##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 28, 2008
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission file number: 0-24663
 ASPECT MEDICAL SYSTEMS, INC.
  Delaware
    
    04-2985553(State or Other Jurisdiction of 
Incorporation or Organization)
    
    (I.R.S. Employer Identification No.)One Upland Road, Norwood, Massachusetts
(Address of Principal Executive Offices)
    
    02062
(Zip Code)
 (617) 559-7000
  
 þ o
  Large accelerated filer oAccelerated filer þNon-accelerated filer o(Do not check if a smaller reporting company)Smaller reporting company o o þ




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##### 



PagePART I
    
    FINANCIAL INFORMATION
    
    
    1Item 1.
    
    Condensed Consolidated Financial Statements (unaudited)
    
    
    1Condensed Consolidated Balance Sheets (unaudited)
as of June 28, 2008 and December 31, 2007
    
    
    1Condensed Consolidated Statements of Income
(unaudited) for the Three and Six Months Ended June
28, 2008 and June 30, 2007
    
    
    2Condensed Consolidated Statements of Cash Flows
(unaudited) for the Six Months Ended June 28, 2008
and June 30, 2007
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements
Discussion and Analysis of Financial Condition and Results of Operations
    
    
    19Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    32Item 4.
    
    Controls and Procedures
    
    
    32PART II
    
    OTHER INFORMATION
    
    
    33Item 1.
    
    Legal Proceedings
    
    
    33Item 1A.
    
    Risk Factors
    
    
    33Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    51Item 6.
    
    Exhibits
    
    
    52SIGNATURES
    
    
    53Ex-31.1 Section 302 Certification of CEOEx-31.2 Section 302 Certification of CFOEx-32.1 Section 906 Certification of CEOEx-32.2 Section 906 Certification of CFO




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1.
    FINANCIAL STATEMENTS.
 ASPECT MEDICAL SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share data and per share amounts)
(unaudited)
 June 28,
    
    
    December 31,2008
    
    
    2007ASSETSCurrent assets:Cash and cash equivalents
    
    $
    9,137
    
    
    $
    19,828Short-term investments
    
    
    81,270
    
    
    
    82,134Accounts receivable, net of allowance of $325 at June
28, 2008 and $322 at December 31, 2007
    
    
    13,027
    
    
    
    12,544Current portion of investment in sales-type leases
    
    
    1,257
    
    
    
    1,473Inventory
    
    
    6,687
    
    
    
    7,113Deferred tax assets
    
    
    4,729
    
    
    
    4,729Other current assets
    
    
    3,258
    
    
    
    2,677Total current assets
    
    
    119,365
    
    
    
    130,498Property and equipment, net
    
    
    8,226
    
    
    
    8,455Long-term restricted cash
    
    
    1,009
    
    
    
    1,004Long-term investments
    
    
    15,654
    
    
    
    6,518Long-term investment in sales-type leases
    
    
    1,983
    
    
    
    2,618Deferred financing fees
    
    
    3,576
    
    
    
    4,213Long-term deferred tax assets
    
    
    18,683
    
    
    
    20,171Total assets
    
    $
    168,496
    
    
    $
    173,477LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,670
    
    
    $
    1,836Accrued liabilities
    
    
    8,941
    
    
    
    9,723Current portion of obligation under capital lease
    
    
    67
    
    
    
    28Deferred revenue
    
    
    46
    
    
    
    87Total current liabilities
    
    
    10,724
    
    
    
    11,674Long-term portion of obligation under capital lease
    
    
    111
    
    
    
    89Long-term portion of deferred revenue
    
    
    98
    
    
    
    39Long-term debt
    
    
    115,000
    
    
    
    125,000Commitments and contingenciesStockholders equity:Preferred stock, $.01 par value; 5,000,000 shares
authorized, no shares issued or outstanding
    
    
    
    
    
    
    Common stock, $.01 par value; 60,000,000 shares
authorized, 17,266,771 and 17,118,037 shares issued
and outstanding at June 28, 2008 and December 31,
2007, respectively
    
    
    175
    
    
    
    174Treasury stock, at cost; 276,493 shares
    
    
    (5,008
    )
    
    
    (5,008
    )Additional paid-in capital
    
    
    183,284
    
    
    
    178,837Accumulated other comprehensive (loss) income
    
    
    (44
    )
    
    
    180Accumulated deficit
    
    
    (135,844
    )
    
    
    (137,508
    )Total stockholders equity
    
    
    42,563
    
    
    
    36,675Total liabilities and stockholders equity
    
    $
    168,496
    
    
    $
    173,477
  1




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
(unaudited)
 Three Months Ended
    
    
    Six Months EndedJune 28, 2008
    
    
    June 30, 2007
    
    
    June 28, 2008
    
    
    June 30, 2007Product revenue
    
    $
    25,185
    
    
    $
    23,079
    
    
    $
    49,613
    
    
    $
    45,514Strategic alliance revenue
    
    
    
    
    
    
    3,562
    
    
    
    
    
    
    
    5,246Total revenue
    
    
    25,185
    
    
    
    26,641
    
    
    
    49,613
    
    
    
    50,760Costs of revenue (1)
    
    
    6,353
    
    
    
    5,767
    
    
    
    12,839
    
    
    
    11,846Gross profit
    
    
    18,832
    
    
    
    20,874
    
    
    
    36,774
    
    
    
    38,914Operating expenses: (1)Research and development
    
    
    3,934
    
    
    
    4,194
    
    
    
    7,873
    
    
    
    8,414Sales and marketing
    
    
    11,672
    
    
    
    10,199
    
    
    
    21,874
    
    
    
    20,244General and administrative
    
    
    4,172
    
    
    
    4,016
    
    
    
    8,114
    
    
    
    7,680Total operating
expenses
    
    
    19,778
    
    
    
    18,409
    
    
    
    37,861
    
    
    
    36,338(Loss) income from operations
    
    
    (946
    )
    
    
    2,465
    
    
    
    (1,087
    )
    
    
    2,576Other income (expense):Interest income
    
    
    1,103
    
    
    
    1,020
    
    
    
    2,381
    
    
    
    2,001Interest expense
    
    
    (928
    )
    
    
    (115
    )
    
    
    (1,876
    )
    
    
    (115
    )Gain on repurchase of debt
    
    
    3,940
    
    
    
    
    
    
    
    3,940
    
    
    
    Income before income taxes
    
    
    3,169
    
    
    
    3,370
    
    
    
    3,358
    
    
    
    4,462Provision for income taxes
    
    
    1,270
    
    
    
    1,882
    
    
    
    1,694
    
    
    
