<PAGE>
                                  UNITED STATES

                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

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

                                    FORM 10-Q

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

                FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 29, 2001

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

            FOR THE TRANSITION PERIOD FROM ___________ TO ___________


                         Commission file number: 0-24663

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

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

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


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

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

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

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

                                 YES [X] NO [ ]

The Registrant had 17,770,492 shares of Common Stock, $0.01 par value per share,
outstanding as of November 7, 2001.


<PAGE>

                          ASPECT MEDICAL SYSTEMS, INC.

                                TABLE OF CONTENTS


<TABLE>
<CAPTION>
                                                                                                                PAGE
                                                                                                                ----
<S>               <C>                                                                                          <C>
PART I.           FINANCIAL INFORMATION                                                                            1

Item 1.           Financial Statements (Unaudited)                                                                 1

                  Consolidated Balance Sheets as of September 29, 2001 and December 31, 2000                       1

                  Consolidated Statements of Operations for the Three and Nine Months Ended
                  September 29, 2001 and September 30, 2000                                                        2

                  Consolidated Statements of Cash Flows for the Nine Months Ended
                  September 29, 2001 and September 30, 2000                                                        3

                  Notes to Consolidated Financial Statements                                                       4

Item 2.           Management's Discussion and Analysis of Financial Condition and Results of Operations            9

Item 3.           Quantitative and Qualitative Disclosures About Market Risk                                      23

PART II.          OTHER INFORMATION                                                                               24

Item 1.           Legal Proceedings                                                                               24

Item 2.           Changes in Securities and Use of Proceeds                                                       24

Item 3.           Defaults Upon Senior Securities                                                                 24

Item 4.           Submission of Matters to a Vote of Security Holders                                             24

Item 5.           Other Information                                                                               24

Item 6.           Exhibits and Reports on Form 8-K                                                                24

SIGNATURE                                                                                                         25

</TABLE>

<PAGE>

                         PART I -- FINANCIAL INFORMATION

ITEM 1.    FINANCIAL STATEMENTS

                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                           CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                              September 29,          December 31,
                                                                                                  2001                   2000
                                                                                              --------------        --------------
                                                                                               (Unaudited)
<S>                                                                                            <C>                   <C>
ASSETS
Current assets:
   Cash and cash equivalents                                                                   $ 24,154,092          $ 23,776,617
   Marketable securities                                                                         21,651,612            34,712,325
   Accounts receivable, net of allowance of $472,000 at September 29,
     2001 and $422,000 at December 31, 2000                                                       4,733,947             3,665,572
   Current portion of investment in sales-type leases                                             1,474,537             1,677,312
   Inventory                                                                                      6,167,680             4,764,479
   Other current assets                                                                           1,153,961             1,542,597
                                                                                               ------------          ------------
           Total current assets                                                                  59,335,829            70,138,902
Property and equipment, net                                                                       6,177,739             6,807,192
Long-term investment in sales-type leases                                                         1,824,784             2,465,139
Other long-term assets                                                                            1,233,068                  --
                                                                                               ------------          ------------
           Total assets                                                                        $ 68,571,420          $ 79,411,233
                                                                                               ============          ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
   Current portion of long-term debt                                                           $    866,105          $  2,530,707
   Working capital line of credit                                                                 4,000,000                  --
   Accounts payable                                                                                 944,920             1,877,295
   Accrued liabilities                                                                            7,374,135             6,473,887
   Deferred revenue                                                                                 503,629               802,489
                                                                                               ------------          ------------
           Total current liabilities                                                             13,688,789            11,684,378
                                                                                               ------------          ------------
Deferred revenue                                                                                  1,055,000             1,136,676
Long-term debt                                                                                    1,130,007             2,616,657
                                                                                               ------------          ------------
Commitments and contingencies
Stockholders' 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,
     17,747,536 and 17,377,257 shares issued and outstanding at
     September 29, 2001 and December 31, 2000, respectively                                         177,475               173,773
   Additional paid-in capital                                                                   126,312,021           124,934,402
   Warrants                                                                                         121,684               121,684
   Notes receivable from employees and directors                                                   (335,777)             (510,787)
   Deferred compensation                                                                            (37,363)              (75,043)
   Accumulated other comprehensive income                                                            93,940                63,029
   Accumulated deficit                                                                          (73,634,356)          (60,733,536)
                                                                                               ------------          ------------
           Total stockholders' equity                                                            52,697,624            63,973,522
                                                                                               ------------          ------------
           Total liabilities and stockholders' equity                                          $ 68,571,420          $ 79,411,233
                                                                                               ============          ============
</TABLE>


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

                                       1

<PAGE>


                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF OPERATIONS


<TABLE>
<CAPTION>
                                                       Three Months Ended                          Nine Months Ended
                                                ----------------------------------        ------------------------------------
                                                September 29,        September 30,        September 29,         September 30,
                                                    2001                 2000                  2001                  2000
                                                -------------        -------------        -------------         -------------
                                                 (Unaudited)          (Unaudited)          (Unaudited)           (Unaudited)

<S>                                              <C>                  <C>                  <C>                   <C>
Revenue                                          $ 8,528,080          $ 7,231,033          $ 26,363,921          $27,956,577
Costs and expenses:
    Costs of revenue                               3,051,077            2,097,716             8,702,214            8,563,151
    Research and development                       1,968,659            1,304,227             5,587,219            4,106,976
    Sales and marketing                            6,851,143            5,484,308            21,038,124           15,410,937
    General and administrative                     2,003,111            1,738,341             6,092,629            4,732,854
                                                 -----------          -----------          ------------          -----------
          Total costs and expenses                13,873,990           10,624,592            41,420,186           32,813,918
                                                 -----------          -----------          ------------          -----------

Loss from operations                              (5,345,910)          (3,393,559)          (15,056,265)          (4,857,341)
Interest income                                      586,571            1,173,066             2,456,062            3,427,797
Interest expense                                     (77,769)            (198,065)             (300,617)            (570,208)
                                                 -----------          -----------          ------------          -----------
Net loss                                         $(4,837,108)         $(2,418,558)         $(12,900,820)         $(1,999,752)
                                                 ===========          ===========          ============          ===========

Net loss per share:
    Basic and diluted                            $     (0.27)         $     (0.14)         $      (0.73)         $     (0.13)

Shares used in computing net loss per share:
    Basic and diluted                             17,683,237           17,199,671            17,561,058           15,229,417

