##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended July 1, 2006
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to
 Commission file number: 0-24663
 
 ASPECT MEDICAL SYSTEMS, INC.
  Delaware
    
    04-2985553(State or Other Jurisdiction of
    
    (I.R.S. Employer Identification No.)Incorporation or Organization)141 Needham Street, Newton, Massachusetts
    
    02464-1505(Address of Principal Executive Offices)
    
    (Zip Code)
 (617) 559-7000
 
  þ o
  o þ o
  o þ




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##### 



PagePART I
    
    FINANCIAL INFORMATION
    
    
    1Item 1.
    
    Financial Statements
    
    
    1Consolidated Balance Sheets as of July 1, 2006 (unaudited) and December 31, 2005
    
    
    1Consolidated Statements of Operations for the Three and Six Months Ended
July 1, 2006 and July 2, 2005 (unaudited)
    
    
    2Consolidated Statements of Cash Flows for the Six Months Ended
July 1, 2006 and July 2, 2005 (unaudited)
    
    
    3Notes to Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    28Item 4.
    
    Controls and Procedures
    
    
    29PART II
    
    OTHER INFORMATION
    
    
    30Item 1A.
    
    Risk Factors
    
    
    30Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    43Item 5.
    
    Other Information
    
    
    43Item 6.
    
    Exhibits
    
    
    43SIGNATURESEX-10.1 Addendum 3, Effective 10/1/04, to the OEMEX-10.2  Second Amendment to Net LeaseEX-31.1 Section 302 Certification of C.E.O.EX-31.2 Section 302 Certification of C.F.O.EX-32.1 Section 906 Certification of C.E.O.EX-32.2 Section 906 Certification of C.F.O.




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS.
 ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED BALANCE SHEETS
 (in thousands, except share data)
 July 1,
    
    
    December 31,2006
    
    
    2005(unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    28,719
    
    
    $
    20,437Restricted cash
    
    
    1,100
    
    
    
    82Short-term investments
    
    
    24,930
    
    
    
    23,254Accounts receivable, net of allowance of $193 at July
1, 2006 and $116 at December 31, 2005
    
    
    11,206
    
    
    
    11,717Current portion of investment in sales-type leases
    
    
    1,521
    
    
    
    1,623Inventory
    
    
    6,458
    
    
    
    5,117Other current assets
    
    
    2,489
    
    
    
    1,484Total current assets
    
    
    76,423
    
    
    
    63,714Property and equipment, net
    
    
    4,992
    
    
    
    3,727Long-term investments
    
    
    11,299
    
    
    
    17,568Long-term investment in sales-type leases
    
    
    2,300
    
    
    
    2,123Total assets
    
    $
    95,014
    
    
    $
    87,132LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    2,318
    
    
    $
    2,393Accrued liabilities
    
    
    7,144
    
    
    
    10,196Deferred revenue
    
    
    5,031
    
    
    
    3,137Total current liabilities
    
    
    14,493
    
    
    
    15,726Long-term portion of deferred revenue
    
    
    3,750
    
    
    
    3,983Commitments and contingenciesStockholders equity:Preferred Stock, $.01 par value; 5,000,000 shares
authorized, no shares issued or outstanding
    
    
    
    
    
    
    Common Stock, $.01 par value; 60,000,000 shares
authorized, 22,502,086 and 22,281,155 shares issued
and outstanding at July 1, 2006 and December 31, 2005,
respectively
    
    
    225
    
    
    
    222Additional paid-in capital
    
    
    164,030
    
    
    
    159,281Deferred compensation
    
    
    
    
    
    
    (498
    )Accumulated other comprehensive loss
    
    
    (47
    )
    
    
    (84
    )Accumulated deficit
    
    
    (87,437
    )
    
    
    (91,498
    )Total stockholders equity
    
    
    76,772
    
    
    
    67,423Total liabilities and stockholders equity
    
    $
    95,014
    
    
    $
    87,132
  1




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (in thousands, except per share amounts)
 (unaudited)
 Three Months Ended
    
    
    Six Months EndedJuly 1, 2006
    
    
    July 2, 2005
    
    
    July 1, 2006
    
    
    July 2, 2005Product revenue
    
    $
    21,181
    
    
    $
    18,153
    
    
    $
    41,623
    
    
    $
    35,081Strategic alliance revenue
    
    
    1,450
    
    
    
    588
    
    
    
    2,896
    
    
    
    744Total revenue
    
    
    22,631
    
    
    
    18,741
    
    
    
    44,519
    
    
    
    35,825Costs of revenue (1)
    
    
    5,411
    
    
    
    4,814
    
    
    
    10,757
    
    
    
    9,255Gross profit margin
    
    
    17,220
    
    
    
    13,927
    
    
    
    33,762
    
    
    
    26,570Operating expenses: (1)Research and development
    
    
    3,568
    
    
    
    2,397
    
    
    
    7,215
    
    
    
    4,385Sales and marketing
    
    
    9,105
    
    
    