    2,458Net income
    
    $
    1,899
    
    
    $
    1,488
    
    
    $
    1,664
    
    
    $
    2,004Net income per share:Basic
    
    $
    0.11
    
    
    $
    0.07
    
    
    $
    0.10
    
    
    $
    0.09Diluted
    
    $
    0.10
    
    
    $
    0.07
    
    
    $
    0.10
    
    
    $
    0.09Weighted average shares used in
computing net income per share:Basic
    
    
    17,217
    
    
    
    21,836
    
    
    
    17,183
    
    
    
    22,122Diluted
    
    
    23,754
    
    
    
    23,275
    
    
    
    17,409
    
    
    
    23,076(1) Stock-based compensation
included in costs and expenses:Costs of revenue
    
    $
    124
    
    
    $
    141
    
    
    $
    243
    
    
    $
    286Research and development
    
    
    487
    
    
    
    490
    
    
    
    956
    
    
    
    1,014Sales and marketing
    
    
    669
    
    
    
    789
    
    
    
    1,345
    
    
    
    1,597General and administrative
    
    
    650
    
    
    
    717
    
    
    
    1,328
    
    
    
    1,457
  2




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
 Six Months EndedJune 28,
    
    
    June 30,2008
    
    
    2007Cash flows from operating activities:Net income
    
    $
    1,664
    
    
    $
    2,004Adjustments to reconcile net income to net cash provided by
operating activities Depreciation and amortization
    
    
    1,500
    
    
    
    1,080Gain on repurchase of debt
    
    
    (3,940
    )
    
    
    Provision for doubtful accounts
    
    
    13
    
    
    
    56Stock-based compensation expense
    
    
    3,821
    
    
    
    4,306Tax benefit for stock option exercises
    
    
    17
    
    
    
    Deferred taxes
    
    
    1,489
    
    
    
    2,371Changes in assets and liabilities (Increase) decrease in accounts receivable
    
    
    (497
    )
    
    
    602Decrease (increase) in inventory
    
    
    426
    
    
    
    (375
    )Increase in other current assets
    
    
    (581
    )
    
    
    (321
    )Decrease (increase) in investment in sales-type leases
    
    
    851
    
    
    
    (282
    )Increase in other long-term assets
    
    
    
    
    
    
    (371
    )Decrease in accounts payable
    
    
    (166
    )
    
    
    (409
    )(Decrease) increase in accrued liabilities
    
    
    (782
    )
    
    
    1,156Increase (decrease) in deferred revenue
    
    
    18
    
    
    
    (5,242
    )Net cash provided by operating activities
    
    
    3,833
    
    
    
    4,575Cash flows from investing activities:(Increase) decrease in restricted cash
    
    
    (5
    )
    
    
    40Acquisitions of property and equipment
    
    
    (836
    )
    
    
    (1,894
    )Purchases of marketable securities
    
    
    (65,121
    )
    
    
    (76,154
    )Proceeds from sales and maturities of marketable securities
    
    
    56,625
    
    
    
    69,947Net cash used for investing activities
    
    
    (9,337
    )
    
    
    (8,061
    )Cash flows from financing activities:Repurchases of common stock
    
    
    
    
    
    
    (47,386
    )Payment on deferred financing fees
    
    
    
    
    
    
    (4,471
    )Proceeds from issuance of common stock
    
    
    611
    
    
    
    906Proceeds from long-term debt
    
    
    
    
    
    
    125,000Repayment of long-term debt
    
    
    (5,746
    )
    
    
    Repayment of capital lease
    
    
    (52
    )
    
    
    Net cash (used for) provided by financing activities
    
    
    (5,187
    )
    
    
    74,049Net (decrease) increase in cash and cash equivalents
    
    
    (10,691
    )
    
    
    70,563Cash and cash equivalents, beginning of period
    
    
    19,828
    
    
    
    9,724Cash and cash equivalents, end of period
    
    $
    9,137
    
    
    $
    80,287
  3




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 (1) Basis of Presentation
   (2) Summary of Significant Accounting Policies
  Principles of Consolidation
  Foreign Currency
  Cash, Cash Equivalents and Marketable Securities
  Accounting for Certain Investments
in Debt and Equity Securities
 4




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 Revenue Recognition
  Revenue Recognition, Revenue
Arrangements with Multiple Deliverables
 Accounting For Leases
    Accounting for
Contingencies
 5




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 Research and Development Costs
  Allowance for Doubtful Accounts
  Inventory
  Warranty
  Three Months Ended
    
    
    Six Months EndedJune 28, 2008
    
    
    June 30, 2007
    
    
    June 28, 2008
    
    
    June 30, 2007Beginning balance
    
    $
    226
    
    
    $
    215
    
    
    $
    250
    
    
    $
    220Warranty expense
    
    
    41
    
    
    
    15
    
    
    
    30
    
    
    
    19Deductions and other
    
    
    (13
    )
    
    
    (7
    )
    
    
    (26
    )
    
    
    (16
    )Ending balance
    
    $
    254
    
    
    $
    223
    
    
    $
    254
    
    
    $
    223
 Shipping and Handling Costs
  Advertising Costs
  Property and Equipment
  6




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 Accounting for the Costs of Computer Software Developed
or Obtained for Internal Use
 Accounting For Changes and Error
Corrections
 Income Taxes
 Accounting for Income
Taxes Accounting for Uncertainty in Income
Taxes  an Interpretation of FASB Statement No. 109
 Concentration of Credit Risk
  Single or Limited Source Suppliers
  Net Income Per Share
 Earnings Per Share
  7




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
  Three Months Ended
    
    
    Six Months EndedJune 28,
    
    
    June 30,
    
    
    June 28,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007Basic:Net income
    
    $
    1,899
    
    
    $
    1,488
    
    
    $
    1,664
    
    
    $
    2,004Weighted average shares outstanding
    
    
    17,217
    
    
    
    21,836
    
    
    
    17,183
    
    
    
    22,122Basic net income per share
    
    $
    0.11
    
    
    $
    0.07
    
    
    $
    0.10
    
    
    $
    0.09Diluted:Net income
    
    $
    1,899
    
    
    $
    1,488
    
    
    $
    1,664
    
    
    $
    2,004Interest expense on convertible
debt, net
    
    
    558
    
    
    
    115
    
    
    
    
    
    
    
    115Net income as adjusted
    
    $
    2,457
    
    
    $
    1,603
    
    
    $
    1,664
    
    
    $
    2,119Weighted average shares outstanding
    
    
    17,217
    
    
    
    21,836
    
    
    
    17,183
    
    
    
    22,122Effect of dilutive stock options and
restricted stock
    
    
    111
    
    
    
    638
    
    
    
