<PAGE>   1
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
                           ---------------------------

                                    FORM 10-Q

[X]  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
     ACT OF 1934

                   FOR THE QUARTERLY PERIOD ENDED JULY 1, 2000

[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
     EXCHANGE ACT OF 1934

            FOR THE TRANSITION PERIOD FROM ___________ TO ___________


                         Commission file number: 0-24663

                           ---------------------------

                          ASPECT MEDICAL SYSTEMS, INC.
             (Exact Name of Registrant as Specified in Its Charter)

DELAWARE                                    04-2985553
(State or Other Jurisdiction of             (I.R.S. Employer Identification No.)
Incorporation or Organization)


141 NEEDHAM STREET, NEWTON, MASSACHUSETTS            02464-1505
(Address of Principal Executive Offices)             (Zip Code)

                                 (617) 559-7000
               Registrant's Telephone Number, Including Area Code

                  TWO VISION DRIVE, NATICK, MASSACHUSETTS 01760
                                 Former Address

                           ---------------------------

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 period 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 [ ]

The Registrant had 17,246,074 shares of Common Stock, $0.01 par value per share,
outstanding as of August 4, 2000.

<PAGE>   2
                          ASPECT MEDICAL SYSTEMS, INC.

                                TABLE OF CONTENTS

                                                                           Page
                                                                           ----
PART I.   FINANCIAL INFORMATION                                             1

Item 1.   Financial Statements (Unaudited)                                  1

          Consolidated Balance Sheets as of July 1, 2000
          and December 31, 1999                                             1

          Consolidated Statements of Operations for the Three
          and Six Months Ended July 1, 2000 and July 3, 1999                2

          Consolidated Statements of Cash Flows for the
          Six Months Ended July 1, 2000 and July 3, 1999                    3

          Notes to Consolidated Financial Statements                        4

Item 2.   Management's Discussion and Analysis of Financial
          Condition and Results of Operations                               8

Item 3.   Quantitative and Qualitative Disclosures About Market Risk       19

PART II.  OTHER INFORMATION                                                20

Item 1.   Legal Proceedings                                                20

Item 2.   Changes in Securities and Use of Proceeds                        20

Item 3.   Defaults Upon Senior Securities                                  21

Item 4.   Submission of Matters to a Vote of Security Holders              21

Item 5.   Other Information                                                21

Item 6.   Exhibits and Reports on Form 8-K                                 21

SIGNATURE                                                                  22


<PAGE>   3

                         PART I - FINANCIAL INFORMATION

ITEM 1.   FINANCIAL STATEMENTS

                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>

                                                                        July 1,        December 31,
                                                                         2000               1999
                                                                    -------------      ------------
                                                                     (Unaudited)

<S>                                                                 <C>                <C>
ASSETS
Current assets:
   Cash and cash equivalents                                        $  36,134,198      $ 13,535,364
   Marketable securities                                               26,564,911         1,000,000
   Accounts receivable, net of allowance of $422,000 at July 1,
     2000 and $407,000 at December 31, 1999                             6,558,453         4,300,235
   Current portion of investment in sales-type leases                   1,818,339         1,689,585
   Inventory                                                            2,974,792         1,514,702
   Other current assets                                                 1,251,865         1,006,023
                                                                    -------------      ------------
           Total current assets                                        75,302,558        23,045,909
Property and equipment, net                                             6,334,478         3,449,252
Long-term investment in sales-type leases                               2,899,714         2,906,447
                                                                    -------------      ------------
           Total assets                                             $  84,536,750      $ 29,401,608
                                                                    =============      ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Current portion of long-term debt                                $   2,439,511      $  2,125,526
   Accounts payable                                                     1,893,209         1,569,093
   Accrued liabilities                                                  5,767,140         5,937,554
   Deferred revenue                                                       972,525         1,135,225
                                                                    -------------      ------------
           Total current liabilities                                   11,072,385        10,767,398
                                                                    -------------      ------------
Deferred revenue                                                        1,249,176         1,682,509
Long-term debt                                                          3,399,674         3,872,484
                                                                    -------------      ------------
Commitments and contingencies
Stockholders' equity:
   Preferred Stock, $.01 par value; 5,000,000 shares
     authorized, no shares issued or outstanding                               --                --
   Convertible Preferred Stock, $.01 par value; 22,363,224
     shares authorized, 11,067,238 shares issued and
     outstanding at December 31, 1999                                          --        67,560,365
   Common Stock, $.01 par value; 60,000,000 and 17,030,000
     shares authorized, 17,029,019 and 1,815,840 shares
     issued and outstanding at July 1, 2000 and
     December 31, 1999, respectively                                      170,290            18,158
   Additional paid-in capital                                         124,117,005         1,273,725
   Warrants                                                               145,979           146,606
   Notes receivable from employees and directors                         (279,167)         (305,324)
   Deferred compensation                                                 (285,591)         (225,111)
   Accumulated other comprehensive loss                                   (82,605)               --
   Accumulated deficit                                                (54,970,396)      (55,389,202)
                                                                    -------------      ------------
           Total stockholders' equity                                  68,815,515        13,079,217
                                                                    -------------      ------------
           Total liabilities and stockholders' equity               $  84,536,750      $ 29,401,608
                                                                    =============      ============
</TABLE>

  The accompanying notes are an integral part of these consolidated financial
                                  statements.



                                       1
<PAGE>   4

                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
                                               Three Months Ended                 Six Months Ended
                                          -----------------------------    --------------------------------
                                          July 1, 2000     July 3, 1999      July 1, 2000      July 3, 1999
                                          ------------     ------------      ------------      ------------
                                           (Unaudited)      (Unaudited)       (Unaudited)       (Unaudited)

<S>                                       <C>               <C>              <C>               <C>
Revenue                                   $ 11,066,167      $ 6,385,436      $ 20,725,544      $ 11,712,197
Costs and expenses:
    Costs of revenue                         3,382,298        2,183,567         6,465,435         4,235,937
    Research and development                 1,448,930        1,194,807         2,802,749         2,345,980
    Sales and marketing                      5,212,576        4,154,993         9,926,629         7,565,771
    General and administrative               1,725,900        1,181,022         2,994,513         2,293,062
                                          ------------      -----------      ------------      ------------
             Total costs and expenses       11,769,704        8,714,389        22,189,326        16,440,750
                                          ------------      -----------      ------------      ------------

Loss from operations                          (703,537)      (2,328,953)       (1,463,782)       (4,728,553)
Interest income                              1,266,716          411,226         2,254,731           739,974
Interest expense                              (170,173)         (46,282)         (372,143)          (95,887)
                                          ------------      -----------      ------------      ------------
Net income (loss)                         $    393,006      $(1,964,009)     $    418,806      $ (4,084,466)
                                          ============      ===========      ============      ============

Net income (loss) per share:
    Basic                                 $       0.02      $     (1.31)     $       0.03      $      (2.79)
    Diluted                               $       0.02      $     (1.31)     $       0.03      $      (2.79)

Shares used in computing net income
    (loss) per share:
    Basic                                   16,933,787        1,502,773        14,249,675         1,462,520
    Diluted                                 19,395,504        1,502,773        16,749,812         1,462,520

</TABLE>




  The accompanying notes are an integral part of these consolidated financial
                                  statements.