    7,493
    
    
    
    17,861
    
    
    
    14,769General and administrative
    
    
    3,203
    
    
    
    2,826
    
    
    
    6,141
    
    
    
    5,437Total operating
expenses
    
    
    15,876
    
    
    
    12,716
    
    
    
    31,217
    
    
    
    24,591Income from operations
    
    
    1,344
    
    
    
    1,211
    
    
    
    2,545
    
    
    
    1,979Interest income
    
    
    781
    
    
    
    418
    
    
    
    1,517
    
    
    
    793Interest expense
    
    
    
    
    
    
    (14
    )
    
    
    
    
    
    
    (27
    )Net income
    
    $
    2,125
    
    
    $
    1,615
    
    
    $
    4,062
    
    
    $
    2,745Net income per share:Basic
    
    $
    0.09
    
    
    $
    0.08
    
    
    $
    0.18
    
    
    $
    0.13Diluted
    
    $
    0.09
    
    
    $
    0.07
    
    
    $
    0.17
    
    
    $
    0.12Weighted average shares used in
computing net income per share:Basic
    
    
    22,442
    
    
    
    21,400
    
    
    
    22,389
    
    
    
    21,157Diluted
    
    
    23,513
    
    
    
    23,827
    
    
    
    23,784
    
    
    
    23,518
 
 (1) Stock-based compensation
included in costs and expenses:Costs of revenue
    
    $
    106
    
    
    $
    3
    
    
    $
    211
    
    
    $
    6Research and development
    
    
    373
    
    
    
    34
    
    
    
    743
    
    
    
    44Sales and marketing
    
    
    601
    
    
    
    30
    
    
    
    1,228
    
    
    
    53General and administrative
    
    
    573
    
    
    
    26
    
    
    
    1,111
    
    
    
    51$
    1,653
    
    
    $
    93
    
    
    $
    3,293
    
    
    $
    154
  2




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ASPECT MEDICAL SYSTEMS, INC.
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in thousands)
 (unaudited)
 Six Months EndedJuly 1,
    
    
    July 2,2006
    
    
    2005Cash flows from operating activities:Net income
    
    $
    4,062
    
    
    $
    2,745Adjustments
to reconcile net income to net cash provided by
operating activities Depreciation and amortization
    
    
    753
    
    
    
    808Provision for doubtful accounts
    
    
    77
    
    
    
    91Compensation
expense related to stock options and restricted stock
    
    
    3,294
    
    
    
    154Changes in assets and liabilities Decrease (increase) in accounts receivable
    
    
    434
    
    
    
    (1,118
    )Increase in inventory
    
    
    (1,341
    )
    
    
    (1,702
    )Increase in other assets
    
    
    (1,005
    )
    
    
    (888
    )(Increase)
decrease in investment in sales-type leases
    
    
    (75
    )
    
    
    13Decrease in accounts payable
    
    
    (75
    )
    
    
    (75
    )Decrease in accrued liabilities
    
    
    (3,052
    )
    
    
    (1,295
    )Increase in deferred revenue
    
    
    1,661
    
    
    
    4,100Net cash provided by operating activities
    
    
    4,733
    
    
    
    2,833Cash flows from investing activities:Increase in restricted cash
    
    
    (1,018
    )
    
    
    Acquisition of property and equipment
    
    
    (2,018
    )
    
    
    (706
    )Purchases of marketable securities
    
    
    (20,635
    )
    
    
    (22,264
    )Proceeds from sales and maturities of marketable securities
    
    
    25,264
    
    
    
    19,024Net cash provided by (used for) investing activities
    
    
    1,593
    
    
    
    (3,946
    )Cash flows from financing activities:Principal payments on debt related to investment in sales-type
leases
    
    
    
    
    
    
    (221
    )Proceeds from issuance of common stock
    
    
    1,956
    
    
    
    5,790Net cash provided by financing activities
    
    
    1,956
    
    
    
    5,569Net increase in cash and cash equivalents
    
    
    8,282
    
    
    
    4,456Cash and cash equivalents, beginning of period
    
    
    20,437
    
    
    
    14,761Cash and cash equivalents, end of period
    
    $
    28,719
    
    
    $
    19,217Supplemental disclosure of cash flow information:Interest paid
    
    $
    
    
    
    $
    27
  3




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (tabular amounts in thousands, except per share amounts)
 (unaudited)
 (1) Basis of Presentation
  (2) Summary of Significant Accounting Policies
  Principles of Consolidation
  Foreign Currency
  Cash, Cash Equivalents and Marketable Securities
  Accounting for Certain Investments
in Debt and Equity Securities
 Revenue Recognition
  4




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




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Allowance for Doubtful Accounts
  Inventory
  Warranty
  Three Months Ended
    
    
    Six Months EndedJuly 1, 2006
    
    
    July 2, 2005
    
    
    July 1, 2006
    
    
    July 2, 2005Beginning balance
    
    $
    194
    
    
    $
    158
    
    
    $
    159
    
    
    $
    137Warranty expense
    
    
    30
    
    
    
