##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended October 1, 2005
 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
    
    (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
 
  þ o
  þ o
  o þ




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PagePART I FINANCIAL INFORMATION
    
    
    1Item 1. Financial Statements
    
    
    1Consolidated Balance Sheets as of October 1, 2005 (unaudited) and December 31, 2004
    
    
    1Consolidated Statements of Operations for the Three and Nine Months Ended October 1, 2005 and October 2, 2004 (unaudited)
    
    
    2Consolidated Statements of Cash Flows for the Nine Months Ended October 1, 2005 and October 2, 2004 (unaudited)
    
    
    3Notes to Consolidated Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    16Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    36Item 4. Controls and Procedures
    
    
    36PART II OTHER INFORMATION
    
    
    37Item 6. Exhibits
    
    
    37SIGNATURES
    
    
    38EXHIBIT INDEXEX-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.
 
 CONSOLIDATED BALANCE SHEETS
 (in thousands, except share data)
 October 1,
    
    
    December 31,2005
    
    
    2004(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    25,663
    
    
    $
    14,761Restricted cash
    
    
    82
    
    
    
    82Short-term investments
    
    
    12,489
    
    
    
    17,452Accounts receivable, net of allowance of $150 at
October 1, 2005 and $41 at December 31, 2004
    
    
    9,838
    
    
    
    7,835Current portion of investment in sales-type leases
    
    
    1,640
    
    
    
    1,698Inventory, net
    
    
    4,971
    
    
    
    2,224Other current assets
    
    
    1,900
    
    
    
    1,192Total current assets
    
    
    56,583
    
    
    
    45,244Property and equipment, net
    
    
    3,641
    
    
    
    2,662Long-term investments
    
    
    15,233
    
    
    
    11,439Long-term investment in sales-type leases
    
    
    2,234
    
    
    
    2,320Long-term portion of notes receivable from related parties
    
    
    
    
    
    
    25Total assets
    
    $
    77,691
    
    
    $
    61,690LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current portion of long-term debt
    
    $
    
    
    
    $
    311Accounts payable
    
    
    1,760
    
    
    
    1,920Accrued liabilities
    
    
    8,293
    
    
    
    7,832Deferred revenue
    
    
    4,782
    
    
    
    957Total current liabilities
    
    
    14,835
    
    
    
    11,020Long-term portion of deferred revenue
    
    
    4,117
    
    
    
    4,898Long-term debt
    
    
    
    
    
    
    186Commitments 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, 21,788,806 and 20,838,611 shares issued
and outstanding at October 1, 2005 and December 31,
2004, respectively
    
    
    218
    
    
    
    208Additional paid-in capital
    
    
    153,720
    
    
    
    145,429Deferred compensation
    
    
    (539
    )
    
    
    Accumulated other comprehensive loss
    
    
    (71
    )
    
    
    (78
    )Accumulated deficit
    
    
    (94,589
    )
    
    
    (99,973
    )Total stockholders equity
    
    
    58,739
    
    
    
    45,586Total liabilities and stockholders equity
    
    $
    77,691
    
    
    $
    61,690
  1




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ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (in thousands, except per share amounts)
 (Unaudited)
 Three Months Ended
    
    
    Nine Months EndedOctober 1, 2005
    
    
    October 2, 2004
    
    
    October 1, 2005
    
    
    October 2, 2004Product revenue
    
    $
    18,602
    
    
    $
    13,426
    
    
    $
    53,683
    
    
    $
    39,340Strategic alliance revenue
    
    
    991
    
    
    
    199
    
    
    
    1,735
    
    
    
    508Total revenue
    
    
    19,593
    
    
    
    13,625
    
    
    
    55,418
    
    
    
    39,848Costs of revenue
    
    
    4,877
    
    
    
    3,245
    
    
    
    14,132
    
    
    
    9,287Gross profit margin
    
    
    14,716
    
    
    
    10,380
    
    
    
    41,286
    
    
    
    30,561Operating expenses:Research and development
    
    
    2,695
    
    
    
    1,748
    
    
    
    7,080
    
    
    
    5,495Sales and marketing
    
    
    7,351
    
    
    
    6,129
    
    
    
    22,120
    
    
    
    19,443General and administrative
    
    
    2,532
    
    
    
    2,241
    
    
    
    7,969
    
    
    
    6,905Total operating
expenses
    
    
    12,578
    
    
    
    10,118
    
    
    
    37,169
    
    
    
    31,843Income (loss) from operations
    
    
    2,138
    
    
    