                                       2
<PAGE>   5

                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
                                                                         Six Months Ended
                                                                   ------------------------------
                                                                   July 1, 2000      July 3, 1999
                                                                   ------------      ------------
                                                                    (Unaudited)       (Unaudited)

<S>                                                                <C>               <C>
Cash flows from operating activities:
   Net income (loss)                                               $    418,806      $ (4,084,466)
   Adjustments to reconcile net income (loss) to net cash
     used for operating activities -
     Depreciation and amortization                                      723,320           509,943
     Provision for doubtful accounts                                     15,000           151,015
     Compensation expense related to stock options                      402,174           142,869
     Changes in assets and liabilities -
       Increase in accounts receivable                               (2,273,218)         (912,916)
       Increase in inventory                                         (1,460,090)         (466,425)
       Increase in other current assets                                (245,842)          (63,150)
       Increase in investment in sales-type leases                     (122,021)       (1,494,257)
       Increase in accounts payable                                     324,116           804,052
       (Decrease) increase in accrued liabilities                      (170,414)          653,961
       Decrease in deferred revenue                                    (596,033)         (167,405)
                                                                   ------------      ------------
          Net cash used for operating activities                     (2,984,202)       (4,926,779)
                                                                   ------------      ------------

Cash flows from investing activities:
   Acquisition of property and equipment                             (3,608,546)       (1,379,683)
   Purchases of marketable securities                               (46,397,516)       (1,761,464)
   Proceeds from sales of marketable securities                      20,750,000         4,345,802
                                                                   ------------      ------------
          Net cash (used for) provided by investing activities      (29,256,062)        1,204,655
                                                                   ------------      ------------

Cash flows from financing activities:
   Principal payments on capital lease obligations                           --           (67,737)
   Proceeds from working capital line of credit                              --         1,568,750
   Principal payments on equipment loan                                (360,335)         (360,335)
   Principal payments on term loan                                     (471,230)               --
   Proceeds from sale of investment in sales-type leases              1,020,070                --
   Principal payments on debt related to investment in
     sales-type leases                                                 (347,330)               --
   Proceeds from issuance of common stock                            54,971,766             7,379
   Payments received on notes receivable from employees and
     directors                                                           26,157               859
                                                                   ------------      ------------
          Net cash provided by financing activities                  54,839,098         1,148,916
                                                                   ------------      ------------
Net increase (decrease) in cash and cash equivalents                 22,598,834        (2,573,208)
Cash and cash equivalents, beginning of period                       13,535,364        17,122,993
                                                                   ------------      ------------
Cash and cash equivalents, end of period                           $ 36,134,198      $ 14,549,785
                                                                   ============      ============

Supplemental disclosure of cash flow information:
   Interest paid                                                   $    365,693      $     95,887
                                                                   ============      ============

</TABLE>


  The accompanying notes are an integral part of these consolidated financial
                                  statements.




                                       3
<PAGE>   6

                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)


(1)  Basis of Presentation

     The accompanying unaudited consolidated financial statements of Aspect
Medical Systems, Inc. (the "Company") have been prepared in accordance with
generally accepted accounting principles for interim financial information and
with the instructions to Form 10-Q and 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 normal, recurring adjustments considered necessary for a fair
presentation have been included. The financial statements should be read in
conjunction with the audited financial statements for the year ended December
31, 1999 included in the Registration Statement on Form S-1 of Aspect Medical
Systems, Inc., as amended, filed with the Securities and Exchange Commission
(File No. 333-86295). Interim results of operations are not necessarily
indicative of the results to be expected for the full year or any other interim
periods.


(2)  Computation of Net Income (Loss) Per Share

     In accordance with Statement of Financial Accounting Standards No. 128,
Earnings Per Share, (SFAS No. 128), basic earnings (loss) per share for the
three and six months ended July 1, 2000 and July 3, 1999, were computed by
dividing net income (loss) by the weighted average common shares outstanding
during the periods presented. Diluted earnings (loss) per share for the periods
presented were computed by dividing net income (loss) by the weighted average
common and dilutive potential common shares outstanding, computed in accordance
with the treasury stock method. The computation of basic and diluted earnings
(loss) per share is as follows:

<TABLE>
<CAPTION>
                                                                Three Months Ended               Six Months Ended
                                                          -----------------------------     ----------------------------
                                                          July 1, 2000     July 3, 1999     July 1, 2000    July 3, 1999
                                                          ------------     ------------     ------------    ------------
                                                           (Unaudited)     (Unaudited)       (Unaudited)     (Unaudited)

<S>                                                        <C>             <C>              <C>             <C>
BASIC EARNINGS (LOSS) PER SHARE COMPUTATION
   Numerator:
   Net income (loss) applicable to common stock            $   393,006     $(1,964,009)     $   418,806     $(4,084,466)
                                                           -----------     -----------      -----------     -----------

  Denominator:
  Weighted average common shares outstanding                16,933,787       1,502,773       14,249,675       1,462,520
                                                           -----------     -----------      -----------     -----------
  Basic earnings (loss) per share                          $      0.02     $     (1.31)     $      0.03     $     (2.79)
                                                           ===========     ===========      ===========     ===========

DILUTED EARNINGS (LOSS) PER SHARE COMPUTATION
   Numerator:
   Net income (loss) applicable to common stock            $   393,006     $(1,964,009)     $   418,806     $(4,084,466)
                                                           -----------     -----------      -----------     -----------

  Denominator:
  Weighted average common shares outstanding                16,933,787       1,502,773       14,249,675       1,462,520
  Dilutive effect of assumed exercise of warrants              124,977              --          123,938              --
  Dilutive effect of assumed exercise of stock options       2,255,113              --        2,281,278              --
  Dilutive effect of restricted stock                           81,627              --           94,921              --
                                                           -----------     -----------      -----------     -----------
  Weighted average common and dilutive potential
      common shares outstanding                             19,395,504       1,502,773       16,749,812       1,462,520
                                                           -----------     -----------      -----------     -----------
  Diluted earnings (loss) per share                        $      0.02     $     (1.31)     $      0.03     $     (2.79)
                                                           ===========     ===========      ===========     ===========

</TABLE>




                                       4
<PAGE>   7

(3)  Revenue Recognition

     Revenue from equipment sales, disposable product sales and sales-type
leases are recognized at the time of shipment. Payments received prior to
shipment are recorded as deferred revenue. The Company has entered into certain
licensing and distribution agreements for which payments received in advance are
recorded as deferred revenue. Revenue is recognized as earned per the terms of
the respective agreements. The Company provides for the cost of warranty at the
time of product shipment.


(4)  Comprehensive Income

     Statement of Financial Accounting Standards No. 130 (SFAS No. 130),
Reporting Comprehensive Income, requires disclosure of all components of
comprehensive income on an annual and interim basis. Comprehensive income is
defined as the change in equity of a business enterprise during a period from
transactions and other events and circumstances from non-owner sources. The
Company's total comprehensive income is as follows:

<TABLE>
<CAPTION>
                                         Three Months Ended              Six Months Ended
                                    -----------------------------    ----------------------------
                                    July 1, 2000     July 3, 1999    July 1, 2000    July 3, 1999
                                    ------------     ------------    ------------    ------------
                                     (Unaudited)     (Unaudited)      (Unaudited)     (Unaudited)

<S>                                   <C>            <C>              <C>            <C>
Net income (loss)                     $ 393,006      $(1,964,009)     $ 418,806      $(4,084,466)
Other comprehensive loss:
    Unrealized loss on marketable
      securities                        (39,806)              --        (82,605)          (3,641)
                                      ---------      -----------      ---------      -----------
Comprehensive net income (loss)       $ 353,200      $(1,964,009)     $ 336,201      $(4,088,107)
                                      =========      ===========      =========      ===========

</TABLE>


(5)  Investment in Sales-Type Leases

     The Company leases equipment to customers under sales-type leases. The
components of the Company's net investment in sales-type leases are as follows:

                                                  July 1,       December 31,
                                                   2000           1999
                                                -----------     ----------
                                                (Unaudited)

     Total minimum lease payments receivable     $5,857,850     $5,737,674
       Less-- unearned interest                   1,139,797      1,141,642
                                                 ----------     ----------
     Net investment in sales-type leases          4,718,053      4,596,032
       Less-- current portion                     1,818,339      1,689,585
                                                 ----------     ----------
                                                 $2,899,714     $2,906,447
                                                 ==========     ==========



                                       5
<PAGE>   8

(6)  Inventory

     Inventory consists of the following:

                                   July 1,     December 31,
                                    2000          1999
                                -----------    ------------
                                (Unaudited)

     Raw material               $  827,553      $  421,117
     Work-in-progress              207,891         100,586
     Finished goods              1,939,348         992,999
                                ----------      ----------
                                $2,974,792      $1,514,702
                                ==========      ==========


(7)  Segment Information and Enterprise Reporting

     The Company operates in one reportable segment as it has one family of
anesthesia monitoring systems. The Company does not disaggregate financial
information by product or geographically, other than export sales by region and
sales by product, for management purposes. Substantially all of the Company's
assets are located within the United States. All of the Company's products are
manufactured in the United States.

