##### Table of Contents



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549



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FORM 10-Q



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

For the quarterly period ended September 28, 2002



|[   ] |  |  | 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



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

|                                          |  |                                                
|----------------------------------------- |  | -----------------------------------------------
|Delaware
(State or Other Jurisdiction of  |  | 04-2985553
(I.R.S. Employer Identification No.)
|Incorporation or Organization)            |  |                                                
|                                         
|141 Needham Street, Newton, Massachusetts |  | 02464-1505                                     
|(Address of Principal Executive Offices)  |  | (Zip Code)                                     

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



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

YES [X]     NO [   ]

The Registrant had 19,337,340 shares of Common Stock, $0.01 par value per
share, outstanding as of November 5, 2002.



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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. Qualitative and Quantitative 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 Report on Form 8-K.                                                      
|SIGNATURE                                                                                     
|CERTIFICATIONS                                                                                
|EX-10.1 OEM PRODUCT DEVELOPMENT AGREEMENT 8/7/02                                              
|EX-99.1 CERTIFICATION OF CEO                                                                  
|EX-99.2 CERTIFICATION OF CFO                                                                  



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##### 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 28, 2002 and December 31, 2001                                          |    |      | 1  | 
|              
|               |  | Consolidated Statements of Operations for the Three and Nine Months Ended
September 28, 2002 and September 29, 2001 |    |      | 2  | 
|              
|               |  | Consolidated Statements of Cash Flows for the Nine Months Ended
September 28, 2002 and September 29, 2001           |    |      | 3  | 
|              
|               |  | Notes to Consolidated Financial Statements                                                                          |    |      | 4  | 
|              
|Item 2.        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                               |    |      | 11 | 
|              
|Item 3.        |  | Quantitative and Qualitative Disclosures About Market Risk                                                          |    |      | 28 | 
|              
|Item 4.        |  | Controls and Procedures                                                                                             |    |      | 28 | 
|              
|PART II        |  | OTHER INFORMATION                                                                                                   |    |      | 29 | 
|              
|Item 1.        |  | Legal Proceedings                                                                                                   |    |      | 29 | 
|              
|Item 2.        |  | Changes in Securities and Use of Proceeds                                                                           |    |      | 29 | 
|              
|Item 3.        |  | Defaults Upon Senior Securities                                                                                     |    |      | 29 | 
|              
|Item 4.        |  | Submission of Matters to a Vote of Security Holders                                                                 |    |      | 29 | 
|              
|Item 5.        |  | Other Information                                                                                                   |    |      | 29 | 
|              
|Item 6.        |  | Exhibits and Reports on Form 8-K                                                                                    |    |      | 30 | 
|              
|SIGNATURE      |  |                                                                                                                     | 31 |     
|              
|CERTIFICATIONS |  |                                                                                                                     | 32 |     



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##### Table of Contents






PART I  FINANCIAL INFORMATION




Item 1. Financial Statements.

ASPECT MEDICAL SYSTEMS, INC.




