(c)(1) under the Securities Exchange Act of 1934, as
amended, in connection with the Companys annual meeting of shareholders, if a
shareholder of the Company fails to notify the Company at least 45 days prior
to the date of mailing of the prior years proxy statement, then the proxies of
management would be allowed to use their discretionary voting authority when
any such proposal is raised at the Companys annual meeting of shareholders,
without any discussion of the matter in the proxy statement. Since the Company
mailed its proxy statement for the 2003 annual meeting of shareholders on March
21, 2003, the deadline for receipt of any such shareholder proposal for the
2004 annual meeting of shareholders is February 5, 2004.




ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K:

| |  |                      |  |                                                                                                                                                  
| |  | -------------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Exhibits:            |  |                                                                                                                                                  
| |  |                      |  |                                                                                                                                                  
| |  | Exhibit 31.1:        |  | Certification of Chief Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002                                               
| |  |                      |  |                                                                                                                                                  
| |  | Exhibit 31.2:        |  | Certification of Chief Financial Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002                                               
| |  |                      |  |                                                                                                                                                  
| |  | Exhibit 32.1:        |  | Certification of Chief Executive Officer Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
| |  |                      |  |                                                                                                                                                  
| |  | Exhibit 32.2:        |  | Certification of Chief Financial Officer Pursuant to 18
U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
| |  |                      |  |                                                                                                                                                  
| |  | Reports on Form 8-K:

|                                                                                                                                                                                                                                                                                                                                                                                           
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|On July 21, 2003, we filed a Current Report on Form 8-K under Item 7
(Financial Statements and Exhibits) and furnished disclosure under Item
9 (Regulation FD Disclosure) to report our Press release dated July 21,
2003 announcing GAAP and non-GAAP results for the fiscal quarter ended
June 30, 2003, and comparing such results with the results for the
quarter ended June 30, 2002.

|                                                                                                                                                                                                                                                                                                                                                                                                                                 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|On October 21, 2003, we filed a Current Report on Form 8-K under Item 7
(Financial Statements and Exhibits) and furnished disclosure under Item
12 (Results of Operations and Financial Condition) to report our Press
release dated October 20, 2003 announcing GAAP and non-GAAP results for
the fiscal quarter ended September 30, 2003, and comparing such results
with the results for the quarter ended September 30, 2002.




SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.

| |  |                   |  |                                                                               
| |  | ----------------- |  | ------------------------------------------------------------------------------
| |  |                   |  | INTER-TEL, INCORPORATED                                                       
| |  |                   |  |                                                                               
| |  | November 14, 2003 |  | /s/ Steven G. Mihaylo                                                         
| |  |                   |  |                                                                               
| |  |                   |  | Steven G. Mihaylo
Chairman of the Board, Chief Executive
Officer and President
| |  |                   |  |                                                                               
| |  | November 14, 2003 |  | /s/ Kurt R. Kneip                                                             
| |  |                   |  |                                                                               
| |  |                   |  | Kurt R. Kneip
Sr. Vice President and
Chief Financial Officer                  

33