</TABLE>












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

                                       2

<PAGE>

                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                      CONSOLIDATED STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>
                                                                                                         Nine Months Ended
                                                                                                ------------------------------------
                                                                                                September 29,         September 30,
                                                                                                    2001                   2000
                                                                                                -------------         --------------
                                                                                                 (Unaudited)            (Unaudited)
<S>                                                                                             <C>                    <C>
Cash flows from operating activities:
   Net loss                                                                                     $(12,900,820)          $ (1,999,752)
   Adjustments to reconcile net loss to net cash used for
     operating activities -
     Depreciation and amortization                                                                 1,915,817              1,200,920
     Provision for doubtful accounts                                                                  50,000                 65,000
     Compensation expense related to stock options                                                    52,737                446,963
     Changes in assets and liabilities -
       Increase in accounts receivable                                                            (1,108,007)              (297,650)
       Increase in inventory                                                                      (1,403,201)            (3,688,149)
       Decrease (increase) in other assets                                                           230,459               (214,030)
       Decrease in investment in sales-type leases                                                   843,130                191,178
       (Decrease) increase in accounts payable                                                      (932,375)               377,087
       Increase (decrease) in accrued liabilities                                                    900,248                (77,377)
       Decrease in deferred revenue                                                                 (380,536)              (816,910)
                                                                                                ------------           ------------
          Net cash used for operating activities                                                 (12,732,548)            (4,812,720)
                                                                                                ------------           ------------

Cash flows from investing activities:
   Loans to related parties                                                                       (1,074,891)                  --
   Acquisition of property and equipment                                                          (1,286,364)            (4,126,693)
   Purchases of marketable securities                                                            (20,060,061)           (54,246,480)
   Proceeds from sales and maturities of marketable securities                                    33,151,687             20,750,000
                                                                                                ------------           ------------
          Net cash provided by (used for) investing activities                                    10,730,371            (37,623,173)
                                                                                                ------------           ------------

Cash flows from financing activities:
   Net proceeds from working capital line of credit                                                4,000,000                   --
   Principal payments on equipment loan                                                             (720,670)              (540,502)
   Principal payments on term loan                                                                (1,884,933)              (706,847)
   Proceeds from sale of investment in sales-type leases                                             283,528              1,514,084
   Principal payments on debt related to investment in sales-type
     leases                                                                                         (829,178)              (514,526)
   Proceeds from issuance of common stock                                                          1,355,895             55,460,108
   Payments received on notes receivable from employees and
     directors                                                                                       175,010                 26,157
                                                                                                ------------           ------------
          Net cash provided by financing activities                                                2,379,652             55,238,474
                                                                                                ------------           ------------
Net increase in cash and cash equivalents                                                            377,475             12,802,581
Cash and cash equivalents, beginning of period                                                    23,776,617             13,535,364
                                                                                                ------------           ------------
Cash and cash equivalents, end of period                                                        $ 24,154,092           $ 26,337,945
                                                                                                ============           ============

Supplemental disclosure of cash flow information:
   Interest paid                                                                                $    333,358           $    585,744
                                                                                                ============           ============
</TABLE>



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

                                       3

<PAGE>

                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)


(1)      Basis of Presentation

         The accompanying unaudited consolidated financial statements of Aspect
Medical Systems, Inc. and subsidiaries (the "Company") have been prepared in
accordance with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-Q and Regulation S-X.
Accordingly, they do not include all of the information and footnotes required
by generally accepted accounting principles for complete financial statements.
In the opinion of management, all normal, recurring adjustments considered
necessary for a fair presentation have been included. The consolidated financial
statements and notes included herein should be read in conjunction with the
audited consolidated financial statements for the year ended December 31, 2000
included in the Company's Annual Report on Form 10-K filed with the Securities
and Exchange Commission (the "SEC"). Interim results of operations are not
necessarily indicative of the results to be expected for the full year or any
other interim period.


(2)      Computation of Net Loss Per Share

         In accordance with Statement of Financial Accounting Standards (SFAS)
No. 128, Earnings Per Share, basic and diluted net loss per share amounts for
the three and nine months ended September 29, 2001 and September 30, 2000 were
computed by dividing the net loss by the weighted average common shares
outstanding during the periods presented. The computation of basic and diluted
net loss per share amounts are as follows:

<TABLE>
<CAPTION>
                                                           Three Months Ended                    Nine Months Ended
                                                     --------------------------------     --------------------------------
                                                     September 29,      September 30,     September 29,      September 30,
                                                         2001               2000              2001               2000
                                                     -------------      -------------     -------------      -------------
                                                      (Unaudited)        (Unaudited)       (Unaudited)        (Unaudited)

<S>                                                  <C>                <C>               <C>                 <C>
BASIC AND DILUTED NET LOSS PER SHARE
   COMPUTATION
   Numerator:
   Net loss available to common stockholders         $(4,837,108)       $(2,418,558)      $(12,900,820)       $(1,999,752)
                                                     -----------        -----------       ------------        -----------

  Denominator:
  Weighted average common shares outstanding          17,683,237         17,199,671         17,561,058         15,229,417
                                                     -----------        -----------       ------------        -----------
  Basic and diluted net loss per share               $     (0.27)       $     (0.14)      $      (0.73)       $     (0.13)
                                                     ===========        ===========       ============        ===========
</TABLE>


         The Company has excluded all shares of restricted common stock that are
subject to repurchase by the Company from the weighted average number of common
shares outstanding. For the three and nine months ended September 29, 2001, the
Company has excluded 1,113,000 and 1,135,000 shares, respectively, and for the
three and nine months ended September 30, 2000, the Company has excluded
1,804,000 and 2,339,000 shares, respectively, related to restricted common stock
subject to repurchase and common stock issuable pursuant to the exercise of
stock options and warrants from the calculation of the Company's diluted
earnings per share because the inclusion of these shares would have been
antidilutive as a result of the Company's net loss position.




                                        4


<PAGE>
                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)


(3)      Revenue Recognition

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


(4)      Use of Estimates

         The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenue and expenses during
the reporting period. Actual results could differ from those estimates.


(5)      Comprehensive Income (Loss)

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

<TABLE>
<CAPTION>
                                                             Three Months Ended                          Nine Months Ended
                                                       ---------------------------------       ----------------------------------
                                                       September 29,       September 30,       September 29,        September 30,
                                                           2001                2000                 2001                2000
                                                       -------------       -------------       --------------       -------------
                                                        (Unaudited)         (Unaudited)          (Unaudited)         (Unaudited)

<S>                                                     <C>                 <C>                 <C>                  <C>
Net loss                                                $(4,837,108)        $(2,418,558)        $(12,900,820)        $(1,999,752)
Other comprehensive income:
    Unrealized gain on marketable
      securities                                             52,491             123,287               30,911              40,682
                                                        -----------         -----------         ------------         -----------
Comprehensive loss                                      $(4,784,617)        $(2,295,271)        $(12,869,909)        $(1,959,070)
                                                        ===========         ===========         ============         ===========
</TABLE>



                                       5

<PAGE>
                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

(6)      Investment in Sales-Type Leases

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


<TABLE>
<CAPTION>
                                                                 September 29,              December 31,
                                                                     2001                       2000
                                                                 -------------              -----------
                                                                  (Unaudited)