    226
    
    
    
    553Conversion of convertible notes
    
    
    6,426
    
    
    
    801
    
    
    
    
    
    
    
    401Weighted average shares assuming
dilution
    
    
    23,754
    
    
    
    23,275
    
    
    
    17,409
    
    
    
    23,076Diluted net income per share
    
    $
    0.10
    
    
    $
    0.07
    
    
    $
    0.10
    
    
    $
    0.09
 Comprehensive Income
  Stock-Based Compensation
  Share Based Payment,
 8




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
   Weighted
    
    
    WeightedNumber of
    
    
    Average
    
    
    Average Remaining
    
    
    Aggregate IntrinsicShares
    
    
    Exercise Price
    
    
    Contractual Life
    
    
    ValueOutstanding at December 31, 2007
    
    
    4,266
    
    
    $
    17.31Granted
    
    
    298
    
    
    
    11.28Exercised
    
    
    (120
    )
    
    
    4.36Canceled
    
    
    (63
    )
    
    
    20.35Outstanding at June 28, 2008
    
    
    4,381
    
    
    $
    17.21
    
    
    
    5.68
    
    
    $
    818Vested or expected to vest at June 28, 2008
    
    
    4,329
    
    
    $
    17.20
    
    
    
    5.65
    
    
    $
    816Exercisable at June 28, 2008
    
    
    3,399
    
    
    $
    16.93
    
    
    
    4.94
    
    
    $
    793
   Weighted AverageNumber of
    
    
    Grant Date FairShares
    
    
    ValueUnvested at December 31, 2007
    
    
    275
    
    
    $
    16.90Granted
    
    
    297
    
    
    
    11.47Vested and cancelled
    
    
    (106
    )
    
    
    15.46Unvested at June 28, 2008
    
    
    466
    
    
    $
    13.78
  :
  Three Months Ended
    
    Six Months EndedJune 28, 2008
    
    June 30, 2007
    
    June 28, 2008
    
    June 30, 2007Options granted
    
    
    26
    
    
    
    33
    
    
    
    298
    
    
    
    426Weighted average exercise price
    
    $
    5.60
    
    
    $
    16.03
    
    
    $
    11.28
    
    
    $
    16.14Weighted average grant date
fair value
    
    $
    3.06
    
    
    $
    7.50
    
    
    $
    5.32
    
    
    $
    7.61
 9




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 Three Months Ended
    
    Six Months EndedJune 28, 2008
    
    June 30, 2007
    
    June 28, 2008
    
    June 30, 2007Assumptions:Risk-free interest rate
    
    
    3.37
    %
    
    
    4.72
    %
    
    
    3.00
    %
    
    
    4.54
    %Expected term
    
    5.76 years
    
    
    5 years
    
    
    5.76 years
    
    
    5 yearsExpected volatility
    
    
    56
    %
    
    
    45
    %
    
    
    47
    %
    
    
    46
    %
     :
     10




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 Use of Estimates
  Reclassifications
  Fair Value of Financial Instruments
  Recent Accounting Pronouncements
 Disclosures about Derivative Instruments and
Hedging Activities, an Amendment of FASB Statement No. 133.
 The Hierarchy of Generally Accepted Accounting
Principles The Meaning of Present Fairly in Conformity With Generally
Accepted Accounting Principles The Meaning
of Present Fairly in Conformity With Generally Accepted Accounting Principles
 11




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 (3) Comprehensive Income
  Three Months Ended
    
    
    Six Months EndedJune 28, 2008
    
    

June
30, 2007
    
    
    June 28, 2008
    
    

June
30, 2007Net income
    
    $
    1,899
    
    
    $
    1,488
    
    
    $
    1,664
    
    
    $
    2,004Other comprehensive income:Unrealized (loss) gain
on marketable
securities
    
    
    (447
    )
    
    
    42
    
    
    
    (224
    )
    
    
    37Comprehensive income
    
    $
    1,452
    
    
    $
    1,530
    
    
    $
    1,440
    
    
    $
    2,041
 (4) Investment in Sales-Type Leases
  June 28,
    
    
    December 31,2008
    
    
    2007Total minimum lease payments receivable
    
    $
    4,741
    
    
    $
    5,655Less:Unearned interest income
    
    
    672
    
    
    
    849Allowance for lease payments
    
    
    829
    
    
    
    715Net investment in sales-type leases
    
    
    3,240
    
    
    
    4,091Less  current portion
    
    
    1,257
    
    
    
    1,473$
    1,983
    
    
    $
    2,618
 (5) Inventory
  June 28,
    
    
    December 31,2008
    
    
    2007Raw materials
    
    $
    3,992
    
    
    $
    4,027Work-in-progress
    
    
    71
    
    
    
    52Finished goods
    
    
    2,624
    
    
    
    3,034$
    6,687
    
    
    $
    7,113
 (6) Income Taxes
  12




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
     (7) Fair Value Measurements
 Fair Value Measurements
  Balance at
    




    Fair Value Measurements at June 28, 2008June 28, 2008
    
    Level 1
    
    Level 2
    
    Level 3Cash, cash equivalents and
restricted cash
    
    $
    10,146
    
    
    $
    10,146
    
    
    $
    
    
    
    $
    Available for sale
securities
    
    $
    96,924
    
    
    $
    
    
    
    $
    96,924
    
    
    $
    
 13




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 (8) Segment Information and Enterprise Reporting
   Three Months Ended
    
    
    Six Months EndedJune 28,
    
    
    June 30,
    
    
    June 28,
    
    
    June 30,2008
    
    
    2007
    
    
    2008
    
    
    2007Geographic Area by RegionDomestic
    
    $
    17,347
    
    
    $
    20,708
    
    
    $
    34,410
    
    
    $
    39,082International
    
    
    7,838
    
    
    
    5,933
    
    
    
    15,203
    
    
    
    11,678Total
    
    $
    25,185
    
    
    $
    26,641
    
    
    $
    49,613
    
    
    $
    50,760
 Three Months Ended
    
    Six Months EndedJune 28,
    
    June 30,
    
    June 28,
    
    June 30,2008
    
    2007
    
    2008
    
    2007Geographic Area by RegionDomestic
    
    
    69
    %
    
    
    78
    %
    
    
    69
    %
    
    
    77
    %International
    
    
    31
    
    
    
    22
    
    
    
    31
    
    
    
    23Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
  (9) Commitments and Contingencies
 Leases
    14




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 Legal Proceedings
   (10) Loan Agreements
   (11) Termination and Repurchase Agreement with Boston Scientific Corporation
  15




