##### Table of Contents



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


---



FORM 10-Q

(Mark One)

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

For the quarterly period ended September 27, 2003

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

For the transition period from ___________ to ___________

Commission file number: 0-24663



---

ASPECT MEDICAL SYSTEMS, INC.


(Exact Name of Registrant as Specified in Its Charter)


|                                                                        |  |                                                
|----------------------------------------------------------------------- |  | -----------------------------------------------
|Delaware
(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.

YES [X]  NO [  ]


Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).

YES [  ]  NO [X]


The Registrant had 19,441,364 shares of Common Stock, $0.01 par value per
share, outstanding as of November 3, 2003.





---

TABLE OF CONTENTS



|                                                 |                                                                                               |                                            |  |  |  |  |  | 
|------------------------------------------------ | --------------------------------------------------------------------------------------------- | ------------------------------------------ |  |  |  |  |  | 
|PART I  FINANCIAL INFORMATION                  
|                                                 | Item 1. Financial Statements                                                                 
|                                                 |                                                                                               | CONSOLIDATED BALANCE SHEETS               
|                                                 |                                                                                               | CONSOLIDATED STATEMENTS OF OPERATIONS     
|                                                 |                                                                                               | CONSOLIDATED STATEMENTS OF CASH FLOWS     
|                                                 |                                                                                               | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
|                                                 | Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|                                                 | Item 3. Quantitative and Qualitative Disclosures About Market Risk                           
|                                                 | Item 4. Controls and Procedures                                                              
|PART II  OTHER INFORMATION                     
|                                                 | Item 1. Legal Proceedings                                                                    
|                                                 | Item 2. Changes in Securities and Use of Proceeds                                            
|                                                 | Item 3. Defaults Upon Senior Securities                                                      
|                                                 | Item 4. Submission of Matters to a Vote of Security Holders                                  
|                                                 | Item 5. Other Information                                                                    
|                                                 | Item 6. Exhibits and Reports on Form 8-K                                                     
|SIGNATURE                                       
|EXHIBIT INDEX                                   
|EX-10.1 OEM DEVELOPMENT & PURCHASE AGREEMENT    
|EX-10.2 ADDENDUM 1 TO THE OEM PURCHASE AGREEMENT
|EX-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.     



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

TABLE OF CONTENTS

|          |  |                                                                                       |  |                                                                                                                     |    |      |   | 
|--------- |  | ------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------------- | -- | ---- | - | 
|          |  |                                                                                       |  |                                                                                                                     |    | Page
|          |  |                                                                                       |  |                                                                                                                     |    |     
|PART I    |  | FINANCIAL INFORMATION                                                                 |  |                                                                                                                     | 1  |     
|Item 1.   |  | Financial Statements (Unaudited)                                                      |  |                                                                                                                     | 1  |     
|          |  |                                                                                       |  | Consolidated Balance Sheets as of September 27, 2003 and December 31, 2002                                          |    |      | 1 | 
|          |  |                                                                                       |  | Consolidated Statements of Operations for the Three and Nine Months Ended
September 27, 2003 and September 28, 2002 |    |      | 2 | 
|          |  |                                                                                       |  | Consolidated Statements of Cash Flows for the Nine Months Ended
September 27, 2003 and September 28, 2002           |    |      | 3 | 
|          |  |                                                                                       |  | Notes to Consolidated Financial Statements                                                                          |    |      | 4 | 
|Item 2.   |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  |                                                                                                                     | 13 |     
|Item 3.   |  | Quantitative and Qualitative Disclosures About Market Risk                            |  |                                                                                                                     | 31 |     
|Item 4.   |  | Controls and Procedures                                                               |  |                                                                                                                     | 31 |     
|PART II   |  | OTHER INFORMATION                                                                     |  |                                                                                                                     | 32 |     
|Item 1.   |  | Legal Proceedings                                                                     |  |                                                                                                                     | 32 |     
|Item 2.   |  | Changes in Securities and Use of Proceeds                                             |  |                                                                                                                     | 32 |     
|Item 3.   |  | Defaults Upon Senior Securities                                                       |  |                                                                                                                     | 32 |     
|Item 4.   |  | Submission of Matters to a Vote of Security Holders                                   |  |                                                                                                                     | 32 |     
|Item 5.   |  | Other Information                                                                     |  |                                                                                                                     | 32 |     
|Item 6.   |  | Exhibits and Reports on Form 8-K                                                      |  |                                                                                                                     | 33 |     
|SIGNATURE |  |                                                                                       |  |                                                                                                                     | 34 |     





---



##### Table of Contents






PART I  FINANCIAL INFORMATION




Item 1. Financial Statements.




ASPECT MEDICAL SYSTEMS, INC.

CONSOLIDATED BALANCE SHEETS

|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |              |             |   |            | 
|---------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------ | ----------- | ------------- | ---------- | ------------ | ----------- | - | ---------- | 
|                                                           |                                                                                                                                                                               |  |                                            |             | September 27, |            | December 31,
|                                                           |                                                                                                                                                                               |  |                                            |             | 2003          |            | 2002        
|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |             
|                                                           |                                                                                                                                                                               |  |                                            |             | (Unaudited)   |            |              |             |  
|ASSETS                                                     |                                                                                                                                                                               |  |                                            |             |               |            |              |            
|Current assets:                                            |                                                                                                                                                                               |  |                                            |             |               |            |              |            
|                                                           | Cash and cash equivalents                                                                                                                                                     |  | $                                          | 10,072,980  |               |            | $            | 11,542,833  |  
|                                                           | Restricted cash                                                                                                                                                               |  |                                            | 5,100,000   |               |            |              | 5,100,000   |  
|                                                           | Marketable securities                                                                                                                                                         |  |                                            | 16,252,251  |               |            |              | 20,222,500  |  
|                                                           | Accounts receivable, net of allowance of $235,000 at
September 27, 2003 and $408,000 at December 31, 2002                                                                     |  |                                            | 5,320,741   |               |            |              | 4,666,098   |  
|                                                           | Current portion of investment in sales-type leases                                                                                                                            |  |                                            | 1,818,118   |               |            |              | 1,859,237   |  
|                                                           | Inventory, net                                                                                                                                                                |  |                                            | 1,634,464   |               |            |              | 2,333,385   |  
|                                                           | Other current assets                                                                                                                                                          |  |                                            | 1,705,605   |               |            |              | 1,319,091   |  
|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |              |            
|                                                           |                                                                                                                                                                               |  | Total current assets                       |             |               | 41,904,159 |              |             |   | 47,043,144 | 
|Property and equipment, net                                |                                                                                                                                                                               |  | 3,057,153                                  |             |               |            | 4,121,560    |            
|Long-term investment in sales-type leases                  |                                                                                                                                                                               |  | 2,450,517                                  |             |               |            | 2,282,751    |            
|Long-term portion of notes receivable from related parties |                                                                                                                                                                               |  | 750,125                                    |             |               |            | 1,032,572    |            
|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |              |             |  
|                                                           |                                                                                                                                                                               |  | Total assets                               |             | $             | 48,161,954 |              |             | $ | 54,480,027 | 
|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |              |            
|LIABILITIES AND STOCKHOLDERS EQUITY                       |                                                                                                                                                                               |  |                                            |             |               |            |              |            
|Current liabilities:                                       |                                                                                                                                                                               |  |                                            |             |               |            |              |            
|                                                           | Current portion of long-term debt                                                                                                                                             |  | $                                          | 755,505     |               |            | $            | 887,538     |  
|                                                           | Accounts payable                                                                                                                                                              |  |                                            | 1,097,413   |               |            |              | 1,246,567   |  
|                                                           | Accrued liabilities                                                                                                                                                           |  |                                            | 7,516,651   |               |            |              | 7,127,091   |  
|                                                           | Deferred revenue                                                                                                                                                              |  |                                            | 954,474     |               |            |              | 1,047,651   |  
|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |              |             |  
|                                                           |                                                                                                                                                                               |  | Total current liabilities                  |             |               | 10,324,043 |              |             |   | 10,308,847 | 
|Long-term portion of deferred revenue                      |                                                                                                                                                                               |  | 5,754,184                                  |             |               |            | 6,359,210    |            
|Long-term debt                                             |                                                                                                                                                                               |  | 675,094                                    |             |               |            | 1,015,101    |            
|Commitments and contingencies                              |                                                                                                                                                                               |  |                                            |             |               |            |              |            
|Stockholders equity:                                      |                                                                                                                                                                               |  |                                            |             |               |            |              |            
|                                                           | Preferred Stock, $.01 par value; 5,000,000 shares
authorized, no shares issued or outstanding                                                                                 |  |                                            |            |               |            |              |            |  
|                                                           | Common Stock, $.01 par value; 60,000,000 shares
authorized, 19,424,125 and 19,370,823 shares issued
and outstanding at September 27, 2003 and December 31,
2002, respectively |  |                                            | 194,241     |               |            |              | 193,708     |  
|                                                           | Additional paid-in capital                                                                                                                                                    |  |                                            | 130,788,057 |               |            |              | 130,606,576 |  
|                                                           | Notes receivable from employees and directors                                                                                                                                 |  |                                            | (117,405    | )             |            |              | (271,049    | )
|                                                           | Accumulated other comprehensive income                                                                                                                                        |  |                                            | 2,732       |               |            |              | 20,900      |  
|                                                           | Accumulated deficit                                                                                                                                                           |  |                                            | (99,458,992 | )             |            |              | (93,753,266 | )
|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |              |             |  
|                                                           |                                                                                                                                                                               |  | Total stockholders equity                 |             |               | 31,408,633 |              |             |   | 36,796,869 | 
|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |              |             |  
|                                                           |                                                                                                                                                                               |  | Total liabilities and stockholders equity |             | $             | 48,161,954 |              |             | $ | 54,480,027 | 
|                                                           |                                                                                                                                                                               |  |                                            |             |               |            |              |            

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

1



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.




