##### 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 1934For the quarterly period ended July 2, 2005o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the transition period from  to
  
 ASPECT MEDICAL SYSTEMS, INC.
  Delaware
    
    04-2985553(State or Other Jurisdiction of
    
    (I.R.S. Employer Identification No.)Incorporation or Organization)141 Needham Street, Newton, Massachusetts
    
    02464-1505(Address of Principal Executive Offices)
    
    (Zip Code)
 (617) 559-7000
 
  þ o
  þ o




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PagePART I FINANCIAL INFORMATION
    
    
    1Item 1. Financial Statements
    
    
    1Consolidated
Balance Sheets as of July 2, 2005 (unaudited) and December 31, 2004
    
    
    1Consolidated Statements of Operations for the Three and Six Months Ended
July 2, 2005 and July 3, 2004 (unaudited)
    
    
    2Consolidated Statements of Cash Flows for the Six Months Ended
July 2, 2005 and July 3, 2004 (unaudited)
    
    
    3Notes to Consolidated Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    15Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    35Item 4. Controls and Procedures
    
    
    35PART II OTHER INFORMATION
    
    
    36Item 4. Submission of Matters to a Vote of Security Holders
    
    
    36Item 6. Exhibits
    
    
    36SIGNATURES
    
    
    37EXHIBIT INDEXEX-10.1 Product Development & Distribution PlanEX-31.1 Section 302 Certification of CEOEX-31.2 Section 302 Certification of CFOEX-32.1 Section 906 Certification of CEOEx-32.2 Section 906 Certification of CFO




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS.
 ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED BALANCE SHEETS
 (in thousands, except share data)
 July 2,
    
    December 31,2005
    
    2004(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    19,217
    
    
    $
    14,761Restricted cash
    
    
    82
    
    
    
    82Short-term investments
    
    
    19,356
    
    
    
    17,452Accounts receivable, net of allowance of $133 at July
2, 2005 and $41 at December 31, 2004
    
    
    8,861
    
    
    
    7,835Current portion of investment in sales-type leases
    
    
    1,676
    
    
    
    1,698Inventory, net
    
    
    3,927
    
    
    
    2,224Other current assets
    
    
    2,105
    
    
    
    1,192Total current assets
    
    
    55,224
    
    
    
    45,244Property and equipment, net
    
    
    2,560
    
    
    
    2,662Long-term investments
    
    
    12,782
    
    
    
    11,439Long-term investment in sales-type leases
    
    
    2,329
    
    
    
    2,320Long-term portion of notes receivable from related parties
    
    
    
    
    
    
    25Total assets
    
    $
    72,895
    
    
    $
    61,690LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Current portion of long-term debt
    
    $
    165
    
    
    $
    311Accounts payable
    
    
    1,845
    
    
    
    1,920Accrued liabilities
    
    
    6,537
    
    
    
    7,832Deferred revenue
    
    
    5,385
    
    
    
    957Total current liabilities
    
    
    13,932
    
    
    
    11,020Long-term portion of deferred revenue
    
    
    4,570
    
    
    
    4,898Long-term debt
    
    
    111
    
    
    
    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, 21,567,697 and 20,838,611 shares issued
and outstanding at July 2, 2005 and December 31, 2004,
respectively
    
    
    216
    
    
    
    208Additional paid-in capital
    
    
    151,945
    
    
    
    145,429Deferred compensation
    
    
    (581
    )
    
    
    Accumulated other comprehensive loss
    
    
    (70
    )
    
    
    (78
    )Accumulated deficit
    
    
    (97,228
    )
    
    
    (99,973
    )Total stockholders equity
    
    
    54,282
    
    
    
    45,586Total liabilities and stockholders equity
    
    $
    72,895
    
    
    $
    61,690
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ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (in thousands, except per share amounts)
(Unaudited)
 Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Product revenue
    
    $
    18,153
    
    
    $
    13,270
    
    
    $
    35,081
    
    
    $
    25,914Strategic alliance revenue
    
    
    588
    
    
    