    12
    
    
    
    88
    
    
    
    46Deductions and other
    
    
    (23
    )
    
    
    (27
    )
    
    
    (46
    )
    
    
    (40
    )Ending balance
    
    $
    201
    
    
    $
    143
    
    
    $
    201
    
    
    $
    143
 Shipping and Handling Costs
  Advertising Costs
  Property and Equipment
 Accounting for the Costs of Computer Software Developed or Obtained
for Internal Use
 6




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Income Taxes
 Accounting for Income
Taxes
 Concentration of Credit Risk
  Single or Limited Source Suppliers
  Net Income Per Share
 Earnings Per Share
  7




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  Three Months Ended
    
    
    Six Months EndedJuly 1, 2006
    
    
    July 2, 2005
    
    
    July 1, 2006
    
    
    July 2, 2005Basic:Net income
    
    $
    2,125
    
    
    $
    1,615
    
    
    $
    4,062
    
    
    $
    2,745Weighted average shares outstanding
    
    
    22,442
    
    
    
    21,400
    
    
    
    22,389
    
    
    
    21,157Basic net income per share
    
    $
    0.09
    
    
    $
    0.08
    
    
    $
    0.18
    
    
    $
    0.13Diluted:Net income
    
    $
    2,125
    
    
    $
    1,615
    
    
    $
    4,062
    
    
    $
    2,745Weighted average shares outstanding
    
    
    22,442
    
    
    
    21,400
    
    
    
    22,389
    
    
    
    21,157Effect of dilutive stock options and
restricted stock
    
    
    1,071
    
    
    
    2,427
    
    
    
    1,395
    
    
    
    2,361Weighted average shares assuming
dilution
    
    
    23,513
    
    
    
    23,827
    
    
    
    23,784
    
    
    
    23,518Diluted net income per share
    
    $
    0.09
    
    
    $
    0.07
    
    
    $
    0.17
    
    
    $
    0.12
 Comprehensive Income
  Stock-Based Compensation
  Share Based Payment Accounting for Stock-Based Compensation Accounting for Stock Issued to Employees Statement of Cash Flows
 8




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
     WeightedWeighted
    
    
    AverageNumber of
    
    
    Average
    
    
    Remaining
    
    
    AggregateShares
    
    
    Exercise Price
    
    
    Contractual Life
    
    
    Intrinsic ValueOutstanding at December 31, 2005
    
    
    3,949
    
    
    $
    14.86Granted
    
    
    559
    
    
    
    28.89Exercised
    
    
    (207
    )
    
    
    8.66Canceled
    
    
    (43
    )
    
    
    23.72Outstanding at July 1, 2006
    
    
    4,258
    
    
    $
    16.91
    
    
    
    6.65
    
    
    $
    17,294Vested or expected to vest at July 1, 2006
    
    
    4,156
    
    
    $
    16.78
    
    
    
    6.60
    
    
    $
    17,166Exercisable at July 1, 2006
    
    
    2,720
    
    
    $
    13.93
    
    
    
    5.57
    
    
    $
    15,348
   Weighted AverageNumber of
    
    
    Grant Date FairShares
    
    
    ValueNonvested at December 31, 2005
    
    
    23
    
    
    $
    21.18Granted
    
    
    30
    
    
    
    26.89Vested
    
    
    (6
    )
    
    
    23.95Canceled
    
    
    
    
    
    
    Nonvested at July 1, 2006
    
    
    47
    
    
    $
    24.50
 9




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  :
  Three Months Ended
    
    Six Months EndedJuly 1, 2006
    
    July 2, 2005
    
    July 1, 2006
    
    July 2, 2005Options granted
    
    
    55,125
    
    
    
    95,550
    
    
    
    559,485
    
    
    
    750,250Weighted average exercise price
    
    $
    25.55
    
    
    $
    27.71
    
    
    $
    28.89
    
    
    $
    21.51Weighted average grant date
fair value
    
    $
    11.64
    
    
    $
    12.14
    
    
    $
    12.49
    
    
    $
    10.01Assumptions:Risk-free interest rate
    
    
    5.06
    %
    
    
    4.05
    %
    
    
    4.70
    %
    
    
    3.67
    %Expected term
    
    5 years
    
    
    5 years
    
    
    5 years
    
    
    5 yearsExpected volatility
    
    
    44
    %
    
    
    49
    %
    
    
    42
    %
    
    
    50
    %Expected dividend yield
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
      :
  10




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
    Accounting for Stock-Based Compensation
 Three months
    
    
    Six monthsended
    
    
    endedJuly 2, 2005
    
    
    July 2, 2005Net income :Net income as reported
    
    $
    1,615
    
    
    $
    2,745Add: Stock-based employee
compensation expense included in
reported net income
    
    
    
    
    
    
    Deduct: Stock-based employee
compensation expense determined under
fair value based method for
all awards
    
