##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-Q (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended April 2, 2005 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to Commission file number: 0-24663   ASPECT MEDICAL SYSTEMS, INC.
  Delaware
(State or Other Jurisdiction of
Incorporation or Organization)
    
    04-2985553
(I.R.S. Employer Identification No.)141 Needham Street, Newton, Massachusetts
(Address of Principal Executive Offices)
    
    02464-1505
(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. þ o
 Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of
the Exchange Act). þ o
 The Registrant had 21,365,723 shares of Common Stock, $0.01 par value per share, outstanding as of
May 6, 2005.




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ASPECT MEDICAL SYSTEMS, INC. TABLE OF CONTENTS PagePART I. FINANCIAL INFORMATION
    
    
    1Item 1. Financial Statements (Unaudited)
    
    
    1Consolidated Balance Sheets as of April 2, 2005 and December 31, 2004
    
    
    1Consolidated Statements of Operations for the Three Months Ended April 2, 2005 and April 3, 2004
    
    
    2Consolidated Statements of Cash Flows for the Three Months Ended April 2, 2005 and April 3, 2004
    
    
    3Notes to Consolidated Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    31Item 4. Controls and Procedures
    
    
    32PART II. OTHER INFORMATION
    
    
    33Item 5. Other Information
    
    
    33Item 6.
Exhibits and Reports on Form 8-K
    
    
    33SIGNATURE
    
    
    34EX-10.1 Capital Equipment Supplier AgreementEX-31.1 Section 302 Certification of C.E.O.EX-31.2 Section 302 Certification of C.F.O.EX-32.1 Section 906 Certification of C.E.O.EX-32.2 Section 906 Certification of C.F.O.




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PART I  FINANCIAL INFORMATION 
 Item 1. FINANCIAL STATEMENTS. ASPECT MEDICAL SYSTEMS, INC. 
 CONSOLIDATED BALANCE SHEETS
(in thousands, except share data) April 2,
    
    
    December 31,2005
    
    
    2004(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    10,885
    
    
    $
    14,761Restricted cash
    
    
    82
    
    
    
    82Short-term investments
    
    
    18,035
    
    
    
    17,452Accounts receivable, net of allowances of $49 at April
2, 2005 and $41 at December 31, 2004
    
    
    8,249
    
    
    
    7,835Current portion of investment in sales-type leases
    
    
    1,682
    
    
    
    1,698Inventory, net
    
    
    3,196
    
    
    
    2,224Other current assets
    
    
    2,669
    
    
    
    1,192Total current assets
    
    
    44,798
    
    
    
    45,244Property and equipment, net
    
    
    2,660
    
    
    
    2,662Long-term investments
    
    
    12,855
    
    
    
    11,439Long-term investment in sales-type leases
    
    
    2,279
    
    
    
    2,320Long-term portion of notes receivable from related parties
    
    
    
    
    
    
    25Total assets
    
    $
    62,592
    
    
    $
    61,690LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current portion of long-term debt
    
    $
    229
    
    
    $
    311Accounts payable
    
    
    2,428
    
    
    
    1,920Accrued liabilities
    
    
    5,996
    
    
    
    7,832Deferred revenue
    
    
    929
    
    
    
    957Total current liabilities
    
    
    9,582
    
    
    
    11,020Long-term portion of deferred revenue
    
    
    4,754
    
    
    
    4,898Long-term debt
    
    
    150
    
    
    
    186Commitments and contingenciesStockholders equity:Preferred Stock, $.01 par value; 5,000,000 shares
authorized, no shares issued or outstanding
    
    
    
    
    
    
    Common Stock, $.01 par value; 60,000,000 shares
authorized, 21,130,922 and 20,838,611 shares issued
and outstanding at April 2, 2005 and December 31,
2004, respectively
    
    
    211
    
    
    
    208Additional paid-in capital
    
    
    147,471
    
    
    
    145,429Deferred compensation
    
    
    (622
    )
    
    
    Accumulated other comprehensive loss
    
    
    (110
    )
    
    
    (78
    )Accumulated deficit
    
    
    (98,844
    )
    
    
    (99,973
    )Total stockholders equity
    
    
    48,106
    
    
    
    45,586Total liabilities and stockholders equity
    
    $
    62,592
    
    
    $
    61,690
 The accompanying notes are an integral part of these consolidated financial statements. 1




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ASPECT MEDICAL SYSTEMS, INC. 
 CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts) Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004(Unaudited)
    
    
    (Unaudited)Revenue
    
    $
    17,084
    
    
    $
    12,797Costs of revenue
    
    
    4,442
    
    
    
    2,865Gross profit margin
    
    
    12,642
    
    
    
    9,932Operating expenses:Research and development
    
    
    1,988
    
    
    
    1,946Sales and marketing
    
    
    7,276
    
    
    
    6,565General and administrative
    
    
    2,611
    
    
    
    2,397Total operating expenses
    
    
    11,875
    
    
    
    10,908Income (loss) from operations
    
    
    767
    
    
    
    (976
    )Interest income
    
    
    376
    
    
    
    209Interest expense
    
    
    (13
    )
    
    
    (29
    )Net income (loss)
    
    $
    1,130
    
    
    $
    (796
    )Net income (loss) per share:Basic
    
    $
    0.05
    
    
    $
    (0.04
    )Diluted
    
    $
    0.05
    
    
    $
    (0.04
    )Weighted average shares used in
computing net income (loss) per
share:Basic
    
    
    20,918
    
    
    
    19,596Diluted
    
    
    23,211
    
    
    
    19,596
 The accompanying notes are an integral part of these consolidated financial statements. 2




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ASPECT MEDICAL SYSTEMS, INC. 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands) Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004(Unaudited)
    
    
    (Unaudited)Cash flows from operating activities:Net income (loss)
    
    $
    1,130
    
    
    $
    (796
    )Adjustments to reconcile net income (loss) to net cash used
for operating activities -Depreciation and amortization
    
    
    414
    
    
    
    404Provision for doubtful accounts
    
    
    
    
    
    
    (50
    )Compensation expense related to stock options and
restricted stock
    
    
    61
    
    
    
    34Changes in assets and liabilities -(Increase) decrease in accounts receivable
    
    
    (414
    )
    
    
    489Increase in inventory
    
    
    (972
    )
    
    
    (153
    )Increase in other assets
    
    
    (1,454
    )
    
    
    (537
    )Decrease in investment in sales-type leases
    
    
    58
    
    
    
    129Increase (decrease) in accounts payable
    
    
    508
    
    
    
    (145
    )Decrease in accrued liabilities
    
    
    (1,836
    )
    
    
    (2,054
    )Decrease in deferred revenue
    
    
    (172
    )
    
    
    (202
    )Net cash used for operating activities
    
    
    (2,677
    )
    
    
    (2,881
    )Cash flows from investing activities:Payments on loans to related parties
    
    
    1
    
    
    
    233Acquisition of property and equipment
    
    
    (412
    )
    
    
    (160
    )Purchases of marketable securities
    
    
    (12,255
    )
    
    
    (4,041
    )Proceeds from sales and maturities of marketable securities
    
    
    10,224
    
    
    
    5,835Net cash (used for) provided by investing activities
    
    
    (2,442
    )
    
    
    1,867Cash flows from financing activities:Principal payments on debt related to investment in sales-type
leases
    
    
    (118
    )
    
    
    (210
    )Proceeds from issuance of common stock
    
    
    1,361
    
    
    
    1,194Net cash provided by financing activities
    
    
    1,243
    
    
    
    984Net decrease in cash and cash equivalents
    
    
    (3,876
    )
    
    
    (30
    )Cash and cash equivalents, beginning of period
    
    
    14,761
    
    
    
    12,344Cash and cash equivalents, end of period
    
    $
    10,885
    
    
    $
    12,314Supplemental disclosure of cash flow information:Interest paid
    
    $
    13
    
    
    $
    29
 The accompanying notes are an integral part of these consolidated financial statements. 3




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ASPECT MEDICAL SYSTEMS, INC. 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) (1) Basis of Presentation The accompanying unaudited consolidated financial statements of Aspect Medical Systems, Inc.
(the Company) have been prepared in accordance with accounting principles generally accepted in
the United States for interim financial information and with the instructions to Form 10-Q and
Regulation S-X. Accordingly, they do not include all of the information and footnotes required
by accounting principles generally accepted in the United States for complete financial
statements. In the opinion of management, all normal, recurring adjustments considered necessary
for a fair presentation have been included. The unaudited consolidated financial statements and
notes included herein should be read in conjunction with the audited consolidated financial
statements for the year ended December 31, 2004 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) Summary of Significant Accounting Policies A summary of the significant accounting policies used by the Company in the preparation of
its financial statements follows: Principles of Consolidation The consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated. Foreign Currency The functional currency of the Companys international subsidiaries is the U.S. dollar.
Foreign currency transaction gains and losses are recorded in the consolidated statements of
operations and have not been material. Cash, Cash Equivalents and Marketable Securities The Company invests its excess cash in money market accounts, certificates of deposit,
high-grade commercial paper, high grade corporate bonds and debt obligations of various
government agencies. The Company considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents. The Company accounts for its investments in marketable securities in accordance with
Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments
in Debt and Equity Securities. In accordance with SFAS No. 115, the Company has classified all of
its investments in marketable securities as available-for-sale at April 2, 2005 and December 31,
2004. The investments are reported at fair value, with any unrealized gains or losses excluded
from earnings and reported as a separate component of stockholders equity as accumulated other
comprehensive income (loss). Investments that have contractual maturities of more than twelve
months are included in long-term investments in the accompanying consolidated balance sheets. Revenue Recognition The Company sells its BIS monitors primarily through a combination of a direct sales force
and distributors. The Company sells its BIS Module Kits to original equipment manufacturers who
in turn sell them to the end-user. BIS Sensors are sold through a combination of a direct sales
force, distributors and original equipment manufacturers. Direct product sales are structured as
sales, sales-type lease arrangements or sales under the Companys Equipment Placement
(EP) program. Sales, sales-type lease agreements and sales under the EP program are
subject to the Companys standard terms and conditions of sale and do not include any customer
acceptance criteria, installation or other post shipment obligations (other than warranty) or any
rights of return. The Companys BIS monitor is a standard product and does not require
installation as it can be operated with the instructions included in the operators manual. 4