     Revenue by geographic destination and as a percentage of total revenue is
as follows:

<TABLE>
<CAPTION>
                                            Three Months Ended                 Six Months Ended
                                     ------------------------------      ------------------------------
                                     July 1, 2000      July 3, 1999      July 1, 2000      July 3, 1999
                                     ------------      ------------      ------------      ------------
                                     (Unaudited)       (Unaudited)       (Unaudited)       (Unaudited)

<S>                                  <C>               <C>               <C>               <C>
Geographic Area by Destination
   Domestic                          $ 9,337,416       $ 5,821,878       $17,603,035       $10,636,817
   International                       1,728,751           563,558         3,122,509         1,075,380
                                     -----------       -----------       -----------       -----------
                                     $11,066,167       $ 6,385,436       $20,725,544       $11,712,197
                                     ===========       ===========       ===========       ===========



                                           Three Months Ended                  Six Months Ended
                                     ------------------------------      ------------------------------
                                     July 1, 2000      July 3, 1999      July 1, 2000      July 3, 1999
                                     ------------      ------------      ------------      ------------
                                     (Unaudited)       (Unaudited)        (Unaudited)      (Unaudited)

Geographic Area by Destination
   Domestic                               84%              91%                 85%              91%
   International                          16                9                  15                9
                                         ---              ---                 ---              ---
                                         100%             100%                100%             100%
                                         ===              ===                 ===              ===

</TABLE>



                                       6
<PAGE>   9

(8)  Initial Public Offering

     On February 2, 2000, the Company completed the initial public offering of
its common stock. Upon the closing of the initial public offering, the Company
issued 3,500,000 shares of its common stock at an offering price of $15.00 per
share and all of the Company's convertible preferred stock automatically
converted into 11,067,238 shares of common stock. On February 4, 2000, the
underwriters exercised in full their over-allotment option to purchase an
additional 525,000 shares at $15.00 per share. Cash proceeds from the sale of
the 4,025,000 shares of common stock, net of the underwriters' discount and
offering expenses, totaled approximately $54.6 million. Also upon closing of the
Company's initial public offering, the authorized capital stock of the Company
consisted of 60,000,000 shares of common stock and 5,000,000 shares of preferred
stock. No shares of preferred stock are outstanding and the terms of the
preferred stock have not been designated.




                                       7
<PAGE>   10

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

This Quarterly Report on Form 10-Q contains, in addition to historical
information, forward-looking statements within the meaning of Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking statements
involve risks and uncertainties and are not guarantees of future performance.
Our actual results could differ significantly from the results discussed in such
forward-looking statements. See "Factors Affecting Future Operating Results"
below.

OVERVIEW

We develop, manufacture and market an anesthesia monitoring system that we call
the BIS system. The BIS system enables anesthesia providers to assess and manage
a patient's level of consciousness during surgery. Our proprietary BIS system
includes our BIS monitor or BIS Module Kit and our disposable BIS Sensors. The
BIS system is based on our patented core technology, the Bispectral Index, which
we refer to as the BIS index. Our latest generation monitor, the A-2000 BIS
Monitor, was cleared for marketing by the FDA in February 1998. Our other
monitor products are the A-1000 Monitor, the A-1050 EEG Monitor with BIS and the
BIS Module Kit. After the introduction of the A-2000 BIS Monitor, we ceased
active marketing of the A-1050 EEG Monitor domestically. In addition to the
disposable BIS Sensor, we offer the Zipprep EEG Electrode.

We follow a system of fiscal months as opposed to calendar months. Under this
system, the first eleven months of each fiscal year end on the Saturday closest
to the end of the calendar month and the last month of the fiscal year always
ends on December 31.

We offer customers the option either to purchase BIS monitors outright or to
acquire BIS monitors pursuant to a sales-type lease agreement whereby the
customer contractually commits to purchase a minimum number of BIS Sensors per
BIS monitor per year. Under this agreement, customers purchase BIS Sensors and
the BIS monitor for the purchase price of the BIS Sensors plus an additional
charge per BIS Sensor to pay for the purchase price of the BIS monitor and
related financing costs over the term of the agreement. The customer is granted
an option to purchase the BIS monitor at the end of the term of the agreement,
which is typically three to five years. Revenue related to BIS monitors sold
pursuant to sales-type leases is recognized at the time of shipment of the BIS
monitors. Sales-type leases accounted for approximately 6% and 23% of revenue in
the three months and 8% and 21% of revenue in the six months ended July 1, 2000
and July 3, 1999, respectively.

We derive our revenue primarily from sales of monitors, including related
accessories and BIS Module Kits, and sales of disposable sensors. In the three
months ended July 1, 2000 and July 3, 1999, revenue from the sale of monitors
represented approximately 48% and 55%, respectively, of our revenue, and revenue
from the sale of disposable sensors represented approximately 52% and 45%,
respectively, of our revenue. In the six months ended July 1, 2000 and July 3,
1999, revenue from the sale of monitors represented approximately 47% and 56%,
respectively, of our revenue, and revenue from the sale of disposable sensors
represented approximately 53% and 44%, respectively, of our revenue. In the
three months ended July 1, 2000, revenue from the sale of disposable sensors, as
a percentage of total revenue, decreased to 52% from 54% in the three months
ended April 1, 2000. In the three months ended July 1, 2000 revenue from the
sale of disposable sensors increased by 11% as compared to the three months
ended April 1, 2000. We intend to focus on improving disposable sensor
utilization in the second half of 2000. We expect that with increased focus on
disposable sensor utilization and growth in the installed base of monitors,
revenue from the sale of single-use disposable sensors will continue to increase
as a percentage of revenue.

Revenue from domestic sales in the three months ended July 1, 2000 and July 3,
1999 was approximately $9.3 million and $5.8 million, respectively, which
represented approximately 84% and 91%, respectively, of our revenue. Revenue
from domestic sales in the six months ended July 1, 2000 and July 3, 1999 was
approximately $17.6 million and $10.6 million, respectively, which represented
approximately 85% and 91%, respectively, of our revenue. Revenue from
international sales in the three months ended July 1, 2000 and July 3, 1999 was
approximately $1.7 million and $564,000, respectively, which represented
approximately 16% and 9%, respectively, of our revenue. Revenue from
international sales in the six months ended July 1, 2000 and July 3, 1999 was
approximately $3.1 million and $1.1 million, respectively, which represented
approximately 15% and 9%, respectively, of our revenue. In December 1998 and
March 1999, we established subsidiaries in The Netherlands and the United
Kingdom, respectively, to facilitate our entry into the international market. We
are developing our international sales and distribution program through a
combination of distributors and marketing



                                       8
<PAGE>   11

partners, including companies with which we have entered into original equipment
manufacturer relationships. We expect to enhance our international third-party
distribution program through direct sales efforts and to support our customers
with clinical specialists. In January 1998, we entered into a three-year
distribution agreement with Nihon Kohden Corporation to distribute BIS monitors
in Japan. In March 2000, the Japanese Ministry of Health and Welfare approved
our A-1050 EEG Monitor with BIS for marketing in Japan. Sales to Nihon Kohden
represented approximately 42% and 4% of international revenue for the three
months ended July 1, 2000 and July 3, 1999, respectively. Sales to Nihon Kohden
represented approximately 54% and 6% of international revenue for the six months
ended July 1, 2000 and July 3, 1999, respectively. As a result of our sales and
marketing efforts in the international market, we anticipate that international
sales will increase in absolute dollars.

RESULTS OF OPERATIONS

The following table presents, for the periods indicated, information expressed
as a percentage of revenue. This information has been derived from our
consolidated statements of operations included elsewhere in this Quarterly
Report on Form 10-Q. You should not draw any conclusions about our future
results from the results of operations for any period.


<TABLE>
<CAPTION>
                                               Three Months Ended             Six Months Ended
                                             ----------------------        ----------------------
                                             July 1,        July 3,        July 1,        July 3,
                                              2000           1999           2000           1999
                                             -------        -------        -------        -------

<S>                                            <C>            <C>            <C>            <C>
Revenue                                        100%           100%           100%           100%
Costs and expenses:
    Costs of revenue                            31             34             31             36
    Research and development                    13             19             14             20
    Sales and marketing                         47             65             48             65
    General and administrative                  15             18             14             19
                                              ----           ----           ----           ----
             Total costs and expenses          106            136            107            140
                                              ----           ----           ----           ----

Loss from operations                            (6)           (36)            (7)           (40)
Interest income, net                            10              5              9              5
                                              ----           ----           ----           ----
Net income (loss)                                4%           (31)%            2%           (35)%
                                              ====           ====           ====           ====

</TABLE>

THREE AND SIX MONTHS ENDED JULY 1, 2000 COMPARED TO THREE AND SIX MONTHS ENDED
JULY 3, 1999

Revenue. Our revenue increased to approximately $11.1 million in the three
months ended July 1, 2000 from approximately $6.4 million in the three months
ended July 3, 1999, an increase of approximately 73%. Our revenue increased to
approximately $20.7 million in the six months ended July 1, 2000 from
approximately $11.7 million in the six months ended July 3, 1999, an increase of
approximately 77%. Revenue from the sale of monitors increased to approximately
$5.3 million in the three months ended July 1, 2000 from approximately $3.5
million in the three months ended July 3, 1999, an increase of approximately
51%. Revenue from the sale of monitors increased to approximately $9.7 million
in the six months ended July 1, 2000 from approximately $6.6 million in the six
months ended July 3, 1999, an increase of approximately 47%. The growth in
revenue from the sale of monitors was primarily attributable to an increase of
approximately 68% and 69% in the number of monitors sold in the three and six
months ended July 1, 2000, as compared to the comparable periods in the prior
year. The increase in the number of monitors sold resulted from the growth of
our direct sales force, the development of our domestic distributor network and
the contribution of our international organization.