CONSOLIDATED STATEMENTS OF OPERATIONS

|                                                              |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |            |            | 
|------------------------------------------------------------- | -------------------------- | ------------------------ | ---------- | ------------------ | --------- | ----------------- | ---------- | ------------- | ---------- | ------------- | ---------- | ---------- | ---------- | - | ----------- | ---------- | ---------- | 
|                                                              |                            |                          |            | Three Months Ended |           | Nine Months Ended
|                                                              |                            |                          |            |                    |           |                  
|                                                              |                            |                          |            | September 27,      |           | September 28,     |            | September 27, |            | September 28,
|                                                              |                            |                          |            | 2003               |           | 2002              |            | 2003          |            | 2002         
|                                                              |                            |                          |            |                    |           |                   |            |               |            |              
|                                                              |                            |                          |            | (Unaudited)        |           | (Unaudited)       |            | (Unaudited)   |            | (Unaudited)  
|Revenue                                                       |                            | $                        | 11,189,071 |                    |           | $                 | 9,995,213  |               |            | $             | 32,025,205 |            |            | $ | 29,733,002  |           
|Costs of revenue                                              |                            |                          | 2,760,892  |                    |           |                   | 2,803,279  |               |            |               | 8,026,781  |            |            |   | 9,344,866   |           
|                                                              |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |           
|Gross profit margin                                           |                            |                          | 8,428,179  |                    |           |                   | 7,191,934  |               |            |               | 23,998,424 |            |            |   | 20,388,136  |           
|Operating expenses:                                           |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |           
|                                                              | Research and development   |                          |            | 1,625,458          |           |                   |            | 1,885,866     |            |               |            | 5,370,211  |            |   |             | 5,848,541  |           
|                                                              | Sales and marketing        |                          |            | 6,286,408          |           |                   |            | 6,981,264     |            |               |            | 18,528,144 |            |   |             | 21,294,935 |           
|                                                              | General and administrative |                          |            | 2,070,418          |           |                   |            | 1,960,242     |            |               |            | 6,351,806  |            |   |             | 5,744,221  |           
|                                                              |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |           
|                                                              |                            | Total operating
expenses |            |                    | 9,982,284 |                   |            |               | 10,827,372 |               |            |            | 30,250,161 |   |             |            | 32,887,697 | 
|                                                              |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |           
|Loss from operations                                          |                            |                          | (1,554,105 | )                  |           |                   | (3,635,438 | )             |            |               | (6,251,737 | )          |            |   | (12,499,561 | )         
|Interest income                                               |                            |                          | 215,440    |                    |           |                   | 289,708    |               |            |               | 701,785    |            |            |   | 917,805     |           
|Interest expense                                              |                            |                          | (48,188    | )                  |           |                   | (60,387    | )             |            |               | (155,774   | )          |            |   | (185,717    | )         
|                                                              |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |           
|Net loss                                                      |                            | $                        | (1,386,853 | )                  |           | $                 | (3,406,117 | )             |            | $             | (5,705,726 | )          |            | $ | (11,767,473 | )         
|                                                              |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |           
|Net loss per share:                                           |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |           
|                                                              | Basic and diluted          |                          | $          | (0.07              | )         |                   | $          | (0.18         | )          |               | $          | (0.29      | )          |   | $           | (0.65      | )         
|Weighted average shares used
in computing net loss per
share: |                            |                          |            |                    |           |                   |            |               |            |               |            |            |            |   |             |           
|                                                              | Basic and diluted          |                          |            | 19,420,663         |           |                   |            | 18,733,293    |            |               |            | 19,399,001 |            |   |             | 18,072,978 |           

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

2



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.




CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |               |           |           |            |  
|---------------------------------------------------- | ----------------------------------------------------------------------------- | --------------------------------------------- | ------------------------------------------- | ---------------------------------------------------- | --------- | ----------------- | ---------- | ------------- | --------- | --------- | ---------- | -
|                                                     |                                                                               |                                               |                                             |                                                      |           | Nine Months Ended
|                                                     |                                                                               |                                               |                                             |                                                      |           |                  
|                                                     |                                                                               |                                               |                                             |                                                      |           | September 27,     |            | September 28,
|                                                     |                                                                               |                                               |                                             |                                                      |           | 2003              |            | 2002         
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|                                                     |                                                                               |                                               |                                             |                                                      |           | (Unaudited)       |            | (Unaudited)  
|Cash flows from operating activities:                |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|                                                     | Net loss                                                                      |                                               | $                                           | (5,705,726                                           | )         |                   | $          | (11,767,473   | )        
|                                                     | Adjustments to reconcile net loss to net cash used for
operating activities  |                                               |                                             |                                                      |           |                   |            |               |          
|                                                     |                                                                               | Depreciation and amortization                 |                                             |                                                      | 1,555,986 |                   |            |               | 2,032,128 |          
|                                                     |                                                                               | Provision for doubtful accounts               |                                             |                                                      | (150,000  | )                 |            |               |          |          
|                                                     |                                                                               | Compensation expense related to stock options |                                             |                                                      | 26,746    |                   |            |               | 31,441    |          
|                                                     |                                                                               | Changes in assets and liabilities            |                                             |                                                      |           |                   |            |               |           |          
|                                                     |                                                                               |                                               | (Increase) decrease in accounts receivable  |                                                      |           | (504,643          | )          |               |           | 329,144   |           
|                                                     |                                                                               |                                               | Decrease in inventory                       |                                                      |           | 698,921           |            |               |           | 2,321,467 |           
|                                                     |                                                                               |                                               | Increase in other assets                    |                                                      |           | (222,486          | )          |               |           | (191,981  | )         
|                                                     |                                                                               |                                               | Increase in investment in sales-type leases |                                                      |           | (126,647          | )          |               |           | (606,623  | )         
|                                                     |                                                                               |                                               | Decrease in accounts payable                |                                                      |           | (149,154          | )          |               |           | (301,473  | )         
|                                                     |                                                                               |                                               | Increase (decrease) in accrued liabilities  |                                                      |           | 389,560           |            |               |           | (699,510  | )         
|                                                     |                                                                               |                                               | (Decrease) increase in deferred revenue     |                                                      |           | (698,203          | )          |               |           | 6,240,420 |           
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|                                                     |                                                                               |                                               |                                             | Net cash used for operating activities               |           |                   | (4,885,646 | )             |           |           | (2,612,460 | )
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|Cash flows from investing activities:                |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|                                                     | Loans to related parties                                                      |                                               |                                             |                                                     |           |                   |            | (50,000       | )        
|                                                     | Payments on loans to related parties                                          |                                               |                                             | 118,419                                              |           |                   |            | 87,805        |          
|                                                     | Acquisition of property and equipment                                         |                                               |                                             | (491,579                                             | )         |                   |            | (855,490      | )        
|                                                     | Purchases of marketable securities                                            |                                               |                                             | (12,035,000                                          | )         |                   |            | (9,088,675    | )        
|                                                     | Proceeds from sales and maturities of marketable securities                   |                                               |                                             | 15,987,081                                           |           |                   |            | 22,487,773    |          
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|                                                     |                                                                               |                                               |                                             | Net cash provided by investing activities            |           |                   | 3,578,921  |               |           |           | 12,581,413 |  
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|Cash flows from financing activities:                |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|                                                     | Payment on working capital line of credit                                     |                                               |                                             |                                                     |           |                   |            | (3,000,000    | )        
|                                                     | Proceeds from sale of investment in sales-type leases                         |                                               |                                             | 265,730                                              |           |                   |            | 715,637       |          
|                                                     | Principal payments on debt related to investment in sales-type
leases         |                                               |                                             | (737,770                                             | )         |                   |            | (728,843      | )        
|                                                     | Proceeds from issuance of common stock                                        |                                               |                                             | 155,268                                              |           |                   |            | 3,841,969     |          
|                                                     | Payments received on notes receivable from employees
and directors            |                                               |                                             | 153,644                                              |           |                   |            | 64,728        |          
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|                                                     |                                                                               |                                               |                                             | Net cash (used for) provided by financing activities |           |                   | (163,128   | )             |           |           | 893,491    |  
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|Net (decrease) increase in cash and cash equivalents |                                                                               |                                               | (1,469,853                                  | )                                                    |           |                   | 10,862,444 |              
|Cash and cash equivalents, beginning of period       |                                                                               |                                               | 11,542,833                                  |                                                      |           |                   | 14,325,348 |              
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|Cash and cash equivalents, end of period             |                                                                               | $                                             | 10,072,980                                  |                                                      |           | $                 | 25,187,792 |              
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|Supplemental disclosure of cash flow information:    |                                                                               |                                               |                                             |                                                      |           |                   |            |              
|                                                     | Interest paid                                                                 |                                               | $                                           | 153,759                                              |           |                   | $          | 185,385       |          
|                                                     |                                                                               |                                               |                                             |                                                      |           |                   |            |              

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

3



---



##### Table of Contents






ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(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 consolidated financial statements and notes included herein
should be read in conjunction with the audited consolidated financial
statements for the year ended December 31, 2002 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 all wholly-owned subsidiaries. All material intercompany
accounts and transactions have been eliminated.

Foreign Currency Translation

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, U.S. Treasury bills, high-grade commercial paper 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 September 27,
2003 and December 31, 2002. The marketable securities are reported at fair
value, with any unrealized gains and losses excluded from earnings and
reported as a separate component of stockholders equity as other
comprehensive income (loss).

Revenue Recognition

The Company recognizes revenue from equipment sales, disposable product
sales and sales-type leases at the time of product shipment when
collectibility is reasonably assured. Payments received prior to shipment
are recorded as deferred revenue. The Company has entered into certain
licensing and distribution agreements for which payments received in advance
are recorded as deferred revenue. Revenue under these agreements is
recognized as earned per the terms of the respective agreements. The Company
does not record a provision for estimated sales returns because historically
the Company has experienced only minimal returns that were not covered by
warranty reserves. All shipping and handling costs are included in cost of
revenue.

4



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

In connection with the Stock Purchase Agreement with Boston Scientific
Corporation (BSC) discussed in Note 9, the Company recorded approximately
$6,300,000 of deferred revenue. The deferred revenue is being recognized
ratably over the term of the OEM product development and distribution
agreement with BSC. The term of this agreement continues until such time
that BSC is no longer distributing the Companys products, but in no event
will extend beyond December 31, 2012.

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.

Accounts Receivable

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 the
Companys credit policies. The Company continually monitors collections and
payments from its customers.

Inventory

The Company values inventory at the lower of cost or estimated market,
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 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 will 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 its costs of
revenue at the time of the determination.

Investment in Sales-Type Leases

The
Company follows SFAS No. 13, Accounting For Leases, for its
investment in sales-type leases. 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 net investment in sales-type leases. The cost of the
BIS monitor acquired by the customer is recorded as costs of revenue in the
same period.

In addition, the Company periodically reviews and assesses the net
realizability of its investment in sales-type leases. This review includes
determining if a customer who entered into a sales-type lease is
significantly underperforming relative to the customers committed level of
BIS Sensor purchases. If this review results in a lower estimate of the net
realizable investment balance, an allowance for the unrealized amount is
established in the period in which the estimate is changed and is charged to
revenue.

5



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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 and nine
months ended September 27, 2003, and accrued warranty cost, included in
accrued liabilities in the consolidated balance sheet at September 27, 2003,
was as follows:

|                     |  |                    |         |                   |  |               |           |               |  |   |          |   |  |   |           |  
|-------------------- |  | ------------------ | ------- | ----------------- |  | ------------- | --------- | ------------- |  | - | -------- | - |  | - | --------- | -
|                     |  | Three Months Ended |         | Nine Months Ended
|                     |  |                    |         |                  
|                     |  | September 27,      |         | September 28,     |  | September 27, |           | September 28,
|                     |  | 2003               |         | 2002              |  | 2003          |           | 2002         
|                     |  |                    |         |                   |  |               |           |              
|Beginning balance    |  | $                  | 162,516 |                   |  | $             | 1,141,795 |               |  | $ | 367,798  |   |  | $ | 1,090,120 |  
|Warranty expense     |  |                    | 6,479   |                   |  |               | (586,226  | )             |  |   | (169,026 | ) |  |   | (446,800  | )
|Deductions and other |  |                    | (23,638 | )                 |  |               | (20,918   | )             |  |   | (53,415  | ) |  |   | (108,669  | )
|                     |  |                    |         |                   |  |               |           |               |  |   |          |   |  |   |           |  
|Ending balance       |  | $                  | 145,357 |                   |  | $             | 534,651   |               |  | $ | 145,357  |   |  | $ | 534,651   |  
|                     |  |                    |         |                   |  |               |           |               |  |   |          |   |  |   |           |  

Guarantees

The Company guarantees operating lease obligations of its subsidiaries
for the lease of office space and automobiles. The maximum potential future
payment under these financial guarantees was approximately $139,000 at
September 27, 2003.