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 
    
    the OEM Product Development Agreement dated as of August 7, 2002 (as amended January
31, 2005 and February 5, 2007, the 2002 Agreement), pursuant to which the Company was to
develop certain products that Boston Scientific Corporation would then commercialize in
the area of monitoring patients under sedation in a range of less invasive medical
specialties, and pursuant to which the Company granted Boston Scientific Corporation an
exclusive option to become the distributor for a period of time of certain products;
    
    the Product Development and Distribution Agreement dated as of May 23, 2005 (the 2005
Agreement), pursuant to which the Company was to develop new applications of its
brain-monitoring technology in the area of the diagnosis and treatment of neurological,
psychiatric and pain disorders and Boston Scientific was appointed the exclusive
distributor of such products; and
    
    the Letter Agreement dated August 7, 2002, and Security Agreement dated August 7, 2002,
pursuant to which Boston Scientific Corporation agreed to make revolving interest-bearing
loans to Aspect from time to time at the request of Aspect, such revolving loans being
evidenced by a promissory note in the original principal amount of $5,000,000 dated August
7, 2002.
   (12) Convertible Debt
  16




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
   
    
    during the five business day period after any five consecutive trading day period
(the measurement period) in which the price per note for each trading day of that
measurement period was less than 97% of the product of the last reported sale price of
the Companys common stock and the conversion rate on each such day;
    
    during any calendar quarter (and only during such quarter) after the calendar
quarter ending September 30, 2007, if the last reported sale price of the Companys
common stock for 20 or more trading days in a period of 30 consecutive trading days
ending on the last trading day of the immediately preceding calendar quarter exceeds
120% of the applicable conversion price in effect on the last trading day of the
immediately preceding calendar quarter; or
    
    upon the occurrence of specified corporate events.
       17




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 (13) Stock Repurchase Program
  18




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##### Table of Contents








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


Overview


®






|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|---------------------------------- |  | ---------- | ---- | ----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|                                   |  | Initial    |      |            
|                                   |  | Commercial |      |            
|Product                            |  | Shipment   |      | Description
|                                  
|EQUIPMENT                          |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|BIS VIEW                           |  |            | 2007 |             |  | Basic-featured standalone monitor which has fewer optional user
configurations compared with the BIS VISTA monitor.                                                                                                                                                                                
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|BIS VISTA                          |  |            | 2006 |             |  | Monitor that offers an enhanced display and user interface as well as
greater processing capability compared to our other monitors.                                                                                                                                                                
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|BISx system                        |  |            | 2004 |             |  | BIS monitoring solution that provides the processing technology required
to obtain BIS information from a single device the approximate size of a
hockey puck. The BISx system is designed to integrate with a wide range
of patient monitoring platforms sold by original equipment
manufacturers.
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|BIS XP System                      |  |            | 2001 |             |  | BIS system offering enhanced performance capabilities and expanded
benefits as compared to the previous version of the BIS system, designed
to enable more precise measurement of brain activity to assess the level
of consciousness.                                                             
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|BIS Module Kit
 4 Channel
Support |  |            | 2001 |             |  | Same as standard BIS Module Kit plus 4 channel EEG monitoring capability.                                                                                                                                                                                                                          
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|A-2000 BIS Monitor                 |  |            | 1998 |             |  | Compact, lightweight, portable third-generation BIS monitor.                                                                                                                                                                                                                                       
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|BIS Module Kit                     |  |            | 1998 |             |  | Components of BIS monitoring technology that are integrated into
equipment sold by original equipment manufacturers.                                                                                                                                                                               
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|SENSORS                            |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|Semi-Reusable
(SRS) Sensor         |  |            | 2005 |             |  | Semi-reusable version of a BIS Sensor that uses the same algorithm and
hardware as our disposable sensors. Currently available only in markets
outside the United States, excluding Japan.                                                                                                         
|                                   |  |            |      |             |  |                                                                                                                                                                                                                                                                                                    
|BIS Extend Sensor                  |  |            | 2002 |             |  | Disposable sensor with electronic memory device for use with our BIS
Monitors, BIS Module Kit and BISx System that was designed for patients
who are typically monitored for extended periods.                                                                                                     

19



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##### Table of Contents



InitialCommercialProduct
    
    Shipment
    
    DescriptionBIS Pediatric
Sensor
    
    
    2001
    
    
    Disposable sensor with electronic memory device for use with our
BIS Monitors, BIS Module Kit and BISx System that is smaller and
easier to apply to children.BIS Quatro Sensor
    
    
    2001
    
    
    Disposable sensor with electronic memory device for use with our
BIS Monitors, BIS Module Kit and BISx System that is designed to
offer enhanced performance in deep anesthetic states and enhanced
resistance to interference from noise sources.BIS Sensor Plus
    
    
    2001
    
    
    Second-generation disposable sensor for use with our BIS Monitors
and BIS Module Kit.BIS Standard
Sensor
    
    
    1997
    
    
    Disposable sensor for use with our BIS Monitors and BIS Module Kit.
  Three Months Ended
    
    Six Months EndedJune 28,
    
    June 30,
    
    June 28,
    
    June 30,2008
    
    2007
    
    2008
    
    2007(dollars in thousands)Domestic revenue
    
    $
    17,347
    
    
    $
    20,708
    
    
    $
    34,410
    
    
    $
    39,082Percent of total revenue
    
    
    69
    %
    
    
    78
    %
    
    
    69
    %
    
    
    77
    %International revenue
    
    $
    7,838
    
    
    $
    5,933
    
    
    $
    15,203
    
    
    $
    11,678Percent of total revenue
    
    
    31
    %
    
    
    22
    %
    
    
    31
    %
    
    
    23
    %Total revenue
    
    $
    25,185
    
    
    $
    26,641
    
    
    $
    49,613
    
    
    $
    50,760BIS Sensor revenue
    
    $
    21,395
    
    
    $
    18,563
    
    
    $
    42,031
    
    
    $
    36,117Percent of total revenue
    
    
    85
    %
    
    
    70
    %
    
    
    85
    %
    
    
    71
    %Equipment revenue
    
    $
    3,790
    
    
    $
    4,516
    
    
    $
    7,582
    
    
    $
    9,397Percent of total revenue
    
    
    15
    %
    
    
    17
    %
    
    
    15
    %
    
    
    19
    %Strategic alliance revenue
    
    $
    
    
    
    $
    3,562
    
    
    $
    
    
    
    $
    5,246Percent of total revenue
    
    
    
    
    
    
    13
    %
    
    
    
    
    
    
    10
    %Total revenue
    
    $
    25,185
    
    
    $
    26,641
    
    
    $
    49,613
    
    
    $
    50,760
    20




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##### Table of Contents



Share-Based Payment Accounting for Stock Issued to Employees
 New England Journal
of Medicine
 21