    156
    
    
    
    744
    
    
    
    309Total revenue
    
    
    18,741
    
    
    
    13,426
    
    
    
    35,825
    
    
    
    26,223Costs of revenue
    
    
    4,814
    
    
    
    3,177
    
    
    
    9,255
    
    
    
    6,042Gross profit margin
    
    
    13,927
    
    
    
    10,249
    
    
    
    26,570
    
    
    
    20,181Operating expenses:Research and development
    
    
    2,397
    
    
    
    1,802
    
    
    
    4,385
    
    
    
    3,747Sales and marketing
    
    
    7,493
    
    
    
    6,748
    
    
    
    14,769
    
    
    
    13,313General and administrative
    
    
    2,826
    
    
    
    2,268
    
    
    
    5,437
    
    
    
    4,665Total operating
expenses
    
    
    12,716
    
    
    
    10,818
    
    
    
    24,591
    
    
    
    21,725Income (loss) from operations
    
    
    1,211
    
    
    
    (569
    )
    
    
    1,979
    
    
    
    (1,544
    )Interest income
    
    
    418
    
    
    
    221
    
    
    
    793
    
    
    
    430Interest expense
    
    
    (14
    )
    
    
    (28
    )
    
    
    (27
    )
    
    
    (58
    )Net income (loss)
    
    $
    1,615
    
    
    $
    (376
    )
    
    $
    2,745
    
    
    $
    (1,172
    )Net income (loss) per share:Basic
    
    $
    0.08
    
    
    $
    (0.02
    )
    
    $
    0.13
    
    
    $
    (0.06
    )Diluted
    
    $
    0.07
    
    
    $
    (0.02
    )
    
    $
    0.12
    
    
    $
    (0.06
    )Weighted average shares used
in computing net income
(loss) per share:Basic
    
    
    21,400
    
    
    
    19,914
    
    
    
    21,157
    
    
    
    19,752Diluted
    
    
    23,827
    
    
    
    19,914
    
    
    
    23,518
    
    
    
    19,752
  2




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ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in thousands)
(Unaudited)
 Six Months EndedJuly 2,
    
    July 32005
    
    2004Cash flows from operating activities:Net income (loss)
    
    $
    2,745
    
    
    $
    (1,172
    )Adjustments to reconcile net income (loss) to net cash used
for operating activities Depreciation and amortization
    
    
    808
    
    
    
    788Provision for doubtful accounts
    
    
    91
    
    
    
    (70
    )Compensation expense related to stock options
    
    
    154
    
    
    
    34Changes in
assets and liabilitiesIncrease in accounts receivable
    
    
    (1,118
    )
    
    
    (1,223
    )Increase in inventory
    
    
    (1,702
    )
    
    
    (520
    )Increase in other assets
    
    
    (888
    )
    
    
    (105
    )Decrease in investment in sales-type leases
    
    
    13
    
    
    
    190(Decrease) increase in accounts payable
    
    
    (75
    )
    
    
    303Decrease in accrued liabilities
    
    
    (1,295
    )
    
    
    (1,892
    )Increase in deferred revenue
    
    
    4,100
    
    
    
    59Net cash provided by (used for) operating activities
    
    
    2,833
    
    
    
    (3,608
    )Cash flows from investing activities:Payments on loans to related parties
    
    
    
    
    
    
    498Acquisition of property and equipment
    
    
    (706
    )
    
    
    (539
    )Decrease in restricted cash
    
    
    
    
    
    
    4,900Purchases of marketable securities
    
    
    (22,264
    )
    
    
    (15,101
    )Proceeds from sales and maturities of marketable securities
    
    
    19,024
    
    
    
    12,285Net cash (used for) provided by investing activities
    
    
    (3,946
    )
    
    
    2,043Cash flows from financing activities:Principal payments on debt related to investment in sales-type
leases
    
    
    (221
    )
    