    262
    
    
    
    4,117
    
    
    
    (1,282
    )Interest income
    
    
    522
    
    
    
    285
    
    
    
    1,316
    
    
    
    715Interest expense
    
    
    (21
    )
    
    
    (27
    )
    
    
    (48
    )
    
    
    (85
    )Net income (loss)
    
    $
    2,639
    
    
    $
    520
    
    
    $
    5,385
    
    
    $
    (652
    )Net income (loss) per share:Basic
    
    $
    0.12
    
    
    $
    0.03
    
    
    $
    0.25
    
    
    $
    (0.03
    )Diluted
    
    $
    0.11
    
    
    $
    0.02
    
    
    $
    0.23
    
    
    $
    (0.03
    )Weighted average shares used
in computing net income
(loss) per share:Basic
    
    
    21,664
    
    
    
    20,461
    
    
    
    21,325
    
    
    
    19,986Diluted
    
    
    24,176
    
    
    
    22,433
    
    
    
    23,737
    
    
    
    19,986
  2




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ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in thousands)
 (Unaudited)
 Nine Months EndedOctober 1,
    
    
    October 2,2005
    
    
    2004Cash flows from operating activities:Net income (loss)
    
    $
    5,385
    
    
    $
    (652
    )Adjustments to reconcile net income (loss) to net cash
provided by (used for) operating activities Depreciation and amortization
    
    
    1,181
    
    
    
    1,156Provision for doubtful accounts
    
    
    109
    
    
    
    (39
    )Compensation expense related to stock options
    
    
    207
    
    
    
    61Changes in
assets and liabilities Increase in accounts receivable
    
    
    (2,113
    )
    
    
    (723
    )Increase in inventory
    
    
    (2,747
    )
    
    
    (482
    )Increase in other assets
    
    
    (704
    )
    
    
    (165
    )Decrease in investment in sales-type leases
    
    
    145
    
    
    
    314(Decrease) increase in accounts payable
    
    
    (161
    )
    
    
    26Increase (decrease) in accrued liabilities
    
    
    461
    
    
    
    (411
    )Increase (decrease) in deferred revenue
    
    
    3,044
    
    
    
    (528
    )Net cash provided by (used for) operating activities
    
    
    4,807
    
    
    
    (1,443
    )Cash flows from investing activities:Payments on loans to related parties
    
    
    21
    
    
    
    501Acquisition of property and equipment
    
    
    (2,161
    )
    
    
    (797
    )Decrease in restricted cash
    
    
    
    
    
    
    5,000Purchases of marketable securities
    
    
    (29,952
    )
    
    
    (29,577
    )Proceeds from sales and maturities of marketable securities
    
    
    31,129
    
    
    
    15,060Net cash used for investing activities
    
    
    (963
    )
    
    
    (9,813
    )Cash flows from financing activities:Principal payments on debt related to investment in sales-type
leases
    
    
    (497
    )
    
    
    (575
    )Proceeds from issuance of common stock
    
    
    7,555
    
    
    
    11,648Payments received on notes receivable from employees and
directors
    
    
    
    
    
    
    44Net cash provided by financing activities
    
    
    7,058
    
    
    
    11,117Net increase (decrease) in cash and cash equivalents
    
    
    10,902
    
    
    
    (139
    )Cash and cash equivalents, beginning of period
    
    
    14,761
    
    
    
    12,344Cash and cash equivalents, end of period
    
    $
    25,663
    
    
    $
    21,205Supplemental disclosure of cash flow information:Interest paid
    
    $
    48
    
    
    $
    85
  3




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




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
   Research and Development Costs
  Allowance for Doubtful Accounts
  Inventory
  6




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 Warranty
  Three Months Ended
    
    
    Nine months EndedOctober 1,
    
    
    October 2,
    
    
    October 1,
    
    
    October 2,2005
    
    
    2004
    
    
    2005
    
    
    2004Beginning balance
    
    $
    143
    
    
    $
    156
    
    
    $
    137
    
    
    $
    147Warranty expense
    
    
    34
    
    
    
    14
    
    
    
    80
    
    
    
    64Deductions and other
    
    
    (18
    )
    
    
    (31
    )
    
    
    (58
    )
    
    
    (72
    )Ending balance
    
    $
    159
    
    
    $
    139
    
    
    $
    159
    
    
    $
    139
 Shipping and Handling Costs
  Advertising Costs
  Property and Equipment
 Accounting for the Costs of Computer Software Developed or Obtained
for Internal Use
 Income Taxes
 Accounting for Income
Taxes
 7