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##### Table of Contents



Critical Accounting Policies and Estimates
  Revenue Recognition
 Revenue
Recognition, Revenue Arrangements with Multiple
Deliverables
 Accounting For Leases
  22




---



##### Table of Contents



Stock-Based Compensation
        Allowance for Doubtful Accounts
  Inventories
  23




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##### Table of Contents



Warranty
  Income Taxes
  Accounting for Uncertainty in Income Taxes  an
Interpretation of FASB Statement No. 109
 Results of Operations
  Three Months Ended
    
    Six Months EndedJune 28,
    
    June 30,
    
    June 28,
    
    June 30,2008
    
    2007
    
    2008
    
    2007Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    25
    
    
    
    22
    
    
    
    26
    
    
    
    23Gross margin
    
    
    75
    
    
    
    78
    
    
    
    74
    
    
    
    77Operating expenses:Research and development
    
    
    16
    
    
    
    16
    
    
    
    16
    
    
    
    17Sales and marketing
    
    
    46
    
    
    
    38
    
    
    
    44
    
    
    
    40General and administrative
    
    
    17
    
    
    
    15
    
    
    
    16
    
    
    
    15Total operating expenses
    
    
    79
    
    
    
    69
    
    
    
    76
    
    
    
    72(Loss) income from operations
    
    
    (4
    )
    
    
    9
    
    
    
    (2
    )
    
    
    5Interest income, net
    
    
    1
    
    
    
    4
    
    
    
    1
    
    
    
    4Gain on repurchase of debt
    
    
    16
    
    
    
    
    
    
    
    8
    
    
    
    Income before income taxes
    
    
    13
    
    
    
    13
    
    
    
    7
    
    
    
    9Provision for incomes taxes
    
    
    5
    
    
    
    7
    
    
    
    4
    
    
    
    5Net income
    
    
    8
    %
    
    
    6
    %
    
    
    3
    %
    
    
    4
    %
 24




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##### Table of Contents



Three and Six Months Ended June 28, 2008 Compared with the Three and Six Months Ended June 30, 2007
 Three Months Ended
    
    
    Six Months EndedPercentage
    
    
    
    
    
    
    
    
    
    
    PercentageJune 28,
    
    
    June 30,
    
    
    Increase
    
    
    June 28,
    
    
    June 30,
    
    
    Increase2008
    
    
    2007
    
    
    (Decrease)
    
    
    2008
    
    
    2007
    
    
    (Decrease)(in thousands, except
    
    
    
    
    
    
    (in thousands, except unitunit amounts)
    
    
    
    
    
    
    amounts)Revenue  WorldwideBIS Sensor
    
    $
    21,395
    
    
    $
    18,563
    
    
    
    15
    %
    
    $
    42,031
    
    
    $
    36,117
    
    
    
    16
    %BIS monitor
    
    
    1,944
    
    
    
    2,984
    
    
    
    (35
    )%
    
    
    4,041
    
    
    
    5,879
    
    
    
    (31
    )%Original equipment manufacturer products
    
    
    986
    
    
    
    856
    
    
    
    15
    %
    
    
    1,967
    
    
    
    1,973
    
    
    
    Other equipment and accessories
    
    
    860
    
    
    
    676
    
    
    
    27
    %
    
    
    1,574
    
    
    
    1,545
    
    
    
    2
    %Total Equipment
    
    
    3,790
    
    
    
    4,516
    
    
    
    (16
    )%
    
    
    7,582
    
    
    
    9,397
    
    
    
    (19
    )%Total product revenue
    
    
    25,185
    
    
    
    23,079
    
    
    
    9
    %
    
    
    49,613
    
    
    
    45,514
    
    
    
    9
    %Strategic alliance
    
    
    
    
    
    
    3,562
    
    
    
    (100
    )%
    
    
    
    
    
    
    5,246
    
    
    
    (100
    )%Total revenue
    
    $
    25,185
    
    
    $
    26,641
    
    
    
    (5
    )%
    
    $
    49,613
    
    
    $
    50,760
    
    
    
    (2
    )%Unit Analysis  WorldwideBIS Sensors
    
    
    1,575,000
    
    
    
    1,331,000
    
    
    
    18
    %
    
    
    3,061,000
    
    
    
    2,568,000
    
    
    
    19
    %BIS monitors
    
    
    669
    
    
    
    849
    
    
    
    (21
    )%
    
    
    1,387
    
    
    
    1,807
    
    
    
    (23
    )%Original equipment manufacturer
BIS products
    
    
    1,224
    
    
    
    1,056
    
    
    
    16
    %
    
    
    2,784
    
    
    
    2,530
    
    
    
    10
    %Installed base
    
    
    51,273
    
    
    
    43,366
    
    
    
    18
    %
    
    
    51,273
    
    
    
    43,366
    
    
    
    18
    %
 Revenue.
   25




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##### Table of Contents



26




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##### Table of Contents



Expense Overview
 Three Months Ended
    
    Percentage
    
    Six Months Ended
    
    PercentageJune 28,
    
    June 30,
    
    Increase
    
    June 28,
    
    June 30,
    
    Increase2008
    
    2007
    
    (Decrease)
    
    2008
    
    2007
    
    (Decrease)(in thousands)
    
    
    
    
    
    (in thousands)ExpensesResearch and development
    
    $
    3,934
    
    
    $
    4,194
    
    
    
    (6
    )%
    
    $
    7,873
    
    
    $
    8,414
    
    
    
    (6
    )%Sales and marketing
    
    $
    11,672
    
    
    $
    10,199
    
    
    
    14
    %
    
    $
    21,874
    
    
    $
    20,244
    
    
    
    8
    %General and administrative
    
    $
    4,172
    
    
    $
    4,016
    
    
    
    4
    %
    
    $
    8,114
    
    
    $
    7,680
    
    
    
    6
    %
 Research and Development.
  Sales and Marketing.
  General and Administrative.
  27




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##### Table of Contents



Interest Income.
 Interest Expense.
 Income Taxes.
   Liquidity and Capital Resources
  
    
    net proceeds of approximately $54.6 million from our initial public offering of an
aggregate of 4,025,000 shares of common stock in February 2000;
    
    approximately $3.4 million in equipment financing;
    
    approximately $5.1 million related to our investment in sales-type leases;
    
    proceeds of approximately $10.0 million related to our 2002 OEM product development
and distribution agreement with Boston Scientific Corporation;
    
    proceeds of approximately $8.1 million from the sale of our common stock to Boston
Scientific Corporation in 2004;
    