    
    (387
    )Proceeds from issuance of common stock
    
    
    5,790
    
    
    
    11,104Payments received on notes receivable from employees and
directors
    
    
    
    
    
    
    44Net cash provided by financing activities
    
    
    5,569
    
    
    
    10,761Net increase in cash and cash equivalents
    
    
    4,456
    
    
    
    9,196Cash and cash equivalents, beginning of period
    
    
    14,761
    
    
    
    12,344Cash and cash equivalents, end of period
    
    $
    19,217
    
    
    $
    21,540Supplemental disclosure of cash flow information:Interest paid
    
    $
    27
    
    
    $
    57
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ASPECT MEDICAL SYSTEMS, INC.
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (tabular amounts in thousands, except per share amounts)
(Unaudited)
 (1) Basis of Presentation
  (2) Summary of Significant Accounting Policies
  Principles of Consolidation
  Foreign Currency
  Cash, Cash Equivalents and Marketable Securities
  Accounting for Certain Investments
in Debt and Equity Securities
 Revenue Recognition
  4




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




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
  Research and Development Costs
  Allowance for Doubtful Accounts
  Inventory
  Warranty
  Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Beginning balance
    
    $
    158
    
    
    $
    152
    
    
    $
    137
    
    
    $
    147Warranty expense
    
    
    12
    
    
    
    25
    
    
    
    46
    
    
    
    51Deductions and other
    
    
    (27
    )
    
    
    (21
    )
    
    
    (40
    )
    
    
    (42
    )Ending balance
    
    $
    143
    
    
    $
    156
    
    
    $
    143
    
    
    $
    156
 6




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 Shipping and Handling Costs
  Advertising Costs
  Property and Equipment
 Accounting for the Costs of Computer Software Developed or Obtained for Internal Use
 Income Taxes
 Accounting for Income
Taxes
 Concentration of Credit Risk
  Single or Limited Source Suppliers
  7




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 Net Income (Loss) Per Share
 Earnings Per Share
   Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Basic:Net income (loss)
    
    $
    1,615
    
    
    $
    (376
    )
    
    $
    2,745
    
    
    $
    (1,172
    )Weighted average shares outstanding
    
    
    21,400
    
    
    
    19,914
    
    
    
    21,157
    
    
    
    19,752Basic net income (loss) per share
    
    $
    0.08
    
    
    $
    (0.02
    )
    
    $
    0.13
    
    
    $
    (0.06
    )Diluted:Net income (loss)
    
    $
    1,615
    
    
    $
    (376
    )
    
    $
    2,745
    
    
    $
    (1,172
    )Weighted average shares outstanding
    
    
    21,400
    
    
    
    19,914
    
    
    
    21,157
    
    
    
    19,752Effect of dilutive stock options and
restricted stock
    
    
    2,427
    
    
    
    
    
    
    
    2,361
    
    
    
    Weighted average shares assuming
dilution
    
    
    23,827
    
    
    
    19,914
    
    
    
    23,518
    
    
    
    19,752Diluted net income (loss) per share
    
    $
    0.07
    
    
    $
    (0.02
    )
    
    $
    0.12
    
    
    $
    (0.06
    )
 Comprehensive Income (Loss)
  Stock-Based Compensation
 Accounting for Stock-Based Compensation Accounting for Stock-Based
Compensation  Transition and Disclosure
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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Risk-free interest rate
    
    
    4.05
    %
    
    
    3.71
    %
    
    
    3.67
    %
    
    
    3.17
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Expected life of options
    
    5 years
    
    5 years
    
    5 years
    
    5 yearsExpected volatility
    
    
    49
    %
    
    
    53
    %
    
    
    50
    %
    
    
    56
    %Weighted average fair
market value of options
granted
    
    $
    12.14
    
    
    $
    6.82
    
    
    $
    10.01
    
    
    $
    9.00
  Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Net income (loss):Net income (loss) as reported
    
    $
    1,615
    
    
    $
    (376
    )
    