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) The Company recognizes revenue from product sales when earned in accordance with Staff
Accounting Bulletin (SAB) No. 104, Revenue Recognition,and Emerging Issues Task Force (EITF)
00-21, Revenue Arrangements with Multiple Deliverables. Revenue is recognized when persuasive
evidence of an arrangement exists, product delivery has occurred or services have been rendered,
the price is fixed or determinable and collectibility is reasonably assured. For product sales,
revenue is not recognized until title and risk of loss have transferred to the customer. The
Companys revenue arrangements with multiple elements are divided into separate units of
accounting if specified criteria are met, including whether the delivered element has stand-alone
value to the customer and whether there is objective and reliable evidence of the fair value of
the undelivered items. The consideration received is allocated among the separate units based on
their respective fair values, and the applicable revenue recognition criteria are applied to each
of the separate units. The Company follows SFAS No. 13, Accounting For Leases, for its sales-type lease agreements.
Under the Companys sales-type leases, 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. In
accordance with SFAS No. 13, the minimum lease payment, consisting of the additional charge per
BIS Sensor, less the unearned interest income, which is computed at the interest rate implicit in
the lease, is recorded as the net investment in sales-type leases. The Company recognizes
equipment revenue under sales-type lease agreements either at shipment or delivery in accordance
with the agreed upon contract terms with interest income recognized over the life of the
sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of
revenue in the same period. In addition, the Company reviews and assesses the net realizability of its investment in
sales-type leases at each reporting period. This review includes determining, on a customer
specific basis, if a customer is significantly underperforming relative to the customers
cumulative level of committed BIS Sensor purchases as required by the sales-type lease agreement.
If a customer is underperforming, the Company records an allowance for lease payments as a
charge to revenue to reflect the lower estimate of the net realizable investment in sales-type
lease balance. As of April 2, 2005, the Company does not consider any sales-type lease agreement, against
which an allowance for lease payments has been established, an impaired asset. Under the Companys EP program, the customer is granted the right to use the BIS monitors
for a mutually agreed upon period of time. During this period, the customer purchases BIS
Sensors at a price that typically 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
the agreed upon period, the customer has the option of purchasing the BIS monitors, continuing to
use them under the EP program or returning them to the Company. Under the EP program, no
equipment revenue is recognized as the equipment remains the Companys property and title does
not pass to the customer, and the criteria for sales-type leases under SFAS No. 13 are not met.
The BIS monitors under the EP program are depreciated over two years and the depreciation is
charged to costs of revenue. BIS Sensor revenue is recognized either at shipment or delivery of
the BIS Sensors in accordance with the agreed upon contract terms. The Companys obligations under warranty are limited to repair or replacement of any product
that the Company reasonably determines to be covered by the warranty. The Company records an
estimate for its total warranty obligation in accordance with SFAS No. 5, Accounting for
Contingencies. In connection with the Stock Purchase Agreement and OEM Product Development Agreement with
Boston Scientific Corporation (BSC) discussed in Note 9, the Company recorded approximately
$6,300,000 of deferred revenue in August 2002. The deferred revenue is being recognized ratably
over the term of the OEM product development and distribution agreement with BSC, which
represents the Companys best estimate of its period of significant continuing obligation to
provide BSC exclusive distribution rights to newly developed technology. The term of the OEM
product development and distribution agreement continues until such time that BSC is no longer
distributing the Companys products under the agreement, but in no event will extend beyond
December 31, 2014. 5




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) Research and Development Costs The Company charges research and development costs to operations as incurred. Research and
development costs include costs associated with new product development, product improvements and
extensions, clinical studies and project consulting expenses. Allowance for Doubtful Accounts Estimates are used in determining the Companys allowance for doubtful accounts based on the
Companys historical collections experience, historical write-offs of its receivables, current
trends, credit policy and a percentage of the Companys accounts receivable by aging category.
The Company also reviews the credit quality of its customer base as well as changes in its credit
policies. The Company continually monitors collections and payments from its customers and
adjusts the allowance for doubtful accounts as needed. Inventory The Company values inventory at the lower of cost or estimated market value, and determines
cost on a first-in, first-out basis. The Company regularly reviews inventory quantities on hand
and records a provision for excess or obsolete inventory primarily based on production history
and on its estimated forecast of product demand. The medical device industry in which the
Company markets its products is characterized by rapid product development and technological
advances that could result in obsolescence of inventory. Additionally, the Companys estimates
of future product demand may prove to be inaccurate, in which case it would need to change its
estimate of the provision required for excess and obsolete inventory. If revisions are deemed
necessary, the Company would recognize the adjustments in the form of a charge to its costs of
revenue at the time of the determination. Warranty Equipment that the Company sells is generally covered by a warranty period of one year. The
Company accrues a warranty reserve for estimated costs to provide warranty services. The
Companys estimate of costs to service its warranty obligations is based on historical experience
and an expectation of future conditions. Warranty expense for the three months ended April 2,
2005 and April 3, 2004, and accrued warranty cost, included in accrued liabilities in the
consolidated balance sheet at April 2, 2005, was as follows: Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004Beginning balance
    
    $
    137
    
    
    $
    147Warranty expense
    
    
    34
    
    
    
    25Deductions and other
    
    
    (13
    )
    
    
    (20
    )Ending balance
    
    $
    158
    
    
    $
    152
 Shipping and Handling Costs Shipping and handling costs are included in costs of revenue in the consolidated statements
of operations. Advertising Costs Advertising costs are expensed as incurred. These costs are included in sales and marketing
expense in the consolidated statements of operations. 6




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) Property and Equipment Property and equipment is recorded at cost and depreciated using the straight-line method
over the estimated useful lives of the related equipment. Equipment held under capital leases is
stated at the lower of the fair market value of the equipment or the present value of the minimum
lease payments at the inception of the lease, and is amortized using the straight-line method
over the shorter of the lives of the related assets or the term of the leases. Repair and
maintenance expenditures are charged to expense as incurred. The Company does not develop
software for internal use and the costs of software acquired for internal use are accounted for
in accordance with the American Institute of Certified Public Accountants Statement of Position
98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Income Taxes The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income
Taxes. Under this method, deferred tax assets and liabilities are recognized for the expected
future tax consequences, utilizing currently enacted tax rates, of temporary differences between
the carrying amounts and the tax basis of assets and liabilities. Deferred tax assets are
recognized, net of any valuation allowance, for the estimated future tax effects of deductible
temporary differences and tax operating loss and credit carryforwards. Concentration of Credit Risk Financial instruments that potentially expose the Company to concentrations of credit risk
primarily consist of cash, cash equivalents, investments, accounts receivable and investment in
sales-type lease receivables. To minimize the financial statement risk with respect to accounts
receivable and investment in sales-type lease receivables, the Company maintains reserves for
potential credit losses and such losses, in the aggregate, have not exceeded managements
expectations. The Company maintains cash, cash equivalents and investments with various financial
institutions. The Company performs periodic evaluations of the relative credit quality of
investments and Company policy is designed to limit exposure to any one institution or type of
investment. The primary objective of the Companys investment strategy is the safety of the
principal invested. The Company does not maintain foreign exchange contracts or other
off-balance sheet financial investments. Single or Limited Source Suppliers The Company currently obtains certain key components of its products from single or limited
sources. The Company purchases components pursuant to purchase orders rather than long-term
supply agreements and generally does not maintain large volumes of inventory. The Company has
experienced shortages and delays in obtaining certain components of its products in the past.
The Company may experience similar shortages and delays in the future. The disruption or
termination of the supply of components or a significant increase in the costs of these
components from these sources could have a material adverse effect on the Companys business,
financial position and results of operations and cash flows. Net Income (Loss) Per Share In accordance with SFAS No. 128, Earnings Per Share, basic net income (loss) per share
amounts for the three months ended April 2, 2005 and April 3, 2004 were computed by dividing the
net income (loss) available to common stockholders by the weighted average number of common shares outstanding during those periods and diluted net income (loss) per share was computed
using the weighted average number of common shares outstanding and other dilutive securities, as
applicable, during those periods. For the three months ended April 2, 2005, the Company has included in the calculation of the
Companys diluted net income per share approximately 2,293,000 shares related to common stock
issuable pursuant to the exercise of stock options and restricted stock under the treasury stock
method. 7




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) Basic
and diluted net income (loss) per share amounts for the three months ended April 2, 2005 and
April 3, 2004 were determined as follows: Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004Basic:Net income (loss)
    
    $
    1,130
    
    
    $
    (796
    )Weighted average shares outstanding
    
    
    20,918
    
    
    
    19,596Basic net income (loss) per share
    
    $
    0.05
    
    
    $
    (0.04
    )Diluted:Net income (loss)
    
    $
    1,130
    
    
    $
    (796
    )Weighted average shares outstanding
    
    
    20,918
    
    
    
    19,596Effect of dilutive stock options and
restricted stock
    
    
    2,293
    
    
    
    Weighted average shares assuming
dilution
    
    
    23,211
    
    
    
    19,596Diluted net income (loss) per share
    
    $
    0.05
    
    
    $
    (0.04
    )
 Comprehensive Income (Loss) 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.
Other than the Companys net income (loss), the only other element of comprehensive income (loss)
impacting the Company is the unrealized gains (losses) on its investments for all periods
presented. Stock-Based Compensation SFAS No. 123, Accounting for Stock-Based Compensation, requires the measurement of the fair
value of stock options or warrants to be included in the statement of income or disclosed in the
notes to financial statements. The Company accounts for stock-based compensation for employees
using the intrinsic value method under APB Opinion No. 25 and has adopted the fair value
disclosure-only alternative under SFAS No. 148, Accounting for Stock-Based Compensation 
Transition and Disclosure. The Company has computed the weighted-average fair value of options
granted in the three months ended April 2, 2005 and April 3, 2004 using the Black-Scholes
option-pricing model pursuant to SFAS No. 123. The following table shows the weighted average
assumptions used in the applicable periods and the weighted average fair market value of the
options granted in each period. Three Months EndedApril 2,
    
    April 3,2005
    
    2004Risk free interest rate
    
    3.62%
    
    3.15%Expected dividend yield
    
    
    
    Expected life of options
    
    5 years
    
    5 yearsExpected volatility
    
    50%
    
    56%Weighted average fair market value of options
granted
    
    $9.71
    
    $9.07
 8




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) If the Company had recognized compensation cost for these awards consistent with SFAS No.
123, the Companys net income (loss) and pro forma net income (loss) per common share would have
increased to the following pro forma amounts: Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004Net income (loss):Net income (loss) as reported
    
    $
    1,130
    
    
    $
    (796
    )Add: Stock-based employee
compensation expense includedin reported net income (loss)
    
    
    
    
    
    
    Deduct: Stock-based employee
compensation expense determinedunder fair value based method
for
all awards
    