    $10.0 million in installment payments from Boston Scientific Corporation received in
May 2005 and May 2006 pursuant to the 2005 product development and distribution
agreement with Boston Scientific Corporation; and
 28




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##### Table of Contents




    
    net proceeds of $121.0 million received from the issuance of our 2.5% convertible
senior notes in June 2007.
        29




---



##### Table of Contents



Cash provided by operations.
 Cash used for investing activities.
 Cash provided by financing activities.
 Off-Balance Sheet Arrangements
  Effects of Inflation
  30




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##### Table of Contents



Recent Accounting Pronouncements
 Disclosures about Derivative Instruments and
Hedging Activities an Amendment of FASB Statement No. 133
 The Hierarchy of Generally Accepted Accounting
Principles The Meaning of Present Fairly in Conformity With Generally
Accepted Accounting Principles The Meaning
of Present Fairly in Conformity With Generally Accepted Accounting Principles
 31




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##### Table of Contents



Forward-Looking Statements
 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, including information relating to our ability to maintain profitability, information with
respect to market acceptance of our BIS system, continued growth in sales of our BIS monitors,
original equipment manufacturer products and BIS Sensors, our dependence on the BIS system,
regulatory approvals for our products, our ability to remain competitive and achieve future growth,
information with respect to other plans and strategies for our business and factors that may
influence our revenue for the fiscal quarter ending September 27, 2008 and thereafter. These
forward-looking statements involve risks and uncertainties and are not guarantees of future
performance. Words such as expect, anticipate, intend, plan, believe, seek, estimate
and variations of these words and similar expressions are intended to identify forward-looking
statements. Our actual results could differ significantly from the results discussed in these
forward-looking statements. The important factors discussed under Part II  Item 1A. Risk
Factors below represent some of the current challenges to us that create risk and uncertainty. In
addition, subsequent events and developments may cause our expectations to change. While we may
elect to update these forward-looking statements we specifically disclaim any obligation to do so,
even if our expectations change.
 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 Interest Rate Exposure
   Foreign Currency Exposure
  
 Item 4. Controls and Procedures.
 (a)
    
    Evaluation of Disclosure Controls and Procedures.Our management, with the participation of our chief executive officer and chief financial
officer evaluated the effectiveness of our disclosure controls and procedures as of June 28,
2008. The term disclosure controls and procedures, as defined in Rules 13a-15(e) and
15d-15(e) under the Exchange Act, means controls and other procedures of a company that are
designed to ensure that information required to be disclosed by a company in the reports that
it files or submits under the Exchange Act is recorded, processed, summarized and reported,
within the time periods specified in the SECs rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is accumulated and communicated to the companys management, including
its principal executive and principal financial officers, as appropriate to allow timely
decisions regarding required disclosure. Management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only reasonable assurance
of achieving
 32




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##### Table of Contents



their objectives and management necessarily applies its judgment in evaluating the
cost-benefit relationship of possible controls and procedures. Based on the evaluation of
our disclosure controls and procedures as of June 28, 2008, our chief executive officer and
chief financial officer concluded that, as of such date, our disclosure controls and
procedures were effective at the reasonable assurance level.(b)
    
    Changes in Internal Controls.No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended June 28, 2008 that
has materially affected, or is reasonably likely to materially affect, our internal control
over financial reporting.
 
 PART II  OTHER INFORMATION
 
 Item 1. Legal Proceedings
  
 Item 1A. Risk Factors
  We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our
BIS system and purchase our BIS Sensors in sufficient quantities.
  New England Journal of Medicine
 33




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##### Table of Contents



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.
  Various factors may adversely affect our quarterly operating results through the third fiscal
quarter of 2008 and beyond.
  
    
    a third party study recently published in the New England Journal of Medicine compared BIS monitoring with a
protocol based on end-tidal gas anesthetic in a patient population considered to be at high risk of awareness and
concluded that, based upon a similar occurrence of awareness in both groups, no benefit of BIS monitoring was
demonstrated. The publication of this study may have an adverse effect on the rate at which existing or potential
new customers purchase and use our products, which could adversely affect our operating results;
    
    we are expanding our sales force and expect that such expansion will increase our operating expenses in
future periods and that such an increase would not be offset at least initially by an increase in revenue; as a
result our operating results in such periods could be adversely affected;
    
    we continue to shift the focus of our sales and marketing efforts from expanding our customer base to
deepening our relationships with our existing customers and increasing their sensor utilization and procedure
penetration. As a result of this shift in focus, we expect our revenue from the sale of equipment to decrease. As
such, if we do not increase revenue from sales of our BIS Sensors as quickly as we plan, or at all, our operating
results could be adversely affected;
    
    we may not realize expected benefits of favorable industry pronouncements on anesthesia awareness, including
the position statements issued by the Joint Commission on Accreditation of Healthcare Organizations, the American
Society of Anesthesiologists House of Delegates, and the American Association of Nurse Anesthetists.; and
    
    we have recently repurchased a portion of our 2.5% convertible senior notes due 2014, referred to as our
notes, and we may make additional repurchases in the future. If any such repurchases are made at a discount to the
face value of the note, we expect to record a gain on such transaction, which could affect our operating results in
the quarter in which any such repurchase is made.
    
    we face risks beyond our control with respect to the continued challenges of the U.S. and worldwide
economies including without limitation the effects of domestic
inflation and the global rise in energy costs.
 34




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##### Table of Contents



Fluctuations in our quarterly operating results could cause our stock price to decrease.
  
    
    the timing and volume of customer orders for our BIS system;
    
    market acceptance of our BIS VISTA monitor;
    
    use of and demand for our BIS Sensors;
    
    transition of sales focus from expanding our customer base to developing our existing
customers and increasing their sensor utilization and procedure penetration;
    
    customer cancellations;
    
    introduction of competitive products;
    
    regulatory approvals;
    
    changes in management;
    
    turnover in our direct sales force;
    
    we are expanding our sales force and expect that such expansion will increase our
operating expenses in future periods and that such an increase would not be offset at
least initially by an increase in revenue;
    
    effectiveness of new marketing and sales programs;
    
    communications published by industry organizations or other professional entities in
the anesthesia community that are unfavorable to our business, including publications
of the results of clinical studies;
    
    trading in our convertible debt instruments;
    
    repurchases of shares of our common stock or our 2.5% notes;
    
    the amount of our outstanding indebtedness and interest payments under debt obligations;
    
reductions in orders by our distributors and original equipment manufacturers; and
    
    the timing and amount of our expenses.
  If the estimates we make, and the assumptions on which we rely, in preparing our financial
statements prove inaccurate, our actual results may vary from those reflected in our financial
statements.
 35