    $
    2,745
    
    
    $
    (1,172
    )Add: Stock-based employee
compensation expense
included in reported net
income (loss)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: Stock-based
employee compensation
expense determined under
fair value based method
for
all awards
    
    
    (1,543
    )
    
    
    (2,038
    )
    
    
    (3,079
    )
    
    
    (3,913
    )Pro forma net income (loss)
    
    $
    72
    
    
    $
    (2,414
    )
    
    $
    (334
    )
    
    $
    (5,085
    )Net income (loss) per share:Basic:As reported
    
    $
    0.08
    
    
    $
    (0.02
    )
    
    $
    0.13
    
    
    $
    (0.06
    )Pro forma
    
    $
    0.00
    
    
    $
    (0.12
    )
    
    $
    (0.02
    )
    
    $
    (0.26
    )Diluted:As reported
    
    $
    0.07
    
    
    $
    (0.02
    )
    
    $
    0.12
    
    
    $
    (0.06
    )Pro forma
    
    $
    0.00
    
    
    $
    (0.12
    )
    
    $
    (0.02
    )
    
    $
    (0.26
    )
  Use of Estimates
  9




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 Fair Value of Financial Instruments
  Reclassifications
  Recent Accounting Pronouncements
 Share Based Payment Accounting for Stock-Based Compensation Accounting for Stock Issued to Employees Statement of Cash Flows
   Accounting Changes and Error Corrections. Accounting Changes Reporting Accounting
Changes in Interim Financial Statements
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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
 (3) Comprehensive Income (Loss)
  Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Net income (loss)
    
    $
    1,615
    
    
    $
    (376
    )
    
    $
    2,745
    
    
    $
    (1,172
    )Other comprehensive income (loss):Unrealized gain (loss) on
marketable securities
    
    
    40
    
    
    
    (32
    )
    
    
    8
    
    
    
    (32
    )Comprehensive income (loss)
    
    $
    1,655
    
    
    $
    (408
    )
    
    $
    2,753
    
    
    $
    (1,204
    )
 (4) Investment in Sales-Type Leases
  July 2,
    
    December 31,2005
    
    2004Total minimum lease payments receivable
    
    $
    5,656
    
    
    $
    5,815Less:Unearned interest income
    
    
    812
    
    
    
    842Allowance for lease payments
    
    
    839
    
    
    
    955Net investment in sales-type leases
    
    
    4,005
    
    
    
    4,018Less  current portion
    
    
    1,676
    
    
    
    1,698$
    2,329
    
    
    $
    2,320
 (5) Inventory
  July 2,
    
    December 31,2005
    
    2004Raw materials
    
    $
    1,754
    
    
    $
    959Work-in-progress
    
    
    84
    
    
    
    66Finished goods
    
    
    2,089
    
    
    
    1,199$
    3,927
    
    
    $
    2,224
 (6) Segment Information and Enterprise Reporting
  11




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
  Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Geographic Area by RegionDomestic
    
    $
    14,257
    
    
    $
    10,442
    
    
    $
    27,192
    
    
    $
    20,822International
    
    
    4,484
    
    
    
    2,984
    
    
    
    8,633
    
    
    
    5,401Total
    
    $
    18,741
    
    
    $
    13,426
    
    
    $
    35,825
    
    
    $
    26,223
 Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Geographic Area by RegionDomestic
    
    
    76
    %
    
    
    78
    %
    
    
    76
    %
    
    
    79
    %International
    
    
    24
    
    
    
    22
    
    
    
    24
    
    
    
    21Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
  (7) Related Party Transactions
   (8) Loan Agreements
  12




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
   (9) Agreements with Boston Scientific Corporation
    13




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(Unaudited)
    (10) Shareholder Rights Plan
  14




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
 Overview
    Three Months Ended
    