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 Concentration of Credit Risk
  Single or Limited Source Suppliers
  Net Income (Loss) Per Share
 Earnings Per Share
  8




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
  Three Months Ended
    
    
    Nine months EndedOctober 1,
    
    
    October 2,
    
    
    October 1,
    
    
    October 2,2005
    
    
    2004
    
    
    2005
    
    
    2004Basic:Net income (loss)
    
    $
    2,639
    
    
    $
    520
    
    
    $
    5,385
    
    
    $
    (652
    )Weighted average shares outstanding
    
    
    21,664
    
    
    
    20,461
    
    
    
    21,325
    
    
    
    19,986Basic net income (loss) per share
    
    $
    0.12
    
    
    $
    0.03
    
    
    $
    0.25
    
    
    $
    (0.03
    )Diluted:Net income (loss)
    
    $
    2,639
    
    
    $
    520
    
    
    $
    5,385
    
    
    $
    (652
    )Weighted average shares outstanding
    
    
    21,664
    
    
    
    20,461
    
    
    
    21,325
    
    
    
    19,986Effect of dilutive stock options and
restricted stock
    
    
    2,512
    
    
    
    1,972
    
    
    
    2,412
    
    
    
    Weighted average shares assuming
dilution
    
    
    24,176
    
    
    
    22,433
    
    
    
    23,737
    
    
    
    19,986Diluted net income (loss) per share
    
    $
    0.11
    
    
    $
    0.02
    
    
    $
    0.23
    
    
    $
    (0.03
    )
 Comprehensive Income (Loss)
  Stock-Based Compensation
 Accounting for Stock-Based Compensation Accounting for Stock-Based
Compensation  Transition and Disclosure
 9




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 Three Months Ended
    
    Nine Months EndedOctober 1,
    
    October 2,
    
    October 1,
    
    October 2,2005
    
    2004
    
    2005
    
    2004Risk-free interest rate
    
    
    4.22
    %
    
    
    3.63
    %
    
    
    3.72
    %
    
    
    3.21
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Expected life of options
    
    5 years
    
    5 years
    
    5 years
    
    5 yearsExpected volatility
    
    
    55
    %
    
    
    55
    %
    
    
    50
    %
    
    
    55
    %Weighted average fair
market value of options
granted
    
    $
    14.58
    
    
    $
    8.21
    
    
    $
    10.41
    
    
    $
    8.92
  Three Months Ended
    
    
    Nine Months EndedOctober 1,
    
    
    October 2,
    
    
    October 1,
    
    
    October 2,2005
    
    
    2004
    
    
    2005
    
    
    2004Net income (loss):Net income (loss) as reported
    
    $
    2,639
    
    
    $
    520
    
    
    $
    5,385
    
    
    $
    (652
    )Add: Stock-based employee
compensation expense
included in reported net
income (loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: Stock-based
employee compensation
expense determined under
fair value based method
for
all awards
    
    
    (1,445
    )
    
    
    (1,478
    )
    
    
    (4,521
    )
    
    
    (5,402
    )Pro forma net income (loss)
    
    $
    1,194
    
    
    $
    (958
    )
    
    $
    864
    
    
    $
    (6,054
    )Net income (loss) per share:Basic:As reported
    
    $
    0.12
    
    
    $
    0.03
    
    
    $
    0.25
    
    
    $
    (0.03
    )Pro forma
    
    $
    0.06
    
    
    $
    (0.05
    )
    
    $
    0.04
    
    
    $
    (0.30
    )Diluted:As reported
    
    $
    0.11
    
    
    $
    0.02
    
    
    $
    0.23
    
    
    $
    (0.03
    )Pro forma
    
    $
    0.05
    
    
    $
    (0.05
    )
    
    $
    0.04
    
    
    $
    (0.30
    )
  10




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 Use of Estimates
  Fair Value of Financial Instruments
  Reclassifications
  Recent Accounting Pronouncements
 Share Based Payment Accounting for Stock-Based Compensation Accounting for Stock Issued to Employees Statement of Cash Flows
   Accounting Changes and Error Corrections. Accounting Changes Reporting Accounting
Changes in Interim Financial Statements
 11




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
  (3)
    
    Comprehensive Income (Loss)
  Three Months Ended
    
    
    Nine Months EndedOctober 1,
    
    
    October 2,
    
    
    October 1,
    
    
    October 2,2005
    
    
    2004
    
    
    2005
    
    
    2004Net income (loss)
    