    
    (1,536
    )
    
    
    (1,874
    )Pro forma net loss
    
    $
    (406
    )
    
    $
    (2,670
    )Net income (loss) per share:Basic:As reported
    
    $
    0.05
    
    
    $
    (0.04
    )Pro forma
    
    $
    (0.02
    )
    
    $
    (0.14
    )Diluted:As reported
    
    $
    0.05
    
    
    $
    (0.04
    )Pro forma
    
    $
    (0.02
    )
    
    $
    (0.14
    )
 The Black-Scholes option-pricing model was developed for use in estimating the fair value of
traded options, which have no vesting restrictions and are fully transferable. In addition, the
Black-Scholes option-pricing model requires the input of highly subjective assumptions, including
expected stock price volatility. Because the Companys employee stock options have characteristics
significantly different from those of traded options, and because changes in the subjective input
assumptions can materially affect the fair value estimate, in managements opinion, the existing
models do not necessarily provide a reliable single measure of the fair value of its employee stock
options. Also, because options vest over several years and the Company expects to grant options in
future years, the above pro forma results of applying the provisions of SFAS No. 123 are not
necessarily representative of the pro forma results in future years. Use of Estimates The preparation of financial statements in conformity with generally accepted accounting
principles 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 revenues and expenses during the reporting period.
Actual results could differ from those estimates. Fair Value of Financial Instruments The estimated fair market values of the Companys financial instruments, which include cash
equivalents, investments, accounts receivable, investment in sales-type leases, accounts payable
and long-term debt, approximate their carrying values. Recent Accounting Pronouncements On December 16, 2004, the Financial Accounting Standards Board, or FASB, issued Statement No.
123 (revised 2004), Share Based Payment, or SFAS No. 123R, which is a revision of Statement No.
123, Accounting for Stock-Based Compensation, or SFAS 123. SFAS 123R supersedes APB Opinion No.
25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows.
Under SFAS No. 123R, companies must calculate and record in the income statement the cost of equity
instruments, such as stock options or restricted stock, awarded to employees for services received;
pro forma disclosure is not longer permitted. The cost of the equity instruments is to be measured
based on fair value of the instruments on the date they are granted (with certain exceptions) and
is required to be recognized over the period during which the employees are required to provide
services in exchange for the equity instruments. 9




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) SFAS No. 123R provides two alternatives for adoption: (1) a modified prospective method in
which compensation cost is recognized for all awards granted subsequent to the effective date of
this statement as well as for the unvested portion of awards outstanding as of the effective date;
or (2) a modified retrospective method which follows the approach in the modified prospective
method, but also permits entities to restate prior periods to record compensation cost calculated
under SFAS No. 123 for the pro forma disclosure. Since the Company currently accounts for stock
options granted to employees and shares issued under its employee stock purchase plan in accordance
with the intrinsic value method permitted under APB Opinion No. 25, no compensation expense
generally is recognized. The Company expects that the adoption of SFAS No. 123R will have a
significant impact on the Companys results of operations, although it will have no impact on the
Companys overall financial position. The impact of adopting SFAS No. 123R on periods after
adoption cannot be accurately estimated at this time, as it will depend on the market value and the
amount of share based awards granted in future periods. However, had the Company adopted SFAS No.
123R in prior periods, the impact of that standard would have approximated the impact of SFAS No.
123 as described in the disclosure of pro forma net income (loss) and earnings (loss) per share
included in Note 2 to the Companys unaudited consolidated financial statements. In April 2005, the SEC deferred the deadline for adoption of SFAS 123Rs provisions on
share-based payment. Specifically, SEC registrants previously required to adopt SFAS 123Rs
provisions at the beginning of the first interim period after June 15, 2005 may now adopt the
provisions at the beginning of their first annual period beginning after June 15, 2005, under the
new SEC rule. As such, the Company intends to adopt SFAS 123R on January 1, 2006.  (3)
    Comprehensive Income (Loss)The Companys total comprehensive income (loss) is as follows: Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004Net income (loss)
    
    $
    1,130
    
    
    $
    (796
    )Other comprehensive loss:Unrealized loss on marketable
securities
    
    
    (32
    )
    
    
    Comprehensive income (loss)
    
    $
    1,098
    
    
    $
    (796
    )
  (4)
    Investment in Sales-Type LeasesThe components of the Companys net investment in sales-type leases are as follows: April 2,
    
    
    December 31,2005
    
    
    2004Total minimum lease payments receivable
    $
    
    5,681
    
    
    $
    5,815Less:Unearned interest income
    
    
    812
    
    
    
    842Allowance for lease payments
    
    
    908
    
    
    
    955Net investment in sales-type leases
    
    
    3,961
    
    
    
    4,018Less  current portion
    
    
    1,682
    
    
    
    1,698$
    
    2,279
    
    
    $
    2,320
 10




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)  (5)
    Inventory  Inventory consists of the following: April 2,
    
    
    December 31,2005
    
    
    2004Raw materials
    
    $
    1,566
    
    
    $
    959Work-in-progress
    
    
    106
    
    
    
    66Finished goods
    
    
    1,524
    
    
    
    1,199$
    3,196
    
    
    $
    2,224
  (6)
    Segment Information and Enterprise Reporting The Company operates in one reportable segment as it markets and sells one family of
anesthesia monitoring systems. The Company does not disaggregate financial information by
product or geographically, other than sales by region and sales by product, for management
purposes. Substantially all of the Companys assets are located within the United States. All
of the Companys products are manufactured in the United States. Revenue by geographic region and as a percentage of total revenue is as follows: Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004Geographic Area by RegionDomestic
    
    $
    12,935
    
    
    $
    10,380International
    
    
    4,149
    
    
    
    2,417Total
    
    $
    17,084
    
    
    $
    12,797
 Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004Geographic Area by RegionDomestic
    
    
    76
    %
    
    
    81
    %International
    
    
    24
    
    
    
    19Total
    
    
    100
    %
    
    
    100
    %
 The Company did not have sales in any individual country, other than the United States, that
accounted for more than 10% of the Companys total revenue for the three months ended April 2,
2005 and April 3, 2004. (7) Related Party Transactions Through May 2002, the Company loaned, on a full recourse basis, an aggregate of $1,491,000,
to certain officers, employees and a consultant of the Company. All loans are evidenced by
promissory notes bearing interest with rates ranging from 5.00% to 8.00% per annum. The loans
are payable over periods ranging from one to five years and in each case are secured by certain
assets of the borrower, including shares of the Companys common stock owned by the borrower. At
April 2, 2005 and December 31, 2004, the aggregate outstanding balance on these loans was
approximately $46,000 and $47,000, respectively. At April 2, 2005, the entire $46,000 was
classified as short-term and included in other current assets in the accompanying consolidated
balance sheet. 11




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) (8) Loan Agreements In May 2001, the Company entered into an agreement with a commercial bank for a revolving
line of credit. The Company is entitled to borrow up to $5,000,000 under the revolving line of
credit, which expires in May 2005 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. At April 2, 2005, the Company had outstanding standby letters of credit with
the commercial bank of approximately $80,000. At April 2, 2005 there was no outstanding balance
under this revolving line 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, which are shown as restricted cash in the accompanying consolidated balance sheets. In
connection with the extension of the revolving line of credit in May 2004, the Company is
required to maintain restricted cash in an amount equal to 102% of the outstanding amounts under
the revolving line of credit agreement. Prior to the amendment in May 2004, the Company was
required to maintain restricted cash in an amount equal to 102% of the $5,000,000 commitment, or
$5,100,000. At April 2, 2005, the Company was in compliance with all covenants contained in the
revolving line of credit agreement. At April 2, 2005, the interest rate on the revolving line of
credit was 5.75%. The Company is currently in the process of negotiating a one year extension to
the revolving line of credit with the commercial bank. In August 2002, the Company entered into an agreement for a $5,000,000 revolving line of
credit with BSC in connection with a strategic alliance (see Note 9). (9) Strategic Alliance with Boston Scientific Corporation On August 7, 2002, the Company formed a strategic alliance with BSC. In connection with
this strategic alliance, the Company sold 1,428,572 shares of the Companys common stock at a
purchase price per share of $7.00 to BSC pursuant to a stock purchase agreement. Gross cash
proceeds from this sale of common stock were $10,000,004. In addition, the Company granted BSC an
option under an OEM product development and distribution agreement to distribute newly developed
technology for monitoring patients under sedation in a range of less-invasive medical
specialties. The Company allocated the fair market value between the common stock and the option
to be the exclusive distributor. The excess of $4.41 per share paid by BSC over the closing
price of the Companys common stock on August 7, 2002, or approximately $6,300,000 in total, was
attributed to the value of the rights provided to BSC under the OEM product development and
distribution agreement. Approximately $4,800,000 of the aggregate purchase price is recorded as deferred revenue in
the accompanying consolidated balance sheet at April 2, 2005, which represents the unamortized
portion of the purchase price in excess of the closing price of the Companys common stock on
August 7, 2002. The deferred revenue is being recognized ratably over the term of the OEM
product development and distribution agreement, which represents the Companys best estimate of
its period of significant continuing obligation to provide BSC exclusive distribution rights to
newly developed technology. The term of the agreement continues until such time that BSC is no
longer distributing the Companys products, but in no event will extend beyond December 31, 2014
pursuant to an amendment to the OEM product development agreement entered into with BSC in
January 2005. On January 31, 2005, the Company amended its OEM product development agreement with
BSC to provide a two year extension to the period during which BSC may exercise an option to
distribute sedation management technology for interventional and specialty medical procedure
suites. The amendment extends until December 31, 2006 BSCs right to exercise its option and
also extends until the end of 2014 the term of BSCs distribution rights. This amendment will
reduce the revenue that the Company records on a quarterly basis by approximately $31,000.
Approximately $123,000 and $154,000, respectively, was recognized as revenue in the three months
ended April 2, 2005 and April 3, 2004, respectively. 12