    Six Months EndedJuly 2,
    
    July 3,
    
    July 2,
    
    July 3,2005
    
    2004
    
    2005
    
    2004(in thousands)Domestic revenue
    
    $
    14,257
    
    
    $
    10,442
    
    
    $
    27,192
    
    
    $
    20,822Percent of total revenue
    
    
    76
    %
    
    
    78
    %
    
    
    76
    %
    
    
    79
    %International revenue
    
    $
    4,484
    
    
    $
    2,984
    
    
    $
    8,633
    
    
    $
    5,401Percent of total revenue
    
    
    24
    %
    
    
    22
    %
    
    
    24
    %
    
    
    21
    %Total revenue
    
    $
    18,741
    
    
    $
    13,426
    
    
    $
    35,825
    
    
    $
    26,223BIS Sensor revenue
    
    $
    13,140
    
    
    $
    9,640
    
    
    $
    25,623
    
    
    $
    18,846Percent of total revenue
    
    
    70
    %
    
    
    72
    %
    
    
    72
    %
    
    
    72
    %Equipment revenue
    
    $
    5,013
    
    
    $
    3,630
    
    
    $
    9,458
    
    
    $
    7,068Percent of total revenue
    
    
    27
    %
    
    
    27
    %
    
    
    26
    %
    
    
    27
    %Strategic alliance revenue
    
    $
    588
    
    
    $
    156
    
    
    $
    744
    
    
    $
    309Percent of total revenue
    
    
    3
    %
    
    
    1
    %
    
    
    2
    %
    
    
    1
    %Total revenue
    
    $
    18,741
    
    
    $
    13,426
    
    
    $
    35,825
    
    
    $
    26,223
   15




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16




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Critical Accounting Policies and Estimates
  Revenue Recognition
 Revenue
Recognition, Revenue Arrangements with Multiple
Deliverables
   17




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Accounting For Leases
  Allowance for Doubtful Accounts
  Inventories
  Warranty
  18




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Results of Operations
  Three Months Ended
    
    Six Months EndedJuly 2, 2005
    
    July 3, 2004
    
    July 2, 2005
    
    July 3, 2004Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    26
    
    
    
    24
    
    
    
    26
    
    
    
    23Gross profit margin
    
    
    74
    
    
    
    76
    
    
    
    74
    
    
    
    77Operating expenses:Research and development
    
    
    13
    
    
    
    13
    
    
    
    12
    
    
    
    14Sales and marketing
    
    
    40
    
    
    
    50
    
    
    
    41
    
    
    
    51General and administrative
    
    
    15
    
    
    
    17
    
    
    
    15
    
    
    
    18Total operating expenses
    
    
    68
    
    
    
    80
    
    
    
    68
    
    
    
    83Income (loss) from operations
    
    
    6
    
    
    
    (4
    )
    
    
    6
    
    
    
    (6
    )Interest income, net
    
    
    2
    
    
    
    1
    
    
    
    2
    
    
    
    1Net income (loss)
    
    
    8
    %
    
    
    (3
    )%
    
    
    8
    
    
    
    (5
    )%
 Three and Six Months Ended July 2, 2005 Compared with the Three and Six Months Ended July 3, 2004
 Three Months Ended
    
    Six Months EndedPercentage
    
    
    
    
    
    
    
    
    
    PercentageJuly 2,
    
    July 3,
    
    Increase
    
    July 2,
    
    July 3,
    
    Increase2005
    
    2004
    
    (Decrease)
    
    2005
    
    2004
    
    (Decrease)(in thousands, except
    
    
    
    
    
    (in thousands, except unitunit amounts)
    
    
    
    
    
    amounts)Revenue  WorldwideBIS Sensor
    
    $
    13,140
    
    
    $
    9,640
    
    
    
    36
    %
    
    $
    25,623
    
    
    $
    18,846
    
    
    
    36
    %BIS monitor
    
    
    3,157
    
    
    
    2,185
    
    
    
    44
    %
    
    
    5,845
    
    
    
    4,378
    
    
    
    34
    %Original equipment manufacturer products
    
    
    1,211
    
    
    
    804
    
    
    