    $
    2,639
    
    
    $
    520
    
    
    $
    5,385
    
    
    $
    (652
    )Other comprehensive income (loss):Unrealized gain (loss) on
marketable securities
    
    
    
    
    
    
    1
    
    
    
    7
    
    
    
    (31
    )Comprehensive income (loss)
    
    $
    2,639
    
    
    $
    521
    
    
    $
    5,392
    
    
    $
    (683
    )
 (4)
    
    Investment in Sales-Type Leases
  October 1,
    
    
    December 31,2005
    
    
    2004Total minimum lease payments receivable
    
    $
    5,450
    
    
    $
    5,815Less:Unearned interest income
    
    
    779
    
    
    
    842Allowance for lease payments
    
    
    797
    
    
    
    955Net investment in sales-type leases
    
    
    3,874
    
    
    
    4,018Less  current portion
    
    
    1,640
    
    
    
    1,698$
    2,234
    
    
    $
    2,320
 (5)
    
    Inventory
  October 1,
    
    
    December 31,2005
    
    
    2004Raw materials
    
    $
    2,717
    
    
    $
    959Work-in-progress
    
    
    124
    
    
    
    66Finished goods
    
    
    2,130
    
    
    
    1,199$
    4,971
    
    
    $
    2,224
 12




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 (6) Segment Information and Enterprise Reporting
   Three Months Ended
    
    
    Nine Months EndedOctober 1,
    
    
    October 2,
    
    
    October 1,
    
    
    October 2,2005
    
    
    2004
    
    
    2005
    
    
    2004Geographic Area by RegionDomestic
    
    $
    14,628
    
    
    $
    10,477
    
    
    $
    41,820
    
    
    $
    31,299International
    
    
    4,965
    
    
    
    3,148
    
    
    
    13,598
    
    
    
    8,549Total
    
    $
    19,593
    
    
    $
    13,625
    
    
    $
    55,418
    
    
    $
    39,848
 Three Months Ended
    
    
    Nine Months EndedOctober 1,
    
    
    October 2,
    
    
    October 1,
    
    
    October 2,2005
    
    
    2004
    
    
    2005
    
    
    2004Geographic Area by RegionDomestic
    
    
    75
    %
    
    
    77
    %
    
    
    75
    %
    
    
    79
    %International
    
    
    25
    
    
    
    23
    
    
    
    25
    
    
    
    21Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
  (7)
    
    Related Party Transactions
   (8)
    
    Loan Agreements
  13




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
   (9)
    
    Agreements with Boston Scientific Corporation
    14




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
    (10)
    
    Shareholder Rights Plan
  
 15




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
 Overview
    Three Months Ended
    
    
    Nine Months EndedOctober 1,
    
    
    October 2,
    
    
    October 1,
    
    
    October 2,2005
    
    
    2004
    
    
    2005
    
    
    2004(in thousands)Domestic revenue
    
    $
    14,628
    
    
    $
    10,477
    
    
    $
    41,820
    
    
    $
    31,299Percentage of total revenue
    
    
    75%
    
    
    
    77%
    
    
    
    75%
    
    
    
    79%International revenue
    
    $
    4,965
    
    
    $
    3,148
    
    
    $
    13,598
    
    
    $
    8,549Percentage of total revenue
    
    
    25%
    
    
    
    23%
    
    
    
    25%
    
    
    
    21%Total revenue
    
    $
    19,593
    
    
    $
    13,625
    
    
    $
    55,418
    
    
    $
    39,848BIS Sensor revenue
    
    $
    13,458
    
    
    $
    9,835
    
    
    $
    39,081
    
    
    $
    28,681Percentage of total revenue
    
    
    69%
    
    
    
    72%
    
    
    
    71%
    
    
    
    72%Equipment revenue
    
    $
    5,144
    
    
    $
    3,591
    
    
    $
    14,602
    
    
    $
    10,659Percentage of total revenue
    
    
    26%
    
    
    
    26%
    
    
    
    26%
    
    
    
    27%Strategic alliance revenue
    
    $
    991
    
    
    $
    199
    
    
    $
    1,735
    
    
    $
    508Percentage of total revenue
    
    
    5%
    
    
    
    2%
    
    
    
    3%
    
    
    
    1%Total revenue
    
    $
    19,593
    
    
    $
    13,625
    
    
    $
    55,418
    
    
    $
    39,848
   16




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Critical Accounting Policies and Estimates
  Revenue Recognition
 Revenue
Recognition, Revenue Arrangements with Multiple
Deliverables
   18