CONSOLIDATED BALANCE SHEETS

|                                          |                                                                                                                                                                               |                                            |           |               |            |              |           |             |            | 
|----------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | --------- | ------------- | ---------- | ------------ | --------- | ----------- | ---------- | 
|                                          |                                                                                                                                                                               |                                            |           | September 28, |            | December 31,
|                                          |                                                                                                                                                                               |                                            |           | 2002          |            | 2001        
|                                          |                                                                                                                                                                               |                                            |           |               |            |             
|                                          |                                                                                                                                                                               |                                            |           | (Unaudited)   |            |              |           |            
|ASSETS                                    |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|Current assets:                           |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|                                          | Cash and cash equivalents                                                                                                                                                     |                                            | $         | 25,187,792    |            |              | $         | 14,325,348  |           
|                                          | Restricted cash                                                                                                                                                               |                                            |           | 5,100,000     |            |              |           | 5,100,000   |           
|                                          | Marketable securities                                                                                                                                                         |                                            |           | 8,593,917     |            |              |           | 22,032,628  |           
|                                          | Accounts receivable, net of allowance of $519,000 at
September 28, 2002 and $522,000 at December 31, 2001                                                                     |                                            |           | 5,065,952     |            |              |           | 5,395,096   |           
|                                          | Current portion of investment in sales-type leases                                                                                                                            |                                            |           | 1,597,087     |            |              |           | 1,473,260   |           
|                                          | Inventory                                                                                                                                                                     |                                            |           | 2,786,699     |            |              |           | 5,108,166   |           
|                                          | Other current assets                                                                                                                                                          |                                            |           | 1,416,015     |            |              |           | 1,182,385   |           
|                                          |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|                                          |                                                                                                                                                                               | Total current assets                       |           |               | 49,747,462 |              |           |             | 54,616,883 | 
|Property and equipment, net               |                                                                                                                                                                               |                                            | 4,518,798 |               |            |              | 5,695,436 |            
|Long-term investment in sales-type leases |                                                                                                                                                                               |                                            | 2,417,495 |               |            |              | 1,934,699 |            
|Other long-term assets                    |                                                                                                                                                                               |                                            | 1,042,572 |               |            |              | 1,122,026 |            
|                                          |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|                                          |                                                                                                                                                                               | Total assets                               |           | $             | 57,726,327 |              |           | $           | 63,369,044 | 
|                                          |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|LIABILITIES AND STOCKHOLDERS EQUITY      |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|Current liabilities:                      |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|                                          | Working capital line of credit                                                                                                                                                |                                            | $         |              |            |              | $         | 3,000,000   |           
|                                          | Current portion of long-term debt                                                                                                                                             |                                            |           | 834,251       |            |              |           | 829,947     |           
|                                          | Accounts payable                                                                                                                                                              |                                            |           | 1,262,517     |            |              |           | 1,563,990   |           
|                                          | Accrued liabilities                                                                                                                                                           |                                            |           | 6,736,726     |            |              |           | 7,436,236   |           
|                                          | Deferred revenue                                                                                                                                                              |                                            |           | 575,599       |            |              |           | 521,119     |           
|                                          |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|                                          |                                                                                                                                                                               | Total current liabilities                  |           |               | 9,409,093  |              |           |             | 13,351,292 | 
|Long-term portion of deferred revenue     |                                                                                                                                                                               |                                            | 7,183,753 |               |            |              | 997,813   |            
|Long-term debt                            |                                                                                                                                                                               |                                            | 946,303   |               |            |              | 963,813   |            
|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, 19,336,840 and 17,791,967 shares issued
and outstanding at September 28, 2002 and December 31,
2001, respectively |                                            |           | 193,368       |            |              |           | 177,920     |           
|                                          | Additional paid-in capital                                                                                                                                                    |                                            |           | 130,368,739   |            |              |           | 126,533,939 |           
|                                          | Warrants                                                                                                                                                                      |                                            |           | 121,684       |            |              |           | 121,684     |           
|                                          | Notes receivable from employees and directors                                                                                                                                 |                                            |           | (271,049      | )          |              |           | (335,777    | )         
|                                          | Deferred compensation                                                                                                                                                         |                                            |           |              |            |              |           | (23,162     | )         
|                                          | Accumulated other comprehensive (loss) income                                                                                                                                 |                                            |           | (5,996        | )          |              |           | 33,617      |           
|                                          | Accumulated deficit                                                                                                                                                           |                                            |           | (90,219,568   | )          |              |           | (78,452,095 | )         
|                                          |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|                                          |                                                                                                                                                                               | Total stockholders equity                 |           |               | 40,187,178 |              |           |             | 48,056,126 | 
|                                          |                                                                                                                                                                               |                                            |           |               |            |              |           |            
|                                          |                                                                                                                                                                               | Total liabilities and stockholders equity |           | $             | 57,726,327 |              |           | $           | 63,369,044 | 
|                                          |                                                                                                                                                                               |                                            |           |               |            |              |           |            