    
    (1,543
    )
    
    
    (3,079
    )Pro forma net income (loss)
    
    $
    72
    
    
    $
    (334
    )Net income (loss) per share:Basic:As reported
    
    $
    0.08
    
    
    $
    0.13Pro forma
    
    $
    0.00
    
    
    $
    (0.02
    )Diluted:As reported
    
    $
    0.07
    
    
    $
    0.12Pro forma
    
    $
    0.00
    
    
    $
    (0.02
    )
    11




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 Use of Estimates
  Fair Value of Financial Instruments
  Recent
Accounting Pronouncements
 Accounting for Uncertainty in Income Taxes  an
Interpretation of FASB Statement No. 109 Accounting for Income Taxes.
 (3)
    
    Comprehensive IncomeThe Companys total comprehensive income is as follows:
 Three Months Ended
    
    
    Six Months EndedJuly 1, 2006
    
    
    July 2, 2005
    
    
    July 1, 2006
    
    
    July 2, 2005Net income
    
    $
    2,125
    
    
    $
    1,615
    
    
    $
    4,062
    
    
    $
    2,745Other comprehensive income:Unrealized gain on
marketable securities
    
    
    26
    
    
    
    40
    
    
    
    37
    
    
    
    8Comprehensive income
    
    $
    2,151
    
    
    $
    1,655
    
    
    $
    4,099
    
    
    $
    2,753
 (4)
    
    Investment in Sales-Type LeasesThe components of the Companys net investment in sales-type leases are as follows:
 July 1,
    
    
    December 31,2006
    
    
    2005Total minimum lease payments receivable
    
    $
    5,547
    
    
    $
    5,275Less:Unearned interest income
    
    
    843
    
    
    
    752Allowance for lease payments
    
    
    883
    
    
    
    777Net investment in sales-type leases
    
    
    3,821
    
    
    
    3,746Less  current portion
    
    
    1,521
    
    
    
    1,623$
    2,300
    
    
    $
    2,123
 (5)
    
    InventoryInventory consists of the following:
 July 1,
    
    
    December 31,2006
    
    
    2005Raw materials
    
    $
    3,414
    
    
    $
    2,939Work-in-progress
    
    
    158
    
    
    
    145Finished goods
    
    
    2,886
    
    
    
    2,033$
    6,458
    
    
    $
    5,117
 12




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 (6)
    
    Segment Information and Enterprise Reporting
   Three Months Ended
    
    
    Six Months EndedJuly 1, 2006
    
    
    July 2, 2005
    
    
    July 1, 2006
    
    
    July 2, 2005Geographic Area by RegionDomestic
    
    $
    17,845
    
    
    $
    14,257
    
    
    $
    34,662
    
    
    $
    27,192International
    
    
    4,786
    
    
    
    4,484
    
    
    
    9,857
    
    
    
    8,633Total
    
    $
    22,631
    
    
    $
    18,741
    
    
    $
    44,519
    
    
    $
    35,825
 Three Months Ended
    
    Six Months EndedJuly 1, 2006
    
    July 2, 2005
    
    July 1, 2006
    
    July 2, 2005Geographic Area by RegionDomestic
    
    
    79
    %
    
    
    76
    %
    
    
    78
    %
    
    
    76
    %International
    
    
    21
    
    
    
    24
    
    
    
    22
    
    
    
    24Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
  (7) Commitments and Contingencies
  (8) Related Party Transactions
   13




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
 (9) Loan Agreements
    (10) Agreements with Boston Scientific Corporation
 2002 Strategic Alliance
   14




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  2002 Line of Credit Agreement
  2004 Stock Purchase Agreement
  2005 Product Development and Distribution Agreement
   15




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except per share amounts)
(unaudited)
  (11)     Subsequent Event
  16




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##### Table of Contents



Item 2.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
 Overview
 ®
   Three Months Ended
    