<S>                                                               <C>                        <C>
Total minimum lease payments receivable                           $4,076,930                 $5,143,738
  Less -- unearned interest                                          777,609                  1,001,287
                                                                  ----------                 ----------
Net investment in sales-type leases                                3,299,321                  4,142,451
  Less -- current portion                                          1,474,537                  1,677,312
                                                                  ----------                 ----------
                                                                  $1,824,784                 $2,465,139
                                                                  ==========                 ==========
</TABLE>


(7)      Inventory

        Inventory consists of the following:

<TABLE>
<CAPTION>
                                                                 September 29,              December 31,
                                                                     2001                       2000
                                                                 -------------              -----------
                                                                  (Unaudited)

<S>                                                               <C>                        <C>
Raw materials                                                     $3,305,491                 $2,200,119
Work-in-progress                                                     292,216                      1,742
Finished goods                                                     2,569,973                  2,562,618
                                                                  ----------                 ----------
                                                                  $6,167,680                 $4,764,479
                                                                  ==========                 ==========
</TABLE>


(8)      Segment Information and Enterprise Reporting

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







                                       6

<PAGE>
                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

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


<TABLE>
<CAPTION>
                                                 Three Months Ended                             Nine Months Ended
                                          -----------------------------------         ------------------------------------
                                          September 29,         September 30,         September 29,          September 30,
                                              2001                  2000                  2001                   2000
                                          -------------         -------------         -------------          -------------
                                           (Unaudited)           (Unaudited)           (Unaudited)            (Unaudited)
<S>                                        <C>                    <C>                  <C>                    <C>
Geographic Area by Destination
   Domestic                                $ 6,917,188            $ 5,743,043          $20,420,949            $23,346,078
   International                             1,610,892              1,487,990            5,942,972              4,610,499
                                           -----------            -----------          -----------            -----------
                                           $ 8,528,080            $ 7,231,033          $26,363,921            $27,956,577
                                           ===========            ===========          ===========            ===========
</TABLE>

<TABLE>
<CAPTION>
                                                 Three Months Ended                             Nine Months Ended
                                          -----------------------------------         ------------------------------------
                                          September 29,         September 30,         September 29,          September 30,
                                              2001                  2000                  2001                   2000
                                          -------------         -------------         -------------          -------------
                                           (Unaudited)           (Unaudited)           (Unaudited)            (Unaudited)
<S>                                        <C>                    <C>                  <C>                    <C>
Geographic Area by Destination
   Domestic                                     81%                  79%                   77%                    84%
   International                                19                   21                    23                     16
                                               ---                  ---                   ---                    ---
                                               100%                 100%                  100%                   100%
                                               ===                  ===                   ===                    ===
</TABLE>

         The Company did not have sales in any individual country that accounted
for more than 10% of the Company's total revenue for the three and nine months
ended September 29, 2001 and September 30, 2000.


(9)      Initial Public Offering

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


(10)     Related Party Transactions

         In April 2001, the Company loaned, on a full recourse basis, an
aggregate of $1,081,000, to an officer, certain employees and a consultant of
the Company. The loans, included in other assets in the accompanying balance
sheet as of September 29, 2001, are payable over periods ranging from four to
five years and are in each case secured by assets of the borrower, including
shares of the Company's common stock owned by the borrower. At September 29,
2001, approximately $1,038,000 was outstanding on these loans.


                                       7

<PAGE>
                  ASPECT MEDICAL SYSTEMS, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

(11)     Loan Agreements

         In May 2001, the Company paid the outstanding principal on both the
equipment portion and term loan portion of its loan agreement with a commercial
bank. Following the termination of this loan agreement, the Company entered into
an agreement with another commercial bank for a revolving line of credit. The
revolving line of credit is for $5,000,000 and expires in May 2002 and, subject
to annual review by the commercial bank, may be extended at the discretion of
the commercial bank. Interest on any borrowings under the revolving line of
credit is, at the election of the Company, either the prime rate or at LIBOR
plus 2.25%. Up to $1,500,000 of the $5,000,000 revolving line of credit is
available for standby letters of credit.

         The revolving line of credit agreement contains restrictive covenants
that require the Company to maintain liquidity and net worth ratios and is
secured by certain investments of the Company. At September 29, 2001, $4,000,000
of the revolving line of credit was outstanding, and the Company was in
compliance with all covenants contained in the revolving line of credit
agreement.











                                       8

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

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


OVERVIEW

    We develop, manufacture and market an anesthesia monitoring system that we
call the BIS system. The BIS system is based on our patented core technology,
the BIS index. The BIS system provides new information about a patient's status
that allows clinicians to better assess and manage a patient's level of
consciousness in the operating room and intensive care settings and administer
the precise amount of anesthesia needed by each patient. Our proprietary BIS
system includes our BIS monitor or BIS Module Kit, which allows original
equipment manufacturers to incorporate the BIS index into their monitoring
products, and our disposable BIS Sensors. We collectively refer to the BIS
Sensor, BIS Sensor Plus, BIS Pediatric Sensor and BIS Sensor XP as BIS Sensors.
Our latest generation monitor, the A-2000 BIS Monitor, was cleared for marketing
by the Food and Drug Administration, or the FDA, in February 1998. Our latest
version of the BIS system, the BIS XP system, was cleared for marketing by the
FDA in June 2001. The BIS XP system offers expanded performance capabilities and
expanded benefits, enabling more precise measurement of brain activity to assess
the level of consciousness across the full spectrum of clinical practice. The
BIS XP system is designed to detect and filter interference from muscle artifact
and is resistant to electrocautery devices. Additionally, it is able to provide
enhanced detection of near suppression, a brain wave pattern occasionally seen
during deep anesthesia and cardiac cases. Our other monitor products are the
A-1000 Monitor, the A-1050 EEG Monitor with BIS and the BIS Module Kit. After
the introduction of the A-2000 BIS Monitor, we ceased active marketing in the
United States of the A-1050 EEG Monitor. In addition to the disposable BIS
Sensors, we offer the Zipprep EEG Electrode.

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

    We offer customers the option either to purchase the BIS monitors outright
or to acquire the BIS monitors pursuant to a sales-type lease agreement whereby
the customer contractually commits to purchase a minimum number of BIS Sensors
per BIS monitor per year. Under this agreement, customers purchase BIS Sensors
and the BIS monitor for the purchase price of the BIS Sensors plus an additional
charge per BIS Sensor to pay for the purchase price of the BIS monitor and
related financing costs over the term of the agreement. These customers are
granted an option to purchase the BIS monitor at the end of the term of the
agreement, which is typically three to five years. Revenue related to BIS
monitors sold pursuant to sales-type leases is recognized at the time of
shipment of the BIS monitors. Sales-type leases accounted for approximately 4%
and 3% of revenue in the three months and 2% and 7% in the nine months ended
September 29, 2001 and September 30, 2000, respectively.