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ASPECT MEDICAL SYSTEMS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited) As part of the strategic alliance with BSC, the Company also entered into an agreement
pursuant to which BSC has agreed to provide the Company a $5,000,000 revolving line of credit,
which expires in August 2007 and may be extended at the discretion of BSC. Interest on any
borrowings under this revolving line of credit is at a rate equal to the LIBOR rate at which BSC,
under its own revolving credit facility, is entitled to borrow funds, plus any additional amounts
payable thereon by BSC under such revolving credit facility, plus eighty basis points. The
Companys revolving line of credit with BSC is secured by the Companys inventory and certain of
the Companys accounts receivable and contains certain restrictive covenants covering the
collateral. At April 2, 2005, there was no outstanding balance under this revolving line of
credit, and the Company was in compliance with all covenants contained in the revolving line of
credit agreement. On April 7, 2004, the Company entered into an agreement with BSC to issue and sell 500,000
shares of the Companys common stock to BSC pursuant to a stock purchase agreement. The Company
completed the sale on June 8, 2004. The purchase price per share was $16.21 and the aggregate
gross proceeds from the transaction were $8,105,000. In connection with this sale of common
stock, the Company has granted BSC the right to require the Company to register these shares for
resale under the Securities Act of 1933. (10) Shareholder Rights Plan On November 29, 2004, the Company adopted a shareholder rights plan. In connection with the
adoption of this plan, the Companys Board of Directors declared a dividend of one right for each
outstanding share of the Companys Common Stock, $0.01 par value per share, to stockholders of
record at the close of business on December 10, 2004. Pursuant to the Rights Agreement, each
Right entitles the registered holder to purchase from the Company one one-thousandth of a share
of the Companys Series A Junior Participating Preferred Stock, $0.01 par value per share, at a
purchase price of $150.00 per share in cash. The Rights are not exercisable until the
Distribution Date as defined in the Rights Agreement filed with the Securities and Exchange
Commission on December 1, 2004 and will expire upon the close of business on November 29, 2014
unless earlier redeemed or exchanged as defined in the Rights Agreement.   13




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##### Table of Contents



Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS. 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 Bispectral Index, which we
refer to as the BIS index. The BIS system provides information 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, BIS Module Kit or BISx system, which allows original equipment
manufacturers to incorporate the BIS index into their monitoring products, and our group of sensor
products, which we collectively refer to as BIS Sensors. In January 2005, we introduced our
semi-reusable sensor product in the international market, excluding Japan. Our latest generation of stand-alone monitor, the A-2000® BIS Monitor, was cleared for
marketing by the United States 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 enhanced performance capabilities and expanded benefits as compared
with the previous version of our BIS system, enabling more precise measurement of brain activity to
assess the level of consciousness. In addition to our A-2000 BIS Monitor, we offer original
equipment manufacturers our BIS Module Kit for integration into equipment sold by the original
equipment manufacturers. Our BISx system, which was cleared for marketing by the FDA in February
2004, is our latest BIS monitoring system for integration into the equipment sold by original
equipment manufacturers. The BISx system provides the BIS XP functionality in a single device
approximately the size of a hockey puck, simplifying the incorporation of the BIS XP system into
third-party patient monitoring systems. We derive our revenue primarily from sales of BIS monitors, our original equipment
manufacturer products (including BIS Module Kits and the BISx system) and related accessories,
which we collectively refer to as Equipment, and sales of BIS Sensors. For management purposes, we
segregate our revenue by export sales by region and sales by products as shown in the following
table: Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004(in thousands)Domestic revenue
    
    $
    12,935
    
    
    $
    10,380Percent of total revenue
    
    
    76%
    
    
    
    81%International revenue
    
    $
    4,149
    
    
    $
    2,417Percent of total revenue
    
    
    24%
    
    
    
    19%Total revenue
    
    $
    17,084
    
    
    $
    12,797BIS Sensor revenue
    
    $
    12,483
    
    
    $
    9,207Percent of total revenue
    
    
    73%
    
    
    
    72%Equipment revenue
    
    $
    4,601
    
    
    $
    3,590Percent of total revenue
    
    
    27%
    
    
    
    28%Total revenue
    
    $
    17,084
    
    
    $
    12,797
 At April 2, 2005, we had cash, cash equivalents, restricted cash and short-term investments of
approximately $29.0 million and working capital of approximately $35.2 million. 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. 14




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##### Table of Contents



We believe our ability to grow our revenue is directly related to our ability to sell our
Equipment to healthcare organizations and influence our customers after they purchase our Equipment
to continue to purchase and use our BIS Sensors. We believe the increase in our installed base of
Equipment resulting from the sale of BIS monitors and the sale of original equipment manufacturers
equipment incorporating our BIS Module Kit or BISx system has been the primary reason for the
growth in revenue from the sale of BIS Sensors. In order to successfully grow our revenue, we need
to continue to focus on both selling our Equipment and improving our per monitor and per original
equipment manufacturer product sensor utilization rate. To achieve this growth, we continue to
implement new sales and marketing programs. We expect that as we grow our business, revenue from
the sale of BIS Sensors will continue to contribute an increasing percentage of total revenue.
Additionally, we believe that, over time, revenue from the sale of BIS Module Kits and our BISx
system will increase as a percentage of total Equipment revenue as healthcare organizations
purchase our technology as part of an integrated solution offered by our original equipment
manufacturers. We were profitable for the fiscal quarters ended December 31, 2004 and April 2, 2005. We
believe that maintaining our gross profit margin and controlling the growth of our operating
expenses are important factors in sustaining profitability. To maintain our gross profit margin we
believe we must continue to focus on maintaining our average unit sales prices of our BIS Sensors,
increasing revenue from the sale of BIS Sensors as a percentage of total revenue, as BIS Sensors
have a higher gross profit margin than Equipment, and continuing to reduce the costs of
manufacturing our products. For those healthcare organizations desiring to acquire our BIS monitors directly from us, we
offer two options. Our customers have the option either to purchase BIS monitors outright or to
acquire BIS monitors pursuant to a sales-type lease agreement whereby the customer contractually
commits to purchase a minimum number of BIS Sensors per BIS monitor per year. Under our sales-type
leases, 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. We also grant these customers an
option to purchase the BIS monitors at the end of the term of the agreement, which is typically
three to five years. We recognize Equipment revenue under sales-type lease agreements either at
shipment or delivery in accordance with the agreed upon contract terms with interest income
recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the
customer is recorded as costs of revenue in the same period. Sales-type leases accounted for
approximately 2% and 3% of total revenue in the three months ended April 2, 2005 and April 3, 2004,
respectively. Under certain limited 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, the customer is granted the right to use the BIS monitors for a mutually agreed upon
period of time. During this period, the customer purchases 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 the agreed upon period, the customer has the
option of purchasing the BIS monitors, continuing to use them under the EP program or returning
them to us. We have subsidiaries in The Netherlands and the United Kingdom to facilitate the sale of our
products into the international market. We are continuing to develop 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. In January 1998, we entered into a distribution agreement with Nihon Kohden Corporation to
distribute BIS monitors in Japan. Although Nihon Kohden has received approval from the Japanese
Ministry of Health, Labor and Welfare for marketing in Japan our A-1050 EEG Monitor with BIS and
our A-2000 BIS Monitor, Nihon Kohden has requested, but has not yet received, approval to market
the BIS XP system in Japan. In January 2002, the Japanese Ministry of Health, Labor and Welfare
granted reimbursement approval for use of our BIS monitors. With this approval, healthcare
providers in Japan are eligible to receive partial reimbursement of 1,000 Yen each time BIS
monitoring is used. In July 2002, the Japanese Ministry of Health, Labor and Welfare approved our
BIS module for marketing in Japan. Sales to Nihon Kohden represented approximately 23% and 12%,
respectively, of international revenue for the three months ended April 2, 2005 and April 3, 2004,
respectively. Various factors may adversely affect our quarterly operating results through the second fiscal
quarter of 2005 and beyond. These factors may have a potentially adverse effect on Equipment
revenue and gross profit margin on Equipment as we continue to shift the focus of our placements
from BIS monitors to BIS modules and BISx systems. In addition, in Japan, Nihon Kohden is awaiting
approval of the BIS XP system, and we believe customers in Japan may continue to delay purchases of
our products or may choose not to purchase our products pending this approval. 15




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##### Table of Contents



Critical Accounting Policies Managements discussion and analysis of financial condition and results of operations is based
upon our consolidated financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States for interim financial information. Note 2 of
the Notes to Consolidated Financial Statements included elsewhere in this Quarterly Report on Form
10-Q includes a summary of our significant accounting policies and methods used in the preparation
of our financial statements. In preparing these financial statements, we have made estimates and
judgments in determining certain amounts included in the financial statements. The application of
these accounting policies involves the exercise of judgment and use of assumptions as to future
uncertainties and, as a result, actual results could differ from these estimates. We do not
believe there is a significant likelihood that materially different amounts would be reported under
different conditions or using different assumptions. We believe that our critical accounting
policies and estimates are as follows: Revenue Recognition We sell our BIS monitors primarily through a combination of a direct sales force and
distributors. Our original equipment manufacturer products are sold to original equipment
manufacturers who in turn sell them to the end-user. BIS Sensors are sold through a combination of
a direct sales force, distributors and original equipment manufacturers. Direct product sales are
structured as sales, sales-type lease arrangements or sales under our EP program. We recognize
revenue from product sales when earned in accordance with Staff Accounting Bulletin, or SAB, No.
104, Revenue Recognition,and Emerging Issues Task Force, or EITF, 00-21, Revenue Arrangements with
Multiple Deliverables. Revenue is recognized when persuasive evidence of an arrangement exists,
product delivery has occurred or services have been rendered, the price is fixed or determinable
and collectibility is reasonably assured. For product sales, revenue is not recognized until title
and risk of loss have transferred to the customer. We also recognize revenue from prepaid license and royalty fees. This revenue is deferred
until product shipment or delivery in accordance with the terms of the agreement and license and
royalty fees are earned in accordance with the terms of the respective agreements. In August 2002,
we recorded approximately $6,300,000 of deferred revenue related to an OEM product development and
distribution agreement with Boston Scientific Corporation. The deferred revenue is being recognized
ratably over the term of the OEM product development and distribution agreement, as amended, which
represents our best estimate of our period of significant continuing obligation to provide Boston
Scientific Corporation exclusive distribution rights to newly developed technology. We amended the
OEM product development and distribution agreement in January 2005 and extended the estimate of our
period of significant continuing obligation by two years. This will reduce the revenue that we
record on a quarterly basis by approximately $31,000 in 2005 and beyond. If our estimate of the
period of significant continuing obligation is revised, this may have an impact on our revenue
recognition of the deferred revenue related to the Boston Scientific Corporation agreement. We follow Statement of Financial Accounting Standards, or SFAS, No. 13, Accounting For Leases,
for our sales-type lease agreements. Under our sales-type leases, customers purchase BIS Sensors
and the BIS monitor for the purchase price of the BIS Sensors plus an additional charge per BIS
Sensor to pay for the purchase price of the BIS monitor and related financing costs over the term
of the agreement. The minimum lease payment, consisting of the additional charge per BIS Sensor,
less the unearned interest income, which is computed at the interest rate implicit in the lease, is
recorded as the net investment in sales-type leases. We recognize Equipment revenue under
sales-type lease agreements either at shipment or delivery in accordance with the agreed upon
contract terms with interest income recognized over the life of the sales-type lease. The cost of
the BIS monitor acquired by the customer is recorded as costs of revenue in the same period. We
review and assess the net realizability of our investment in sales-type leases at each reporting
period. This review includes determining, on a customer specific basis, if a customer is
significantly underperforming relative to the customers cumulative level of committed BIS Sensor
purchases as required by the sales-type lease agreement. If a customer is underperforming, we
record an allowance for lease payments as a charge to revenue to reflect the lower estimate of the
net realizable investment in sales-type lease balance. 16