Revenue from the sale of disposable sensors increased to approximately $5.8
million in the three months ended July 1, 2000 from approximately $2.9 million
in the three months ended July 3, 1999, an increase of approximately 100%.
Revenue from the sale of disposable sensors increased to approximately $11.1
million in the six months ended July 1, 2000 from approximately $5.1 million in
the six months ended July 3, 1999, an increase of approximately 116%. The
increase in revenue from the sale of disposable sensors was primarily
attributable to growth in the installed base of monitors, which resulted in an
increase of approximately 102% and 117% in the number of disposable sensors sold
in the three and six months ended July 1, 2000 as compared to the three and six
months ended July 3, 1999, respectively.



                                       9
<PAGE>   12

Our gross profit was approximately 69% of revenue in the three months ended July
1, 2000 as compared to a gross profit of approximately 66% of revenue in the
three months ended July 3, 1999. Our gross profit was approximately 69% of
revenue in the six months ended July 1, 2000 as compared to a gross profit of
approximately 64% of revenue in the six months ended July 3, 1999. The increase
in the gross profit percentage in the three and six months ended July 1, 2000 as
compared to the three and six months ended July 3, 1999 was primarily
attributable to an increase in sales of disposable sensors as a percentage of
revenue. Disposable sensors have a higher profit margin than monitors and
contributed approximately 74% and 73% of the increase in gross profit in the
three and six months ended July 1, 2000 as compared to the comparable periods in
the prior year. We expect that sales of higher-margin disposable sensors will
continue to increase as a percentage of revenue as the installed base of
monitors continues to grow and we increase our focus on improving disposable
sensor utilization.

Research and Development. Research and development expenses increased to
approximately $1.4 million in the three months ended July 1, 2000 from
approximately $1.2 million in the three months ended July 3, 1999, an increase
of approximately 21%. Research and development expenses increased to
approximately $2.8 million in the six months ended July 1, 2000 from
approximately $2.3 million in the six months ended July 3, 1999, an increase of
approximately 20%. Research and development expenses decreased as a percentage
of revenue for the same periods. The increase in research and development
expenses for the three and six months ended July 1, 2000 as compared to the
three and six months ended July 3, 1999, was primarily attributable to an
increase in research and development personnel and related payroll and other
expenses, which represented approximately 82% and 87% of the increase,
respectively. These expenses were incurred in connection with the continued
product development efforts related to the A-2000 BIS Monitor, BIS Sensor and
BIS Module Kit and the development of products for use outside the operating
room in the intensive care unit and for procedural sedation. We expect research
and development expenses to increase as we continue to invest in the development
of product improvements, product extensions and new applications for our
technology.

Sales and Marketing. Sales and marketing expenses increased to approximately
$5.2 million in the three months ended July 1, 2000 from approximately $4.2
million in the three months ended July 3, 1999, an increase of approximately
26%. Sales and marketing expenses increased to approximately $9.9 million in the
six months ended July 1, 2000 from approximately $7.6 million in the six months
ended July 3, 1999, an increase of approximately 31%. Sales and marketing
expenses decreased as a percentage of revenue for the same periods. The increase
in sales and marketing expenses in the three and six months ended July 1, 2000
was primarily attributable to an increase in sales and marketing personnel and
related payroll and other expenses, which represented approximately 59% of the
increase in each period, and the increased operations of our international
subsidiaries, which represented approximately 27% and 25%, respectively, of the
increase. We expect sales and marketing expenses to increase as we continue to
expand our international operations, increase our direct sales force and
clinical specialists in the United States and engage in activities to further
educate and promote the use of the BIS system by our customers.

General and Administrative. General and administrative expenses increased to
approximately $1.7 million in the three months ended July 1, 2000 from
approximately $1.2 million in the three months ended July 3, 1999, an increase
of approximately 46%. General and administrative expenses increased to
approximately $3.0 million in the six months ended July 1, 2000 from
approximately $2.3 million in the six months ended July 3, 1999, an increase of
approximately 31%. General and administrative expenses decreased as a percentage
of revenue for the same periods. The increase in general and administrative
expenses in the three and six months ended July 1, 2000 was primarily
attributable to an increase in general and administrative personnel to support
our growth and related payroll and other expenses, which represented
approximately 22% and 42%, respectively, of the increase, compensation expense
related to stock options, which represented approximately 32% and 49%,
respectively, of the increase, and incremental expenses related to being a
public company, such as expenses related to enhancements of our investor
relations capabilities and insurance expenses, which represented approximately
23% and 26%, respectively, of the increase. We expect general and administrative
expenses to increase as we increase the number of personnel and related
resources required to support our growth.

Interest Income, Net. Interest income, net, increased to approximately $1.1
million in the three months ended July 1, 2000 from approximately $365,000 in
the three months ended July 3, 1999, an increase of approximately 201%. Interest
income, net, increased to approximately $1.9 million in the six months ended
July 1, 2000 from approximately $644,000 in the six months ended July 3, 1999,
an increase of approximately 192%. Interest income increased to approximately
$1.3 million in the three months ended July 1, 2000 from approximately $411,000
in the three months ended July 3, 1999, an increase of approximately 208%.
Interest income increased



                                       10
<PAGE>   13

to approximately $2.3 million in the six months ended July 1, 2000 from
approximately $740,000 in the six months ended July 3, 1999, an increase of
approximately 205%. The increase in interest income was primarily attributable
to a higher average balance of cash and investments resulting from our initial
public offering of common stock in February 2000 and the proceeds from the sale
of a portion of our investment in sales-type leases. Interest expense increased
to approximately $170,000 in the three months ended July 1, 2000 from
approximately $46,000 in the three months ended July 3, 1999, an increase of
approximately 268%. Interest expense increased to approximately $372,000 in the
six months ended July 1, 2000 from approximately $96,000 in the six months ended
July 3, 1999, an increase of approximately 288%. The increase in interest
expense in the three and six months ended July 1, 2000 was a result of higher
average outstanding debt obligations resulting from borrowings under a term loan
we entered into in December 1999 and debt obligations related to the sale of a
portion of our investments in sales-type leases in the second half of 1999 and
the first half of 2000. We expect interest income to increase during the
remainder of 2000 because of higher cash and investments balances that resulted
from our initial public offering.

Net Income (Loss). As a result of the factors discussed above, in the three and
six months ended July 1, 2000, we had net income of approximately $393,000 and
$419,000, respectively, as compared to a net loss of approximately $2.0 million
and $4.1 million in the three and six months ended July 3, 1999, respectively.
We have not included a provision for federal income taxes in the three and six
months ended July 1, 2000, because we have net operating loss and research and
development tax credit carryforwards to offset current year income.

LIQUIDITY AND CAPITAL RESOURCES

From our inception through January 2000, we financed our operations primarily
from the sale of our convertible preferred stock. Through July 1, 2000, we
raised approximately $67.6 million from private equity financings and have
received approximately $3.4 million in equipment financing and approximately
$2.9 million of financing related to our investments in sales-type leases. We
received approximately $2.8 million of financing under a term loan in December
1999. In February 2000, we closed our initial public offering of an aggregate of
4,025,000 shares of common stock and received net proceeds of approximately
$54.6 million. At July 1, 2000, we had approximately $730,000 committed
primarily to the purchase of equipment related to the expansion of our automated
BIS Sensor production line.