    Under certain circumstances, we also offer customers the opportunity to use
the BIS monitors under our Equipment Placement program, which we refer to as the
EP program. Under the EP program, these customers are granted the right to use
the BIS monitors for a mutually agreed-upon period of time. During this period,
these customers purchase BIS Sensors at a price that includes a premium above
the list price of the BIS Sensors to cover the rental of the equipment, but
without any minimum purchase commitments. At the end of this agreed-upon period
of time, these customers have the option of purchasing the BIS monitors,
continuing to use them under the EP program or returning them to us.

    We derive our revenue primarily from sales of monitors, BIS Module Kits, and
related accessories, which we collectively refer to as Equipment, and sales of
BIS Sensors. In the three months ended September 29, 2001 and September 30,
2000, revenue from the sale of Equipment represented approximately 32% and 31%,
respectively, of our revenue, and revenue from the sale of BIS Sensors
represented approximately 68% and 69%, respectively, of our revenue. In the nine
months ended September 29, 2001 and September 30, 2000, revenue from the sale of
Equipment represented approximately 31% and 43%, respectively, of our revenue,
and revenue from the sale of BIS Sensors represented approximately 69% and 57%,
respectively, of our revenue. Although we believe that



                                       9

<PAGE>
revenue from the sale of BIS Sensors will increase as a result of our growing
installed base, it will likely decline as a percentage of revenue in the fourth
fiscal quarter of 2001 because we expect that revenue from Equipment sales will
increase as a result of the commercial introduction of the BIS XP system, a
reduction in our focus on the free placement of monitors in the medical
community, the shipments of BIS Module Kits to our original equipment
manufacturers and marketing clearance received from Japan's Ministry of Health,
Labor and Welfare to sell the A-2000 BIS Monitor in Japan.

    Revenue from domestic sales in the three months ended September 29, 2001 and
September 30, 2000 was approximately $6.9 million and $5.7 million,
respectively, which represented approximately 81% and 79%, respectively, of our
revenue. For the nine months ended September 29, 2001 and September 30, 2000,
revenue from domestic sales was approximately $20.4 million and $23.3 million,
respectively, which represented approximately 77% and 84%, respectively, of our
revenue. Revenue from international sales in the three months ended September
29, 2001 and September 30, 2000 was approximately $1.6 million and $1.5 million,
respectively, which represented approximately 19% and 21%, respectively, of our
revenue. Revenue from international sales in the nine months ended September 29,
2001 and September 30, 2000 was approximately $5.9 million and $4.6 million,
respectively, which represented approximately 23% and 16%, respectively, of our
revenue.

    In December 1998 and March 1999, we established subsidiaries in The
Netherlands and the United Kingdom, respectively, to facilitate our entry into
the international market. We are developing our international sales and
distribution program through a combination of distributors and marketing
partners, including companies with which we have entered into original equipment
manufacturer relationships. We expect to enhance our international third-party
distribution program through direct sales efforts and to support our customers
with clinical specialists. In January 1998, we entered into a distribution
agreement with Nihon Kohden Corporation to distribute BIS monitors in Japan. In
March 2000, Japan's Ministry of Health, Labor and Welfare approved our A-1050
EEG Monitor with BIS for marketing in Japan. In May 2001, Japan's Ministry of
Health, Labor and Welfare approved our A-2000 BIS Monitor for marketing in
Japan. Sales to Nihon Kohden represented approximately 37% and 24%,
respectively, of international revenue for the three and nine month periods
ended September 29, 2001 and approximately 33% and 47%, respectively, of
international revenue for the three and nine month periods ended September 30,
2000.


RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>
                                                 Three Months Ended                             Nine Months Ended
                                          -----------------------------------         ------------------------------------
                                          September 29,         September 30,         September 29,          September 30,
                                              2001                  2000                  2001                   2000
                                          -------------         -------------         -------------          -------------
<S>                                       <C>                      <C>                   <C>                    <C>
Revenue                                       100%                  100%                  100%                   100%
Costs and expenses:
    Costs of revenue                           36                    29                    33                     31
    Research and development                   23                    18                    21                     14
    Sales and marketing                        80                    76                    80                     55
    General and administrative                 24                    24                    23                     17
                                             ----                  ----                  ----                   ----
             Total costs and expenses         163                   147                   157                    117
                                             ----                  ----                  ----                   ----

Loss from operations                          (63)                  (47)                  (57)                   (17)
Interest income, net                            6                    14                     8                     10
                                             ----                  ----                  ----                   ----
Net loss                                      (57)%                 (33)%                 (49)%                   (7)%
                                             ====                  ====                  ====                   ====
</TABLE>


                                       10


<PAGE>
THREE AND NINE MONTHS ENDED SEPTEMBER 29, 2001 COMPARED TO THREE AND NINE MONTHS
ENDED SEPTEMBER 30, 2000

Revenue. Our revenue increased to approximately $8.5 million in the three months
ended September 29, 2001 from approximately $7.2 million in the three months
ended September 30, 2000, an increase of approximately 18%. Revenue from the
sale of Equipment increased to approximately $2.7 million in the three months
ended September 29, 2001 from approximately $2.2 million in the three months
ended September 30, 2000, an increase of approximately 22%. The increase in
Equipment revenue for the three months ended September 29, 2001 is attributable
to an increase in the number of monitors and modules sold, a higher average
domestic selling price of our monitors as a result of our reduction in our focus
on the free placement of monitors, including monitors placed under our Equipment
Placement program, and an increase of approximately 171% in revenue from the
sale of accessories.

    For the nine months ended September 29, 2001, revenue decreased to
approximately $26.4 million from approximately $28.0 million in the nine months
ended September 30, 2000, a decrease of approximately 6%. Revenue from the sale
of Equipment decreased to approximately $8.2 million in the nine months ended
September 29, 2001 from approximately $11.9 million in the nine months ended
September 30, 2000, a decrease of approximately 31%. We believe there were three
primary factors that contributed to the decrease in Equipment revenue for the
nine months ended September 29, 2001 as compared to the nine months ended
September 30, 2000. In the first six months of 2001 many of our customers
acquired monitors under our Equipment Placement program which was not introduced
until the second half of 2000 and had an adverse impact on our revenue from the
sale of monitors in the first six months of 2001 as compared to the same period
in 2000. Under the Equipment Placement program, monitors are placed free of
charge for customers that agree to purchase BIS Sensors for a premium price.
Second, because of FDA approval of a competitive monitoring product, domestic
customers have not purchased our product because they are evaluating the
competitive product. Third, revenue from Japan decreased approximately 34% in
the nine months ended September 29, 2001 as compared to the nine months ended
September 30, 2000 primarily because our Japanese distributor delayed purchases
while awaiting marketing approval for our A-2000 BIS Monitor from Japan's
Ministry of Health, Labor and Welfare. This approval was received in May 2001.
The decrease in revenue from the sale of Equipment for the nine months ended
September 29, 2001, was offset by an increase in BIS Sensor revenue of
approximately 13% as compared to the nine months ended September 30, 2000.