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##### Table of Contents



We recognize revenue either at shipment or delivery in accordance with the agreed upon
contract terms with distributors and original equipment manufacturers in accordance with SAB No.
104. Sales to distributors and original equipment manufacturers include a clause in the contracts
that indicates that customer acceptance is limited to confirmation that our products function in
accordance with our applicable product specifications in effect at the time of delivery. Formal
acceptance by the distributor or original equipment manufacturer is not necessary to recognize
revenue provided that we objectively demonstrate that the criteria specified in the acceptance
provisions are satisfied. Each product is tested prior to shipment to ensure that it meets the
applicable product specifications in effect at the time of delivery. Additionally, we have
historically had a minimal number of defective products shipped to distributors and original
equipment manufacturers and any defective products are subject to repair or replacement under
warranty as distributors and original equipment manufacturers do not have a right of return. Allowance for Doubtful Accounts We determine our allowance for doubtful accounts by using estimates based on our historical
collections experience, current trends, historical write-offs of our receivables, credit policy and
a percentage of our accounts receivable by aging category. We also review the credit quality of our
customer base as well as changes in our credit policies. We continuously monitor collections and
payments from our customers. While credit losses have historically been within our expectations and
the provisions established, our credit loss rates in the future may not be consistent with our
historical experience. To the extent we experience a deterioration in our historical collections
experience or increased credit losses, bad debt expense would likely increase in future periods. Inventories We value inventory at the lower of cost or estimated market value, and determine cost on a
first-in, first-out basis. We regularly review inventory quantities on hand and record a provision
for excess or obsolete inventory primarily based on production history and on our estimated
forecast of product demand. The medical device industry in which we market our products is
characterized by rapid product development and technological advances that could result in
obsolescence of inventory. Additionally, our estimates of future product demand may prove to be
inaccurate, in which case we would need to change our estimate of the provision required for excess
or obsolete inventory. If revisions are deemed necessary, we would recognize the adjustments in the
form of a charge to costs of revenue at the time of the determination. Therefore, although we
continually update our forecasts of future product demand, any significant unanticipated declines
in demand or technological developments, such as the introduction of new products by our
competitors, could have a significant negative impact on the value of our inventory, results of
operations and cash flows in future periods. Warranty Equipment that we sell generally is covered by a warranty period of one year. We accrue a
warranty reserve for estimated costs to provide warranty services. Our estimate of costs to service
our warranty obligations is based on our historical experience and expectation of future
conditions. While our warranty costs have historically been within our expectations and the
provisions established, to the extent we experience an increased number of warranty claims or
increased costs associated with servicing those claims, our warranty expenses will increase, and we
may experience decreased gross profit margin and cash flow. 17




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Results of Operations The following tables present, for the periods indicated, expenses and other financial
information expressed as a percentage of revenue and a summary of our total revenue. This
information has been derived from our unaudited 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. Three Months EndedApril 2,
    
    
    April 3,2005
    
    
    2004Revenue
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    26
    
    
    
    22Gross profit margin
    
    
    74
    
    
    
    78Operating expenses:Research and development
    
    
    12
    
    
    
    15Sales and marketing
    
    
    42
    
    
    
    51General and administrative
    
    
    15
    
    
    
    19Total operating expenses
    
    
    69
    
    
    
    85Income (loss) from operations
    
    
    5
    
    
    
    (7
    )Interest income, net
    
    
    2
    
    
    
    1Net income (loss)
    
    
    7
    %
    
    
    (6
    )%
 Three Months Ended April 2, 2005 Compared to Three Months Ended April 3, 2004 Three Months Ended
    
    
    PercentageApril 2,
    
    
    April 3,
    
    
    Increase2005
    
    
    2004
    
    
    (Decrease)(in thousands, except unitamounts)Revenue  WorldwideBIS Sensor
    
    $
    12,483
    
    
    $
    9,207
    
    
    
    36
    %BIS monitor
    
    
    2,688
    
    
    
    2,193
    
    
    
    23
    %Original equipment manufacturer products
    
    
    1,148
    
    
    
    542
    
    
    
    112
    %Other equipment and accessories
    
    
    765
    
    
    
    855
    
    
    
    (11
    %)Total Equipment
    
    
    4,601
    
    
    
    3,590
    
    
    
    28
    %Total revenue
    
    $
    17,084
    
    
    $
    12,797
    
    
    
    33
    %Unit Analysis  WorldwideBIS Sensors
    
    
    879,000
    
    
    
    651,000
    
    
    
    35
    %BIS monitors
    
    
    671
    
    
    
    416
    
    
    
    61
    %Original equipment manufacturer products
    
    
    1,035
    
    
    
    377
    
    
    
    175
    %Installed base
    
    
    25,895
    
    
    
    20,613
    
    
    
    26
    %
 Revenue.The 36% increase in revenue from the sale of BIS Sensors in the three months ended
April 2, 2005 compared with the three months ended April 3, 2004 was primarily attributable to an
increase of approximately 35% in the number of BIS Sensors sold as a result of growth in the
installed base of BIS monitors and original equipment manufacturer products. The increase in the
number of BIS Sensors sold was combined with an increase in both the domestic and international
sensor average selling price. During this period, domestic sensor units sold increased
approximately 24% with an increase in the domestic average selling price of approximately 4% while
international sensor units sold increased approximately 82% with an increase in the average selling
price of approximately 2%. Our installed base of BIS monitors and original equipment manufacturer
products increased approximately 26% to 25,895 units at April 2, 2005 compared with 20,613 units at
April 3, 2004. The 28% increase in revenue from the sale of Equipment in the three months ended April 2, 2005
compared with the three months ended April 3, 2004 was primarily driven by a 112% increase in
original equipment manufacturer product revenue. The increase in original equipment manufacture
product revenue was the result of an increase in the number of original equipment manufacturer
products shipped during this period. In the three months ended April 2, 2005, the number of
original equipment manufacturer products shipped to our original equipment manufacturers increased
approximately 175%, from 377 original equipment manufacturer products shipped in the first quarter
of 2004 compared with 1,035 original equipment manufacturer products shipped in the first quarter
of 2005. 18




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Our gross profit margin was approximately 74% of revenue in the first quarter of 2005 compared
with a gross profit margin of approximately 78% of revenue in the first quarter of 2004. The
decrease in the gross profit margin in the first quarter of 2005 from the same quarter in the prior
year was primarily the result of three factors. First, we had an increase in both revenue and unit
shipments of our original equipment manufacturer products which have
lower margins compared with our BIS monitors. Second, we had an increase of
approximately 61% in sales of our BIS monitors with a corresponding decrease in our average monitor
selling prices. Finally, international revenue increased as a percentage of total revenue from 19%
in the first quarter of 2004 to 24% in the first quarter of 2005. International revenue carries a
lower margin as we sell primarily through distributors in the international market while in the
U.S. we sell through a direct sales force. Expense Overview Three Months EndedApril 2,
    
    
    April 3,
    
    
    Percentage2005
    
    
    2004
    
    
    Increase(in thousands)ExpensesResearch and development
    
    $
    1,988
    
    
    $
    1,946
    
    
    
    2
    %Sales and marketing
    
    $
    7,276
    
    
    $
    6,565
    
    
    
    11
    %General and administrative
    
    $
    2,611
    
    
    $
    2,397
    
    
    
    9
    %
 Research and Development.The slight increase in research and development expenses in the
three months ended April 2, 2005 compared with the three months ended April 3, 2004 was primarily
attributable to an increase in salary expense of approximately $126,000, offset by a decrease in
clinical study expenses of approximately $77,000. The increase in salary expense reflects annual
salary increases which became effective in January 2005. We expect research and development
expenses to increase in the second quarter of 2005 compared with the first quarter of 2005 as we
continue to invest in clinical studies in an effort to expand applications for our technology,
including our continued initiatives into neuroscience. Sales and Marketing.The increase in sales and marketing expenses in the three months ended
April 2, 2005 compared with the three months ended April 3, 2004 was primarily attributable to an
increase in operating expenses associated with our international subsidiaries of approximately
$380,000, an increase of approximately $256,000 in compensation and benefits of which approximately
$163,000 relates to an increase in commissions expense and a portion of the increase relates to
annual salary increases, and an increase in recruiting fees of approximately $44,000. The $380,000
increase in our international operating expenses was the result of an increase of approximately
$271,000 in compensation and benefits partly due to annual salary increases, and an increase of
approximately $45,000 in travel and entertainment expenses. We expect sales and marketing expenses
to increase in the second quarter of 2005 compared with the first quarter of 2005. General and Administrative.The increase in general and administrative expenses in the three
months ended April 2, 2005 compared with the three months ended April 3, 2004 was primarily
attributable to an increase in compensation and benefits of approximately $103,000 as a result of
increased headcount and annual salary increases, an increase in accounting and tax services of
approximately $87,000 and an increase in recruiting fees of
approximately $26,000. We expect
general and administrative expenses in the second quarter of 2005 to
remain consistent with the first quarter of 2005. Interest Income.Interest income increased to approximately $376,000 in the three months
ended April 2, 2005 from approximately $209,000 in the three months ended April 3, 2004, an
increase of approximately 80%. The increase in interest income was primarily attributable to an
increase in our cash, cash equivalent and investment balance in the
three months ended April 2, 2005 compared with the three months
ended April 3, 2004. We expect interest income
in the second quarter of 2005 to decrease slightly compared with the first quarter of 2005. Interest Expense.Interest expense decreased to approximately $13,000 in the three months
ended April 2, 2005 from approximately $29,000 in the three months ended April 3, 2004, a decrease
of approximately 55%. The decrease in interest expense in the three months ended April 2, 2005 was
a result of lower average outstanding debt obligations. We expect interest expense in the second
quarter of 2005 to remain relatively constant compared with the first quarter of 2005 as we do not
anticipate that our outstanding debt obligations will increase. 19