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##### Table of Contents



Compliance with changing regulation of corporate governance and public disclosure as well as
potential new accounting pronouncements are likely to impact our future financial position or
results of operations.
 Share-Based Payment,
  Failure to maintain effective internal controls in accordance with section 404 of the
Sarbanes-Oxley act could have a material adverse effect on our business and stock price.
  We may need additional financing for our future capital needs and may not be able to raise
additional funds on terms acceptable to us, or at all.
  
    
    the research and development costs of our products or technology currently under development, including costs to fund
our neuroscience program following termination in June 2007 of our alliance with Boston Scientific Corporation,
increase beyond current estimates;
    
    we decide to expand faster than currently planned;
    
    we develop new or enhanced services or products ahead of schedule;
    
    we decide to undertake new sales and/or marketing initiatives;
 36




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##### Table of Contents




    
    we are required to defend or enforce our intellectual property rights,
or respond to other legal challenges with
respect to our products, including product liability claims;
    
    sales of our products do not meet our expectations domestically or internationally, including sales of our BIS Sensors;
    
    we are required or elect to pay the principal under our 2.5% notes in cash at or prior to maturity or we determine to
repurchase any portion of our 2.5% notes;
    
    we experience unexpected losses in our cash investments or
are otherwise unable to liquidate these investments due to
unfavorable conditions in the capital markets;
    
    we need to respond to competitive pressures; or
    
    we decide to acquire complementary products, businesses or technologies.
  Cases of awareness with recall during monitoring with the BIS system could limit market acceptance
of the BIS system and could expose us to product liability claims.
  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.
  
    
    other 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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If we do not maintain our relationships with the anesthesia community and if anesthesiologists and
other healthcare providers do not recommend and endorse our products, our sales may decline or we
may be unable to increase our sales and profits.
  New England Journal of Medicine
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Negative publicity or unfavorable media coverage could damage our reputation and harm our
operations.
  If we do not successfully develop or acquire and introduce enhanced or new products we could lose
revenue opportunities and customers.
  
    
    identify and respond, in a timely manner, to new market trends or opportunities;
    
    assess customer needs;
    
    successfully develop or acquire competitive products;
    
    complete regulatory clearance in a timely manner;
    
    successfully develop cost effective manufacturing processes;
    
    introduce such products to our customers in a timely manner; and
    
    achieve market acceptance of the BIS system.
  
    
    we may not successfully adapt the BIS system to function properly for
procedural sedation, when used with anesthetics we have not tested or
with patient populations we have not studied, such as infants; and
    
    our technology is complex, and we may not be able to develop it
further for applications outside anesthesia monitoring, such as the
diagnosis and tracking of neurological diseases.
   If our clinical trials are delayed or unsuccessful, our business could be adversely affected.
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
    
    delays or the inability to obtain required approvals from institutional review boards or other governing
entities at clinical sites selected for participation in our clinical trials;
    
    delays in enrolling patients and volunteers into clinical trials;
    
    lower than anticipated retention rates of patients and volunteers in clinical trials;
    
    negative results from clinical trials for any of our potential products, including those involving the
management of depression and the early diagnosis and tracking of Alzheimers disease; and
    
    failure of our clinical trials to demonstrate the efficacy or clinical utility of our potential products.
  If we do not develop and implement a successful sales and marketing strategy, we will not expand
our business.
  
    
    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;
    
    establish and implement successful sales and marketing and education programs that
encourage our customers to purchase our products or the products that are made by original
equipment manufacturers incorporating our technology;
    
    manage geographically dispersed operations; and
    
    modify our products and marketing and sales programs for foreign markets.
 We encourage our direct sales force, distributors and original equipment manufacturers to maximize
the amount of our products they sell and they may engage in aggressive sales practices that may
harm our reputation.
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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.
  We may not be able to generate enough additional revenue from our international expansion to offset
the costs associated with establishing and maintaining 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.
  
    
    failure of local laws to provide adequate protection against infringement of our intellectual property;
    
    protectionist laws and business practices that favor local competitors, which could slow or prohibit our
growth in international markets;
    
    difficulties in terminating or modifying distributor arrangements because of restrictions in markets
outside the United States;
    
    less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors;
    
    delays in regulatory approval of our products;
    
    currency conversion issues arising from sales denominated in currencies other than the United States dollar;
    
    foreign currency exchange rate fluctuations;
    
    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.
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We may experience customer dissatisfaction and our reputation could suffer if we fail to
manufacture enough products to meet our customers demands.
  Our reliance on sole-source suppliers could adversely affect our ability to meet our customers
demands for our products in a timely manner or within budget.
  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 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.
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
    
    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 may be costly, time-consuming and may not be successful.
 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.
  Several class action lawsuits have been filed against the underwriters of our initial public
offering which may result in negative publicity and potential litigation against us that would be
costly to defend and the outcome of which is uncertain and may harm our business.
   We and Boston Scientific recently jointly terminated our strategic alliance and other agreements
and, as a result, we may not have sufficient funding to finance our neuroscience programs.
  
    
    the original equipment manufacturer product development agreement dated as of August
7, 2002, pursuant to which we were seeking to develop certain products that Boston
Scientific Corporation would then commercialize in the area of monitoring patients under
sedation in a range of less invasive medical specialties, and pursuant to which we
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granted Boston Scientific Corporation an exclusive option to become the distributor for
a period of time of certain of our products.
    
    the product development and distribution agreement dated as of May 23, 2005,
pursuant to which we were seeking to develop new applications of its brain-monitoring
technology in the area of the diagnosis and treatment of neurological, psychiatric and
pain disorders and Boston Scientific Corporation was appointed the exclusive distributor
of such products. Under this agreement, which we refer to as the neuroscience alliance,
Boston Scientific Corporation had agreed to provide $25.0 million of funding over a five
year period. We received $10.0 million under this agreement.
    