    51
    %
    
    
    2,358
    
    
    
    1,346
    
    
    
    75
    %Other equipment and accessories
    
    
    645
    
    
    
    641
    
    
    
    1
    %
    
    
    1,255
    
    
    
    1,344
    
    
    
    (7
    %)Total Equipment
    
    
    5,013
    
    
    
    3,630
    
    
    
    38
    %
    
    
    9,458
    
    
    
    7,068
    
    
    
    34
    %Total product revenue
    
    
    18,153
    
    
    
    13,270
    
    
    
    37
    %
    
    
    35,081
    
    
    
    25,914
    
    
    
    35
    %Strategic alliance
    
    
    588
    
    
    
    156
    
    
    
    277
    %
    
    
    744
    
    
    
    309
    
    
    
    141
    %Total revenue
    
    $
    18,741
    
    
    $
    13,426
    
    
    
    40
    %
    
    $
    35,825
    
    
    $
    26,223
    
    
    
    37
    %Unit Analysis  WorldwideBIS Sensors
    
    
    944,000
    
    
    
    695,000
    
    
    
    36
    %
    
    
    1,823,000
    
    
    
    1,346,000
    
    
    
    35
    %BIS monitors
    
    
    754
    
    
    
    460
    
    
    
    64
    %
    
    
    1,425
    
    
    
    876
    
    
    
    63
    %Original equipment manufacturerBIS products
    
    
    1,239
    
    
    
    517
    
    
    
    140
    %
    
    
    2,274
    
    
    
    894
    
    
    
    154
    %Installed base
    
    
    27,625
    
    
    
    21,411
    
    
    
    29
    %
    
    
    27,625
    
    
    
    21,411
    
    
    
    29
    %
 19




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Revenue.
     20




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Expense Overview
 Three Months Ended
    
    
    
    
    
    Six Months EndedPercentage
    
    
    
    
    
    
    
    
    
    PercentageJuly 2,
    
    July 3,
    
    Increase
    
    July 2,
    
    July 3,
    
    Increase2005
    
    2004
    
    (Decrease)
    
    2005
    
    2004
    
    (Decrease)(in thousands)
    
    
    
    
    
    (in thousands)ExpensesResearch and development
    
    $
    2,397
    
    
    $
    1,802
    
    
    
    33
    %
    
    $
    4,385
    
    
    $
    3,747
    
    
    
    17
    %Sales and marketing
    
    $
    7,493
    
    
    $
    6,748
    
    
    
    11
    %
    
    $
    14,769
    
    
    $
    13,313
    
    
    
    11
    %General and administrative
    
    $
    2,826
    
    
    $
    2,268
    
    
    
    25
    %
    
    $
    5,437
    
    
    $
    4,665
    
    
    
    17
    %
 Research and Development.
  Sales and Marketing.
  General and Administrative.
 21




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Interest Income.
 Interest expense.
 Net Income (Loss).
 Liquidity and Capital Resources
   22




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Agreements
with Boston Scientific Corporation
        Cash
Used for Operations.
 23