    Revenue from the sale of BIS Sensors increased to approximately $5.8 million
in the three months ended September 29, 2001 from approximately $5.0 million in
the three months ended September 30, 2000, an increase of approximately 16%.
Revenue from the sale of BIS Sensors increased to approximately $18.1 million in
the nine months ended September 29, 2001 from approximately $16.1 million in the
nine months ended September 30, 2000, an increase of approximately 13%. The
increase in revenue from the sale of BIS Sensors in each period in 2001 was
primarily attributable to an increase of approximately 18% and 12%,
respectively, in the number of BIS Sensors sold as a result of growth in the
installed base of monitors and BIS Module Kits compared to the three and nine
month periods ended September 30, 2000.

    Our gross profit was approximately 64% and 67% of revenue in the three and
nine months ended September 29, 2001 as compared to a gross profit of
approximately 71% and 69% of revenue in the three and nine months ended
September 30, 2000. We believe that the decrease in gross profit for the three
and nine months ended September 29, 2001 was primarily the result of four
factors. First, the worldwide average selling price of our monitors decreased.
Second, we had additional cost of sales related to the depreciation on monitors
placed under our Equipment Placement program and monitors used by customers for
evaluation purposes. In addition, we have a lower gross margin percentage on the
BIS Module Kits and accessories as compared to monitors and BIS Sensors.
Finally, we experienced under absorption of manufacturing overhead due to
reduced monitor production in the third fiscal quarter of 2001. In the near
term, we believe that our gross margin percentage will remain comparable to the
gross margin percentage of the third fiscal quarter of 2001. We believe that the
following factors will contribute to this near term trend in gross margin
percentage: an increase in sales of lower gross margin percentage BIS Module
Kits, the effect of transitioning our existing installed base to the BIS XP
system through the sale of low gross margin percentage upgrade kits, continued
depreciation expense on monitors placed under our Equipment Placement program
and monitors used by customers for evaluation purposes and increased pricing
pressure as competitive products are introduced to the market. We expect that
the pressure exerted on our gross margin percentage by these factors will be
partially offset by increased sales of our BIS Sensors as the installed base of
monitors and BIS Module Kits grows. BIS Sensors have a higher gross margin than
our Equipment.


                                       11

<PAGE>
Research and Development. Research and development expenses increased to
approximately $2.0 million in the three months ended September 29, 2001 from
approximately $1.3 million in the three months ended September 30, 2000, an
increase of approximately 51%. Research and development expenses increased to
approximately $5.6 million in the nine months ended September 29, 2001 from
approximately $4.1 million in the nine months ended September 30, 2000, an
increase of approximately 36%. The increase in research and development expenses
for the three and nine months ended September 29, 2001 as compared to the three
and nine months ended September 30, 2000, was primarily attributable to an
increase of approximately 38% and 39%, respectively, in research and development
personnel and related payroll and other expenses, an increase of approximately
25% and 21%, respectively, in clinical study expenses, and an increase of
approximately 2% and 9%, respectively, in external consultants and contractor
expenses. In addition, the increase in research and development expenses for the
three and nine months ended September 29, 2001 as compared to the three and nine
months ended September 30, 2000, was attributable to increased costs incurred in
connection with the continued product development efforts related to the BIS
Sensor XP and BIS Pediatric Sensor, each of which was recently approved by the
FDA, the BIS Module Kit and product improvement efforts related to the BIS XP
system. We expect research and development expenses to increase slightly as we
continue to invest in the development of product improvements, product
extensions and new applications for our technology.

Sales and Marketing. Sales and marketing expenses increased to approximately
$6.9 million in the three months ended September 29, 2001 from approximately
$5.5 million in the three months ended September 30, 2000, an increase of
approximately 25%. Sales and marketing expenses increased to approximately $21.0
million in the nine months ended September 29, 2001 from approximately $15.4
million in the nine months ended September 30, 2000, an increase of
approximately 37%. The increase in sales and marketing expenses in the three and
nine months ended September 29, 2001 as compared to the three and nine months
ended September 30, 2000 was primarily attributable to an increase of
approximately 28% and 44%, respectively, in sales and marketing personnel and
related payroll and other expenses, an increase of approximately 32% and 6%,
respectively, in expenses associated with increasing name and brand awareness
through advertising, public relations and the internet, an increase of
approximately 13% and 19%, respectively, in external consultant expenses
primarily relating to our investment in new sales and marketing programs, an
increase of approximately 12% in operating expenses associated with our
international subsidiaries, and an increase of approximately 9% and 7%,
respectively, in fees and commissions related to the agreements with group
purchasing organizations, original equipment manufacturers and distributors. We
expect sales and marketing expenses to increase slightly as we continue to
expand our international operations, leverage our existing relationships with
group purchasing organizations, and enhance our sales and marketing programs,
including professional education that promotes the use of the BIS system by our
customers.

General and Administrative. General and administrative expenses increased to
approximately $2.0 million in the three months ended September 29, 2001 from
approximately $1.7 million in the three months ended September 30, 2000, an
increase of approximately 15%. General and administrative expenses increased to
approximately $6.1 million in the nine months ended September 29, 2001 from
approximately $4.7 million in the nine months ended September 30, 2000, an
increase of approximately 29%. The increase in general and administrative
expenses in the three and nine months ended September 29, 2001 as compared to
the three and nine months ended September 30, 2000 was attributable to an
increase of approximately 32% and 21%, respectively, in general and
administrative personnel and related payroll and other expenses. The increase
also included an increase in expenses related to enhancements of our investor
relations capabilities, insurance expenses, and other professional services of
approximately 38% and 43%, respectively. We expect general and administrative
expenses to increase slightly as we continue to seek improvements in our
administrative infrastructure.