Advertising Costs

Advertising costs are expensed as incurred. These costs are included in
sales and marketing expense in the consolidated statements of operations.

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 on a straight-line
basis 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.

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 and Single or Limited Source Suppliers

Financial instruments that potentially expose the Company to
concentrations of credit risk primarily consist of cash, cash equivalents,
accounts receivable, investment in sales-type lease receivables and
marketable securities. 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 in marketable securities
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.

6



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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. There can be no assurance that the Company will not experience similar
shortages or 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.

Net Loss Per Share

In
accordance with SFAS No. 128, Earnings Per Share, basic and diluted
net loss per share amounts for the three and nine months ended September 27,
2003 and September 28, 2002, were computed by dividing the net loss available
to common stockholders by the weighted average number of shares of common
stock outstanding during those periods.

All shares of restricted common stock, stock options and warrants have
been excluded from the calculation of diluted net loss per share since the
inclusion of such amounts would be antidilutive.

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 loss, the
only other element of comprehensive income (loss) impacting the Company is
the unrealized gains (losses) on its marketable securities 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 under APB
Opinion No. 25 and follows the disclosure-only alternative under SFAS No.
123. The Company has computed the weighted-average fair value of options
granted in the three and nine months ended September 27, 2003 and September
28, 2002 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 Ended |         | Nine Months Ended
|                                                      |  |                    |         |                  
|                                                      |  | September 27,      |         | September 28,     |  | September 27, |         | September 28,
|                                                      |  | 2003               |         | 2002              |  | 2003          |         | 2002         
|                                                      |  |                    |         |                   |  |               |         |              
|Risk-free interest rate                               |  |                    | 1.88    | %                 |  |               | 4.40    | %             |  |   | 3.83    | % |  |   | 4.40    | %
|Expected dividend yield                               |  |                    |        |                   |  |               |        |               |  |   |        |   |  |   |        |  
|Expected life of options                              |  |                    | 5 years |                   |  |               | 5 years |               |  |   | 5 years |   |  |   | 5 years |  
|Expected volatility                                   |  |                    | 75      | %                 |  |               | 75      | %             |  |   | 75      | % |  |   | 75      | %
|Weighted average fair
market value of options
granted |  | $                  | 6.28    |                   |  | $             | 3.01    |               |  | $ | 3.28    |   |  | $ | 6.27    |  

7



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

If the Company had recognized compensation cost for these awards
consistent with SFAS No. 123, the Companys net loss and pro forma net loss
per common share would have been increased to the following pro forma
amounts:

|                    |                      |                                                                                                  |   |                    |            |                   |   |               |            |               |   |             |            |   |   |             |            |  
|------------------- | -------------------- | ------------------------------------------------------------------------------------------------ | - | ------------------ | ---------- | ----------------- | - | ------------- | ---------- | ------------- | - | ----------- | ---------- | - | - | ----------- | ---------- | -
|                    |                      |                                                                                                  |   | Three Months Ended |            | Nine Months Ended
|                    |                      |                                                                                                  |   |                    |            |                  
|                    |                      |                                                                                                  |   | September 27,      |            | September 28,     |   | September 27, |            | September 28,
|                    |                      |                                                                                                  |   | 2003               |            | 2002              |   | 2003          |            | 2002         
|                    |                      |                                                                                                  |   |                    |            |                   |   |               |            |              
|Net loss:           |                      |                                                                                                  |   |                    |            |                   |   |               |            |               |   |             |            |   |   |            
|                    | Net loss as reported |                                                                                                  | $ | (1,386,853         | )          |                   | $ | (3,406,117    | )          |               | $ | (5,705,726  | )          |   | $ | (11,767,473 | )         
|                    |                      | Add: stock-based
compensation
expense included
in reported net
loss                              |   |                    | 13,209     |                   |   |               | 9,429      |               |   |             | 26,746     |   |   |             | 31,441     |  
|                    |                      | Deduct: stock-based
compensation
expense
determined under
fair value based
method for all
awards |   |                    | (1,818,312 | )                 |   |               | (1,955,087 | )             |   |             | (5,608,715 | ) |   |             | (5,941,299 | )
|                    |                      |                                                                                                  |   |                    |            |                   |   |               |            |               |   |             |            |   |   |             |           
|                    | Pro forma net loss   |                                                                                                  | $ | (3,191,956         | )          |                   | $ | (5,351,775    | )          |               | $ | (11,287,695 | )          |   | $ | (17,677,331 | )         
|                    |                      |                                                                                                  |   |                    |            |                   |   |               |            |               |   |             |            |   |   |            
|Net loss per share: |                      |                                                                                                  |   |                    |            |                   |   |               |            |               |   |             |            |   |   |            
|                    |                      | Basic and diluted
net loss per
common share:                                                     |   |                    |            |                   |   |               |            |               |   |             |            |   |   |             |            |  
|                    |                      | As reported                                                                                      |   | $                  | (0.07      | )                 |   | $             | (0.18      | )             |   | $           | (0.29      | ) |   | $           | (0.65      | )
|                    |                      | Pro forma                                                                                        |   | $                  | (0.16      | )                 |   | $             | (0.29      | )             |   | $           | (0.58      | ) |   | $           | (0.98      | )

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, option-pricing models require 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
stock options vest over several years and the Company expects to grant stock
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 accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of 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, marketable securities, accounts receivable,
investment in sales-type leases, accounts payable and long-term debt,
approximate their carrying values.

Reclassifications

Certain amounts in the prior years financial statements have been
reclassified to conform with the current-year presentation.

8



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Recent Accounting Pronouncements

In November 2002, the Financial Accounting Standards Board (FASB) issued
Financial Interpretation No. 45 (FIN 45), Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others. FIN 45 requires a guarantor to disclose (a) the nature
of the guarantee, and the events or circumstances that would require the
guarantor to perform under the guarantee; (b) the maximum potential amount of
future payments under the guarantee; (c) the carrying amount of the liability,
if any, for the guarantors obligations under the guarantee; and (d) the nature
and extent of any recourse provisions or available collateral that would enable
the guarantor to recover the amounts paid under the guarantee. FIN 45 also
clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability at fair value for the obligations it has undertaken in
issuing the guarantee, including its ongoing obligation to stand ready to
perform over the term of the guarantee in the event that the specified
triggering events or conditions occur. The initial recognition and initial
measurement provisions of FIN 45 are applicable on a prospective basis to
guarantees issued or modified after December 31, 2002. FIN 45 also addresses
the disclosure requirements regarding product warranties. Instead of
disclosing the maximum potential amount of future payments under the product
warranty guarantee, a guarantor is required to disclose its accounting policy
and methodology used in determining its liability for product warranties, as
well as a tabular reconciliation of the changes in the guarantors product
warranty liability for the reporting period. The Company adopted FIN 45 as of
January 1, 2003. The adoption of FIN 45 did not have a material effect on the
Companys results of operations, cash flows or financial position.

In January 2003, the FASB issued FIN 46, Consolidation of Variable
Interest Entities.FIN 46 requires that if an entity has a controlling
financial interest in a variable interest entity, the assets, liabilities and
results of activities of the variable interest entity should be included in the
consolidated financial statements of the entity. FIN 46 is effective
immediately for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first
interim or annual period ending after December 15, 2003. The adoption of FIN
46 did not have a material effect on the Companys results of operations, cash
flows or financial position.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity.
SFAS No. 150 establishes standards for how an issuer classifies and measures in
its statement of financial position certain financial instruments with
characteristics of both liabilities and equity. SFAS No. 150 requires that an
issuer classify a financial instrument that is within its scope as a liability
(or an asset in some circumstances) because that financial instrument embodies
an obligation of the issuer. This statement is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. The Company adopted SFAS No. 150 as of July 1, 2003. The adoption of
SFAS No. 150 did not have a material effect on the Companys results of
operations, cash flows or financial position.

9



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)



|(3) |  | Comprehensive Income (Loss)
|--- |  | ---------------------------

The Companys total comprehensive income (loss) is as follows:

|                                   |                                          |   |                    |         |                   |   |               |        |               |   |            |         |   |   |             |         |  
|---------------------------------- | ---------------------------------------- | - | ------------------ | ------- | ----------------- | - | ------------- | ------ | ------------- | - | ---------- | ------- | - | - | ----------- | ------- | -
|                                   |                                          |   | Three Months Ended |         | Nine Months Ended
|                                   |                                          |   |                    |         |                  
|                                   |                                          |   | September 27,      |         | September 28,     |   | September 27, |        | September 28,
|                                   |                                          |   | 2003               |         | 2002              |   | 2003          |        | 2002         
|                                   |                                          |   |                    |         |                   |   |               |        |              
|                                   |                                          |   | (Unaudited)        |         | (Unaudited)       |   | (Unaudited)   |        | (Unaudited)  
|Net loss                           |                                          | $ | (1,386,853         | )       |                   | $ | (3,406,117    | )      |               | $ | (5,705,726 | )       |   | $ | (11,767,473 | )      
|Other comprehensive income (loss): |                                          |   |                    |         |                   |   |               |        |               |   |            |         |   |   |             |        
|                                   | Unrealized loss on marketable
securities |   |                    | (19,001 | )                 |   |               | (8,093 | )             |   |            | (18,168 | ) |   |             | (39,613 | )
|                                   |                                          |   |                    |         |                   |   |               |        |               |   |            |         |   |   |             |        
|Comprehensive loss                 |                                          | $ | (1,405,854         | )       |                   | $ | (3,414,210    | )      |               | $ | (5,723,894 | )       |   | $ | (11,807,086 | )      
|                                   |                                          |   |                    |         |                   |   |               |        |               |   |            |         |   |   |             |        



|(4) |  | Investment in Sales-Type Leases
|--- |  | -------------------------------