    the letter agreement dated August 7, 2002, and the security agreement dated August 7,
2002, pursuant to which Boston Scientific Corporation agreed to make revolving
interest-bearing loans to us from time to time at our request, such revolving loans
being evidenced by a promissory note in the original principal amount of $5,000,000
dated August 7, 2002 made by us in favor of Boston Scientific Corporation.
  We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could
result in unanticipated expenses and fluctuations in operating results.
  We may not be able to compete effectively, which could result in price reductions and decreased
demand for our products.
  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.
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Even if we obtain the necessary FDA clearances or approvals, if we or our suppliers fail to comply
with ongoing regulatory requirements our products could be subject to restrictions or withdrawal
from the market.
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
    
    untitled letters, warning letters, fines, injunctions and civil penalties;
    
    administrative detention, which is the detention by the FDA of medical devices believed to be
adulterated or misbranded;
    
    customer notification, or orders for repair, replacement or refund;
    
    voluntary or mandatory recall or seizure of our products;
    
    operating restrictions, partial suspension or total shutdown of production;
    
    refusal to review pre-market notification or pre-market approval submissions;
    
    rescission of a substantial equivalence order or suspension or withdrawal of a pre-market approval; and
    
    criminal prosecution.
  We may be subject, directly or indirectly, to federal and state healthcare fraud and abuse laws and
regulations and, if we are unable to fully comply with such laws, could face substantial penalties.
  If we do not retain our senior management and other key employees, we may not be able to
successfully implement our business strategy.
  If we do not attract and retain skilled personnel, or if we do not maintain good relationships with
our employees, we will not be able to expand our business.
   If we make any acquisitions, we will incur a variety of costs and may never successfully integrate
the acquired business into ours.
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Our employees may engage in misconduct or other improper activities, including insider trading.
   Failure of users of the BIS system, or users of future products we may develop, to obtain adequate
reimbursement from third-party payors could limit market acceptance of the BIS system and other
products, which could prevent us from sustaining profitability.
   The market price of our stock is highly volatile, and this volatility could cause your investment
in our stock to suffer a decline in value and cause us to incur significant costs from class action
litigation.
  
    
    variations in our quarterly operating results or those of companies that are perceived
to be similar to us;
    
    third-party sales of large blocks of our common stock;
    
    rumors relating to us or our competitors;
    
    changes to our research and development plans and/or announcements regarding new
technologies by us or our competitors;
    
    adverse results in clinical trials of our BIS monitoring system products and products
under development;
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
    
    lawsuits involving us;
    
    sales by us of equity or debt to fund our operations;
    
    the loss of any of our key scientific or management personnel;
    
    FDA or international regulatory actions or lawsuits concerning the safety of our
products; and
    
    market conditions, both in the medical device sector and generally.
  Transactions engaged in by our largest stockholders, our directors or executives involving our
common stock may have an adverse effect on the price of our stock.
   We have various mechanisms in place to discourage takeover attempts, which may reduce or eliminate
our stockholders ability to sell their shares for a premium in a change of control transaction.
  
    
    preferred stock that could be issued by our board of directors to make it more difficult for a third
party to acquire, or to discourage a third party from acquiring, a majority of our outstanding voting
stock;
    
    classification of our directors into three classes with respect to the time for which they hold office;
    
    non-cumulative voting for directors;
    
    control by our board of directors of the size of our board of directors;
    
    limitations on the ability of stockholders to call special meetings of stockholders;
    
    inability of our stockholders to take any action by written consent; and
    
    advance notice requirements for nominations of candidates for election to our board of directors or
for proposing matters that can be acted upon by our stockholders at stockholder meetings.
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Risks Related to our Issuance of $125 Million Principal Amount of
2.5% Convertible Senior Notes due 2014
 Our increased indebtedness as a result of the issuance of $125 million principal amount of 2.5%
convertible senior notes, or the notes, may harm our financial condition and results of operations.
  
    
    it could adversely affect our ability to satisfy our obligations under the notes;
    
    a substantial portion of our cash flows from operations will have to be dedicated to
interest payments, principal payments and, if we irrevocably elect to net share settle the
notes, conversion payments and may not be available for operations, working capital,
capital expenditures, expansion, acquisitions or general corporate or other purposes;
    
    it may impair our ability to obtain additional financing in the future;
    
    it may limit our flexibility in planning for, or reacting to, changes in our business
and industry; and
    
    it may make us more vulnerable to downturns in our business, our industry or the economy
in general.
  We may not have the cash necessary to pay interest on the notes, to settle conversions of the notes
(if we have obtained stockholder approval to elect net share settlement of the notes, and we
irrevocably elect such settlement method) or to repurchase the notes upon a fundamental change.
  
    
    pay cash in an amount equal to the lesser of one-fortieth of the principal amount of the
notes being converted and the daily conversion value (the product of the conversion rate
and the current trading price) of the notes being converted and,;
    
    issue shares of our common stock only to the extent that the daily conversion value of
the notes exceeded one-fortieth of the principal amount of the notes being converted for
each trading day of the relevant 40 trading day observation period.
  The net share settlement feature of the notes, if available, may have adverse consequences.
  
    
    result in holders receiving no shares of our common stock upon conversion or fewer
shares of our common stock relative to the conversion value of the notes;
    
    reduce our liquidity because we will be required to pay the principal portion in cash;
    
    delay holders receipt of the proceeds upon conversion; and
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
    
    subject holders to market risk before receiving any shares upon conversion.
   If we repurchase any portion of the notes, such repurchases could adversely affect the holders of
the notes and our common stock and could also adversely affect our financial condition and
operating results.
  Future sales of our common stock in the public market or the issuance of securities senior to our
common stock could adversely affect the trading price of our common stock and the value of the
notes and our ability to raise funds in new securities offerings.
   Conversion of the notes will dilute the ownership interest of existing stockholders, including
holders who had previously converted their notes.
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Provisions in the indenture for the notes may deter or prevent a business combination that may be
favorable to note holders.
  The notes may not be rated or may receive a lower rating than anticipated.
  The effective subordination of the notes to our secured indebtedness to the extent of the
collateral securing such indebtedness may limit our ability to satisfy our obligations under the
notes.
  The structural subordination of the notes to our secured liabilities and all liabilities and
preferred equity of our subsidiaries may limit our ability to satisfy our obligations under the
notes.
  
 Item 4.
    
    Submission of Matters to a Vote of Security Holders.
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Item 6.  Exhibits.
 The exhibits listed in the Exhibit Index immediately preceding the exhibits are filed
as part of this Quarterly Report on Form 10-Q.
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SIGNATURE
  ASPECT MEDICAL SYSTEMS, INC.Date: August 7, 2008
    By:
    /s/ Michael FalveyMichael FalveyVice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 53




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EXHIBIT INDEX
 EXHIBITNUMBER
    
    EXHIBIT10.1
    
    2001 Stock Incentive Plan, as amended is incorporated herein by
reference to Exhibit 10.1 to the Registrants Current Report on
Form 8-K dated May 22, 2008.10.2
    
    Amendment No. 3 to Rights Agreement by and between the Registrant
and Computershare Trust Company, N.A. (formerly EquiServe Trust
Company, N.A.) is incorporated herein by reference to Exhibit 4.1
to the Registrants Current Report on Form 8-K dated June 2, 2008.31.1
    
    Certification by Chief Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.31.2
    
    Certification by Chief Financial Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.32.1
    
    Certification by Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification by Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.