Working capital at July 1, 2000 was approximately $64.2 million compared to
approximately $12.3 million at December 31, 1999. The increase in working
capital from December 31, 1999 to July 1, 2000 was primarily attributable to the
proceeds from our initial public offering.

We used approximately $3.0 million of cash for operations in the six months
ended July 1, 2000 as compared to approximately $4.9 million in the six months
ended July 3, 1999. Cash used for operations during the six months ended July 1,
2000 was primarily driven by increases in net accounts receivable, inventory,
investment in sales-type leases and other current assets and decreases in
accrued liabilities and deferred revenue which were offset by an increase in
accounts payable.

We used approximately $29.3 million of cash for investing activities in the six
months ended July 1, 2000 as compared to receiving approximately $1.2 million in
the six months ended July 3, 1999. The cash used for investing activities in the
six months ended July 1, 2000 was primarily the result of the investment of the
proceeds we received from our February 2000 initial public offering of common
stock. Capital expenditures were approximately $3.6 million in the six months
ended July 1, 2000, primarily for manufacturing equipment and leasehold
improvements for our new facility, as compared to approximately $1.4 million in
the six months ended July 3, 1999.

We received approximately $54.8 million of cash from financing activities in the
six months ended July 1, 2000 as compared to approximately $1.1 million in the
six months ended July 3, 1999. The cash received from financing activities in
the six months ended July 1, 2000 was primarily a result of the closing of our
initial public offering of common stock. Cash from financing activities during
the six months ended July 3, 1999 resulted primarily from borrowings under a
working capital line of credit.

In December 1999, we renegotiated our loan agreement with Imperial Bank.
Borrowings outstanding at July 1, 2000 of approximately $1.1 million under the
equipment portion of the new loan agreement are payable in monthly installments
of approximately $60,000 plus interest through December 31, 2001. The working
capital portion of the original loan agreement was replaced with a term loan
portion. Borrowings under the term loan



                                       11
<PAGE>   14

portion outstanding at July 1, 2000 of approximately $2.4 million are payable in
36 monthly installments of approximately $79,000 plus interest which commenced
in January 2000. Interest on both the equipment portion and the term loan
portion of the new loan agreement accrued at the prime rate plus 1.0% through
the closing date of our initial public offering of common stock. Since the
closing date of our initial public offering, the interest rate has been the
prime rate plus 0.5%. The new loan agreement contains restrictive covenants that
require us to maintain liquidity and borrowing base ratios and restrict us from
declaring and paying cash dividends. The new loan agreement is secured by
substantially all of our assets. At December 31, 1999, no additional amounts may
be borrowed under the equipment portion or term loan portion of the new loan
agreement. Approximately $1.5 million is available under the standby letter of
credit portion of the new loan agreement.

In July 1999, we entered into an agreement under which we can sell a portion of
our existing and future investments in sales-type leases to AmeriCorp Financial,
Inc. Through July 1, 2000, we sold approximately $2.9 million of our investments
in sales-type leases. In accordance with Statement of Financial Accounting
Standards No. 125, Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities, the proceeds from these sales are classified
as debt. Payments on the outstanding principal under this debt match the timing
of the payments due on the underlying investments in sales-type leases.

We anticipate that capital expenditures will continue to increase in support of
our increased manufacturing capacity and new product activities and to build the
infrastructure necessary to accommodate our anticipated growth.

We believe that the financial resources available to us, including our current
working capital, together with the proceeds from selling our investments in
sales-type leases, will be sufficient to finance our planned operations and
capital expenditures at least through 2000. However, our future liquidity and
capital requirements will depend upon numerous factors, including the resources
required to further develop our marketing and sales organization domestically
and internationally, to expand manufacturing capacity, to finance our sales-type
lease program and to meet market demand for our products.

INCOME TAXES
We have net operating loss and research and development tax credit carryforwards
for federal income tax purposes that will expire commencing in the year 2002
through the year 2019 if not utilized.

The net operating loss and research and development tax credit carryforwards are
subject to review by the Internal Revenue Service. Ownership changes, as defined
in the Internal Revenue Code, may limit the amount of these tax attributes that
can be utilized annually to offset future taxable income or tax liabilities. The
amount of the annual limitation is determined based on our value immediately
prior to the ownership change. Subsequent ownership changes may further affect
the limitation in future years.

CONVERSION TO EURO

Eleven of the 15 members of the European Union have agreed to adopt the Euro as
their legal currency. Our current information systems allow us to process
Euro-denominated transactions. We are also assessing the business implications
of the conversion to the Euro, including long-term competitive implications and
the effect of market risk with respect to financial instruments. Substantially
all of our international sales are denominated in United States dollars. We do
not believe the Euro will have a significant effect on our business, financial
condition or results of operations. We will continue to assess the impact of
Euro conversion issues as the applicable accounting, tax, legal and regulatory
guidance evolves.

RECENT ACCOUNTING PRONOUNCEMENTS

In June 1998, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards No. 133 (SFAS No. 133), Accounting
for Derivatives and Hedging Activities, which establishes accounting and
reporting standards of derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. In June
1999, the FASB issued Statement of Financial Accounting Standards No. 137,
Accounting for Derivatives and Hedging Activities -- Deferral of the Effective
Date of FASB Statement No. 133, which defers the effective date of SFAS No. 133
to be effective for all fiscal quarters beginning after June 15, 2000. The
adoption of SFAS No. 133, as amended, is not expected to have a material effect
on our financial condition and results of operations as we do not currently hold
any derivative instruments or engage in hedging activities.



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<PAGE>   15

FACTORS AFFECTING FUTURE OPERATING RESULTS

Certain of the information contained in this Quarterly Report on Form 10-Q,
including our ability to sustain profitability, information with respect to
market acceptance of our BIS system, continued growth in sales of our BIS
monitors and BIS Sensors, our dependence on the BIS system, our ability to
remain competitive and achieve future growth and information with respect to
other plans and strategies for our business, consists of forward-looking
statements. The following factors represent current challenges to us that create
risk and uncertainty. Failure to adequately overcome any of the following
challenges, singularly or in combination, could have a material adverse effect
on our results of operations, business or financial condition.

WE WILL NOT BE PROFITABLE IF HOSPITALS AND ANESTHESIA PROVIDERS DO NOT BUY AND
USE OUR BIS SYSTEM IN SUFFICIENT QUANTITIES.

Customers may determine that the cost of the BIS system exceeds cost savings in
drugs, personnel and post-anesthesia care recovery resulting from use of the BIS
system. In addition, hospitals and anesthesia providers may not accept the BIS
system as an accurate means of assessing a patient's level of consciousness
during surgery if patients regain consciousness during surgery while being
monitored with the BIS system. If extensive or frequent malfunctions occur,
these providers may also conclude that the BIS system is unreliable. If
hospitals and anesthesia providers do not accept the BIS system as
cost-effective, accurate or reliable, they will not buy and use the BIS system
in sufficient quantities to enable us to be profitable.

WE DEPEND ON OUR BIS SYSTEM FOR SUBSTANTIALLY ALL OF OUR REVENUE, AND IF THE BIS
SYSTEM DOES NOT GAIN WIDESPREAD MARKET ACCEPTANCE, THEN OUR REVENUE WILL NOT
GROW.

We began selling our current BIS system in early 1998. To date, we have not
achieved widespread market acceptance of the BIS system. Because we depend on
our BIS system for substantially all of our revenue and we have no other
significant products, if we fail to achieve widespread market acceptance we will
not be able to sustain or grow our product revenue.

CASES OF SURGICAL AWARENESS DURING MONITORING WITH THE BIS SYSTEM COULD LIMIT
MARKET ACCEPTANCE OF BIS SYSTEMS AND COULD EXPOSE US TO PRODUCT LIABILITY
CLAIMS.

Clinicians have reported to us a total of 50 cases of possible surgical
awareness during surgical procedures monitored with the BIS system as of July 1,
2000. Not all cases of surgical awareness during surgical procedures monitored
with the BIS system may be reported to us, and we have not systematically
solicited reports of surgical awareness. Anesthesia providers and hospitals may
elect not to purchase and use BIS systems if there is adverse publicity
resulting from the report of cases of surgical awareness that were not detected
during procedures monitored with the BIS system. If anesthesia providers and
hospitals do not purchase and use the BIS system, then we may not sustain or
grow our product revenue. Although we do not claim that patient monitoring with
the BIS system will reduce the incidence of surgical awareness, we may be
subject to product liability claims for cases of surgical awareness during
surgical procedures monitored with the BIS system. These claims could require us
to spend significant time and money in litigation or to pay significant damages.