The components of the Companys net investment in sales-type leases are
as follows:

|                                        |                          |   |               |           |              |   |           |           | 
|--------------------------------------- | ------------------------ | - | ------------- | --------- | ------------ | - | --------- | --------- | 
|                                        |                          |   | September 27, |           | December 31,
|                                        |                          |   | 2003          |           | 2002        
|                                        |                          |   |               |           |             
|                                        |                          |   | (Unaudited)   |           |              |   |          
|Total minimum lease payments receivable |                          | $ | 5,213,068     |           |              | $ | 5,091,303 |          
|                                        | Less  unearned interest |   |               | 944,433   |              |   |           | 949,315   | 
|                                        |                          |   |               |           |              |   |           |          
|Net investment in sales-type leases     |                          |   | 4,268,635     |           |              |   | 4,141,988 |          
|                                        | Less  current portion   |   |               | 1,818,118 |              |   |           | 1,859,237 | 
|                                        |                          |   |               |           |              |   |           |          
|                                        |                          | $ | 2,450,517     |           |              | $ | 2,282,751 |          
|                                        |                          |   |               |           |              |   |           |          



|(5) |  | Inventory
|--- |  | ---------

Inventory consists of the following:

|                 |  |               |           |              |  |   |           | 
|---------------- |  | ------------- | --------- | ------------ |  | - | --------- | 
|                 |  | September 27, |           | December 31,
|                 |  | 2003          |           | 2002        
|                 |  |               |           |             
|                 |  | (Unaudited)   |           |              |  |  
|Raw materials    |  | $             | 787,683   |              |  | $ | 1,060,709 | 
|Work-in-progress |  |               | 99,829    |              |  |   | 129,673   | 
|Finished goods   |  |               | 746,952   |              |  |   | 1,143,003 | 
|                 |  |               |           |              |  |   |           | 
|                 |  | $             | 1,634,464 |              |  | $ | 2,333,385 | 
|                 |  |               |           |              |  |   |           | 

10



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)



|(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
export sales by region and sales by product, for management purposes.
Substantially all of the Companys assets are located within the United
States. All of the Companys products are manufactured in the United States.

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

|                               |               |   |                    |           |                   |   |               |           |               |   |            |            |  |   |            |            | 
|------------------------------ | ------------- | - | ------------------ | --------- | ----------------- | - | ------------- | --------- | ------------- | - | ---------- | ---------- |  | - | ---------- | ---------- | 
|                               |               |   | Three Months Ended |           | Nine Months Ended
|                               |               |   |                    |           |                  
|                               |               |   | September 27,      |           | September 28,     |   | September 27, |           | September 28,
|                               |               |   | 2003               |           | 2002              |   | 2003          |           | 2002         
|                               |               |   |                    |           |                   |   |               |           |              
|                               |               |   | (Unaudited)        |           | (Unaudited)       |   | (Unaudited)   |           | (Unaudited)  
|Geographic area by destination |               |   |                    |           |                   |   |               |           |               |   |            |            |  |   |            |           
|                               | Domestic      |   | $                  | 9,219,658 |                   |   | $             | 8,324,774 |               |   | $          | 25,838,196 |  |   | $          | 24,695,207 | 
|                               | International |   |                    | 1,969,413 |                   |   |               | 1,670,439 |               |   |            | 6,187,009  |  |   |            | 5,037,795  | 
|                               |               |   |                    |           |                   |   |               |           |               |   |            |            |  |   |            |            | 
|                               |               | $ | 11,189,071         |           |                   | $ | 9,995,213     |           |               | $ | 32,025,205 |            |  | $ | 29,733,002 |           
|                               |               |   |                    |           |                   |   |               |           |               |   |            |            |  |   |            |           

|                               |               |  |                    |    |                   |  |               |    |               |  |     |    |   |  |     |    |  
|------------------------------ | ------------- |  | ------------------ | -- | ----------------- |  | ------------- | -- | ------------- |  | --- | -- | - |  | --- | -- | -
|                               |               |  | Three Months Ended |    | Nine Months Ended
|                               |               |  |                    |    |                  
|                               |               |  | September 27,      |    | September 28,     |  | September 27, |    | September 28,
|                               |               |  | 2003               |    | 2002              |  | 2003          |    | 2002         
|                               |               |  |                    |    |                   |  |               |    |              
|                               |               |  | (Unaudited)        |    | (Unaudited)       |  | (Unaudited)   |    | (Unaudited)  
|Geographic area by destination |               |  |                    |    |                   |  |               |    |               |  |     |    |   |  |     |   
|                               | Domestic      |  |                    | 82 | %                 |  |               | 83 | %             |  |     | 81 | % |  |     | 83 | %
|                               | International |  |                    | 18 |                   |  |               | 17 |               |  |     | 19 |   |  |     | 17 |  
|                               |               |  |                    |    |                   |  |               |    |               |  |     |    |   |  |     |    |  
|                               |               |  | 100                | %  |                   |  | 100           | %  |               |  | 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 and nine months ended September 27, 2003 and September
28, 2002.



|(7) |  | Related Party Transactions
|--- |  | --------------------------

Through April 30, 2002, the Company loaned, on a full recourse basis, an
aggregate of $1,441,000, to an officer, certain employees and a consultant of
the Company. In May 2002, the Company loaned, on a full recourse basis,
$50,000 to another officer of the Company, which together with accrued
interest, was paid in full in March 2003, after that officer left the employ
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 assets
of the borrower, including shares of the Companys common stock owned by the
borrower. The long-term portion of the loans is included in long-term notes
receivable from related parties, and the short-term portion of approximately
$288,000 and $128,000 at September 27, 2003 and December 31, 2002,
respectively, is included in other current assets in the accompanying
consolidated balance sheets. The aggregate outstanding balance on these
loans at September 27, 2003 and December 31, 2002 was approximately
$1,038,000 and $1,160,000, respectively.

In January 2002, the Company entered into a consulting agreement with
one of its directors to provide consulting, advisory and neurodiagnostics
business planning services to the Company. Effective April 11,
2003, this director resigned from the Companys Board of Directors. As
of September 27, 2003, the Company has paid approximately $9,000 to this
former director under this consulting agreement.

11



---



##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(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 2004 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 September 27,
2003, the Company had outstanding standby letters of credit totaling
$190,137.

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 an amount equal to
102% of the $5,000,000 commitment, or $5,100,000. At September 27, 2003,
there was no outstanding balance under the revolving line of credit. In
addition, the Company was in compliance with all covenants contained in the
revolving line of credit agreement as of September 27, 2003. At September
27, 2003, the interest rate on the revolving line of credit was 4.00%.

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. 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. Gross cash proceeds from
this sale of common stock were $10,000,004. Approximately $5,685,000 of the
aggregate purchase price is recorded as deferred revenue in the accompanying
consolidated balance sheet at September 27, 2003, which represents the
portion of the purchase price in excess of the closing price of the Companys
common stock on August 7, 2002. The deferred revenue will be recognized
ratably over the term of the OEM agreement. Approximately $154,000 was
recognized as revenue in the three months ended September 27, 2003 and
approximately $461,000 was recognized as revenue in the nine months ended
September 27, 2003. 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, 2012.

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 September 27, 2003, 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.

12



---



##### Table of Contents






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

This Quarterly Report on Form 10-Q contains, in addition to historical
information, forward-looking statements within the meaning of Section 21E of
the Securities Exchange Act of 1934. 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. In addition,
subsequent events and developments may cause our expectations to change. While
we may elect to update these forward-looking statements, we specifically
disclaim any obligation to do so, even if our expectations change. See the
important factors in the cautionary statements below under the heading Factors
Affecting Future Operating Results that we believe could cause our actual
results to differ materially from the forward-looking statements we make.

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, or our BIS
Module Kit, which allows original equipment manufacturers to incorporate the
BIS index into their monitoring products, and our single-use disposable BIS
Sensors. We collectively refer to our group of disposable sensors as BIS
Sensors.

Our latest generation 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. 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.

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

We derive our revenue primarily from sales of monitors, BIS Module Kits,
and related accessories, which we collectively refer to as Equipment, and sales
of BIS Sensors. In the three months ended September 27, 2003 and September 28,
2002, revenue from the sale of Equipment represented approximately 33% and 31%,
respectively, of our revenue, and revenue from the sale of BIS Sensors
represented approximately 67% and 69%, respectively, of our revenue. In the
nine months ended September 27, 2003 and September 28, 2002, revenue from the
sale of Equipment represented approximately 32% and 34%, respectively, of our
revenue, and revenue from the sale of BIS Sensors represented approximately 68%
and 66%, respectively of our revenue.

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 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 has been the primary reason for the growth in revenue from the sale
of BIS Sensors. In order to successfully grow our business, we need to
continue to focus on both selling our Equipment and improving our per monitor
and per module 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 should contribute an increasing
percentage of total revenue. Additionally, we believe that over time, revenue
from the sale of BIS Module Kits 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.

For those healthcare organizations desiring to purchase our BIS monitors,
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 this agreement, our
customers purchase BIS Sensors and the BIS monitor for the purchase price of
the BIS Sensors plus an additional charge per BIS Sensor to pay for the
purchase price of the BIS monitor and related financing costs over the term of
the agreement. These customers are granted an option to purchase the BIS
monitors at the end of the term of the agreement, which is typically three to
five years. Revenue related to BIS monitors sold pursuant to sales-type leases
is recognized at the time of shipment of the BIS monitors. Sales-type leases
accounted for approximately 3% and 4% of total revenue in both the three and
nine month periods ended September 27, 2003 and September 28, 2002,
respectively.

13



---



##### Table of Contents



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.
Beginning in 2002, we substantially reduced our focus and reliance on the EP
program.

Revenue from domestic sales in the three months ended September 27, 2003
and September 28, 2002 was approximately $9.2 million and $8.3 million,
respectively, which represented approximately 82% and 83%, respectively, of our
revenue for those periods. For the nine months ended September 27, 2003 and
September 28, 2002, revenue from domestic sales was approximately $25.8 million
and $24.7 million, respectively, which represented approximately 81% and 83%,
respectively, of our revenue for those periods. Revenue from international
sales in the three months ended September 27, 2003 and September 28, 2002 was
approximately $2.0 million and $1.7 million, respectively, which represented
approximately 18% and 17%, respectively, of our revenue for those periods.
Revenue from international sales in the nine months ended September 27, 2003
and September 28, 2002 was approximately $6.2 million and $5.0 million,
respectively, which represented approximately 19% and 17%, respectively, of our
revenue for those periods.

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. In March 2000, Nihon Kohden
received approval from the Japanese Ministry of Health, Labor and Welfare for
marketing in Japan our A-1050 EEG Monitor with BIS and in May 2001, received
approval for marketing in Japan 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 12% and
13%, respectively, of international revenue for the three and nine months ended
September 27, 2003 and approximately 16% and 25%, respectively of international
revenue for the three and nine months ended September 28, 2002.

We believe that maintaining our gross margin and controlling the growth of
our operating expenses are important factors for us to manage in order to
successfully grow our business and achieve profitability. To maintain our
gross margin we believe we must continue to focus on maintaining our average
unit prices for both monitors and BIS Sensors, increase revenue from the sale
of BIS Sensors as a percentage of total revenue, as BIS Sensors have a higher
gross margin than Equipment, and continue to reduce the costs to manufacture
our products.