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##### Table of Contents



Cash from Investing Activities.
 Cash from Financing Activities.
 Accounting for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities  A replacement of FASB Statement No. 125
   Off-Balance Sheet Arrangements
  Income Taxes
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Effects of Inflation
  Recent Accounting Pronouncements
 Share Based Payment Accounting for Stock-Based Compensation Accounting for Stock Issued to Employees Statement of Cash Flows
   Accounting Changes and Error Corrections. Accounting Changes Reporting Accounting
Changes in Interim Financial Statements
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FACTORS AFFECTING FUTURE OPERATING RESULTS
 This Quarterly Report on Form 10-Q contains, in addition to historical information,
forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of
1934, including information relating to our ability to maintain profitability, information with
respect to market acceptance of our BIS system, continued growth in sales of our BIS monitors,
original equipment manufacturer products and BIS Sensors, our dependence on the BIS system,
regulatory approvals for our products, our ability to remain competitive and achieve future growth,
information with respect to other plans and strategies for our business and factors that may
influence our revenue for the fiscal quarter ending October 1, 2005 and thereafter. These
forward-looking statements involve risks and uncertainties and are not guarantees of future
performance. Words such as expect, anticipate, intend, plan, believe, seek, estimate
and variations of these words and similar expressions are intended to identify forward-looking
statements. Our actual results could differ significantly from the results discussed in these
forward-looking statements. The following important factors represent some of the current
challenges to us that create risk and uncertainty. Failure to adequately overcome any of the
following challenges could have a material adverse effect on our results of operations, business or
financial condition. In addition, subsequent events and developments may cause our expectations to
change. While we may elect to update these forward-looking statements, we specifically disclaim any
obligation to do so, even if our expectations change.
 We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our
BIS system in sufficient quantities.
   We depend on our BIS system for substantially all of our revenue, and if the BIS system does not
gain widespread market acceptance, then our revenue will not grow.
  Various market factors may adversely affect our quarterly operating results through the third
fiscal quarter of 2005.
  26




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Fluctuations in our quarterly operating results could cause our stock price to decrease.
  
    
    the timing and volume of customer orders for our BIS system,
    
    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.
  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.
  27




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If approval of our BIS XP system is not obtained in Japan, our revenue and operating results could
be adversely affected.
  We may need additional financing for our future capital needs and may not be able to raise
additional funds on terms acceptable to us, or at all.
  
    
    the research and development costs of our products currently under development increase
beyond current estimates,
    
    we decide to expand faster than currently planned,
    
    we develop new or enhanced services or products ahead of schedule,
    
    we decide to undertake new sales and/or marketing initiatives,
    
    we are required to defend or enforce our intellectual property rights,
    
    sales of our products do not meet our expectations domestically or internationally,
    
    we need to respond to competitive pressures, or
    
    we decide to acquire complementary products, businesses or technologies.
  Cases of awareness with recall during monitoring with the BIS system could limit market acceptance
of BIS systems and could expose us to product liability claims.
  28




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We may not be able to compete with new products or alternative techniques developed by others,
which could impair our ability to remain competitive and achieve future growth.
  
    
    other new monitoring products, based on new or improved technologies,
    
    new products or technologies used on patients or in the operating room during surgery in
lieu of monitoring devices,
    
    electrical or mechanical interference from new or existing products or technologies,
    
    alternative techniques for evaluating the effects of anesthesia,
    
    significant changes in the methods of delivering anesthesia, and
    
    the development of new anesthetic agents.
  If we do not successfully develop and introduce enhanced or new products we could lose revenue
opportunities and customers.
  
    
    we may not successfully adapt the BIS system to function properly for procedural
sedation, when used with anesthetics we have not tested or with patient populations we have
not studied, such as infants, and
    
    our technology is complex, and we may not be able to develop it further for applications
outside anesthesia monitoring, such as the diagnosis and tracking of neurological diseases.
  29




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If we do not develop and implement a successful sales and marketing strategy, we will not expand
our business.
  
    
    provide or assure that distributors and original equipment manufacturers provide the
technical and educational support customers need to use the BIS system successfully,
    
    promote frequent use of the BIS system so that sales of our disposable BIS Sensors
increase,
    
    establish and implement successful sales and marketing and education programs that
encourage our customers to purchase our products or the products that are made by original
equipment manufacturers incorporating our technology,
    
    manage geographically dispersed operations, and
    
    modify our products and marketing and sales programs for foreign markets.
 Our third-party distribution and original equipment manufacturer relationships could negatively
affect our profitability, cause sales of our products to decline and be difficult to terminate if
we are dissatisfied.
  We may not be able to generate enough additional revenue from our international expansion to offset
the costs associated with establishing and maintaining foreign operations.
  30




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We may not be able to meet the unique operational, legal and financial challenges that we will
encounter in our international operations, which may limit the growth of our business.
  