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Net Income (Loss).As a result of the factors discussed above, for the three months ended
April 2, 2005, we had net income of approximately $1.1 million compared with a net loss of
approximately $796,000 for the three months ended April 3, 2004 We did not record a provision for
income taxes for the quarter ended April 2, 2005 as we have significant deferred tax assets
available to offset any income tax liabilities and expenses. At April 2, 2005, we had a full
valuation allowance against these gross deferred tax assets as we have determined that it is more
likely than not that some portion or all of the deferred tax assets will not be realized. Liquidity and Capital Resources Our liquidity requirements have historically consisted of research and development expenses,
sales and marketing expenses, capital expenditures, working capital and general corporate expenses.
From our inception through January 2000, we financed our operations primarily from the sale of
convertible preferred stock. Through April 2, 2005, we raised approximately $85.7 million from
private equity financings, received approximately $3.4 million in equipment financing and received
approximately $5.1 million of financing related to our investment 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
completed 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 Bank of America (formerly Fleet National Bank),
for a $5.0 million revolving line of credit, which expires in May 2005. The revolving line of
credit contains restrictive covenants that require us to maintain liquidity and net worth ratios
and is secured by certain investments, which are shown as restricted cash on our consolidated
balance sheets. In connection with the extension of our revolving line of credit agreement in May
2004, we are now required to maintain restricted cash in an amount equal to 102% of the outstanding
amounts under the revolving line of credit. Prior to the extension in May 2004, we were required
to maintain restricted cash in an amount equal to 102% of the $5.0 million commitment. At April 2,
2005, we were in compliance with all covenants contained in the revolving line of credit agreement.
Interest on any borrowings under the revolving line of credit is, at our election, either the prime
rate or at LIBOR plus 2.25%. At April 2, 2005, the interest rate on the line of credit was 5.75%.
Up to $1.5 million of the $5.0 million revolving line of credit is available for standby letters of
credit. At April 2, 2005, there was no amount outstanding under this line of credit and we had
standby letters of credit outstanding in the amount of $80,000. We are currently in the process
of negotiating a one year extension to the revolving line of credit with Bank of America. In August 2002, we entered into a strategic alliance with Boston Scientific Corporation
whereby we sold 1,428,572 shares of our common stock at a purchase price per share of $7.00 to
Boston Scientific Corporation. Gross cash proceeds from this sale of common stock were
approximately $10.0 million. Note 9 of our Notes to Consolidated Financial Statements included
elsewhere in this Quarterly Report on Form 10-Q includes additional information relating to the
strategic alliance with Boston Scientific Corporation. In connection with our strategic alliance with Boston Scientific Corporation, we also entered
into an agreement with Boston Scientific Corporation for a revolving line of credit under which we
are entitled to borrow up to $5.0 million. The revolving line of credit expires in August 2007 and
may be extended at the discretion of Boston Scientific Corporation. Interest on any borrowings
under this revolving line of credit is at a rate equal to the LIBOR rate at which Boston Scientific
Corporation, under its own revolving credit facility, is entitled to borrow funds, plus any
additional amounts payable thereon by Boston Scientific Corporation under such revolving credit
facility, plus eighty basis points. Our revolving line of credit with Boston Scientific
Corporation is secured by our inventory and certain of our accounts receivable and contains certain
restrictive covenants covering the collateral. At April 2, 2005, there was no outstanding balance
under this revolving line of credit and we were in compliance with all covenants contained in the
revolving line of credit agreement. On April 7, 2004, in order to raise cash for working capital and other general corporate
purposes, we entered into another stock purchase agreement with Boston Scientific Corporation to
issue and sell to Boston Scientific Corporation an aggregate of 500,000 shares of our common stock
at a purchase price of $16.21 per share. We completed the sale on June 8, 2004. Gross cash
proceeds from this sale of common stock were approximately $8.1 million. We expect to meet our short-term liquidity needs through the use of cash and short-term
investments on hand at April 2, 2005. We believe that the financial resources available to us,
including our current working capital, our long-term investments and available revolving lines of
credit will be sufficient to finance our planned operations and capital expenditures through at
least the end of 2006. 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 finance our research and development programs, to
implement new marketing programs, to finance our sales-type lease program and to meet market demand
for our products. 20




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We expect to fund the growth of our business over the long term through cash flow from
operations and through issuances of capital stock, promissory notes or other securities. Any sale of additional equity or debt securities may result in additional dilution to our
stockholders, and we cannot be certain that additional public or private financing will be
available in amounts or on terms acceptable to us at all. If we are unable to obtain this
additional financing, we may be required to delay, reduce the scope of, or eliminate one or more
aspects of our business development activities, which could harm the growth of our business. Working capital at April 2, 2005 was approximately $35.2 million compared to approximately
$34.2 million at December 31, 2004. The increase in working capital from December 31, 2004 to
April 2, 2005 was primarily attributable to a decrease of approximately $1.3 million in our
accounts payable and accrued liabilities. Cash Used for Operations.We used approximately $2.7 million of cash for operations in the
three months ended April 2, 2005 compared with approximately $2.9 million in the three months ended
April 3, 2004. Cash used for operations in the three months ended April 2, 2005 was primarily
driven by a decrease in accrued liabilities of approximately $1.8 million and an increase in other
assets of approximately $1.5 million. These were partially
offset by net income of approximately $1.1 million and an increase in accounts payable of
approximately $508,000. The decrease in accrued liabilities of $1.8 million was primarily driven
by a decrease in accrued bonus as we paid our 2004 bonuses in the first quarter of 2005. The
increase in other assets relates to the renewal of our commercial insurance lines and directors and
officers insurance of approximately $692,000 and an increase of approximately $630,000 in
receivables from stock option exercises. Cash Used for Investing Activities.We used approximately $2.4 million of cash from investing
activities in the three months ended April 2, 2005 compared with approximately $1.9 million of cash
provided by investing activities in the three months ended April 3, 2004. The cash used by
investing activities in the three months ended April 2, 2005 was primarily the result of the net
purchases of investments of approximately $2.0 million and capital expenditures of approximately $412,000 related to leasehold improvements to our facilities and the purchase of computer hardware and machinery and equipment. In the three months ended April 3, 2004, we received
approximately $1.8 million, net, of proceeds from sales and maturities of marketable securities and
invested approximately $160,000 primarily related to expenditures for the purchase of computer
hardware and third-party software. Cash Provided from Financing Activities.We received approximately $1.2 million of cash from
financing activities in the three months ended April 2, 2005 primarily as a result of proceeds from
the issuance of our common stock upon the exercise of stock options granted under our stock option
plans of approximately $1.4 million, offset by payments of principal on debt related to our
investment in sales-type leases of approximately $118,000. In the three months ended April 4,
2004, we received approximately $1.2 million of proceeds from the issuance of our common stock upon
the exercise of stock options granted under our stock option plans, offset by approximately
$210,000 of payments of principal on debt related to out investment in sales-type leases. In July 1999, we entered into an agreement under which we can sell a portion of our existing
and future investment in sales-type leases to Americorp Financial, Inc. Through April 2, 2005, we
sold approximately $5.1 million of our investment in sales-type leases. In accordance with SFAS
No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities  A replacement of FASB Statement No. 125, the proceeds from these sales are classified
as debt. Payments on the outstanding principal under this debt match the timing of the payments due
on the underlying investment in sales-type leases. At April 2, 2005, approximately $379,000 is
recorded as debt on our unaudited consolidated balance sheet. We had capital expenditures of approximately $412,000 for the quarter ended April 2, 2005,
which related primarily to leasehold improvements to our facilities and the purchase of computer
hardware and third-party software. At April 2, 2005, we did not have any commitments for capital
expenditures. We anticipate that the level of capital expenditures in the second quarter of 2005
will remain constant with the level of capital expenditures during the first quarter of 2005. In February 2005, we entered into an agreement with the supplier of our electronic memory
device used in the XP family of our disposable sensors to purchase a sufficient quantity of these
electronic memory devices to maintain our inventory levels through at least the end of 2005. This
commitment is expected to be approximately $1.4 million. 21




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Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements or relationships with unconsolidated
entities or financial partnerships, such as entities often referred to as structured finance or
special purpose entities, which are typically established for the purpose of facilitating
off-balance sheet arrangements or other contractually narrow or limited purposes. Income Taxes We have net operating loss and research and development tax credit carryforwards for federal
income tax purposes that began expiring in 2002 and will continue to expire through 2023 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 Sections 382 and 383
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. We have substantial net operating loss
carryforwards that have generated significant deferred tax assets. We have provided a full
valuation allowance against these deferred tax assets as we have determined that it is more likely
than not that we will not be able to fully utilize these net operating loss carryforwards. Effects of Inflation We believe that inflation and changing prices over the past year have not had a significant
impact on our revenue or on our results of operations. Recent Accounting Pronouncements On December 16, 2004, the Financial Accounting Standards Board, or FASB, issued Statement No.
123 (revised 2004), Share Based Payment, or SFAS No. 123R, which is a revision of Statement No.
123, Accounting for Stock-Based Compensation, or SFAS 123. SFAS 123R supersedes APB Opinion No.
25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows.
Under SFAS No. 123R, companies must calculate and record in the income statement the cost of equity
instruments, such as stock options or restricted stock, awarded to employees for services received;
pro forma disclosure is not longer permitted. The cost of the equity instruments is to be measured
based on fair value of the instruments on the date they are granted (with certain exceptions) and
is required to be recognized over the period during which the employees are required to provide
services in exchange for the equity instruments. SFAS No. 123R provides two alternatives for adoption: (1) a modified prospective method in
which compensation cost is recognized for all awards granted subsequent to the effective date of
this statement as well as for the unvested portion of awards outstanding as of the effective date;
or (2) a modified retrospective method which follows the approach in the modified prospective
method, but also permits entities to restate prior periods to record compensation cost calculated
under SFAS No. 123 for the pro forma disclosure. Since we currently account for stock options
granted to employees and shares issued under our employee stock purchase plan in accordance with
the intrinsic value method permitted under APB Opinion No. 25, no compensation expense generally is
recognized. We expect that the adoption of SFAS No. 123R will have a significant impact on our
results of operations, although it will have no impact on our overall financial position. The
impact of adopting SFAS No. 123R on periods after adoption cannot be accurately estimated at this
time, as it will depend on the market value and the amount of share based awards granted in future
periods. However, had we adopted SFAS No. 123R in prior periods, the impact of that standard
would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net
income (loss) and earnings (loss) per share included in Note 2 to the Companys unaudited
consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. In April 2005, the SEC deferred the deadline for adoption of SFAS 123Rs provisions on
share-based payment. Specifically, SEC registrants previously required to adopt SFAS 123Rs
provisions at the beginning of the first interim period after June 15, 2005 may now adopt the
provisions at the beginning of their first annual period beginning after June 15, 2005, under the
new SEC rule. As such, we intend to adopt SFAS 123R on January 1, 2006. 22