In addition, the transition from monitor placements to module placements
has adversely impacted our gross margin on Equipment. However, we believe that
this transition should, over time, improve our total gross margin as we expect
module placements to be a contributing factor to increasing revenue from the
sale of our BIS Sensors.

In the fourth quarter of 2002, we reduced our headcount. We believe this
headcount reduction, in combination with other cost reductions implemented in
2002 and our continuing focus on cost control in 2003, should drive us closer
to our goal of achieving profitability.

Various factors may adversely affect our quarterly operating results
through the fourth quarter of 2003. These factors include a potentially
adverse effect on Equipment revenue and gross margin on Equipment as we
continue to shift the focus of our placements from BIS monitors to BIS modules.
In addition, in Japan, Nihon Kohden is awaiting approval of the BIS XP system,
and we believe customers may continue to delay purchases of our products or may
choose not to purchase our products pending this approval. Finally, on
November 1, 2003, our international master distribution agreement with
Datex-Ohmeda expired. We plan to replace this agreement with country-specific
distribution agreements with Datex-Ohmeda sales subsidiaries and other
distributors. A delay in signing these country-specific distribution
agreements may adversely affect Equipment revenue in the international market.
To date, we have entered into several new country-specific distribution
agreements, and we continue to negotiate others.

14



---



##### Table of Contents



Critical Accounting Policies

Financial Reporting Release No. 60, which was released by the Securities
and Exchange Commission, or SEC, in December 2001, proposes a rule that
requires all companies to include a discussion of critical accounting policies
or methods used in the preparation of financial statements. Note 2 of the
Notes to Consolidated Financial Statements 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 great likelihood that materially
different amounts would be reported under different conditions or using
different assumptions. We believe that our critical accounting policies are as
follows:

Revenue Recognition

Our revenue is recognized in accordance with SEC Staff Accounting
Bulletin, or SAB, No. 101, Revenue Recognition in Financial
Statements, which
provides guidance related to revenue recognition in financial statements. We
recognize revenue from Equipment sales, disposable product sales and sales-type
leases at the time of product shipment when collectibility is reasonably
assured. Payments received prior to shipment are recorded as deferred revenue.
We have entered into certain licensing and distribution agreements for which
payments received in advance are also recorded as deferred revenue. Revenue
under these agreements is recognized as earned in accordance with the terms of
the respective agreements.

We do not record a provision for estimated sales returns because
historically we have experienced only minimal returns that were not covered by
warranty reserves. To the extent returns increase in future periods, we would
be required to re-evaluate our revenue recognition policy in accordance with
Statement of Financial Accounting Standards, or SFAS, No. 48, Revenue
Recognition When Right of Return Exists.

Accounts Receivable

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, 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 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 will need to change our
estimate of the provision required for excess and obsolete inventory. If
revisions are deemed necessary, we would recognize the adjustments in our costs
of revenue at the time of the determination. Therefore, although we
continually update our forecasts of future product demand, any significant
unanticipated changes in demand or technological developments could have a
significant impact on the value of our inventory and our results of operations
in future periods.

15



---



##### Table of Contents



Investment in Sales-Type Leases

We
follow SFAS No. 13, Accounting For Leases, for our investment in
sales-type leases. 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. 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 net
investment in sales-type leases. The cost of the BIS monitor acquired by the
customer is recorded as costs of revenue in the same period.

In addition, we periodically review and assess the net realizability of
our investment in sales-type leases. This review includes determining if a
customer who entered into a sales-type lease is significantly underperforming
relative to the customers committed level of BIS Sensor purchases. If this
review results in a lower estimate of the net realizable investment balance, an
allowance for the unrealized amount is established in the period in which the
estimate is changed and charged to revenue. Therefore, if in any period where
we determine that a significant number of customers who entered into sales-type
leases are underperforming in their respective commitments, it could have an
impact on our results of operations.

Warranty

Equipment that we sell is generally 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 increased warranty claim
activity or increased costs associated with servicing those claims, our
warranty accrual will increase, and we would experience decreased gross profit
margin.

Results of Operations

The following table presents, for the three and nine month periods ended
September 27, 2003 and September 28, 2002, certain information from our
consolidated statements of operations expressed as a percentage of revenue.
This information has been derived from our consolidated statements of
operations included elsewhere in this Quarterly Report on Form 10-Q. You
should not draw any conclusions about our future results from the results of
operations for any period.

|                     |                            |                          |     |                    |    |                   |     |               |     |               |     |    |    |  |     |    |     | 
|-------------------- | -------------------------- | ------------------------ | --- | ------------------ | -- | ----------------- | --- | ------------- | --- | ------------- | --- | -- | -- |  | --- | -- | --- | 
|                     |                            |                          |     | Three Months Ended |    | Nine Months Ended
|                     |                            |                          |     |                    |    |                  
|                     |                            |                          |     | September 27,      |    | September 28,     |     | September 27, |     | September 28,
|                     |                            |                          |     | 2003               |    | 2002              |     | 2003          |     | 2002         
|                     |                            |                          |     |                    |    |                   |     |               |     |              
|Revenue              |                            |                          | 100 | %                  |    |                   | 100 | %             |     |               | 100 | %  |    |  | 100 | % 
|Costs of revenue     |                            |                          | 25  |                    |    |                   | 28  |               |     |               | 25  |    |    |  | 31  |   
|                     |                            |                          |     |                    |    |                   |     |               |     |               |     |    |    |  |     |   
|Gross profit margin  |                            |                          | 75  |                    |    |                   | 72  |               |     |               | 75  |    |    |  | 69  |   
|Operating expenses:  |                            |                          |     |                    |    |                   |     |               |     |               |     |    |    |  |     |   
|                     | Research and development   |                          |     | 14                 |    |                   |     | 19            |     |               |     | 17 |    |  |     | 20 |    
|                     | Sales and marketing        |                          |     | 56                 |    |                   |     | 70            |     |               |     | 58 |    |  |     | 72 |    
|                     | General and administrative |                          |     | 19                 |    |                   |     | 19            |     |               |     | 20 |    |  |     | 19 |    
|                     |                            |                          |     |                    |    |                   |     |               |     |               |     |    |    |  |     |   
|                     |                            | Total operating expenses |     |                    | 89 |                   |     |               | 108 |               |     |    | 95 |  |     |    | 111 | 
|                     |                            |                          |     |                    |    |                   |     |               |     |               |     |    |    |  |     |   
|Loss from operations |                            |                          | (14 | )                  |    |                   | (36 | )             |     |               | (20 | )  |    |  | (42 | ) 
|Interest income, net |                            |                          | 2   |                    |    |                   | 2   |               |     |               | 2   |    |    |  | 2   |   
|                     |                            |                          |     |                    |    |                   |     |               |     |               |     |    |    |  |     |   
|Net loss             |                            |                          | (12 | )%                 |    |                   | (34 | )%            |     |               | (18 | )% |    |  | (40 | )%
|                     |                            |                          |     |                    |    |                   |     |               |     |               |     |    |    |  |     |   

16



---



##### Table of Contents



Three and Nine Months Ended September 27, 2003 Compared to Three and Nine
Months Ended September 28, 2002

Revenue.Our revenue increased approximately 12% from approximately $11.2
million in the three months ended September 27, 2003 to approximately $10.0
million in the three months ended September 28, 2002. Our revenue increased
approximately 8% to approximately $32.0 million in the nine months ended
September 27, 2003 from approximately $29.7 million in the nine months ended
September 28, 2002.

Revenue from the sale of BIS Sensors increased approximately 9% from
approximately $7.5 million in the three months ended September 27, 2003 to
approximately $6.9 million in the three months ended September 28, 2002. The
increase in revenue from the sale of BIS Sensors in the three months ended
September 27, 2003 compared to the three months ended September 28, 2002 was
attributable to an increase of approximately 7% in the average selling price of
BIS Sensors and an increase of approximately 2% in the number of BIS Sensors
sold as a result of growth in the installed base of monitors and modules.
Revenue from the sale of Equipment increased approximately 18% to approximately
$3.7 million in the three months ended September 27, 2003 from approximately
$3.1 million in the three months ended September 28, 2002. The increase in
Equipment revenue in the three months ended September 27, 2003 compared to the
three months ended September 28, 2002 was primarily driven by an increase of
approximately 166% in module revenue and an increase of approximately 9% in
monitor revenue. The increase in module revenue for this period was a result
of an approximate 152% increase in unit volume, as we shipped 740 modules to
our original equipment manufacturers in the third quarter of 2003 as compared
to 294 modules shipped to our original equipment manufacturers in the third
quarter of 2002. The increase in monitor revenue in the same period was
primarily due to an increase of approximately 8% in the average unit price on
comparable unit volume. In the third quarter of 2003, we shipped 342 monitors
as compared to 339 monitors in the third quarter of 2002. The increase in
module and monitor revenue in the three months ended September 27, 2003
compared to the three months ended September 28, 2002 was partially offset by a
decrease in revenue from the sale of XP upgrade kits and accessories of
approximately 22%. The decrease in revenue from the sale of XP upgrade kits
and accessories was primarily related to a decrease of approximately 24% in
revenue from the sale of XP upgrade kits which resulted from a decrease of
approximately 25% in the average unit price on comparable unit volume.

In the nine months ended September 27, 2003, revenue from the sale of BIS
Sensors increased approximately 10% to approximately $21.7 million from
approximately $19.7 million in the nine months ended September 28, 2002. The
increase in revenue from the sale of BIS Sensors for the nine month period
ended September 27, 2003 compared to the nine month period ended September 28,
2002 resulted primarily from an increase of approximately 5% in the average
selling price of BIS Sensors and an increase of approximately 5% in the number
of BIS Sensors sold. Our installed base of monitors and modules increased
approximately 21% at September 27, 2003 compared to September 28, 2002, to more
than 18,600 units. In the nine months ended September 27, 2003, Equipment
revenue increased approximately 3% to approximately $10.3 million from
approximately $10.0 million in the nine months ended September 28, 2002. In
the nine months ended September 27, 2003 compared to the nine months ended
September 28, 2002, the increase in Equipment revenue was primarily driven by
an increase in module revenue of approximately 133%. The increase in module
revenue in this period was the result of an increase of approximately 113% in
the number of module kits shipped to our original equipment manufacturers, from
827 module kits in the first nine months of 2002 to 1,758 module kits in the
first nine months of 2003. The increase in module revenue in this same period
was partially offset by a decrease in monitor revenue of approximately 19%.
The decrease in monitor revenue in the nine month period resulted from a
decrease of approximately 28% in unit volume, as we shipped 993 monitors in the
nine months ended September 27, 2003 compared to 1,378 monitors in the nine
months ended September 28, 2002. In this same period, domestic monitor sales
decreased from 800 monitors to 575 monitors, a decrease of approximately 28%.
Additionally, because Nihon Kohden is awaiting approval from the Japanese
Ministry of Health, Labor and Welfare of the XP technology, sales of monitor
units in Japan decreased from 200 monitors in the first nine months of 2002 to
none in the first nine months of 2003.