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Accounting For Leases
  Allowance for Doubtful Accounts
  Inventories
  Warranty
  19




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Results of Operations
  Three Months Ended
    
    Nine Months EndedOctober 1,
    
    October 2,
    
    October 1,
    
    October 2,2005
    
    2004
    
    2005
    
    2004Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    25
    
    
    
    24
    
    
    
    25
    
    
    
    23Gross profit margin
    
    
    75
    
    
    
    76
    
    
    
    75
    
    
    
    77Operating expenses:Research and development
    
    
    14
    
    
    
    13
    
    
    
    13
    
    
    
    14Sales and marketing
    
    
    37
    
    
    
    45
    
    
    
    40
    
    
    
    49General and administrative
    
    
    13
    
    
    
    16
    
    
    
    14
    
    
    
    17Total operating expenses
    
    
    64
    
    
    
    74
    
    
    
    67
    
    
    
    80Income (loss) from operations
    
    
    11
    
    
    
    2
    
    
    
    8
    
    
    
    (3
    )Interest income, net
    
    
    2
    
    
    
    2
    
    
    
    2
    
    
    
    1Net income (loss)
    
    
    13
    %
    
    
    4
    %
    
    
    10
    
    
    
    (2
    )%
 Three and Nine months Ended October 1, 2005 Compared with the Three and Nine months Ended October
2, 2004
 Three Months Ended
    
    
    Nine Months EndedPercentage
    
    
    
    
    
    
    
    
    
    
    PercentageOctober 1,
    
    
    October 2,
    
    
    Increase
    
    
    October 1,
    
    
    October 2,
    
    
    Increase2005
    
    
    2004
    
    
    (Decrease)
    
    
    2005
    
    
    2004
    
    
    (Decrease)(in thousands, except
    
    
    
    
    
    
    (in thousands, except unitunit amounts)
    
    
    
    
    
    
    amounts)Revenue  WorldwideBIS Sensor
    
    $
    13,458
    
    
    $
    9,835
    
    
    37
    %
    
    $
    39,081
    
    
    $
    28,681
    
    
    
    36
    %BIS monitor
    
    
    3,034
    
    
    
    2,145
    
    
    41
    %
    
    
    8,879
    
    
    
    6,523
    
    
    
    36
    %Original equipment manufacturer products
    
    
    1,490
    
    
    
    748
    
    
    99
    %
    
    
    3,848
    
    
    
    2,094
    
    
    
    84
    %Other equipment and accessories
    
    
    620
    
    
    
    698
    
    
    (11
    %)
    
    
    1,875
    
    
    
    2,042
    
    
    
    (8
    %)Total Equipment
    
    
    5,144
    
    
    
    3,591
    
    
    43
    %
    
    
    14,602
    
    
    
    10,659
    
    
    
    37
    %Total product revenue
    
    
    18,602
    
    
    
    13,426
    
    
    39
    %
    
    
    53,683
    
    
    
    39,340
    
    
    
    36
    %Strategic alliance
    
    
    991
    
    
    
    199
    
    
    398
    %
    
    
    1,735
    
    
    
    508
    
    
    
    241
    %Total revenue
    
    $
    19,593
    
    
    $
    13,625
    
    
    44
    %
    
    $
    55,418
    
    
    $
    39,848
    
    
    
    39
    %Unit Analysis  WorldwideBIS Sensors
    
    
    991,000
    
    
    
    702,000
    
    
    41
    %
    
    
    2,814,000
    
    
    
    2,048,000
    
    
    
    37
    %BIS monitors
    
    
    787
    
    
    
    436
    
    
    80
    %
    
    
    2,212
    
    
    
    1,312
    
    
    
    69
    %Original equipment manufacturer
BIS products
    
    
    1,350
    
    
    
    562
    
    
    140
    %
    
    
    3,714
    
    
    
    1,456
    
    
    
    149
    %Installed base
    
    
    29,650
    
    
    
    22,395
    
    
    32
    %
    
    
    29,484
    
    
    
    22,395
    
    
    
    32
    %
 20




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Revenue.
     21




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Expense Overview
 Three Months Ended
    
    
    
    
    
    
    Nine Months EndedPercentage
    
    
    
    
    
    
    
    
    
    
    PercentageOctober 1,
    
    
    October 2,
    
    
    Increase
    
    
    October 1,
    
    
    October 2,
    
    
    Increase2005
    
    
    2004
    
    
    (Decrease)
    