WE MAY NOT BE ABLE TO COMPETE WITH NEW PRODUCTS OR ALTERNATIVE TECHNIQUES
DEVELOPED BY OTHERS, WHICH COULD IMPAIR OUR ABILITY TO REMAIN COMPETITIVE AND
ACHIEVE FUTURE GROWTH.

The medical industry in which we market our products is characterized by rapid
product development and technological advances. Our current or planned products
are at risk of obsolescence from:

-    new monitoring products, based on new or improved technologies,

-    new products or technologies used on patients or in the operating room
     during surgery in lieu of monitoring devices,

-    electrical or mechanical interference from new or existing products or
     technologies,

-    alternative techniques for evaluating the effects of anesthesia,

-    significant changes in the methods of delivering anesthesia, and

-    the development of new anesthetic agents.



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<PAGE>   16

We may not be able to improve our products or develop new products or
technologies quickly enough to maintain a competitive position in our markets
and continue to grow our business.

IF WE DO NOT SUCCESSFULLY DEVELOP AND INTRODUCE ENHANCED OR NEW PRODUCTS WE
COULD LOSE REVENUE OPPORTUNITIES AND CUSTOMERS.

As the market for our BIS system matures, we need to develop and introduce new
products for anesthesia monitoring or other applications. We face at least the
following risks:

-    we may not successfully adapt the BIS system to function properly in the
     intensive care unit, for procedural sedation, when used with anesthetics we
     have not tested or with patient populations we have not studied, such as
     infants and young children, and

-    our technology is complex, and we may not be able to develop it further for
     applications outside anesthesia monitoring.

If we do not successfully adapt the BIS system for new products and applications
both within and outside the field of anesthesia monitoring, then we could lose
revenue opportunities and customers.

IF WE DO NOT DEVELOP AND IMPLEMENT A SUCCESSFUL SALES AND MARKETING STRATEGY, WE
WILL NOT EXPAND OUR BUSINESS.

Our current sales and marketing operation is not sufficient to achieve the level
of market awareness and sales we need to expand our business. We have only
limited sales and marketing experience both in the United States and
internationally and may not be successful in developing and implementing our
strategy. We need to:

-    provide or assure that distributors and original equipment manufacturers
     provide the technical and educational support customers need to use the BIS
     system successfully,

-    promote frequent use of the BIS system so that sales of our disposable BIS
     Sensors increase,

-    encourage our customers to purchase our products prior to availability of
     products that are made by original equipment manufacturers incorporating
     our technology,

-    manage geographically dispersed operations, and

-    modify our products for foreign markets.

IN ORDER TO REACH THE LEVEL OF SALES WE NEED TO SUSTAIN PROFITABILITY, WE NEED
TO FURTHER DEVELOP OUR DIRECT AND INDIRECT SALES CHANNELS.

In order to increase our sales, we need to add domestic and international
distributors, original equipment manufacturers and other sales channels and
increase sales through these channels. In addition, we need to hire and train
more sales persons and clinical specialists. If we do not further develop our
direct and indirect sales channels, we will not reach the level of sales
necessary to sustain profitability. In addition, we are transitioning to a new
vice president of sales. This may impact our revenue depending in part on the
time required to successfully implement the transition.

OUR THIRD-PARTY DISTRIBUTION AND ORIGINAL EQUIPMENT MANUFACTURER RELATIONSHIPS
COULD NEGATIVELY AFFECT OUR PROFITABILITY, CAUSE SALES OF OUR PRODUCTS TO
DECLINE AND BE DIFFICULT TO TERMINATE IF WE ARE DISSATISFIED.

Sales through distributors could be less profitable than direct sales. Sales of
our products through multiple channels could also confuse customers and cause
the sale of our products to decline. We do not control our original equipment
manufacturers and distribution partners. Our partners could sell competing
products and may devote insufficient sales efforts to our products. Our partners
are generally not required to purchase minimum quantities. As a result, even if
we are dissatisfied with the performance of our partners, we may be unable to
terminate our agreements with these partners or enter into alternative
arrangements.



                                       14
<PAGE>   17

WE MAY NOT BE ABLE TO GENERATE ENOUGH ADDITIONAL REVENUE FROM OUR PLANNED
INTERNATIONAL EXPANSION TO OFFSET THE COSTS ASSOCIATED WITH ESTABLISHING AND
MAINTAINING FOREIGN OPERATIONS.

A component of our growth strategy is to expand our presence in foreign markets.
We conduct international business primarily in Europe and Japan and we are
attempting to increase the number of countries in which we do business. It will
be costly to establish international facilities and operations and to promote
the BIS system in international markets. In addition, we have little experience
in marketing and distributing products for these markets. Revenue from
international activities may not offset the expense of establishing and
maintaining these foreign operations.

WE MAY NOT BE ABLE TO MEET THE UNIQUE OPERATIONAL, LEGAL AND FINANCIAL
CHALLENGES THAT WE WILL ENCOUNTER IN OUR INTERNATIONAL OPERATIONS, WHICH MAY
LIMIT THE GROWTH OF OUR BUSINESS.

We are increasingly subject to a number of challenges which specifically relate
to our international business activities. These challenges include:

-    failure of local laws to provide the same degree of protection against
     infringement of our intellectual property,

-    protectionist laws and business practices that favor local competitors,
     which could slow our growth in international markets,

-    less acceptance by foreign anesthesia providers of the use of disposable
     products similar to the BIS Sensor,

-    longer sales cycles to sell products like the BIS system to hospitals and
     outpatient surgical centers, which could slow our revenue growth from
     international sales, and

-    longer accounts receivable payment cycles and difficulties in collecting
     accounts receivable.

If we are unable to meet and overcome these challenges, our international
operations may not be successful which would limit the growth of our business.

WE MAY EXPERIENCE CUSTOMER DISSATISFACTION AND OUR REPUTATION COULD SUFFER IF WE
FAIL TO MANUFACTURE ENOUGH PRODUCTS TO MEET OUR CUSTOMERS' DEMANDS.

We rely on third-party manufacturers to assemble and manufacture the components
of our BIS monitors and a portion of our BIS Sensors. We manufacture
substantially all BIS Sensors in our own manufacturing facility. We have only
one manufacturing facility. If we fail to produce enough products at our own
manufacturing facility or at a third-party manufacturing facility or experience
a termination or modification of any manufacturing arrangement with a third
party, we may be unable to deliver products to our customers on a timely basis.
Our failure to deliver products on a timely basis could lead to customer
dissatisfaction and damage our reputation.

OUR RELIANCE ON SOLE SUPPLIERS COULD ADVERSELY AFFECT OUR ABILITY TO MEET OUR
CUSTOMERS' DEMANDS FOR OUR PRODUCTS IN A TIMELY MANNER OR WITHIN BUDGET.

Some of the components that are necessary for the assembly of our BIS system,
including some of the components used in the BIS Sensor, are currently provided
to us by separate sole suppliers or a limited group of suppliers. We purchase
components through purchase orders rather than long-term supply agreements and
generally do not maintain large volumes of inventory. We have experienced
shortages and delays in obtaining some of the components of our BIS systems in
the past, and we may experience similar delays or shortages in the future. The
disruption or termination of the supply of components could cause a significant
increase in the costs of these components, which could affect our profitability.
A disruption or termination in the supply of components could also result in our
inability to meet demand for our products, which could lead to customer
dissatisfaction and damage our reputation. Furthermore, if we are required to
change the manufacturer of a key component of the BIS system, we may be required
to verify that the new manufacturer maintains facilities and procedures that
comply with quality standards and with all applicable regulations and
guidelines. The delays associated with the verification of a new manufacturer
could delay our ability to manufacture BIS systems in a timely manner or within
budget.



                                       15
<PAGE>   18

WE MAY BE REQUIRED TO BRING LITIGATION TO ENFORCE OUR INTELLECTUAL PROPERTY
RIGHTS, WHICH MAY RESULT IN SUBSTANTIAL EXPENSE AND MAY DIVERT OUR ATTENTION
FROM THE IMPLEMENTATION OF OUR BUSINESS STRATEGY.