Our gross profit margin was approximately 75% of revenue in both the three
and nine months ended September 27, 2003 compared to a gross profit margin of
approximately 72% and 69% of revenue in the three and nine months ended
September 28, 2002, respectively. The increase in gross profit margin for the
three and nine months ended September 27, 2003 compared to the three and nine
months ended September 28, 2002 was the result of four factors. First, we
experienced increased sales of our BIS Sensors as a percentage of total revenue
during the nine month period ended September 27, 2003 compared to the nine
months ended September 28, 2002. In the three months ended September 27, 2003
compared to the three months ended September 28, 2002, sales of our BIS Sensors
as a percentage of total revenue decreased slightly. However, in both the
three and nine month periods there was an increase in the average unit price of
BIS Sensors. BIS Sensors have a higher gross margin than Equipment. Second,
we had a higher average unit price on monitors in both periods of 2003 compared
to 2002. Third, we have had a reduction in depreciation expense related to
monitors used in the EP program as the existing pool of monitors becomes fully
depreciated and we substantially reduce our focus and reliance on the EP
program. Finally, we recognized approximately $154,000 and $461,000 of
deferred revenue in the three and nine months ended September 27, 2003 related
to the strategic alliance with Boston Scientific Corporation without any
corresponding costs of revenue, increasing the gross profit margin by
approximately 2% in both the three and nine month periods.

17



---



##### Table of Contents



Research and Development.Research and development expenses decreased
approximately 14% to approximately $1.6 million in the three months ended
September 27, 2003 from approximately $1.9 million in the three months ended
September 28, 2002. Research and development expenses decreased approximately
8% to approximately $5.4 million in the nine months ended September 27, 2003
from approximately $5.8 million in the nine months ended September 28, 2002.
The decrease in research and development expenses for the three months ended
September 27, 2003 was primarily attributable to a decrease in clinical studies
expenses of approximately $177,000 as a result of the completion of various
multi-center, multinational studies to assess the incidence of awareness, and a
decrease in payroll expense of approximately $80,000.

The decrease in research and development expenses for the nine months
ended September 27, 2003 was primarily attributable to a decrease in personnel
and related payroll and other expenses of approximately $395,000 and a decrease
in clinical studies expenses of approximately $186,000. These decreases were
offset by increases in consulting expenses of approximately $152,000 and
product development expenses of approximately $104,000. We expect research and
development expenses to increase in the fourth quarter of 2003 compared to the
third quarter of 2003 as we continue to invest in clinical studies and expand
applications for our technology, including our initiatives into neuroscience.

Sales and Marketing.Sales and marketing expenses decreased approximately
10% to approximately $6.3 million in the three months ended September 27, 2003
from approximately $7.0 million in the three months ended September 28, 2002.
Sales and marketing expenses decreased approximately 13% to approximately $18.5
million in the nine months ended September 27, 2003 from approximately $21.3
million in the nine months ended September 28, 2002. The decrease in sales and
marketing expenses in the three months ended September 27, 2003 was
attributable to decreases in travel and entertainment expenses of approximately
$165,000, operating expenses associated with our international subsidiaries of
approximately $214,000 and approximately $288,000 in expenses related to
advertising, public relations, tradeshows and the internet. These decreases
were partially offset by an increase in commissions expense of approximately
$239,000.

The decrease in sales and marketing expenses for the nine months ended
September 27, 2003 was primarily attributable to decreases in payroll expense
of approximately $498,000, operating expenses associated with our international
subsidiaries of approximately $1.0 million, approximately $691,000 in expenses
related to advertising, public relations, tradeshows and the internet, travel
and entertainment expenses of approximately $618,000 and approximately $134,000
in clinical education initiative expenses. These decreases were partially
offset by an increase in commissions expense of approximately $783,000. The
decrease of approximately $1.0 million in operating expenses associated with
our international subsidiaries was driven by a decrease of approximately
$644,000 in personnel related payroll and other expenses. We expect sales and
marketing expenses in the fourth quarter of 2003 to decrease compared to the
third quarter of 2003 as a result of cost reductions in various programs and
improved control over discretionary spending.

General and Administrative.General and administrative expenses increased
approximately 6% to approximately $2.1 million in the three months ended
September 27, 2003 from approximately $2.0 million in the three months ended
September 28, 2002. General and administrative expenses increased
approximately 11% to approximately $6.4 million in the nine months ended
September 27, 2003 from approximately $5.7 million in the nine months ended
September 28, 2002. The increase in general and administrative expenses for
the three months ended September 27, 2003 was primarily attributable to an
increase in personnel related payroll and other expenses of approximately
$284,000. This increase was partially offset by a decrease of approximately
$50,000 in our provision for doubtful accounts. In the nine months ended
September 27, 2003, the increase in general and administrative expenses was due
to an increase in personnel and related payroll and other expenses of
approximately $752,000, which includes an accrual of approximately $367,000 related to the
special bonus program for our chief executive officer, and an increase of
approximately $98,000 primarily as a result of an increase in the annual
premium for our directors and officers liability insurance coverage. These
increases were offset by a decrease of approximately $150,000 in our provision
for doubtful accounts due to improvements in our historical collection
experience. We expect general and administrative expenses in the fourth
quarter of 2003 to remain comparable to the third quarter of 2003.

18



---



##### Table of Contents



Interest Income, Net.Net interest income decreased approximately 27% to
approximately $167,000 in the three months ended September 27, 2003 from
approximately $229,000 in the three months ended September 28, 2002. Net
interest income decreased approximately 25% to approximately $546,000 in the
nine months ended September 27, 2003 from approximately $732,000 in the nine
months ended September 28, 2002. Interest income decreased approximately 26%
to approximately $215,000 in the three months ended September 27, 2003 from
approximately $290,000 in the three months ended September 28 2002. Interest
income decreased approximately 24% to approximately $702,000 in the nine months
ended September 27, 2003 from approximately $918,000 in the nine months ended
September 28, 2002. The decrease in interest income was primarily attributable
to lower cash and investment balances resulting from continued operating losses
and our other uses of cash, and lower interest rates on our investments as a
result of general interest rate declines.

Interest expense decreased approximately 20% to approximately $48,000 in
the three months ended September 27, 2003 from approximately $60,000 in the
three months ended September 28, 2002. Interest expense decreased
approximately 16% to approximately $156,000 in the nine months ended September
27, 2003 from approximately $186,000 in the nine months ended September 28,
2002. The decrease in interest expense in the three and nine months ended
September 27, 2003 was a result of lower average outstanding debt obligations
because we did not draw down on our lines of credit for the three and nine
months ended September 27, 2003. We expect net interest income to decrease
slightly in the fourth quarter of 2003 as compared to the third quarter of 2003
as a result of continuing low interest rates and a lower cash and investments
balance.

Net Loss.As a result of the factors discussed above, for the three and
nine months ended September 27, 2003, we had a net loss of approximately $1.4
million and $5.7 million, respectively, as compared to a net loss of
approximately $3.4 million and $11.8 million for the three and nine months
ended September 28, 2002.

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 our
convertible preferred stock. Through September 27, 2003, we raised
approximately $77.6 million from private equity financings and have received
approximately $3.4 million in equipment financing and approximately $5.1
million of financing related to our investments in sales-type leases. We also
received approximately $2.8 million of financing under a term loan in December
1999. The outstanding principal on the equipment and term loans was paid in
May 2001. In February 2000, we closed our initial public offering of an
aggregate of 4,025,000 shares of common stock and received net proceeds of
approximately $54.6 million. In May 2001, we entered into an agreement with
Fleet National Bank for a $5.0 million revolving line of credit which expires
in May 2004. The revolving line of credit agreement contains restrictive
covenants that require us to maintain liquidity and net worth ratios and is
secured by certain of our investments which are shown as restricted cash on our
consolidated balance sheet. We are required to maintain restricted cash and
securities with a net equity value equal to 102% of the $5.0 million
commitment.

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 pursuant
to a stock purchase agreement. Gross cash proceeds from this sale of common
stock were $10,000,004.

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 under the revolving line of credit which 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 September 27, 2003, there was no outstanding balance under this revolving
line of credit.

We expect to meet our short-term liquidity needs through the use of cash
and short-term investments on hand at September 27, 2003.

19



---



##### Table of Contents



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
the end of 2004. 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.

Working capital at September 27, 2003 was approximately $31.6 million
compared to approximately $36.7 million at December 31, 2002. The decrease in
working capital from December 31, 2002 to September 27, 2003 was primarily
attributable to our continued net loss of approximately $5.7 million.

We used approximately $4.9 million of cash for operations in the nine
months ended September 27, 2003 as compared to approximately $8.9 million,
excluding an increase in deferred revenue of approximately $6.3 million related
to proceeds received in connection with the strategic alliance entered into in
August 2002, in the nine months ended September 28, 2002. The $6.3 million of
deferred revenue represents the portion of the purchase price of the shares of
our common stock in excess of the closing price of our common stock on the date
of the sale. Cash used for operations in the nine months ended September 27,
2003 was primarily driven by operating losses, an increase in accounts
receivable of approximately $505,000, an increase in other assets of
approximately $222,000 and a decrease in deferred revenue of approximately
$698,000, offset by a decrease in inventory of approximately $699,000. In the
nine months ended September 28, 2002 cash used for operations was primarily
driven by operating losses offset by a decrease in inventory of approximately
$2.3 million.

We received approximately $3.6 million of cash from investing activities
in the nine months ended September 27, 2003 as compared to approximately $12.6
million in the nine months ended September 28, 2002. The cash received from
investing activities in the nine months ended September 27, 2003 was primarily
the result of the sales and maturities of our investments in marketable
securities. We received approximately $4.0 million, net, of proceeds from
sales and maturities of marketable securities and invested approximately
$492,000 primarily in our information systems in the nine
months ended September 27, 2003. In the nine months ended September 28, 2002,
we received approximately $13.4 million, net, of proceeds from sales and
maturities of marketable securities and invested approximately $855,000
primarily in information systems and machinery and equipment.

We used approximately $163,000 of cash for financing activities in the
nine months ended September 27, 2003 primarily as a result of payments of
principal on debt related to our investment in sales-type leases of
approximately $738,000 offset by proceeds from the sale of our investment in
sales-type leases of approximately $266,000, payments received on notes
receivable from employees and directors of approximately $154,000 and the
issuance of shares of our common stock upon the exercise of stock options and
for purchases under our employee stock purchase plan of approximately $155,000.
In the nine months ended September 28, 2002, we received approximately
$893,000 of cash from financing activities primarily as a result of proceeds
from the issuance of shares of our common stock in connection with a strategic
alliance entered into in August 2002 of approximately $3.8 million and
approximately $716,000 in proceeds from the sale of our investment in
sales-type leases. These were offset by payment on our working capital line of
credit of approximately $3.0 million and approximately $729,000 of payments of
principal on debt related to our investment in sales-type leases.