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FACTORS AFFECTING FUTURE OPERATING RESULTS This Quarterly Report onForm 10-Qcontains, in addition to historical information,
forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of
1934, including information relating to our ability to maintain profitability, information with
respect to market acceptance of our BIS system, continued growth in sales of our BIS monitors,
original equipment manufacturer products and BIS Sensors, our dependence on the BIS system,
regulatory approvals for our products, our ability to remain competitive and achieve future growth,
information with respect to other plans and strategies for our business and factors that may
influence our revenue for the fiscal quarter ending July 2, 2005 and thereafter. These
forward-looking statements involve risks and uncertainties and are not guarantees of future
performance. Words such as expect, anticipate, intend, plan, believe, seek, estimate
and variations of these words and similar expressions are intended to identify forward-looking
statements. Our actual results could differ significantly from the results discussed in these
forward-looking statements. The following important factors represent some of the current
challenges to us that create risk and uncertainty. Failure to adequately overcome any of the
following challenges could have a material adverse effect on our results of operations, business or
financial condition. In addition, subsequent events and developments may cause our expectations to
change. While we may elect to update these forward-looking statements we specifically disclaim any
obligation to do so, even if our expectations change. We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our
BIS system in sufficient quantities. Our 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 or in the intensive care unit. If extensive or
frequent malfunctions occur, healthcare 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 and reliable, they will not buy and use the BIS system in sufficient quantities to enable
us to continue to be profitable. The success of our business also depends in a large part on continued use of the BIS system by
our customers and, accordingly, sales by us of BIS Sensors. We expect that over time, sales of BIS
Sensors will increase as a percentage of our revenue as compared to sales of Equipment as we build
our installed base of monitors and modules. If use of our BIS system, and accordingly, sales of our
BIS Sensors, do not increase, our ability to grow our revenue could be adversely affected. 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 latest version, the
BIS XP system, at the end of the third fiscal quarter of 2001. We also offer BIS monitoring
systems, including the BISx system, for the integration into equipment sold by original equipment
manufacturers. To date, we have not achieved widespread market acceptance of the BIS system for
use in the operating room or in the intensive care unit from healthcare providers or professional
anesthesia organizations. 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. Various market factors may adversely affect our quarterly operating results through the second
fiscal quarter of 2005 and beyond. Various factors may adversely affect our quarterly operating results through the second fiscal
quarter of 2005. First, we continue to shift the focus of our placements from BIS monitors to
original equipment manufacturer products which may lead to a reduction in Equipment revenue and
gross margin on Equipment. Second, in Japan, Nihon Kohden is awaiting approval of the BIS XP system
from the Japanese Ministry of Health, Labor and Welfare which may cause delays in purchasing
decisions by customers in Japan, or these potential customers may choose not to purchase our
products. The continuation of difficult worldwide economic conditions, reductions in hospital
purchasing programs and the cost of transitioning our installed base to the BIS XP system may also
adversely impact our revenue and operating results through the second fiscal quarter of 2005 and
beyond. Additionally, on October 7, 2004, the Joint Commission on Accreditation of Healthcare
Organizations, or JCAHO, issued a Sentinel Event Alert aimed at preventing and managing the impact
of anesthesia awareness. The Alert identifies the incidence of awareness, describes common
underlying causes and suggests steps for healthcare professionals and institutions to take in order
to manage and prevent future occurrences and recommends healthcare organizations develop and
implement policies to address anesthesia awareness. While we believe this report is favorable to
our business, industry organizations and others in the anesthesia community may not agree with the
position 23




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taken in the Alert and, accordingly, potential benefits to our business that could have
resulted from this Alert may not be realized. 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,
    implementation of, and our subsequent reduction on the focus of, our EP program,
    use of and demand for our BIS Sensors,
    transition of sales focus from BIS monitors to original equipment manufacturer products,
    customer cancellations,
    introduction of competitive products,
    regulatory approvals,
    changes in management,
    turnover in our direct sales force,
    effectiveness of new marketing and sales programs,
    communications published by industry organizations or other in the anesthesia community
that are unfavorable to our business,
    reductions in orders by our distributors and original equipment manufacturers, and
    the timing and amount of our expenses. Because of these fluctuations, it is likely that in some future quarter or quarters our
operating results could fall below the expectations of securities analysts or investors. If our
quarterly operating results are below expectations in the future, the market price of our common
stock would likely decrease. In addition, because we do not have a substantial 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 continue to experience 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 debt allowances in
any quarter. If the estimates we make, and the assumptions on which we rely in preparing our financial
statements prove inaccurate, our actual results may vary from those reflected in our financial
statements. Our financial statements have been prepared in accordance with accounting principles generally
accepted in the United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of our assets, liabilities, revenues and
expenses, the amounts of charges accrued by us and related disclosure of contingent assets and
liabilities. This includes estimates on warranty reserves, inventory valuations and allowances for
doubtful accounts. We base our estimates on historical experience and on various other assumptions
that we believe to be reasonable under the circumstances. There can be no assurance, however, that
our estimates, or the assumptions underlying them, will be correct. 24




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If approval of our BIS XP system is not obtained in Japan, our revenue and operating results could
be adversely affected. In Japan, Nihon Kohden is awaiting approval of the BIS XP system from the Japanese Ministry of
Health, Labor and Welfare. Until approval is obtained, customers in Japan may delay their
purchasing decisions with respect to our products or may decide not to purchase our products at
all. As a result, if approval for this product is not obtained in Japan in the near future, or at
all, it could limit the growth of our international revenue. We may need additional financing for our future capital needs and may not be able to raise
additional funds on terms acceptable to us, or at all. We believe that the financial resources available to us, including our current working capital
and available revolving lines of credit, will be sufficient to finance our planned operations and
capital expenditures through at least the end of 2006. If we are unable to increase our revenue and
maintain positive cash flow, we will need to raise additional funds. We may also need additional
financing if:  
    the research and development costs of our products currently under development increase,
    we decide to expand faster than currently planned,
    we develop new or enhanced services or products ahead of schedule,
    we decide to undertake new sales and/or marketing initiatives,
    we are required to defend or enforce our intellectual property rights,
    sales of our products do not meet our expectations domestically or internationally,
    we need to respond to competitive pressures, or
    we decide to acquire complementary products, businesses or technologies. We can provide no assurance that we will be able to raise additional funds on terms acceptable
to us, if at all. If future financing is not available or is not available on acceptable terms, we
may not be able to fund our future operations which would significantly limit our ability to
implement our business plan. In addition, we may have to issue securities that may have rights,
preferences and privileges senior to our common stock. Cases of awareness with recall during monitoring with the BIS system could limit market acceptance
of BIS systems and could expose us to product liability claims. Clinicians have reported to us cases of possible awareness with recall 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 with recall in these
patients. However, in a small number of these reported cases, awareness with recall may not have
been detected by monitoring with the BIS system. We have not systematically solicited reports of
awareness with recall. It is possible that additional cases of awareness with recall during
surgical procedures monitored with the BIS system have not been reported to us. 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 awareness with recall 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 our multi-center,
multinational clinical studies have demonstrated that the use of BIS monitoring to help guide
anesthetic administration may be associated with the reduction of the incidence of awareness with
recall in adults using general anesthesia and sedation, we may be subject to product liability
claims for cases of awareness with recall 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. Moreover, if the patient safety benefits of BIS monitoring are not persuasive
enough to lead to wider adoption of our BIS technology, our business could be adversely affected. 25




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We may not be able to compete with new products or alternative techniques developed by others,
which could impair our ability to remain competitive and achieve future growth. The medical device industry in which we market our products is characterized by rapid product
development and technological advances. Our competitors have introduced commercially anesthesia
monitoring products which have been cleared by the United States Food and Drug Administration, or
FDA. If we do not compete effectively with these monitoring products, 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. In 2002, we introduced commercially the BIS Extend
Sensor for patients who are typically monitored for an extended period of time, such as in
intensive care unit settings. We do not know whether the use of the BIS system in the intensive
care unit will achieve market acceptance. In addition, we have begun to research the use of BIS
monitoring to diagnose and track neurological diseases, and face at least the following two related
risks:  
    we may not successfully adapt the BIS system to function properly for procedural
sedation, when used with anesthetics we have not tested or with patient populations we have
not studied, such as infants, and
    our technology is complex, and we may not be able to develop it further for applications
outside anesthesia monitoring, such as the diagnosis and tracking of neurological diseases. If we do not successfully adapt the BIS system for new products and applications both within
and outside the field of anesthesia monitoring, or if such products and applications are developed
but not successfully commercialized, 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 the past, we have experienced high turnover in our direct sales force. It is possible that
high turnover may occur in the future. If new sales representatives do not acquire the
technological skills to sell our products in a timely and successful manner or we experience high
turnover in our direct sales force, we may not be able to sustain and grow our product revenue. In
addition, in order to increase our sales, we need to continue to strengthen our relationships with
our international distributors and continue to add international distributors. Also, we need to
continue to strengthen our relationships with our original equipment manufacturers and other sales
channels and increase sales through these channels. On an ongoing basis, we develop and introduce
new sales and marketing programs and clinical education programs to promote the use of the BIS
system by our customers. If we do not implement these new sales and marketing and education
programs in a timely and successful manner, we may not be able to achieve the level of market
awareness and sales required 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. Among other things, 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, 26