    
    failure of local laws to provide adequate protection against infringement of our
intellectual property,
    
    protectionist laws and business practices that favor local competitors, which could slow
our growth in international markets,
    
    difficulties in terminating or modifying distributor arrangements because of restrictions
in markets outside the United States,
    
    less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors,
    
    delays in regulatory approval of our products,
    
    currency conversion issues arising from sales denominated in currencies other than the United States dollar,
    
    foreign currency exchange rate fluctuations,
    
    longer sales cycles to sell products like the BIS system to hospitals and outpatient
surgical centers, which could slow our revenue growth from international sales, and
    
    longer accounts receivable payment cycles and difficulties in collecting accounts
receivable.
  We may experience customer dissatisfaction and our reputation could suffer if we fail to
manufacture enough products to meet our customers demands.
  Our reliance on sole-source suppliers could adversely affect our ability to meet our customers
demands for our products in a timely manner or within budget.
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We may be required to bring litigation to enforce our intellectual property rights, which may
result in substantial expense and may divert our attention from the implementation of our business
strategy.
  We may be sued by third parties which claim that our products infringe on their intellectual
property rights, particularly because there is substantial uncertainty about the validity and
breadth of medical device patents.
  
    
    cease selling, incorporating or using any of our products that incorporate the challenged
intellectual property, which would adversely affect our revenue,
    
    obtain a license from the holder of the infringed intellectual property right, which
license may not be available on reasonable terms, if at all, and
    
    redesign our products, which may be costly and time-consuming.
 We could be exposed to significant product liability claims which could divert management attention
and adversely affect our cash balances, our ability to obtain and maintain insurance coverage at
satisfactory rates or in adequate amounts and our reputation.
  Several class action lawsuits have been filed against the underwriters of our initial public
offering which may result in negative publicity and potential litigation against us that would be
costly to defend and the outcome of which is uncertain and may harm our business.
  32




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Boston Scientific Corporation may be able to affect corporate actions requiring stockholder
approval because it owns a significant amount of our common stock, additionally, if our strategic
alliance with Boston Scientific Corporation is not successful, our operating results could be
adversely affected.
  We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could
result in unanticipated expenses and fluctuations in operating results.
  We may not be able to compete effectively, which could result in price reductions and decreased
demand for our products.
  Our ability to market and sell our products and generate revenue depends upon receipt of domestic
and foreign regulatory approval of our products and manufacturing operations.
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If we do not retain our senior management and other key employees, we may not be able to
successfully implement our business strategy.
  If we do not attract and retain skilled personnel, we will not be able to expand our business.
  Failure of users of the BIS system to obtain adequate reimbursement from third-party payors could
limit market acceptance of the BIS system, which could prevent us from sustaining profitability.
  34




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Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 Interest Rate Exposure
   Foreign Currency Exposure
  
 Item 4. Controls and Procedures.
 (a)
    
    Evaluation of Disclosure Controls and Procedures.Our management, with the participation of our Chief Executive Officer, or CEO, and Chief
Financial Officer, or CFO, evaluated the effectiveness of our disclosure controls and
procedures as of July 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 July 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 July 2,
2005 that has materially affected, or is reasonably likely to materially affect, our internal
control over financial reporting.
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PART II  OTHER INFORMATION
 
 Item 4. Submission of Matters to a Vote of Security Holders.
      
 Item 6. Exhibits.
 
 36




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SIGNATURE
  ASPECT MEDICAL SYSTEMS, INC.Date: August 11, 2005
    By:
    /s/ Michael FalveyMichael FalveyVice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 37




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EXHIBIT INDEX
 EXHIBITNUMBER
    
    EXHIBIT10.1 
    
    Product Development and Distribution Agreement between Boston
Scientific Corporation and the Registrant dated May 23, 2005.31.1
    
    Certification by Chief Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.31.2
    
    Certification by Chief Financial Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.32.1
    
    Certification by Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification by Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
 
 
    
    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.