In May 2001, we entered into an agreement with Fleet National Bank for a
revolving line of credit, which provides for borrowing of up to $5.0 million.
The revolving line of credit expires in May 2004 and, subject to annual review
by the bank, may be extended at the discretion of Fleet National Bank.
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 September 27, 2003,
the interest rate on the line of credit was 4.00%. The revolving line of
credit agreement contains restrictive covenants that require us to maintain
liquidity and net worth ratios and is secured by certain of our investments
which are shown as restricted cash on our consolidated balance sheet. We are
required to maintain restricted cash and securities with a net equity value
equal to 102% of the $5.0 million commitment. Up to $1.5 million of the $5.0
million revolving line of credit is available for standby letters of credit.
There was no outstanding balance under the line of credit at September 27,
2003. At September 27, 2003, we had standby letters of credit outstanding in
the amount of $190,137.

We guarantee approximately $139,000 of operating lease obligations of our
subsidiaries for the lease of office space and automobiles.

20



---



##### Table of Contents



In July 1999, we entered into an agreement under which we can sell a
portion of our existing and future investments in sales-type leases to
Americorp Financial, Inc. Through September 27, 2003, we sold approximately
$5.1 million of our investments 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 investments in sales-type leases. At September 27, 2003,
approximately $1.4 million is recorded as debt on our consolidated balance
sheet.

We had capital expenditures of approximately $492,000 for the nine months
ended September 27, 2003, primarily related to our information systems. At
September 27, 2003, we did not have any commitments for capital expenditures.
We anticipate that the level of capital expenditures in the fourth quarter of
2003 will be slightly higher than the level of capital expenditures in the
third quarter of 2003.

We have summarized below our contractual cash obligations as of September
27, 2003:

|                                                            |  |                        |           |          |  |           |           |              |  |               |           |           |  |   |         |  |  |   |   | 
|----------------------------------------------------------- |  | ---------------------- | --------- | -------- |  | --------- | --------- | ------------ |  | ------------- | --------- | --------- |  | - | ------- |  |  | - | - | 
|                                                            |  | Payments Due By Period
|                                                            |  |                       
|                                                            |  |                        |           |          |  | Less Than |           | One to Three |  | Three to Five |           | More Than
|Contractual Obligations                                     |  | Total                  |           | One Year |  | Years     |           | Years        |  | Five Years   
|                                                            |  |                        |           |          |  |           |           |              |  |              
|Operating lease obligations                                 |  | $                      | 3,461,000 |          |  | $         | 1,190,000 |              |  | $             | 2,022,000 |           |  | $ | 249,000 |  |  | $ | 
|Debt related to the sale of investment in sales-type leases |  | $                      | 1,431,000 |          |  | $         | 756,000   |              |  | $             | 590,000   |           |  | $ | 85,000  |  |  | $ | 
|                                                            |  |                        |           |          |  |           |           |              |  |               |           |           |  |   |         |  |  |   |  
|Total contractual cash obligations                          |  | $                      | 4,892,000 |          |  | $         | 1,946,000 |              |  | $             | 2,612,000 |           |  | $ | 334,000 |  |  | $ | 
|                                                            |  |                        |           |          |  |           |           |              |  |               |           |           |  |   |         |  |  |   |  

Income Taxes

We have net operating loss and research and development tax credit
carryforwards for federal income tax purposes that began expiring in the year
2002 and will continue to expire through the year 2022 if not utilized.

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

Subsequent ownership changes may further affect the limitation in future years.

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.

Conversion to Euro

Twelve of the 15 members of the European Union have adopted the Euro as
their legal currency. Our current information systems allow us to process
Euro-denominated transactions. We are also assessing the business implications
of the conversion to the Euro, including long-term competitive implications and
the effect of market risk with respect to financial instruments. The majority
of our international sales are denominated in U.S. dollars. We do not believe
the Euro has had a significant effect on our business, financial condition or
results of operations. However, the expenses and capital spending of our
international subsidiaries are transacted in the respective countrys local
currency. As a result, changes in foreign currency exchange rates or weak
economic conditions in foreign markets could affect our financial condition or
results of operations.

21



---



##### Table of Contents



Recent Accounting Pronouncements

In November 2002, the FASB issued Financial Interpretation No. 45, or FIN
45, Guarantors Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires a
guarantor to disclose (a) the nature of the guarantee, and the events or
circumstances that would require the guarantor to perform under the guarantee;
(b) the maximum potential amount of future payments under the guarantee; (c)
the carrying amount of the liability, if any, for the guarantors obligations
under the guarantee; and (d) the nature and extent of any recourse provisions
or available collateral that would enable the guarantor to recover the amounts
paid under the guarantee. FIN 45 also clarifies that a guarantor is required
to recognize, at the inception of a guarantee, a liability at fair value for
the obligations it has undertaken in issuing the guarantee, including its
ongoing obligation to stand ready to perform over the term of the guarantee in
the event that the specified triggering events or conditions occur. The
initial recognition and initial measurement provisions of FIN 45 are applicable
on a prospective basis to guarantees issued or modified after December 31,
2002. FIN 45 also addresses the disclosure requirements regarding product
warranties. Instead of disclosing the maximum potential amount of future
payments under the product warranty guarantee, a guarantor is required to
disclose its accounting policy and methodology used in determining its
liability for product warranties, as well as, a tabular reconciliation of the
changes in the guarantors product warranty liability for the reporting period.
We adopted FIN 45 as of January 1, 2003. The adoption of FIN 45 did not have
a material effect on our results of operations, cash flows or financial
position.

In January 2003, the FASB issued FIN 46, Consolidation of Variable
Interest Entities.FIN 46 requires that if an entity has a controlling
financial interest in a variable interest entity, the assets, liabilities and
results of activities of the variable interest entity should be included in the
consolidated financial statements of the entity. FIN 46 is effective
immediately for all new variable interest entities created or acquired after
January 31, 2003. For variable interest entities created or acquired prior to
February 1, 2003, the provisions of FIN 46 must be applied for the first
interim or annual period ending after December 15, 2003. The adoption of FIN
46 did not have a material effect on our results of operations, cash flows or
financial position.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain
Financial Instruments with Characteristics of Both Liabilities and Equity.
SFAS No. 150 establishes standards for how an issuer classifies and measures in
its statement of financial position certain financial instruments with
characteristics of both liabilities and equity. SFAS No. 150 requires that an
issuer classify a financial instrument that is within its scope as a liability
(or an asset in some circumstances) because that financial instrument embodies
an obligation of the issuer. This statement is effective for financial
instruments entered into or modified after May 31, 2003, and otherwise is
effective at the beginning of the first interim period beginning after June 15,
2003. We adopted SFAS No. 150 as of July 1, 2003. The adoption of SFAS No.
150 did not have a material effect on our results of operations, cash flows or
financial position.

FACTORS AFFECTING FUTURE OPERATING RESULTS

This Quarterly Report on Form 10-Q includes forward-looking statements,
including information relating to our ability to achieve profitability,
information with respect to market acceptance of our BIS system, continued
growth in sales of our BIS monitors, BIS Module Kits and BIS Sensors, our
dependence on the BIS system, our ability to remain competitive and achieve
future growth, information with respect to other plans and strategies for our
business and factors that may influence our revenue for the fiscal quarter
ending December 31, 2003. The following important factors represent current
challenges to us that create risk and uncertainty. Failure to adequately
overcome any of the following challenges could have a material adverse effect
on our results of operations, business or financial condition.

We will not be profitable if hospitals and anesthesia providers do not buy and
use our BIS system in sufficient quantities.

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, these providers may also conclude that the BIS
system is unreliable. If hospitals and anesthesia providers do not accept the
BIS system as cost-effective, accurate and reliable, they will not buy and use
the BIS system in sufficient quantities to enable us 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, it could adversely
affect our revenue.

22



---



##### Table of Contents



We depend on our BIS system for substantially all of our revenue, and if the
BIS system does not gain widespread market acceptance, then our revenue will
not grow.

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. In 2002, we introduced commercially the BIS Extend Sensor for patients
who are monitored over an extended period of time, such as in intensive care
unit settings. 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.
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 fourth fiscal quarter of 2003.

Various factors may adversely affect our quarterly operating results
through the fourth fiscal quarter of 2003. First, we continue to shift the
focus of our placements from BIS monitors to BIS modules 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 possible delays in
purchasing decisions by customers in Japan, or these potential customers may
choose not to purchase our products. Third, on November 1, 2003, our
international master distribution agreement with Datex-Ohmeda expired. We plan
to replace this agreement with country-specific distribution agreements with
Datex-Ohmeda sales subsidiaries and other distributors. A delay in signing
these country-specific distribution agreements may adversely affect Equipment
revenue in the international market. The continuation of difficult worldwide
economic conditions, reductions in hospital purchasing programs, and the cost
of transitioning our installed base to the new BIS XP system may also adversely
impact our revenue and operating results through the fourth fiscal quarter of
2003.

Fluctuations in our quarterly operating results could cause our stock price to
decrease.

Our operating results have fluctuated significantly from quarter to
quarter in the past and are likely to vary in the future. These fluctuations
are due to several factors relating to the sale of our products, including:



| |  |  | the timing and volume of customer orders for our BIS system,                      
| | - |  | ----------------------------------------------------------------------------------
|
| |  |  | the introduction of the BIS XP system,                                            
|
| |  |  | implementation of, 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 BIS Module Kits,                   
|
| |  |  | customer cancellations,                                                           
|
| |  |  | introduction of competitive products,                                             
|
| |  |  | regulatory approvals,                                                             
|
| |  |  | changes in management,                                                            
|
| |  |  | turnover in our direct sales force,                                               
|
| |  |  | effectiveness of new marketing and sales programs,                                
|
| |  |  | 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 again fall below the expectations of
securities analysts or investors. If our quarterly operating results are below
expectations in the future, the market price of our common stock would also
likely decrease. In addition, because we do not have a significant backlog of
customer orders for our BIS system, revenue in any quarter depends on orders
received in that quarter. Our quarterly results may also be adversely affected
because some customers may have inadequate financial resources to purchase our
products or may fail to pay for our products after receiving them. In
particular, hospitals are increasingly

23



---



##### Table of Contents



experiencing financial constraints, consolidations and reorganizations as
a result of cost containment measures and declining third-party reimbursement
for services, which may result in decreased product orders or an increase in
bad debts in any quarter.

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 projections and accruals.

Our financial statements have been prepared in accordance with accounting
principles generally accepted in the United States of America. 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, such as those made in connection with our
restructurings, and related disclosure of contingent assets and liabilities.
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.

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
the end of 2004. If we are unable to increase our revenue and achieve positive
cash flow, we will need to raise additional funds. We may also need additional
financing if:



| |  |  | we need additional cash to fund research and development costs of
products currently under development,
| | - |  | -------------------------------------------------------------------------------------------------------
|
| |  |  | 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 in the United States
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
needs 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 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. It is possible that
additional cases of awareness with recall during surgical procedures monitored
with the BIS system have not been reported to us, and we have not
systematically solicited reports of awareness with recall. 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

24



---



##### Table of Contents



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
clinical studies have demonstrated that patient monitoring with the BIS system
may reduce the incidence of awareness with recall we may be subject to product
liability claims for cases of surgical awareness during surgical procedures
monitored with the BIS system. These claims could require us to spend
significant time and money in litigation or to pay significant damages.