    
    2005
    
    
    2004
    
    
    (Decrease)(in thousands)
    
    
    
    
    
    
    (in thousands)ExpensesResearch and development
    
    $
    2,695
    
    
    $
    1,748
    
    
    54
    %
    
    $
    7,080
    
    
    $
    5,495
    
    
    
    29
    %Sales and marketing
    
    $
    7,351
    
    
    $
    6,129
    
    
    20
    %
    
    $
    22,120
    
    
    $
    19,443
    
    
    
    14
    %General and administrative
    
    $
    2,532
    
    
    $
    2,241
    
    
    13
    %
    
    $
    7,970
    
    
    $
    6,905
    
    
    
    15
    %
 Research and Development.
  Sales and Marketing.
  General and Administrative.
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Interest Income.
 Interest expense.
 Net Income (Loss).
 Liquidity and Capital Resources
   23




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Agreements with Boston Scientific Corporation
        Cash Used for Operations.
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Cash from Investing Activities.
 Cash from Financing Activities.
 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities  A replacement of FASB Statement No. 125
   Off-Balance Sheet Arrangements
  Income Taxes
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Effects of Inflation
  Recent Accounting Pronouncements
 Share Based Payment Accounting for Stock-Based Compensation Accounting for Stock Issued to Employees Statement of Cash Flows
   Accounting Changes and Error Corrections. Accounting Changes Reporting Accounting
Changes in Interim Financial Statements
 Audit
Committee Composition Compliance with Nasdaq Marketplace Rules
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FACTORS AFFECTING FUTURE OPERATING RESULTS
 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 December 31, 2005 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 following important factors represent some of the current
challenges to us that create risk and uncertainty. Failure to adequately overcome any of the
following challenges could have a material adverse effect on our results of operations, business or
financial condition. 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.
 We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our
BIS system in sufficient quantities.
   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 market factors may adversely affect our quarterly operating results through the fourth
fiscal quarter of 2005.
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Fluctuations in our quarterly operating results could cause our stock price to decrease.
  
    
    the timing and volume of customer orders for our BIS system,
    
    use of and demand for our BIS Sensors,
    
    transition of sales focus from BIS monitors to original equipment manufacturer products,
    
    customer cancellations,
    
    introduction of competitive products,
    
    regulatory approvals,
    
    changes in management,
    
    turnover in our direct sales force,
    
    effectiveness of new marketing and sales programs,
    
    communications published by industry organizations or other in the anesthesia community
that are unfavorable to our business,
    
    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.
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If approval of our BIS XP system is not obtained in Japan, our revenue and operating results could
be adversely affected.
  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 currently under development 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,
    
    we are required to defend or enforce our intellectual property rights,
    
    sales of our products do not meet our expectations domestically or internationally,
    
    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 BIS systems and could expose us to product liability claims.
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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.
  If we do not successfully develop and introduce enhanced or new products we could lose revenue
opportunities and customers.
  
    
    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 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,
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
    
    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.
 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
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.
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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.
  
    
    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 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.
  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.
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Boston Scientific Corporation may be able to affect corporate actions requiring stockholder
approval because it owns a significant amount of our common stock, additionally, if our strategic
alliance with Boston Scientific Corporation is not successful, our operating results could be
adversely affected.
  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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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, we will not be able to expand our business.
  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.
  35




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Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 Interest Rate Exposure
   Foreign Currency Exposure
  
 Item 4. Controls and Procedures.
 Evaluation of Disclosure Controls and Procedures.
  Changes in Internal Controls.
  36




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PART II  OTHER INFORMATION
 
 Item 6. Exhibits.
  37




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SIGNATURE
  ASPECT MEDICAL SYSTEMS, INC.Date: November 10, 2005
    
    By:
    
    /s/ Michael Falvey

Michael FalveyVice President and Chief Financial Officer(Principal Financial and Accounting Officer)
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##### Table of Contents



EXHIBIT INDEX
 EXHIBITNUMBER
    
    EXHIBIT10.1
    
    Purchase Agreement by and between
the Registrant and General Electric, dated as of August 31,
2005, is incorporated herein by reference to Exhibit 10.1 to the Registrants Current
Report on Form 8-K dated November 10, 2005.10.2
    
    BISx License, Development and
Supply Agreement by and between the Registrant and Spacelabs Medical,
Inc., dated as of October 17, 2005, is incorporated herein by
reference to Exhibit 10.2 to the Registrants Current Report on Form 8-K dated
November 10, 2005.31.1
    
    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.