    Six Months EndedJuly 1,
    
    July 2,
    
    July 1,
    
    July 2,2006
    
    2005
    
    2006
    
    2005(dollars in thousands)Domestic revenue
    
    $
    17,845
    
    
    $
    14,257
    
    
    $
    34,662
    
    
    $
    27,192Percent of total revenue
    
    
    79
    %
    
    
    76
    %
    
    
    78
    %
    
    
    76
    %International revenue
    
    $
    4,786
    
    
    $
    4,484
    
    
    $
    9,857
    
    
    $
    8,633Percent of total revenue
    
    
    21
    %
    
    
    24
    %
    
    
    22
    %
    
    
    24
    %Total revenue
    
    $
    22,631
    
    
    $
    18,741
    
    
    $
    44,519
    
    
    $
    35,825BIS Sensor revenue
    
    $
    15,868
    
    
    $
    13,140
    
    
    $
    31,453
    
    
    $
    25,623Percent of total revenue
    
    
    70
    %
    
    
    70
    %
    
    
    71
    %
    
    
    72
    %Equipment revenue
    
    $
    5,313
    
    
    $
    5,013
    
    
    $
    10,170
    
    
    $
    9,458Percent of total revenue
    
    
    24
    %
    
    
    27
    %
    
    
    23
    %
    
    
    26
    %Strategic alliance revenue
    
    $
    1,450
    
    
    $
    588
    
    
    $
    2,896
    
    
    $
    744Percent of total revenue
    
    
    6
    %
    
    
    3
    %
    
    
    6
    %
    
    
    2
    %Total revenue
    
    $
    22,631
    
    
    $
    18,741
    
    
    $
    44,519
    
    
    $
    35,825
   17




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Share-Based Payment
 18




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Accounting for
Stock Issued to Employees
  Quarterly Developments
  Critical Accounting Policies and Estimates
  Revenue Recognition
 Revenue
Recognition, Revenue Arrangements with Multiple
Deliverables
  19




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Accounting For Leases
  Stock-Based Compensation
    20




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Allowance for Doubtful Accounts
  Inventories
  Warranty
  21




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Results of Operations
  Three Months Ended
    
    Six Months EndedJuly 1, 2006
    
    July 2, 2005
    
    July 1, 2006
    
    July 2, 2005Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    24
    
    
    
    26
    
    
    
    24
    
    
    
    26Gross profit margin
    
    
    76
    
    
    
    74
    
    
    
    76
    
    
    
    74Operating expenses:Research and development
    
    
    16
    
    
    
    13
    
    
    
    16
    
    
    
    12Sales and marketing
    
    
    40
    
    
    
    40
    
    
    
    40
    
    
    
    41General and administrative
    
    
    14
    
    
    
    15
    
    
    
    14
    
    
    
    15Total operating expenses
    
    
    70
    
    
    
    68
    
    
    
    70
    
    
    
    68Income from operations
    
    
    6
    
    
    
    6
    
    
    
    6
    
    
    
    6Interest income, net
    
    
    3
    
    
    
    2
    
    
    
    3
    
    
    
    2Net income
    
    
    9
    %
    
    
    8
    %
    
    
    9
    %
    
    
    8
    %
 Three and Six Months Ended July 1, 2006 Compared with the Three and Six Months Ended July 2, 2005
 Three Months Ended
    
    
    Six Months EndedPercentage
    
    
    
    
    
    
    
    
    
    
    PercentageJuly 1,
    
    
    July 2,
    
    
    Increase
    
    
    July 1,
    
    
    July 2,
    
    
    Increase2006
    
    
    2005
    
    
    (Decrease)
    
    
    2006
    
    
    2005
    
    
    (Decrease)(in thousands, except unit amounts)
    
    
    
    
    
    
    (in thousands, except unit amounts)Revenue  WorldwideBIS Sensor
    
    $
    15,868
    
    
    $
    13,140
    
    
    
    21
    %
    
    $
    31,453
    
    
    $
    25,623
    
    
    
    23
    %BIS monitor
    
    
    3,670
    
    
    
    3,157
    
    
    
    16
    %
    
    
    6,318
    
    
    
    5,845
    
    
    
    8
    %Original equipment
manufacturer products
    
    
    1,173
    
    
    
    1,211
    
    
    
    (3
    %)
    
    
    2,771
    
    
    
    2,358
    
    
    
    18
    %Other equipment and accessories
    
    
    470
    
    
    
    645
    
    
    
    (27
    %)
    
    
    1,081
    
    
    
    1,255
    
    
    
    (14
    %)Total Equipment
    
    
    5,313
    
    
    
    5,013
    
    
    
    6
    %
    
    
    10,170
    
    
    
    9,458
    
    
    
    8
    %Total product revenue
    
    
    21,181
    
    
    
    18,153
    
    
    
    17
    %
    
    
    41,623
    
    
    
    35,081
    
    
    
    19
    %Strategic alliance
    
    
    1,450
    
    
    
    588
    
    
    
    147
    %
    
    
    2,896
    
    
    
    744
    
    
    
    289
    %Total revenue
    
    $
    22,631
    
    
    $
    18,741
    
    
    
    21
    %
    
    $
    44,519
    
    
    $
    35,825
    
    
    
    24
    %Unit Analysis  WorldwideBIS Sensors
    
    
    1,124,000
    
    
    
    944,000
    
    
    
    19
    %
    
    
    2,211,000
    
    
    
    1,823,000
    
    
    
    21
    %BIS monitors
    
    
    1,193
    
    
    
    754
    
    
    
    58
    %
    
    
    2,045
    
    
    
    1,425
    
    
    
    44
    %Original
equipment manufacturer
BIS products
    
    
    1,294
    
    
    
    1,239
    
    
    
    4
    %
    
    
    2,794
    
    
    
    2,274
    
    
    
    23
    %Installed base
    
    
    36,226
    
    
    
    27,625
    
    
    
    31
    %
    
    
    36,226
    
    
    
    27,625
    
    
    