We believe that the success of our business depends, in part, on obtaining
patent protection for our products, defending our patents once obtained and
preserving our trade secrets. We rely on a combination of contractual
provisions, confidentiality procedures and patent, trademark and trade secret
laws to protect the proprietary aspects of our technology. These legal measures
afford only limited protection and competitors may gain access to our
intellectual property and proprietary information. Litigation may be necessary
to enforce our intellectual property rights, to protect our trade secrets and to
determine the validity and scope of our proprietary rights. Any litigation could
result in substantial expense and diversion of our attention from the growth of
the business and may not be adequate to protect our intellectual property
rights.

WE DO NOT OWN THE TRADEMARK "ASPECT" AND ANY COMPETITIVE ADVANTAGE WE DERIVE
FROM THE NAME MAY BE IMPAIRED BY THIRD-PARTY USE.

We are a party to a license agreement with a third party under which we have
obtained the nonexclusive right to make, use or sell products under the name
"Aspect." The licensor of the Aspect name markets products for use in the health
care industry. There may be confusion in the market between the licensor and us
and this confusion could compromise the competitive advantage, if any, we derive
from our name.

WE MAY BE SUED BY THIRD PARTIES WHICH CLAIM THAT OUR PRODUCTS INFRINGE ON THEIR
INTELLECTUAL PROPERTY RIGHTS, PARTICULARLY BECAUSE THERE IS SUBSTANTIAL
UNCERTAINTY ABOUT THE VALIDITY AND BREADTH OF MEDICAL DEVICE PATENTS.

We may be exposed to litigation by third parties based on claims that our
products infringe the intellectual property rights of others. This risk is
exacerbated by the fact that the validity and breadth of claims covered in
medical technology patents involve complex legal and factual questions for which
important legal principles are unresolved. Any litigation or claims against us,
whether or not valid, could result in substantial costs, could place a
significant strain on our financial resources and could harm our reputation. In
addition, intellectual property litigation or claims could force us to do one or
more of the following:

-    cease selling, incorporating or using any of our products that incorporate
     the challenged intellectual property, which would adversely affect our
     revenue,

-    obtain a license from the holder of the infringed intellectual property
     right, which license may not be available on reasonable terms, if at all,
     and

-    redesign our products, which would be costly and time-consuming.

WE COULD BE EXPOSED TO SIGNIFICANT PRODUCT LIABILITY CLAIMS WHICH COULD DIVERT
MANAGEMENT ATTENTION AND ADVERSELY AFFECT OUR CASH BALANCES, OUR ABILITY TO
OBTAIN AND MAINTAIN INSURANCE COVERAGE AT SATISFACTORY RATES OR IN ADEQUATE
AMOUNTS AND OUR REPUTATION.

The manufacture and sale of our products expose us to product liability claims
and product recalls, including those which may arise from misuse or malfunction
of, or design flaws in, our products or use of our products with components or
systems not manufactured or sold by us. Product liability claims or product
recalls, regardless of their ultimate outcome, could require us to spend
significant time and money in litigation or to pay significant damages. We
currently maintain insurance; however, it might not cover the costs of any
product liability claims made against us. Furthermore, we may not be able to
obtain insurance in the future at satisfactory rates or in adequate amounts. In
addition, publicity pertaining to the misuse or malfunction of, or design flaws
in, our products could impair our ability to successfully market and sell our
products.



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<PAGE>   19

FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS COULD CAUSE OUR STOCK PRICE TO
DECREASE.

Our operating results have fluctuated significantly from quarter to quarter in
the past and are likely to vary in the future. These fluctuations are due to
several factors relating to the sale of our products, including the timing and
volume of customer orders for our BIS system, use of and demand for our BIS
Sensors, customer cancellations, reductions in orders by our distribution
partners and the timing and amount of our expenses. Because of these
fluctuations, it is likely that in some future quarter or quarters our operating
results could fall below the expectations of securities analysts or investors.
If so, the market price of our stock would likely decrease. In addition, because
we do not have a significant backlog of customer orders for our BIS system,
revenue in any quarter depends on orders received in that quarter. Our quarterly
results may also be adversely affected because some customers may have
inadequate financial resources to purchase our products or may fail to pay for
our products after receiving them. In particular, hospitals are increasingly
experiencing financial constraints, consolidations and reorganizations as a
result of cost containment measures and declining third-party reimbursement for
services, which may result in decreased product orders or an increase in bad
debts in any quarter.

VARIOUS MARKET FACTORS MAY ADVERSELY AFFECT OUR QUARTERLY OPERATING RESULTS FOR
THE THIRD FISCAL QUARTER OF 2000.

Various factors may adversely affect our quarterly operating results for the
third fiscal quarter of 2000. We are facing increased competition in the
domestic level of consciousness monitoring market as a result of recent FDA
approval of a new monitoring system. Second, we are making a transition to a new
vice president of sales. This may adversely impact our revenue for the third
fiscal quarter of 2000, depending in part on the amount of time required to
successfully implement the transition. Third, revenue from sales of our BIS
Sensors as a percent of total revenue in the second fiscal quarter of 2000
declined as compared to the first fiscal quarter of 2000. Fourth, revenue for
the third fiscal quarter of 2000 may be adversely affected by seasonal factors.

WE MAY NOT RESERVE AMOUNTS ADEQUATE TO COVER PRODUCT OBSOLESCENCE, CLAIMS AND
RETURNS, WHICH COULD RESULT IN UNANTICIPATED EXPENSES AND FLUCTUATIONS IN
OPERATING RESULTS.

Depending on factors such as the timing of our introduction of new products
which utilize our BIS technology, as well as warranty claims and product
returns, we may need to reserve amounts in excess of those currently reserved
for product obsolescence, excess inventory, warranty claims and product returns.
These reserves may not be adequate to cover all costs associated with these
items. If these reserves are inadequate, we would be required to incur
unanticipated expenses which could result in unexpected fluctuations in
quarterly operating results.

WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY, WHICH COULD RESULT IN PRICE
REDUCTIONS AND DECREASED DEMAND FOR OUR PRODUCTS.

We are facing increased competition in the domestic level of consciousness
monitoring market as a result of recent FDA approval of a new monitoring
product. This recently approved product is expected to be marketed by a
well-established medical products company with significant resources. We may not
be able to compete effectively with these potential competitors. We may also
face substantial competition from companies developing sensor products that
compete with our proprietary BIS Sensors for use with our BIS monitors or with
third-party monitoring systems or anesthesia delivery systems that incorporate
the BIS index. We also expect to face competition from companies currently
marketing conventional electroencephalogram, or EEG, monitors using standard and
novel signal-processing techniques. Other companies may develop
anesthesia-monitoring systems that perform better than the BIS system and/or
sell for less. In addition, one or more of our competitors may develop products
that are substantially equivalent to our FDA-approved products, in which case
they may be able to use our products as predicate devices to more quickly obtain
FDA approval of their competing products. Medical device companies developing
these and other competitive products may have greater financial, technical,
marketing and other resources than we do. Competition in the sale of
anesthesia-monitoring systems could result in price reductions, fewer orders,
reduced gross margins and loss of market share.



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<PAGE>   20

OUR ABILITY TO MARKET AND SELL OUR PRODUCTS AND GENERATE REVENUE DEPENDS UPON
RECEIPT OF DOMESTIC AND FOREIGN REGULATORY APPROVAL OF OUR PRODUCTS AND
MANUFACTURING OPERATIONS.

Before we can market new products in the United States we must obtain clearance
from the United States Food and Drug Administration, or FDA. If the FDA
concludes that any of our products do not meet the requirements to obtain
clearance of a premarket notification under Section 510(k) of the Food, Drug and
Cosmetic Act, then we would be required to file a premarket approval
application. The approval process for a premarket approval application is
lengthy, expensive and typically requires extensive preclinical and clinical
trial data. We may not obtain clearance of a 510(k) notification or approval of
a premarket approval application with respect to any of our products on a timely
basis, if at all. If we fail to obtain timely clearance or approval for our
products, we will not be able to market and sell our products, which will limit
our ability to generate revenue. We may also be required to obtain clearance of
a 510(k) notification from the FDA before we can market certain previously
marketed products which we modify after they have been cleared. We have made
certain enhancements to our currently marketed products which we have determined
do not necessitate the filing of a new 510(k) notification. However, if the FDA
does not agree with our determination, it will require us to file a new 510(k)
notification for the modification and we may be prohibited from marketing the
modified device until we obtain FDA clearance.