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
    establish and implement successful sales and marketing and education programs that
encourage our customers to purchase our products or the products that are made by original
equipment manufacturers incorporating our technology,
    manage geographically dispersed operations, and
    modify our products and marketing and sales programs for foreign markets. Our third-party distribution and original equipment manufacturer relationships could negatively
affect our profitability, cause sales of our products to decline and be difficult to terminate if
we are dissatisfied. 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. In addition, 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 international 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. We have encountered barriers to
the sale of our BIS system outside the United States, including less acceptance by anesthesia
providers for use of disposable products, such as BIS Sensors, delays in regulatory approvals
outside of the United States, particularly in Japan, and difficulties selling through indirect
sales channels. In addition, we have little experience in marketing and distributing products in
these markets. Revenue from international activities may not offset the expense of establishing and
maintaining these international 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 adequate protection against infringement of our
intellectual property,
    protectionist laws and business practices that favor local competitors, which could slow
our growth in international markets,
    difficulties in terminating or modifying distributor arrangements because of restrictions
in markets outside the United States,
    less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors,
    delays in regulatory approval of our products,
    currency conversion issues arising from sales denominated in currencies other than the United States dollar,
    foreign currency exchange rate fluctuations,
    longer sales cycles to sell products like the BIS system to hospitals and outpatient
surgical centers, which could slow our revenue growth from international sales, and
    longer accounts receivable payment cycles and difficulties in collecting accounts
receivable. 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 and could adversely impact our results of
operations. 27




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We may experience customer dissatisfaction and our reputation could suffer if we fail to
manufacture enough products to meet our customers demands. We rely on third-party manufacturers to assemble and manufacture the components of our BIS
monitors, original equipment manufacturer products 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 for any reason, including damage or destruction of our 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-source 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 sole-source 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 shortages or delays 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. If a supplier is no longer willing or able to manufacture components that
we purchase and integrate into the BIS system, we may attempt to design replacement components
ourselves that would be compatible with our existing technology. In doing so, we would incur
additional research and development expenses, and there can be no assurance that we would be
successful in designing or manufacturing any replacement components. 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 may be costly and time-consuming. 28




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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
product liability insurance; however, it may 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 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. In addition, the underwriters may assert that we are liable for some or all of any
liability that they are found to have to the plaintiffs, pursuant to the indemnification provisions
of the underwriting agreement we entered into as part of the initial public offering, or otherwise. 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
could 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. Even if we are not named as defendants in these lawsuits,
we may also be required to incur significant costs and our management may be distracted by being
required to provide information, documents or testimony in connection with the actions against our
underwriters. 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. Boston Scientific Corporation may be able to affect corporate actions requiring stockholder
approval because it owns a significant amount of our common stock, and, if our strategic alliance
with Boston Scientific Corporation is not successful, our operating results could be adversely
affected. As of May 1, 2005, Boston Scientific Corporation owned approximately 27% of our outstanding
common stock. If Boston Scientific Corporation maintains or increases its ownership of our
outstanding common stock, it may have the ability to affect corporate actions requiring stockholder
approval. On August 7, 2002, we formed a strategic alliance with Boston Scientific Corporation. In
connection with this strategic alliance, we entered into an agreement pursuant to which we granted
Boston Scientific Corporation an option to distribute newly developed technology for monitoring
patients under sedation in a range of less-invasive medical specialties. If such products are not
successfully developed, marketed and sold under the agreement in a manner consistent with our
expectations, the growth of our business and our operating results will be adversely affected. Even
if we successfully develop new sedation management technology for less-invasive medical procedures,
Aspect and Boston Scientific Corporation may not successfully market and sell this new technology. 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. 29




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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 number of competitors monitoring systems which have been cleared by the FDA.
These products are marketed by well-established medical products companies with significant
resources. We may not be able to compete effectively with these 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. 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 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 premarket approval application process 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. 30




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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 who are responsible for customer education and
training and post-installation customer support. Consequently, if we are not able to attract and
retain skilled personnel, we will not be able to expand our business. Failure of users of the BIS system to obtain adequate reimbursement from third-party payors could
limit market acceptance of the BIS system, which could prevent us from sustaining profitability. 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. Interest Rate Exposure Our investment portfolio consists primarily of high-grade commercial paper, high grade
corporate bonds and debt obligations of various governmental agencies. We manage our investment
portfolio in accordance with our investment policy. The primary objectives of our investment
policy are to preserve principal, maintain a high degree of liquidity to meet operating needs, and
obtain competitive returns subject to prevailing market conditions. Investments are made with an
average maturity of 12 months or less and a maximum maturity of 24 months. These investments are
subject to risk of default, changes in credit rating and changes in market value. These
investments are also subject to interest rate risk and will decrease in value if market interest
rates increase. Due to the conservative nature of our investments and relatively short effective
maturities of the debt instruments, we believe interest rate risk is mitigated. Our investment
policy specifies the credit quality standards for our investments and limits the amount of exposure
from any single issue, issuer or type of investment. Our investment in sales-type leases, line of credit agreements and sales-type lease debt
agreements are also subject to market risk. The interest rates implicit in our sales-type leases
and on our sales-type lease debt agreements are fixed and not subject to interest rate risk. The
interest rates on our line of credit agreements are variable and subject to interest rate risk. The
interest rate risk related to the lines of credit is mitigated primarily by the fact that the lines
of credit, when drawn on, are generally outstanding for short periods of time in order to fund
short-term cash requirements. Foreign Currency Exposure Most of our revenue, expenses and capital spending are transacted in U.S. dollars. The
expenses and capital spending of our two international subsidiaries are transacted in the
respective countrys local currency and subject to foreign currency exchange rate risk. Our
foreign currency transactions are translated into U.S. dollars at prevailing rates. Gains or
losses resulting from foreign currency transactions are included in current period income or loss
as incurred. Currently, all material transactions are denominated in U.S. dollars, and we have not
entered into any material transactions that are denominated in foreign currencies. 31




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Item 4. Controls and Procedures.  (a)
    Evaluation of Disclosure Controls and Procedures.Our management, with the participation of our Chief Executive Officer, or CEO, and Chief
Financial Officer, or CFO, evaluated the effectiveness of our disclosure controls and
procedures as of April 2, 2005. The term disclosure controls and procedures, as defined in
Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of
a company that are designed to ensure that information required to be disclosed by a company
in the reports that it files or submits under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in the SECs rules and forms.
Disclosure controls and procedures include, without limitation, controls and procedures
designed to ensure that information required to be disclosed by a company in the reports that
it files or submits under the Exchange Act is accumulated and communicated to the companys
management, including its principal executive and principal financial officers, as
appropriate to allow timely decisions regarding required disclosure. Management recognizes
that any controls and procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving their objectives and management necessarily applies its
judgment in evaluating the cost-benefit relationship of possible controls and procedures.
Based on the evaluation of our disclosure controls and procedures as of April 2, 2005, our
chief executive officer and chief financial officer concluded that, as of such date, our
disclosure controls and procedures were effective at the reasonable assurance level.(b)
    Changes in Internal Controls.No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Securities Exchange Act) occurred during the fiscal quarter ended April
2, 2005 that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting. 32




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PART II  OTHER INFORMATION 
 Item 5. Other Information. On January 12, 2005, we entered into a Capital Equipment Supplier Agreement with Novation,
LLC. Novation provides purchasing opportunities to certain participating health care providers,
which it refers to as its members. Pursuant to the terms and conditions of the supplier agreement, we will make the Quatro
Sensor, Pediatric Sensor, Extend Sensor, Standard Sensor and the A-2000 XP Monitor, which we
collectively refer to as the products, and services related hereto, available for purchase or lease
to the members at prices established in the supplier agreement. We have agreed to adjust the
prices and services offered in connection with the products in the future if necessary to assure
market competitiveness. Novation has agreed to market the purchasing or leasing arrangements for
the products covered by the supplier agreement to the members. In return for the services rendered
by Novation pursuant to the supplier agreement, we will pay a fee to Novation based upon a
percentage of the net sales of products to the members and an additional fee if the growth of
business generated by Novation exceeds the growth of our business from other sources. The members
are not subject to any minimum purchase obligations under the terms of the supplier agreement and
have retained the right to contract directly with the members in exceptional circumstances. The supplier agreement went into effect on February 15, 2005 and expires on February 14, 2008.
Either party may terminate the supplier agreement prior to its expiration for any reason by
providing 90 days advanced written notice. In addition, either party may terminate the agreement
immediately upon written notice in the event of a breach by the other party that remains uncured
for a period of thirty days or due to the bankruptcy or insolvency of the other party. If, during the term of the supplier agreement, we introduce new technology that provides the
same functionality as the products, (i) we have agreed to provide each member the opportunity to
upgrade any product purchased, leased or ordered pursuant to the supplier agreement or (ii) we and
Novation will agree to the terms for making upgrades available to members. In the event that we
fail to disclose the existence of this new technology or we do not agree to terms of upgrades,
Novation will have the right to terminate any products superseded by the new technology and may
elect to contract with other suppliers for similar technology. If another supplier makes available
a product which provides incremental patient care benefits and/or incremental safety benefits over
the products, Novation may contract with a third party vendor, terminate the supplier agreement and
allow the members to re-bid that line of products so members have access to the new technology at
all times. We have agreed to maintain certain insurance coverage, including product liability insurance,
during the term of the supplier agreement and to indemnify Novation, the members and authorized
distributors against certain liabilities arising from (i) bodily injury or property damage caused
by the products, (ii) our acts or omissions and (iii) any claim that the products infringe any
United States patents. Novation has agreed to indemnify us for any violation of Novations
representations and warranties set forth in the supplier agreement. The foregoing summary of the supplier agreement is qualified in its entirety by reference to
the supplier agreement, which is attached as Exhibit 10.1 to the Quarterly Report on Form 10-Q and
is incorporated herein by reference. 
 Item 6. Exhibits and Reports on Form 8-K.  (a)
    ExhibitsThe exhibits listed in the Exhibit Index immediately preceding the exhibits are filed
as part of this Quarterly Report on Form 10-Q. 33




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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: May 12, 2005
    
    By:
    
    /s/ Michael FalveyMichael FalveyVice President and Chief Financial Officer(Principal Financial and Accounting
Officer)
 34




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EXHIBIT INDEX EXHIBITNUMBER
    
    EXHIBIT10.1 
    
    Capital Equipment Supplier Agreement for Level of
Consciousness between Novation, LLC and the Registrant dated
January 27, 2005.10.2
    
    Amendment No. 1 to the OEM Product Development Agreement
between Boston Scientific Corporation and the Registrant dated
January 31, 2005 is incorporated herein by reference to
Exhibit 10.1 to the Registrants Current Report on Form 8-K as
filed with the Commission on February 4, 2005.31.1
    
    Certification by Chief Executive Officer Pursuant to Rule
13a-14(a) and 15d-14(a) of the Securities Exchange Act of
1934, as amended.31.2
    
    Certification by Chief Financial Officer Pursuant to Rule
13a-14(a) and 15d-14(a) of the Securities Exchange Act of
1934, as amended.32.1
    
    Certification by Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification by Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
   

    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.