    31
    %
 22




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Revenue.
     23




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Expense Overview
 Three Months Ended
    
    
    
    
    
    Six Months EndedPercentage
    
    
    
    
    
    
    
    
    
    PercentageJuly 1,
    
    July 2,
    
    Increase
    
    July 1,
    
    July 2,
    
    Increase2006
    
    2005
    
    (Decrease)
    
    2006
    
    2005
    
    (Decrease)(in thousands)
    
    
    
    
    
    (in thousands)ExpensesResearch and development
    
    $
    3,568
    
    
    $
    2,397
    
    
    
    49
    %
    
    $
    7,215
    
    
    $
    4,385
    
    
    
    65
    %Sales and marketing
    
    $
    9,105
    
    
    $
    7,493
    
    
    
    22
    %
    
    $
    17,861
    
    
    $
    14,769
    
    
    
    21
    %General and administrative
    
    $
    3,203
    
    
    $
    2,826
    
    
    
    13
    %
    
    $
    6,141
    
    
    $
    5,437
    
    
    
    13
    %
 Research and Development.
  24




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Sales and Marketing.
  General and Administrative.
  Interest Income.
 Interest expense.
 25




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Net Income.
 Liquidity and Capital Resources
   Agreements with Boston Scientific Corporation
    26




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Cash
provided by Operations.
 Cash provided by Investing Activities.
 Cash provided by Financing Activities.
  27




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Off-Balance Sheet Arrangements
  Income Taxes
   Effects of Inflation
  Recent
Accounting Pronouncements
 Accounting for Uncertainty in Income Taxes  an
Interpretation of FASB Statement No. 109 Accounting for Income Taxes.
 Forward-Looking Statements
 This Quarterly Report on Form 10-Q contains, in addition to historical information, forward-looking
statements within the meaning of Section 21E of the Securities Exchange Act of 1934, including
information relating to our ability to maintain profitability, information with respect to market
acceptance of our BIS system, continued growth in sales of our BIS monitors, original equipment
manufacturer products and BIS Sensors, our dependence on the BIS system, regulatory approvals for
our products, our ability to remain competitive and achieve future growth, information with respect
to other plans and strategies for our business and factors that may influence our revenue for the
fiscal quarter ending September 30, 2006 and thereafter. These forward-looking statements involve
risks and uncertainties and are not guarantees of future performance. Words such as expect,
anticipate, intend, plan, believe, seek, estimate and variations of these words and
similar expressions are intended to identify forward-looking statements. Our actual results could
differ significantly from the results discussed in these forward-looking statements. The important
factors discussed under Part II  Item 1A. Risk Factors below represent some of the current
challenges to us that create risk and uncertainty. 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.
 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 Interest Rate Exposure
  28




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Foreign Currency Exposure
  
 Item 4. Controls and Procedures.
 (a)
    
    Evaluation of Disclosure Controls and Procedures.Our management, with the participation of our chief executive officer and chief financial
officer evaluated the effectiveness of our disclosure controls and procedures as of July 1,
2006. The term disclosure controls and procedures, as defined in Rules 13a-15(e) and
15d-15(e) under the Exchange Act, means controls and other procedures of a company that are
designed to ensure that information required to be disclosed by a company in the reports that
it files or submits under the Exchange Act is recorded, processed, summarized and reported,
within the time periods specified in the SECs rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to ensure that
information required to be disclosed by a company in the reports that it files or submits
under the Exchange Act is accumulated and communicated to the companys management, including
its principal executive and principal financial officers, as appropriate to allow timely
decisions regarding required disclosure. Management recognizes that any controls and
procedures, no matter how well designed and operated, can provide only reasonable assurance
of achieving their objectives and management necessarily applies its judgment in evaluating
the cost-benefit relationship of possible controls and procedures. Based on the evaluation
of our disclosure controls and procedures as of July 1, 2006, our chief executive officer and
chief financial officer concluded that, as of such date, our disclosure controls and
procedures were effective at the reasonable assurance level.(b)
    
    Changes in Internal Controls.No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and
15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended July 1, 2006 that
has materially affected, or is reasonably likely to materially affect, our internal control
over financial reporting.
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PART II  OTHER INFORMATION
 
 Item 1A. Risk Factors
  We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our
BIS system and purchase our BIS Sensors in sufficient quantities.
   We depend on our BIS system for substantially all of our revenue, and if the BIS system does not
gain widespread market acceptance, then our revenue will not grow.
  Various factors may adversely affect our quarterly operating results through the third fiscal
quarter of 2006.
  30




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Fluctuations in our quarterly operating results could cause our stock price to decrease.
  