Data that was collected in our three multi-center, multinational studies
to assess the incidence of awareness with recall and the impact of BIS
monitoring were reported this year. Results from these studies demonstrate
that awareness with recall usually occurs in 1 to 2 cases per 1,000 patients
during general anesthesia. 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. 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.

We may not be able to compete with new products or alternative techniques
developed by others, which could impair our ability to remain competitive and
achieve future growth.

The medical industry in which we market our products is characterized by
rapid product development and technological advances. Our competitors have
introduced commercially three anesthesia monitoring products approved 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 and the BIS Extend
Sensor for use 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.

25



---



##### Table of Contents



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 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 continue to experience high turnover in
our direct sales force, we may not be able to sustain and grow our product
revenue. On an ongoing basis, we develop and introduce new sales and marketing
programs. If we do not implement these new sales and marketing 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. We need
to:



| |  |  | provide or assure that distributors and original equipment
manufacturers provide the technical and educational support customers
need to use the BIS system successfully,                                            
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | promote frequent use of the BIS system so that sales of our
disposable BIS Sensors increase,                                                                                                                         
|
| |  |  | establish and implement successful marketing and sales programs that
encourage our customers to purchase our products or the products that
are made by original equipment manufacturers incorporating our
technology,
|
| |  |  | manage geographically dispersed operations, and                                                                                                                                                                      
|
| |  |  | modify our products and marketing and sales programs for foreign markets.                                                                                                                                            

In order to reach the level of sales we need to achieve profitability, we need
to further develop our direct and indirect sales channels.

In order to increase our sales, we need to continue to strengthen our
relationships with our domestic and international distributors and continue to
add international distributors. We need to also 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 implement new sales and marketing programs and clinical education
programs to promote the use of the BIS system by our customers. If we do not
further develop our direct and indirect sales channels and successfully
implement the new sales and marketing programs and clinical education programs
that encourage our customers to purchase and use our products, we will not
reach the level of sales necessary to achieve profitability.

Our third-party distribution and original equipment manufacturer relationships
could negatively affect our profitability, cause sales of our products to
decline and be difficult to terminate if we are dissatisfied.

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

We may not be able to generate enough additional revenue from our international
expansion to offset the costs associated with establishing and maintaining
foreign operations.

A component of our growth strategy is to expand our presence in foreign
markets. We conduct international business primarily in Europe and Japan and
we are attempting to increase the number of countries in which we do business.
It is costly to establish international facilities and operations and to
promote the BIS system in international markets. 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 foreign operations.

26



---



##### Table of Contents



We may not be able to meet the unique operational, legal and financial
challenges that we will encounter in our international operations, which may
limit the growth of our business.

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



| |  |  | failure of local laws to provide the same degree of protection
against infringement of our intellectual property,                                                       
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | protectionist laws and business practices that favor local
competitors, which could slow our growth in international markets,                                           
|
| |  |  | difficulties in terminating or modifying distributor arrangements
because of restrictions in markets outside the United States,                                         
|
| |  |  | less acceptance by foreign anesthesia providers of the use of disposable products similar to the BIS Sensors,                                                           
|
| |  |  | delays in regulatory approval of our products,                                                                                                                          
|
| |  |  | currency conversion issues arising from sales denominated in currencies other than the United States dollar,                                                            
|
| |  |  | 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.

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

Our reliance on sole-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. 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.

27



---



##### Table of Contents



We may be required to bring litigation to enforce our intellectual property
rights, which may result in substantial expense and may divert our attention
from the implementation of our business strategy.

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

We may be sued by third parties which claim that our products infringe on their
intellectual property rights, particularly because there is substantial
uncertainty about the validity and breadth of medical device patents.

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



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

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 an underwriting agreement we entered into
as part of the initial public offering, or otherwise.

28



---



##### Table of Contents



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. 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 impact 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 will be adversely affected.

As of November 3, 2003, Boston Scientific Corporation owned approximately
18% of our outstanding common stock. We have an agreement with Boston
Scientific Corporation, pursuant to which Boston Scientific Corporation has
agreed not to acquire any shares of our common stock in excess of 25% of the
outstanding shares of our common stock prior to December 31, 2004 without our
prior approval. If Boston Scientific Corporation increases its ownership of
our outstanding common stock, it may impact corporate actions requiring
stockholder approval. In addition, 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.

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 three competitors monitoring systems which
have been approved 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.

29



---



##### Table of Contents



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 approval process for a premarket
approval application is lengthy, expensive and typically requires extensive
preclinical and clinical trial data. We may not obtain clearance of a 510(k)
notification or approval of a premarket approval application with respect to
any of our products on a timely basis, if at all. If we fail to obtain timely
clearance or approval for our products, we will not be able to market and sell
our products, which will limit our ability to generate revenue. We may also be
required to obtain clearance of a 510(k) notification from the FDA before we
can market certain previously marketed products which we modify after they have
been cleared. We have made certain enhancements to our currently marketed
products which we have determined do not necessitate the filing of a new 510(k)
notification. However, if the FDA does not agree with our determination, it
will require us to file a new 510(k) notification for the modification and we
may be prohibited from marketing the modified device until we obtain FDA
clearance. We filed a 510(k) application with the FDA to revise product
indications for use to reflect results from our awareness trials. In October
2003, the FDA approved our submitted 510(k) application.

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

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

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

If we do not retain our senior management and other key employees, we may not
be able to successfully implement our business strategy.

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

If we do not attract and retain skilled personnel, we will not be able to
expand our business.

Our products are based on complex signal-processing technology.
Accordingly, we require skilled personnel to develop, manufacture, sell and
support our products. Our future success will depend largely on our ability to
continue to hire, train, retain and motivate additional skilled personnel,
particularly sales representatives 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.

30



---



##### Table of Contents



Failure of users of the BIS system to obtain adequate reimbursement from
third-party payors could limit market acceptance of the BIS system, which could
prevent us from achieving profitability.

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




Item 3. Quantitative and Qualitative Disclosures About Market Risk.

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




Item 4. Controls and Procedures.



| | (a) |  | Evaluation of Disclosure Controls and Procedures                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |     |  | Our management, with the participation of our chief executive
officer and chief financial officer, evaluated the effectiveness of
our disclosure controls and procedures (as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of
September 27, 2003. Based on this evaluation, our chief executive
officer and chief financial officer concluded that, as of September
27, 2003, our disclosure controls and procedures were (1) designed
to ensure that material information relating to us, including our
consolidated subsidiaries, is made known to our chief executive
officer and chief financial officer by others within those entities,
particularly during the period in which this report was being
prepared and (2) effective, in that they provide reasonable
assurance that information required to be disclosed by us in the
reports we file or submit under the Securities Exchange Act is
recorded, processed, summarized and reported within the time periods
specified in the Securities and Exchange Commissions rules and
forms.
|
| | (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 September 27,
2003 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   

31



---



##### Table of Contents






PART II  OTHER INFORMATION
















|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Item 1. |  | Legal Proceedings.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        |  | We are not a party to any material threatened or pending legal proceedings.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Item 2. |  | Changes in Securities and Use of Proceeds.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        |  | On February 2, 2000, we sold 3,500,000 shares of our common stock,
at an initial public offering price of $15.00 per share, pursuant to a
Registration Statement on Form S-1 (Registration No. 333-86295), which
was declared effective by the Securities and Exchange Commission on
January 27, 2000. On February 4, 2000, the underwriters exercised in
full their over-allotment option to purchase an additional 525,000
shares of our common stock at $15.00 per share. The managing
underwriters of our initial public offering were Morgan Stanley & Co.
Incorporated, Deutsche Bank Securities Inc. and U.S. Bancorp Piper
Jaffray Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        |  | The aggregate gross proceeds raised in the offering were
approximately $60.4 million. Our total expenses in connection with the
offering were approximately $5.7 million, of which $4.2 million was for
underwriting discounts and commissions and, based on our reasonable
estimate, approximately $1.5 million was for other expenses. Our net
proceeds from the offering were approximately $54.6 million. From
January 27, 2000 through September 27, 2003, we used approximately $9.2
million of the net proceeds for the acquisition of machinery and
equipment, leasehold improvements, furniture and fixtures,
demonstration and evaluation equipment and new information systems. In
addition, from January 27, 2000 through September 27, 2003, we used
approximately $39.3 million of the net proceeds for general corporate
purposes, including working capital, product development, increasing
our sales and marketing capabilities and expanding our international
operations. As of September 27, 2003, we had approximately $6.1
million of proceeds remaining from the offering, and pending use of the
proceeds, we have invested these funds in short-term, interest-bearing,
investment-grade securities.
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Item 3. |  | Defaults Upon Senior Securities.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        |  | None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Item 4. |  | Submission of Matters to a Vote of Security Holders.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        |  | None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|Item 5. |  | Other Information.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|        |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|        |  | None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

32



---



##### Table of Contents






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



| | (a) |  | Exhibits                                                                                                                                                                                                                                       
| | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |     |  | The exhibits listed in the Exhibit Index immediately preceding the
exhibits are filed as part of this Quarterly Report on Form 10-Q.                                                                                                           
|
| | (b) |  | Reports on Form 8-K                                                                                                                                                                                                                            
|
| |     |  | On July 16, 2003 we furnished a Current Report on Form 8-K to the
Securities and Exchange Commission announcing our financial results
for the fiscal quarter ended June 28, 2003. The date of this
Current Report on Form 8-K is July 16, 2003.

33



---



##### Table of Contents






SIGNATURE

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

|                        |  |                              |  |                                             
|----------------------- |  | ---------------------------- |  | --------------------------------------------
|                        |  | ASPECT MEDICAL SYSTEMS, INC.
|                        |  |                              |  |                                             
|Date: November 10, 2003 |  | By:                          |  | /s/ J. Neal Armstrong                       
|                        |  |                              |  |                                             
|                        |  |                              |  | J. Neal Armstrong                           
|                        |  |                              |  | Vice President and Chief Financial Officer  
|                        |  |                              |  | (Principal Financial and Accounting Officer)

34



---



##### Table of Contents






EXHIBIT INDEX

|        |  |                                                                                                                                                                                       
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT |  |                                                                                                                                                                                       
|NUMBER  |  | EXHIBIT                                                                                                                                                                               
|        |  |                                                                                                                                                                                       
|10.1   |  | OEM Development and Purchase Agreement, dated July 24, 2003, by
and between the Registrant and Datascope Corp.                                                                        
|        |  |                                                                                                                                                                                       
|10.2   |  | Addendum 1, effective January 1, 2003, to the OEM Purchase
Agreement, dated September 1, 2000, by and between the Registrant
and Datex-Ohmeda Division of Instrumentarium Corporation.
|        |  |                                                                                                                                                                                       
|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.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------