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

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ASPECT MEDICAL SYSTEMS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

|                                             |                            |                          |            |                    |            |                   |            |               |            |               |             |            |            |   |             |            |            | 
|-------------------------------------------- | -------------------------- | ------------------------ | ---------- | ------------------ | ---------- | ----------------- | ---------- | ------------- | ---------- | ------------- | ----------- | ---------- | ---------- | - | ----------- | ---------- | ---------- | 
|                                             |                            |                          |            | Three Months Ended |            | Nine Months Ended
|                                             |                            |                          |            |                    |            |                  
|                                             |                            |                          |            | September 28,      |            | September 29,     |            | September 28, |            | September 29,
|                                             |                            |                          |            | 2002               |            | 2001              |            | 2002          |            | 2001         
|                                             |                            |                          |            |                    |            |                   |            |               |            |              
|                                             |                            |                          |            | (Unaudited)        |            | (Unaudited)       |            | (Unaudited)   |            | (Unaudited)  
|Revenue                                      |                            | $                        | 9,995,213  |                    |            | $                 | 8,528,080  |               |            | $             | 29,733,002  |            |            | $ | 26,363,921  |           
|Costs and expenses:                          |                            |                          |            |                    |            |                   |            |               |            |               |             |            |            |   |             |           
|                                             | Costs of revenue           |                          |            | 2,803,279          |            |                   |            | 3,051,077     |            |               |             | 9,344,866  |            |   |             | 8,702,214  |           
|                                             | Research and development   |                          |            | 1,885,866          |            |                   |            | 1,968,659     |            |               |             | 5,848,541  |            |   |             | 5,587,219  |           
|                                             | Sales and marketing        |                          |            | 6,981,264          |            |                   |            | 6,851,143     |            |               |             | 21,294,935 |            |   |             | 21,038,124 |           
|                                             | General and administrative |                          |            | 1,960,242          |            |                   |            | 2,003,111     |            |               |             | 5,744,221  |            |   |             | 6,092,629  |           
|                                             |                            |                          |            |                    |            |                   |            |               |            |               |             |            |            |   |             |           
|                                             |                            | Total costs and
expenses |            |                    | 13,630,651 |                   |            |               | 13,873,990 |               |             |            | 42,232,563 |   |             |            | 41,420,186 | 
|                                             |                            |                          |            |                    |            |                   |            |               |            |               |             |            |            |   |             |           
|Loss from operations                         |                            |                          | (3,635,438 | )                  |            |                   | (5,345,910 | )             |            |               | (12,499,561 | )          |            |   | (15,056,265 | )         
|Interest income                              |                            |                          | 289,708    |                    |            |                   | 586,571    |               |            |               | 917,805     |            |            |   | 2,456,062   |           
|Interest expense                             |                            |                          | (60,387    | )                  |            |                   | (77,769    | )             |            |               | (185,717    | )          |            |   | (300,617    | )         
|                                             |                            |                          |            |                    |            |                   |            |               |            |               |             |            |            |   |             |           
|Net loss                                     |                            | $                        | (3,406,117 | )                  |            | $                 | (4,837,108 | )             |            | $             | (11,767,473 | )          |            | $ | (12,900,820 | )         
|                                             |                            |                          |            |                    |            |                   |            |               |            |               |             |            |            |   |             |           
|Net loss per share:                          |                            |                          |            |                    |            |                   |            |               |            |               |             |            |            |   |             |           
|                                             | Basic and diluted          |                          | $          | (0.18              | )          |                   | $          | (0.27         | )          |               | $           | (0.65      | )          |   | $           | (0.73      | )         
|Shares used in computing net
loss per share: |                            |                          |            |                    |            |                   |            |               |            |               |             |            |            |   |             |           
|                                             | Basic and diluted          |                          |            | 18,733,293         |            |                   |            | 17,683,237    |            |               |             | 18,072,978 |            |   |             | 17,561,058 |           

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

2



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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.




CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |               |           |            |             |  
|---------------------------------------------------- | ----------------------------------------------------------------------------- | --------------------------------------------- | ------------------------------------------------------ | ----------------------------------------- | --------- | ----------------- | ---------- | ------------- | --------- | ---------- | ----------- | -
|                                                     |                                                                               |                                               |                                                        |                                           |           | Nine Months Ended
|                                                     |                                                                               |                                               |                                                        |                                           |           |                  
|                                                     |                                                                               |                                               |                                                        |                                           |           | September 28,     |            | September 29,
|                                                     |                                                                               |                                               |                                                        |                                           |           | 2002              |            | 2001         
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|                                                     |                                                                               |                                               |                                                        |                                           |           | (Unaudited)       |            | (Unaudited)  
|Cash flows from operating activities:                |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|                                                     | Net loss                                                                      |                                               | $                                                      | (11,767,473                               | )         |                   | $          | (12,900,820   | )        
|                                                     | Adjustments to reconcile net loss to net cash used for
operating activities - |                                               |                                                        |                                           |           |                   |            |               |          
|                                                     |                                                                               | Depreciation and amortization                 |                                                        |                                           | 2,032,128 |                   |            |               | 1,915,817 |           
|                                                     |                                                                               | Provision for doubtful accounts               |                                                        |                                           |          |                   |            |               | 50,000    |           
|                                                     |                                                                               | Compensation expense related to stock options |                                                        |                                           | 31,441    |                   |            |               | 52,737    |           
|                                                     |                                                                               | Changes in assets and liabilities -           |                                                        |                                           |           |                   |            |               |           |           
|                                                     |                                                                               |                                               | Decrease (increase) in accounts receivable             |                                           |           | 329,144           |            |               |           | (1,108,007 | )          
|                                                     |                                                                               |                                               | Decrease (increase) in inventory                       |                                           |           | 2,321,467         |            |               |           | (1,403,201 | )          
|                                                     |                                                                               |                                               | (Increase) decrease in other assets                    |                                           |           | (185,523          | )          |               |           | 230,459    |            
|                                                     |                                                                               |                                               | (Increase) decrease in investment in sales-type leases |                                           |           | (606,623          | )          |               |           | 843,130    |            
|                                                     |                                                                               |                                               | Decrease in accounts payable                           |                                           |           | (301,473          | )          |               |           | (932,375   | )          
|                                                     |                                                                               |                                               | (Decrease) increase in accrued liabilities             |                                           |           | (699,510          | )          |               |           | 900,248    |            
|                                                     |                                                                               |                                               | Increase (decrease) in deferred revenue                |                                           |           | 6,240,420         |            |               |           | (380,536   | )          
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|                                                     |                                                                               |                                               |                                                        | Net cash used for operating activities    |           |                   | (2,606,002 | )             |           |            | (12,732,548 | )
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|Cash flows from investing activities:                |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|                                                     | Loans to related parties                                                      |                                               |                                                        | 31,347                                    |           |                   |            | (1,074,891    | )        
|                                                     | Acquisition of property and equipment                                         |                                               |                                                        | (855,490                                  | )         |                   |            | (1,286,364    | )        
|                                                     | Increase in restricted cash                                                   |                                               |                                                        |                                          |           |                   |            | (5,100,000    | )        
|                                                     | Purchases of marketable securities                                            |                                               |                                                        | (9,088,675                                | )         |                   |            | (20,060,061   | )        
|                                                     | Proceeds from sales and maturities of marketable securities                   |                                               |                                                        | 22,487,773                                |           |                   |            | 33,151,687    |          
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|                                                     |                                                                               |                                               |                                                        | Net cash provided by investing activities |           |                   | 12,574,955 |               |           |            | 5,630,371   |  
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|Cash flows from financing activities:                |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|                                                     | Proceeds from working capital line of credit                                  |                                               |                                                        |                                          |           |                   |            | 4,000,000     |          
|                                                     | Payment on working capital line of credit                                     |                                               |                                                        | (3,000,000                                | )         |                   |            |              |          
|                                                     | Principal payments on equipment loan                                          |                                               |                                                        |                                          |           |                   |            | (720,670      | )        
|                                                     | Principal payments on term loan                                               |                                               |                                                        |                                          |           |                   |            | (1,884,933    | )        
|                                                     | Proceeds from sale of investment in sales-type leases                         |                                               |                                                        | 715,637                                   |           |                   |            | 283,528       |          
|                                                     | Principal payments on debt related to investment in
sales-type leases         |                                               |                                                        | (728,843                                  | )         |                   |            | (829,178      | )        
|                                                     | Proceeds from issuance of common stock                                        |                                               |                                                        | 3,841,969                                 |           |                   |            | 1,355,895     |          
|                                                     | Payments received on notes receivable from employees
and directors            |                                               |                                                        | 64,728                                    |           |                   |            | 175,010       |          
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|                                                     |                                                                               |                                               |                                                        | Net cash provided by financing activities |           |                   | 893,491    |               |           |            | 2,379,652   |  
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|Net increase (decrease) in cash and cash equivalents |                                                                               |                                               | 10,862,444                                             |                                           |           |                   | (4,722,525 | )            
|Cash and cash equivalents, beginning of period       |                                                                               |                                               | 14,325,348                                             |                                           |           |                   | 23,776,617 |              
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|Cash and cash equivalents, end of period             |                                                                               | $                                             | 25,187,792                                             |                                           |           | $                 | 19,054,092 |              
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|Supplemental disclosure of cash flow information:    |                                                                               |                                               |                                                        |                                           |           |                   |            |              
|                                                     | Interest paid                                                                 |                                               | $                                                      | 185,385                                   |           |                   | $          | 333,358       |          
|                                                     |                                                                               |                                               |                                                        |                                           |           |                   |            |              