    
    the timing and volume of customer orders for our BIS system,
    
    market acceptance of our BIS VISTA,
    
    use of and demand for our BIS Sensors,
    
    transition of sales focus from BIS monitors to original equipment manufacturer products,
    
    customer cancellations,
    
    introduction of competitive products,
    
    regulatory approvals,
    
    changes in management,
    
    turnover in our direct sales force,
    
    effectiveness of new marketing and sales programs,
    
    communications published by industry organizations or other professional entities in the
anesthesia community that are unfavorable to our business,
    
    reductions in orders by our distributors and original equipment manufacturers, and
    
    the timing and amount of our expenses.
  If the estimates we make, and the assumptions on which we rely, in preparing our financial
statements prove inaccurate, our actual results may vary from those reflected in our financial
statements.
  31




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We may need additional financing for our future capital needs and may not be able to raise
additional funds on terms acceptable to us, or at all.
  
    
    the research and development costs of our products currently under development increase
beyond current estimates,
    
    we decide to expand faster than currently planned,
    
    we develop new or enhanced services or products ahead of schedule,
    
    we decide to undertake new sales and/or marketing initiatives,
    
    we are required to defend or enforce our intellectual property rights,
    
    sales of our products do not meet our expectations domestically or internationally,
    
    we need to respond to competitive pressures, or
    
    we decide to acquire complementary products, businesses or technologies.
  Cases of awareness with recall during monitoring with the BIS system could limit market acceptance
of the BIS system and could expose us to product liability claims.
  32




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##### Table of Contents



We may not be able to compete with new products or alternative techniques developed by others,
which could impair our ability to remain competitive and achieve future growth.
  
    
    other new monitoring products, based on new or improved technologies,
    
    new products or technologies used on patients or in the operating room during surgery in
lieu of monitoring devices,
    
    electrical or mechanical interference from new or existing products or technologies,
    
    alternative techniques for evaluating the effects of anesthesia,
    
    significant changes in the methods of delivering anesthesia, and
    
    the development of new anesthetic agents.
  If we do not maintain our relationships with the anesthesia community, our growth will be limited
and our business could be harmed. If anesthesiologists and other healthcare providers do not
recommend and endorse our products, our sales may decline or we may be unable to increase our sales
and profits.
   Negative publicity or unfavorable media coverage could damage our reputation and harm our
operations
  33




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If we do not successfully develop or acquire and introduce enhanced or new products we could lose
revenue opportunities and customers.
  
    
    identify in a timely manner new market trends;
    
    assess customer needs;
    
    successfully develop or acquire competitive products;
    
    complete regulatory clearance in a timely manner;
    
    successfully develop cost effective manufacturing processes;
    
    introduce such products to our customers in a timely manner; and
    
    achieve market acceptance.
  
    
    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 our clinical trials are delayed or unsuccessful, our business could be adversely affected.
   34




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##### Table of Contents




    
    delays or the inability to obtain required approvals from institutional review boards
or other governing entities at clinical sites selected for participation in our clinical
trials,
    
    delays in enrolling patients and volunteers into clinical trials,
    
    lower than anticipated retention rates of patients and volunteers in clinical trials,
    
    negative results from clinical trials for any of our potential products, including
those involving the management of depression and the early diagnosis and tracking of
Alzheimers disease, and
    
    failure of our clinical trials to demonstrate the efficacy or clinical utility of our
potential products.
  If we do not develop and implement a successful sales and marketing strategy, we will not expand
our business.
  
    
    provide or assure that distributors and original equipment manufacturers provide the
technical and educational support customers need to use the BIS system successfully,
    
    promote frequent use of the BIS system so that sales of our disposable BIS Sensors
increase,
    
    establish and implement successful sales and marketing and education programs that
encourage our customers to purchase our products or the products that are made by original
equipment manufacturers incorporating our technology,
    
    manage geographically dispersed operations, and
    
    modify our products and marketing and sales programs for foreign markets.
 We encourage our direct sales force, distributors and original equipment manufacturers to maximize
the amount of our products they sell and they may engage in aggressive sales practices that may
harm our reputation.
  35




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##### Table of Contents



Our third-party distribution and original equipment manufacturer relationships could negatively
affect our profitability, cause sales of our products to decline and be difficult to terminate if
we are dissatisfied.
  We may not be able to generate enough additional revenue from our international expansion to offset
the costs associated with establishing and maintaining foreign operations.
  We may not be able to meet the unique operational, legal and financial challenges that we will
encounter in our international operations, which may limit the growth of our business.
  
    
    failure of local laws to provide adequate protection against infringement of our
intellectual property,
    
    protectionist laws and business practices that favor local competitors, which could slow
our growth in international markets,
    
    difficulties in terminating or modifying distributor arrangements because of restrictions
in markets outside the United States,
    
    less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors,
    
    delays in regulatory approval of our products,
    
    currency conversion issues arising from sales denominated in currencies other than the United States dollar,
    
    foreign currency exchange rate fluctuations,
    
    longer sales cycles to sell products like the BIS system to hospitals and outpatient
surgical centers, which could slow our revenue growth from international sales, and
    
    longer accounts receivable payment cycles and difficulties in collecting accounts
receivable.
  36