Interest Income (Expense). Net interest income decreased to approximately
$509,000 in the three months ended September 29, 2001 from approximately
$975,000 in the three months ended September 30, 2000, a decrease of
approximately 48%. Net interest income decreased to approximately $2.2 million
in the nine months ended September 29, 2001 from approximately $2.9 million in
the nine months ended September 30, 2000, a decrease of approximately 25%.
Interest income decreased to approximately $587,000 in the three months ended
September 29, 2001 from approximately $1.2 million in the comparable period in
2000, a decrease of approximately 50%. Interest income decreased to
approximately $2.5 million in the nine months ended September 29, 2001 from
approximately $3.4 million in the nine months ended September 30, 2000, a
decrease of approximately 28%. The decrease in interest income is primarily
attributable to lower cash and investment balances resulting from continued
operating losses and other uses of cash and lower interest rates on our
investments as a result of changes in the interest rate environment. Interest
expense decreased to approximately $78,000 in the three months ended September
29, 2001 from approximately $198,000 in the comparable period in 2000, a
decrease of approximately 61%. Interest expense decreased to approximately
$301,000 in the nine months ended September 29, 2001 from approximately $570,000
in the nine months ended September 30, 2000,


                                       12


<PAGE>
a decrease of approximately 47%. The decrease in interest expense in the three
and nine months ended September 29, 2001 was a result of the repayment of our
equipment and term loans in May 2001, lower average outstanding debt obligations
resulting from payments under our other debt obligations, and lower interest
rates on our working capital line of credit as compared to the equipment and
term loans.

Net Loss. As a result of the factors discussed above, in the three and nine
months ended September 29, 2001, our net loss increased to approximately $4.8
million and $12.9 million, respectively, from a net loss of approximately $2.4
million and $2.0 million in the three and nine months ended September 30, 2000,
respectively.


LIQUIDITY AND CAPITAL RESOURCES

    From our inception through January 2000, we financed our operations
primarily from the sale of convertible preferred stock. Through September 29,
2001, we raised approximately $67.6 million from private equity financings and
have received approximately $3.4 million in equipment financing and
approximately $3.7 million of financing related to our investments in sales-type
leases. We also received approximately $2.8 million of financing under a term
loan in December 1999. The outstanding principal on the equipment and term loans
was paid in May 2001. In February 2000, we closed our initial public offering of
an aggregate of 4,025,000 shares of common stock and received net proceeds of
approximately $54.6 million. In May 2001, we entered into an agreement with a
commercial bank for a $5.0 million revolving line of credit which expires in May
2002. At September 29, 2001, $4.0 million was outstanding under this line of
credit.

    Working capital at September 29, 2001 was approximately $45.6 million
compared to approximately $58.5 million at December 31, 2000. The decrease in
working capital from December 31, 2000 to September 29, 2001 was primarily
attributable to continued net operating losses of approximately $12.9 million.

    We used approximately $12.7 million of cash for operations in the nine
months ended September 29, 2001 as compared to approximately $4.8 million in the
nine months ended September 30, 2000. Cash used for operations in the nine
months ended September 29, 2001 was primarily driven by operating losses,
increases in net accounts receivable of approximately $1.1 million and inventory
of approximately $1.4 million, and a decrease in accounts payable of
approximately $932,000, offset by a decrease in investment in sales-type leases
of approximately $843,000 and an increase in accrued liabilities of
approximately $900,000.

    We received approximately $10.7 million of cash from investing activities in
the nine months ended September 29, 2001 as compared to using approximately
$37.6 million in the nine months ended September 30, 2000. The cash received
from investing activities in the nine months ended September 29, 2001 was
primarily the result of the sales and maturities of our investments in
marketable securities as compared to the investment of the proceeds from our
initial public offering of common stock in the nine months ended September 30,
2000. Capital expenditures were approximately $1.3 million for the nine months
ended September 29, 2001 primarily for improvements to our information systems,
a new trade show booth, and additions to demonstration equipment. In the nine
months ended September 30, 2000, capital expenditures were approximately $4.1
million which was used primarily for manufacturing equipment and leasehold
improvements to our new facility. In April 2001, we loaned, on a full recourse
basis, a total of approximately $1.1 million to an officer, certain employees
and a consultant. The loans are payable over periods ranging from four to five
years and each loan is secured by assets of the borrower, including shares of
our common stock owned by the borrower.

    We received approximately $2.4 million of cash from financing activities in
the nine months ended September 29, 2001 as compared to approximately $55.2
million of cash from financing activities in the nine months ended September 30,
2000. The cash received from financing activities in the nine months ended
September 29, 2001 was primarily a result of proceeds from our working capital
line of credit of $4.0 million and the issuance of shares of our common stock
upon the exercise of stock options, partially offset by payments of principal on
debt. Cash received for the nine months ended September 30, 2000 was primarily
proceeds from the sale of our common stock as a result of our initial public
offering.

    We had capital expenditures of approximately $360,000 in the third fiscal
quarter of 2001. At September 29, 2001, we did not have any commitments for
capital expenditures, however, we anticipate that the level of capital
expenditures in the fourth fiscal quarter of 2001 will remain comparable to the
level of the third fiscal quarter.



                                       13

<PAGE>
    We believe that the financial resources available to us, including our
current working capital and availability under our revolving line of credit,
will be sufficient to finance our planned operations and capital expenditures at
least through 2002. However, our future liquidity and capital requirements will
depend upon numerous factors, including the resources required to further
develop our marketing and sales organization domestically and internationally,
to implement new marketing programs, to finance our sales-type lease program and
EP program and to meet market demand for our products.


INCOME TAXES

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

    The net operating loss and research and development tax credit carryforwards
are subject to review by the Internal Revenue Service. Ownership changes, as
defined under Section 382 in the Internal Revenue Code, may limit the amount of
these tax attributes that can be utilized annually to offset future taxable
income or tax liabilities. The amount of the annual limitation is determined
based on our value immediately prior to the ownership change. Subsequent
ownership changes may further affect the limitation in future years.


CONVERSION TO EURO

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


RECENT ACCOUNTING PRONOUNCEMENTS

    In June 1998, the Financial Accounting Standards Board, or FASB, issued
Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for
Derivatives and Hedging Activities, which establishes accounting and reporting
standards of derivative instruments, including certain derivative instruments
embedded in other contracts, and for hedging activities. In June 1999, the FASB
issued SFAS No. 137, Accounting for Derivatives and Hedging Activities --
Deferral of the Effective Date of FASB Statement No. 133, which defers the
effective date of SFAS No. 133 to be effective for all fiscal quarters beginning
after June 15, 2000. In June 2000, the FASB issued SFAS No. 138, Accounting for
Certain Derivative Instruments and Certain Hedging Activities - an Amendment of
FASB Statement No. 133, which amends the accounting and reporting standards of
SFAS No. 133 for certain derivative instruments and certain hedging activities.
Effective January 1, 2001, we adopted SFAS No. 133, as amended. The adoption of
SFAS No. 133, as amended, did not have a material effect on our financial
condition and results of operations as we do not currently hold any derivative
instruments or engage in hedging activities.

    In December 1999, the Securities and Exchange Commission, or SEC, issued
Staff Accounting Bulletin (SAB) No. 101, Revenue Recognition in Financial
Statements, which provides guidance related to revenue recognition in financial
statements filed with the SEC. SAB No. 101 requires companies to report any
changes in revenue recognition as a cumulative change in accounting principle at
the time of implementation in accordance with Accounting Principles Board
Opinion No. 20, Accounting Changes. Effective January 1, 2000, we adopted SAB
No. 101. The adoption of SAB No. 101 did not have a material impact on our
results of operations, cash flows or financial position.