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

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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, 2001 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

The functional currency of the Companys international subsidiaries is
the U.S. dollar; therefore, transaction gains and losses from such entities
are recorded in the consolidated statements of operations. Foreign currency
transaction gains and losses 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 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 28,
2002 and December 31, 2001. 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.

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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

In August 2002, the Company sold 1,428,572 shares of its 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. Approximately $6,300,000 of the aggregate purchase
price was recorded as deferred revenue in the accompanying consolidated
balance sheet. This amount represents the difference between the purchase
price of $7.00 per share and the closing price of the Companys common stock
on the date of the sale. The deferred revenue will be recognized ratably
over the term of the OEM product development and distribution agreement.

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 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 continuously 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 and
obsolete inventory based primarily 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.

Warranty

Equipment sold 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.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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 equivalents, accounts
receivable, investment in sales-type lease receivables and marketable
securities. To minimize the 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.

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. 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 delays or shortages 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 28,
2002 and September 29, 2001, were computed by dividing the net loss 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.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

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.

(3) Comprehensive Income (Loss)

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

|                                   |                                                 |   |                    |        |                   |   |               |        |               |   |             |         |   |   |             |        | 
|---------------------------------- | ----------------------------------------------- | - | ------------------ | ------ | ----------------- | - | ------------- | ------ | ------------- | - | ----------- | ------- | - | - | ----------- | ------ | 
|                                   |                                                 |   | Three Months Ended |        | Nine Months Ended
|                                   |                                                 |   |                    |        |                  
|                                   |                                                 |   | September 28,      |        | September 29,     |   | September 28, |        | September 29,
|                                   |                                                 |   | 2002               |        | 2001              |   | 2002          |        | 2001         
|                                   |                                                 |   |                    |        |                   |   |               |        |              
|                                   |                                                 |   | (Unaudited)        |        | (Unaudited)       |   | (Unaudited)   |        | (Unaudited)  
|Net loss                           |                                                 | $ | (3,406,117         | )      |                   | $ | (4,837,108    | )      |               | $ | (11,767,473 | )       |   | $ | (12,900,820 | )     
|Other comprehensive income (loss): |                                                 |   |                    |        |                   |   |               |        |               |   |             |         |   |   |             |       
|                                   | Unrealized (loss) gain on
marketable securities |   |                    | (8,093 | )                 |   |               | 52,491 |               |   |             | (39,613 | ) |   |             | 30,911 | 
|                                   |                                                 |   |                    |        |                   |   |               |        |               |   |             |         |   |   |             |       
|Comprehensive loss                 |                                                 | $ | (3,414,210         | )      |                   | $ | (4,784,617    | )      |               | $ | (11,807,086 | )       |   | $ | (12,869,909 | )     
|                                   |                                                 |   |                    |        |                   |   |               |        |               |   |             |         |   |   |             |       