The FDA also requires us to adhere to current Good Manufacturing Practices
regulations, which include production design controls, testing, quality control,
storage and documentation procedures. The FDA may at any time inspect our
facilities to determine whether adequate compliance has been achieved.
Compliance with current Good Manufacturing Practices regulations for medical
devices is difficult and costly. In addition, we may not continue to be
compliant as a result of future changes in, or interpretations of, regulations
by the FDA or other regulatory agencies. If we do not achieve continued
compliance, the FDA may withdraw marketing clearance or require product recall.
When any change or modification is made to a device or its intended use, the
manufacturer may be required to reassess compliance with current Good
Manufacturing Practices regulations, which may cause interruptions or delays in
the marketing and sale of our products.

Sales of our products outside the United States are subject to foreign
regulatory requirements that vary from country to country. The time required to
obtain approvals from foreign countries may be longer than that required for FDA
approval, and requirements for foreign licensing may differ from FDA
requirements.

The federal, state and foreign laws and regulations regarding the manufacture
and sale of our products are subject to future changes, as are administrative
interpretations of regulatory agencies. If we fail to comply with applicable
federal, state or foreign laws or regulations, we could be subject to
enforcement actions, including product seizures, recalls, withdrawal of
clearances or approvals and civil and criminal penalties.

IF WE DO NOT RETAIN OUR SENIOR MANAGEMENT AND OTHER KEY EMPLOYEES, WE MAY NOT BE
ABLE TO SUCCESSFULLY IMPLEMENT OUR BUSINESS STRATEGY.

Our president and chief executive officer, Nassib Chamoun, joined us at our
inception in 1987. Our chairman, J. Breckenridge Eagle, began serving as a
director in 1988. Many other members of our management and key employees have
extensive experience with us and other companies in the medical device industry.
Our success is substantially dependent on the ability, experience and
performance of these members of our senior management and other key employees.
Because of their ability and experience, if we lose one or more of the members
of our senior management or other key employees, our ability to successfully
implement our business strategy could be seriously harmed.

IF WE DO NOT ATTRACT AND RETAIN SKILLED PERSONNEL, WE WILL NOT BE ABLE TO EXPAND
OUR BUSINESS.

Our products are based on complex signal-processing technology. Accordingly, we
require skilled personnel to develop, manufacture, sell and support our
products. Our future success will depend largely on our ability to continue to
hire, train, retain and motivate additional skilled personnel, particularly
sales representatives and clinical specialists who are responsible for customer
education and training and post-installation customer support. We continue to
experience difficulty in recruiting and retaining skilled personnel because the
pool of experienced persons is small and we compete for personnel with other
companies, many of which have greater resources than we do. Consequently, if we
are not able to attract and retain skilled personnel, we will not be able to
expand our business.



                                       18
<PAGE>   21

FAILURE OF USERS OF THE BIS SYSTEM TO OBTAIN ADEQUATE REIMBURSEMENT FROM
THIRD-PARTY PAYORS COULD LIMIT MARKET ACCEPTANCE OF THE BIS SYSTEM, WHICH COULD
PREVENT US FROM SUSTAINING PROFITABILITY.

Anesthesia providers are generally not reimbursed separately for patient
monitoring activities utilizing the BIS system. For hospitals and outpatient
surgical centers, when reimbursement is based on charges or costs, patient
monitoring with the BIS system may reduce reimbursements for surgical
procedures, because charges or costs may decline as a result of monitoring with
the BIS system. Failure by hospitals and other users of the BIS system to obtain
adequate reimbursement from third-party payors, or any reduction in the
reimbursement by third-party payors to hospitals and other users as a result of
using the BIS system could limit market acceptance of the BIS system, which
could prevent us from sustaining profitability.


ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to financial market risks, including changes in foreign currency
exchange rates and interest rates. Most of our revenue, expenses and capital
spending are transacted in U.S. dollars. However, the expenses and capital
spending of our international subsidiaries are transacted in local currency. As
a result, changes in foreign currency exchange rates or weak economic conditions
in foreign markets could affect our financial results. We do not use derivative
instruments to hedge our foreign exchange risk. Our exposure to market risk for
changes in interest rates relates primarily to our cash and cash equivalent
balances, marketable securities, investment in sales-type leases and our
commercial loan agreement with Imperial Bank. The majority of our investments
are in short-term instruments and subject to fluctuations in U.S. interest
rates. Due to the nature of our short-term investments, we believe that there is
no material risk exposure.



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<PAGE>   22

                          PART II -- OTHER INFORMATION

ITEM 1.   LEGAL PROCEEDINGS

          None.

ITEM 2.   CHANGES IN SECURITIES AND USE OF PROCEEDS

          (a) Initial Public Offering

               On February 2, 2000, we sold 3,500,000 shares of our common
          stock, at an initial public offering price of $15.00 per share,
          pursuant to a Registration Statement on Form S-1 (Registration No.
          333-86295), which was declared effective by the Securities and
          Exchange Commission on January 27, 2000. On February 4, 2000, the
          underwriters exercised in full their over-allotment option to purchase
          an additional 525,000 shares at $15.00 per share. The managing
          underwriters of our initial public offering were Morgan Stanley & Co.
          Incorporated, Deutsche Bank Securities Inc. and U.S. Bancorp Piper
          Jaffray Inc.

               The aggregate gross proceeds raised in the offering were
          approximately $60.4 million. Our total expenses in connection with the
          offering were approximately $5.7 million, of which $4.2 million was
          for underwriting discounts and commissions and, based on our
          reasonable estimate, approximately $1.5 million was for other
          expenses. Our net proceeds from the offering were approximately $54.6
          million. From January 27, 2000 through July 1, 2000, we used
          approximately $3.6 million of the net proceeds for the acquisition of
          machinery and equipment and for leasehold improvements to our new
          facility in Newton, Massachusetts. In addition, from January 27, 2000
          through July 1, 2000, we used approximately $2.6 million of the net
          proceeds for general corporate purposes, including working capital,
          product development, increasing our sales and marketing capabilities
          and expanding our international operations. As of July 1, 2000, we had
          approximately $48.4 million of proceeds remaining from the offering,
          and pending use of the proceeds, we have invested these funds in
          short-term, interest-bearing, investment-grade securities.

          (b) Warrant Exercise

               On May 10, 2000, we issued 606 shares of our common stock to one
          of our stockholders pursuant to the exercise of a warrant issued by us
          in December 1998. The exercise price of the warrant was $12.50 per
          share of our common stock, however the warrant was exercised pursuant
          to a cashless exercise provision contained in the warrant. As a
          result, we received no consideration as a result of the exercise of
          the warrant. The shares of our common stock issued upon exercise of
          the warrant were issued in reliance upon the exemptions from
          registration under Section 4(2) of the Securities Act of 1933, as
          amended, or Regulation D promulgated thereunder, relative to sales by
          an issuer not involving any public offering.

          (c) Grants and Exercises of Stock Options

               During the quarterly period ended July 1, 2000, we granted stock
          options to purchase 151,800 shares of our common stock at exercise
          prices ranging from $28.625 to $46.438 per share to employees,
          consultants and directors pursuant to our 1998 Stock Incentive Plan.

               During the quarterly period ended July 1, 2000, we issued and
          sold an aggregate of 46,040 shares of our common stock to employees
          and consultants for aggregate consideration of approximately $156,700
          pursuant to exercises of options under our Amended and Restated 1991
          Stock Option Plan and 1998 Stock Incentive Plan. These sales were made
          in reliance upon an exemption from registration under Rule 701 of the
          Securities Act of 1933, as amended.



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<PAGE>   23

ITEM 3.   DEFAULTS UPON SENIOR SECURITIES
          None.


ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
          None.


ITEM 5.   OTHER INFORMATION
          None.


ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K
          (a) Exhibits

          27      Financial Data Schedule for the Six Months Ended July 1, 2000

          (b) Reports on Form 8-K

          We did not file any reports on Form 8-K during the quarter ended
July 1, 2000.



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<PAGE>   24

                                    SIGNATURE

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.

                                 ASPECT MEDICAL SYSTEMS, INC.




Date: August 11, 2000            By: /s/ J. Neal Armstrong
                                    ---------------------------------
                                    J. Neal Armstrong
                                    Vice President and Chief Financial Officer
                                    (Principal Financial and Accounting Officer)




                                       22
<PAGE>   25

                                  EXHIBIT INDEX

EXHIBIT
NUMBER           EXHIBIT
-------          -------

  27             Financial Data Schedule for the Six Months Ended July 1, 2000




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