                                       14


<PAGE>


    In October 2000, the FASB issued SFAS No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities - a replacement
of FASB Statement No. 125. SFAS No. 140 reviews criteria for accounting
securitizations, other financial asset transfers and collateral, and introduces
new disclosures. The new disclosure requirements must be implemented for fiscal
years ending after December 15, 2000. The other provisions of SFAS No. 140 apply
prospectively to the transfer of financial assets and extinguishments of
liabilities occurring after March 31, 2001. SFAS No. 140 carries forward most of
the provisions of SFAS No. 125 without amendment. This pronouncement did not
have a material impact on our results of operations, cash flows or financial
position, as we have not currently transferred any financial assets.

    In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. This statement supercedes FASB Statement No.
121, Accounting for the Impairment of Long-Lived Assets to Be Disposed of, and
the accounting and reporting provisions of APB Opinion No. 30, Reporting the
Results of Operations - Reporting the Effects of Disposal of a Segment of a
Business, and Extraordinary, Unusual and Infrequently Occurring Events and
Transactions. Under this statement it is required that one accounting model be
used for long-lived assets to be disposed of by sale, whether previously held
and used or newly acquired, and it broadens the presentation of discontinued
operations to include more disposal transactions. The provisions of this
statement are effective for financial statements issued for fiscal years
beginning after December 15, 2001, and interim periods within those fiscal
years, with early adoption permitted. The Company is currently evaluating
whether it will early adopt the provisions of SFAS No. 144, and management will
not be able to determine the ultimate impact of this statement on its results of
operations or financial position until such time as its provisions are applied.



                                       15

<PAGE>
FACTORS AFFECTING FUTURE OPERATING RESULTS

    This Quarterly Report on Form 10-Q includes forward-looking statements,
including information relating to our ability to achieve profitability,
information with respect to market acceptance of our BIS system, continued
growth in sales of our BIS monitors and BIS Sensors, our dependence on the BIS
system, our ability to remain competitive and achieve future growth, 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, 2001. The
following factors represent 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.

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

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

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

    We began selling our current BIS system in early 1998 and introduced the
next version, the BIS XP system, at the end of the third fiscal quarter of 2001.
To date, we have not achieved widespread market acceptance of the BIS system.
Because we depend on our BIS system for substantially all of our revenue and we
have no other significant products, if we fail to achieve widespread market
acceptance for the BIS system, we will not be able to sustain or grow our
product revenue.

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

    Clinicians have reported to us cases of possible surgical awareness during
surgical procedures monitored with the BIS system. In most of the cases that
were reported to us, when BIS index values were recorded at the time of
awareness, high BIS index values were noted, indicating that the BIS index
correctly identified the increased risk of awareness in these patients. However,
in a small number of these reported cases, surgical awareness may not have been
detected by monitoring with the BIS system. Not all cases of surgical awareness
during surgical procedures monitored with the BIS system may be reported to us,
and we have not systematically solicited reports of surgical awareness.
Anesthesia providers and hospitals may elect not to purchase and use BIS systems
if there is adverse publicity resulting from the report of cases of surgical
awareness that were not detected during procedures monitored with the BIS
system. If anesthesia providers and hospitals do not purchase and use the BIS
system, then we may not sustain or grow our product revenue. Although we do not
claim that patient monitoring with the BIS system will reduce the incidence of
surgical awareness, we may be subject to product liability claims for cases of
surgical awareness during surgical procedures monitored with the BIS system.
These claims could require us to spend significant time and money in litigation
or to pay significant damages.


                                       16

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

    The medical industry in which we market our products is characterized by
rapid product development and technological advances. Our revenue has been
adversely affected by commercial introduction of an FDA-approved competitive
anesthesia monitoring product. If we do not compete effectively with this new
monitoring product, our revenue will be adversely affected. Our current or
planned products are at risk of obsolescence from:

    -   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.

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

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

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

    -   we may not successfully adapt the BIS system to function properly in the
        intensive care unit, for procedural sedation, when used with anesthetics
        we have not tested or with patient populations we have not studied, such
        as infants, and
    -   our technology is complex, and we may not be able to develop it further
        for applications outside anesthesia monitoring.

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

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

    In 2000, we experienced higher than anticipated turnover in our direct sales
force and we underestimated the impact that this turnover in our direct sales
force would have on our sales efforts. In the third fiscal quarter of 2001, we
have reorganized our sales force under a new vice president of North American
field operations. Until the reorganization is complete and newly hired sales
representatives become experienced with respect to our products, customer base
and sales programs, our sales efforts will be adversely affected. If the
reorganization is not completed in a timely and successful manner and we
continue to experience high turnover in our direct sales force, we will not be
able to sustain and grow our product revenue. In addition, our current sales and
marketing operation is not sufficient to achieve the level of market awareness
and sales we need to expand our business. We have only limited sales and
marketing experience both in the United States and internationally and may not
be successful in developing and implementing our strategy. We need to:

    -   provide or assure that distributors and original equipment manufacturers
        provide the technical and educational support customers need to use the
        BIS system successfully,
    -   promote frequent use of the BIS system so that sales of our disposable
        BIS Sensors increase,
    -   establish and implement successful marketing and sales 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 for foreign markets.



                                       17

<PAGE>

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

    In order to increase our sales, we need to continue to strengthen our
relationships with our domestic distributors and continue to add international
distributors and strengthen our relationships with our existing international
distributors. We need to also continue to add original equipment manufacturers
and other sales channels and increase sales through these channels. In addition,
we need to hire and train more sales representatives. In the third quarter we
have reorganized our sales organization and have started to implement new sales
and marketing programs and clinical education programs to promote the use of our
BIS system by our customers. If we do not further develop our direct and
indirect sales channels and successfully implement the new sales organization
and new sales and marketing programs and clinical education programs that
encourage our customers to purchase and use our products, we will not reach the
level of sales necessary to achieve profitability.

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

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

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.

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

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

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

    -   failure of local laws to provide the same degree of protection against
        infringement of our intellectual property,
    -   protectionist laws and business practices that favor local competitors,
        which could slow our growth in international markets,
    -   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 similar to the BIS Sensors,
    -   delays in regulatory approval of our products,
    -   currency conversion issues arising from sales denominated in currencies
        other than the United States dollar,
    -   longer sales cycles to sell products like the BIS system to hospitals
        and outpatient surgical centers, which could slow our revenue growth
        from international sales, and
    -   longer accounts receivable payment cycles and difficulties in collecting
        accounts receivable.