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We may experience customer dissatisfaction and our reputation could suffer if we fail to
manufacture enough products to meet our customers demands.
  Our reliance on sole-source suppliers could adversely affect our ability to meet our customers
demands for our products in a timely manner or within budget.
  We plan to relocate our facilities in 2006 and it may cause disruption to our operations and our
business.
  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.
  37




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##### Table of Contents



We may be sued by third parties which claim that our products infringe on their intellectual
property rights, particularly because there is substantial uncertainty about the validity and
breadth of medical device patents.
  
    
    cease selling, incorporating or using any of our products that incorporate the challenged
intellectual property, which would adversely affect our revenue,
    
    obtain a license from the holder of the infringed intellectual property right, which
license may not be available on reasonable terms, if at all, and
    
    redesign our products, which may be costly, time-consuming and may not be successful.
 We could be exposed to significant product liability claims which could divert management attention
and adversely affect our cash balances, our ability to obtain and maintain insurance coverage at
satisfactory rates or in adequate amounts and our reputation.
  Several class action lawsuits have been filed against the underwriters of our initial public
offering which may result in negative publicity and potential litigation against us that would be
costly to defend and the outcome of which is uncertain and may harm our business.
   38




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Boston Scientific Corporation may be able to affect corporate actions requiring stockholder
approval because it owns a significant amount of our common stock, additionally, if our strategic
alliance with Boston Scientific Corporation is not successful, our operating results could be
adversely affected.
  We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could
result in unanticipated expenses and fluctuations in operating results.
  We may not be able to compete effectively, which could result in price reductions and decreased
demand for our products.
  Our ability to market and sell our products and generate revenue depends upon receipt of domestic
and foreign regulatory approval of our products and manufacturing operations.
  39




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##### Table of Contents



Even if we obtain the necessary FDA clearances or approvals, if we or our suppliers fail to comply
with ongoing regulatory requirements our products could be subject to restrictions or withdrawal
from the market.
  
    
    untitled letters, warning letters, fines, injunctions and civil penalties,
    
    administrative detention, which is the detention by the FDA of medical devices
believed to be adulterated or misbranded,
    
    customer notification, or orders for repair, replacement or refund,
    
    voluntary or mandatory recall or seizure of our products,
    
    operating restrictions, partial suspension or total shutdown of production,
    
    refusal to review pre-market notification or pre-market approval submissions,
    
    rescission of a substantial equivalence order or suspension or withdrawal of a pre-market approval, and
    
    criminal prosecution.
  40




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We may be subject, directly or indirectly, to federal and state healthcare fraud and abuse laws and
regulations and, if we are unable to fully comply with such laws, could face substantial penalties.
  If we do not retain our senior management and other key employees, we may not be able to
successfully implement our business strategy.
  If we do not attract and retain skilled personnel, or if we do not maintain good relationships with
our employees, we will not be able to expand our business.
   Our employees may engage in misconduct or other improper activities, including insider trading.
   41




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##### Table of Contents



Failure of users of the BIS system, or users of future products we may develop, to obtain adequate
reimbursement from third-party payors could limit market acceptance of the BIS system and other
products, which could prevent us from sustaining profitability.
   Transactions engaged in by our largest stockholders, our directors or executives involving our
common stock may have an adverse effect on the price of our stock.
   We have various mechanisms in place to discourage takeover attempts, which may reduce or eliminate
our stockholders ability to sell their shares for a premium in a change of control transaction.
  
    
    preferred stock that could be issued by our board of directors to make it more
difficult for a third party to acquire, or to discourage a third party from acquiring,
a majority of our outstanding voting stock,
    
    classification of our directors into three classes with respect to the time for which they hold office,
    
    non-cumulative voting for directors,
    
    control by our board of directors of the size of our board of directors,
    
    limitations on the ability of stockholders to call special meetings of stockholders,
    
    inability of our stockholders to take any action by written consent, and
    
    advance notice requirements for nominations of candidates for election to our board
of directors or for proposing matters that can be acted upon by our stockholders at
stockholder meetings.
 42




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Item 4. Submission of Matters to a Vote of Security Holders.
    
 Item 5. Other Information
    
 Item 6. Exhibits.
 10-Q.
 43




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SIGNATURE
  ASPECT MEDICAL SYSTEMS, INC.Date: August 10, 2006
    By:
    /s/ Michael FalveyMichael FalveyVice President and Chief Financial Officer
(Principal Financial and Accounting Officer) 44




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##### Table of Contents



EXHIBIT INDEX
 EXHIBITNUMBER
    
    EXHIBIT10.1 
    
    Addendum 3, Effective September 1, 2004, to the OEM Development
and Purchase Agreement, dated August 6, 1999, by and between the
Registrant and Philips Medizinsysteme Boeblingen GmbH (formerly
Agilent Technologies, Inc.).10.2
    
    Second Amendment to Net Lease dated
February 3, 2006, by and
between the Registrant and CFRI/CQ Norwood Upland, L.L.C.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.