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


                                       18



<PAGE>

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

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

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

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

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

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

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

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

    -   cease selling, incorporating or using any of our products that
        incorporate the challenged intellectual property, which would adversely
        affect our revenue,
    -   obtain a license from the holder of the infringed intellectual property
        right, which license may not be available on reasonable terms, if at
        all, and
    -   redesign our products, which would be costly and time-consuming.



                                       19

<PAGE>

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

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

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.

    The underwriters of our initial public offering are named as defendants in
several purported class action complaints which have been filed allegedly on
behalf of certain persons who purchased shares of our common stock between
January 28, 2000 and December 6, 2000. These complaints allege violations of the
Securities Act of 1933 and the Securities Exchange Act of 1934. Primarily they
allege that there was undisclosed compensation received by our underwriters in
connection with our initial public offering. While we and our officers and
directors have not been named as defendants in these suits, based on comparable
lawsuits filed against other companies, there can be no assurance that we and
our officers and directors will not be named in similar complaints in the
future.

    We can provide no assurance as to the outcome of these complaints or any
potential suit against us or our officers and directors. Any conclusion of these
matters in a manner adverse to us would have a material adverse affect on our
financial position and results of operations. In addition, the costs to us of
defending any litigation or other proceeding, even if resolved in our favor,
could be substantial. Such litigation could also substantially divert the
attention of our management and our resources in general. Uncertainties
resulting from the initiation and continuation of any litigation or other
proceedings and the negative publicity associated with this litigation could
harm our ability to compete in the marketplace.

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

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




                                       20

<PAGE>
VARIOUS MARKET FACTORS MAY ADVERSELY AFFECT OUR QUARTERLY OPERATING RESULTS
DURING THE FOURTH FISCAL QUARTER OF 2001 AND FOR THE YEAR ENDING DECEMBER 31,
2001.

    Various factors may adversely affect our quarterly operating results during
the fourth fiscal quarter of 2001 and the year ending December 31, 2001. We are
facing increased competition in the domestic level of consciousness monitoring
market as a result of a new monitoring system approved by the FDA in mid-2000.
Second, during the third fiscal quarter of 2001 we began the reorganization of
our sales and clinical organizations. This may adversely impact our revenue for
the fourth fiscal quarter of 2001, depending in part on both the timing of when
newly hired sales representatives become experienced with respect to our
products, customer base and sales programs. Third, we have underestimated the
amount of clinical education necessary to bring our installed base up to
expected sensor utilization levels. This may adversely impact our revenue for
the fourth fiscal quarter of 2001, depending in part on the timing and
effectiveness of our new sales, marketing and clinical education programs. The
continuation of difficult worldwide economic conditions, reductions in hospital
purchasing programs, placement of monitors under our EP program and the cost of
transitioning our installed base to the new BIS XP system may also adversely
impact our revenue and operating results for the fourth fiscal quarter of 2001.

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

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

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

    We are facing increased competition in the domestic level of consciousness
monitoring market as a result of a new monitoring system approved by the FDA in
mid-2000. This product is marketed by a well-established medical products
company with significant resources. We may not be able to compete effectively
with this and other potential competitors. We may also face substantial
competition from companies which may develop sensor products that compete with
our proprietary BIS Sensors for use with our BIS monitors or with third-party
monitoring systems or anesthesia delivery systems that incorporate the BIS
index. We also expect to face competition from companies currently marketing
conventional electroencephalogram, or EEG, monitors using standard and novel
signal-processing techniques. Other companies may develop anesthesia-monitoring
systems that perform better than the BIS system and/or sell for less. In
addition, one or more of our competitors may develop products that are
substantially equivalent to our FDA-approved products, in which case they may be
able to use our products as predicate devices to more quickly obtain FDA
approval of their competing products. Medical device companies developing these
and other competitive products may have greater financial, technical, marketing
and other resources than we do. Competition in the sale of anesthesia-monitoring
systems could result in price reductions, fewer orders, reduced gross margins
and loss of market share.






                                       21

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

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

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

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

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

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

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

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

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




                                       22

<PAGE>
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 ACHIEVING PROFITABILITY.

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


ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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




                                       23


<PAGE>
                          PART II -- OTHER INFORMATION

ITEM 1.       LEGAL PROCEEDINGS

              None.


ITEM 2.       CHANGES IN SECURITIES AND USE OF PROCEEDS

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

                      The aggregate gross proceeds raised in the offering were
              approximately $60.4 million. Our total expenses in connection with
              the offering were approximately $5.7 million, of which $4.2
              million was for underwriting discounts and commissions and, based
              on our reasonable estimate, approximately $1.5 million was for
              other expenses. Our net proceeds from the offering were
              approximately $54.6 million. From January 27, 2000 through
              September 29, 2001, we used approximately $6.5 million of the net
              proceeds for the acquisition of machinery and equipment and for
              leasehold improvements to our new facility in Newton,
              Massachusetts. In addition, from January 27, 2000 through
              September 29, 2001, we used approximately $25.8 million of the net
              proceeds for general corporate purposes, including working
              capital, product development, increasing our sales and marketing
              capabilities and expanding our international operations. As of
              September 29, 2001, we had approximately $22.3 million of proceeds
              remaining from the offering, and pending use of the proceeds, we
              have invested these funds in short-term, interest-bearing,
              investment-grade securities.



ITEM 3.       DEFAULTS UPON SENIOR SECURITIES
              None.


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


ITEM 5.       OTHER INFORMATION
              None.


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

                  10.1+  Amendment, dated March 1, 2001, to Medical Products
                         Distribution Agreement, dated October 1, 1999,
                         between Philips Medizinsysteme Boeblingen GmbH and
                         the Registrant.

              (b) Reports on Form 8-K

                 We did not file any reports on Form 8-K during the quarter
                 ended September 29, 2001.


                  ----------
                  + Confidential treatment has been requested as to certain
                    portions of this Exhibit. Such portions have been omitted
                    and filed separately with the Securities and Exchange
                    Commission.




                                       24



<PAGE>
                                    SIGNATURE

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

                                        ASPECT MEDICAL SYSTEMS, INC.




   Date:  November 9, 2001              By: /s/ J. Neal Armstrong
                                            ------------------------------------
                                            J. Neal Armstrong
                                            Vice President and Chief Financial
                                            Officer (Principal Financial and
                                            Accounting Officer)







                                       25

<PAGE>
                                  EXHIBIT INDEX

   EXHIBIT
   NUMBER            EXHIBIT
   -------           -------
    10.1+            Amendment, dated March 1, 2001, to Medical Products
                     Distribution Agreement, dated October 1, 1999, between
                     Philips Medizinsysteme Boeblingen GmbH and the Registrant.

----------
 +  Confidential treatment has been requested as to certain portions of this
    Exhibit. Such portions have been omitted and filed separately with the
    Securities and Exchange Commission.