(4) Investment in Sales-Type Leases

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

|                                        |                          |   |               |           |              |   |           |           | 
|--------------------------------------- | ------------------------ | - | ------------- | --------- | ------------ | - | --------- | --------- | 
|                                        |                          |   | September 28, |           | December 31,
|                                        |                          |   | 2002          |           | 2001        
|                                        |                          |   |               |           |             
|                                        |                          |   | (Unaudited)   |           |              |   |          
|Total minimum lease payments receivable |                          | $ | 4,979,443     |           |              | $ | 4,199,380 |          
|                                        | Less  unearned interest |   |               | 964,861   |              |   |           | 791,421   | 
|                                        |                          |   |               |           |              |   |           |          
|Net investment in sales-type leases     |                          |   | 4,014,582     |           |              |   | 3,407,959 |          
|                                        | Less  current portion   |   |               | 1,597,087 |              |   |           | 1,473,260 | 
|                                        |                          |   |               |           |              |   |           |          
|                                        |                          | $ | 2,417,495     |           |              | $ | 1,934,699 |          
|                                        |                          |   |               |           |              |   |           |          

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(5) Inventory

Inventory consists of the following:

|                 |  |               |           |              |  |   |           | 
|---------------- |  | ------------- | --------- | ------------ |  | - | --------- | 
|                 |  | September 28, |           | December 31,
|                 |  | 2002          |           | 2001        
|                 |  |               |           |             
|                 |  | (Unaudited)   |           |              |  |  
|Raw materials    |  | $             | 1,557,879 |              |  | $ | 2,891,400 | 
|Work-in-progress |  |               | 161,868   |              |  |   | 90,076    | 
|Finished goods   |  |               | 1,066,952 |              |  |   | 2,126,690 | 
|                 |  |               |           |              |  |   |           | 
|                 |  | $             | 2,786,699 |              |  | $ | 5,108,166 | 
|                 |  |               |           |              |  |   |           | 

(6) Segment Information and Enterprise Reporting

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

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

|                                        |               |   |                    |           |                   |   |               |           |               |   |            |           |  |   |            |           | 
|--------------------------------------- | ------------- | - | ------------------ | --------- | ----------------- | - | ------------- | --------- | ------------- | - | ---------- | --------- |  | - | ---------- | --------- | 
|                                        |               |   | Three Months Ended |           | Nine Months Ended
|                                        |               |   |                    |           |                  
|                                        |               |   | September 28,      |           | September 29,     |   | September 28, |           | September 29,
|                                        |               |   | 2002               |           | 2001              |   | 2002          |           | 2001         
|                                        |               |   |                    |           |                   |   |               |           |              
|                                        |               |   | (Unaudited)        |           | (Unaudited)       |   | (Unaudited)   |           | (Unaudited)  
|Geographic Area by Destination
Domestic |               | $ | 8,324,774          |           |                   | $ | 6,917,188     |           |               | $ | 24,695,207 |           |  | $ | 20,420,949 |          
|                                        | International |   |                    | 1,670,439 |                   |   |               | 1,610,892 |               |   |            | 5,037,795 |  |   |            | 5,942,972 | 
|                                        |               |   |                    |           |                   |   |               |           |               |   |            |           |  |   |            |          
|                                        |               | $ | 9,995,213          |           |                   | $ | 8,528,080     |           |               | $ | 29,733,002 |           |  | $ | 26,363,921 |          
|                                        |               |   |                    |           |                   |   |               |           |               |   |            |           |  |   |            |          

|                                        |               |  |                    |    |                   |  |               |    |               |  |     |    |  |  |     |    | 
|--------------------------------------- | ------------- |  | ------------------ | -- | ----------------- |  | ------------- | -- | ------------- |  | --- | -- |  |  | --- | -- | 
|                                        |               |  | Three Months Ended |    | Nine Months Ended
|                                        |               |  |                    |    |                  
|                                        |               |  | September 28,      |    | September 29,     |  | September 28, |    | September 29,
|                                        |               |  | 2002               |    | 2001              |  | 2002          |    | 2001         
|                                        |               |  | (Unaudited)        |    | (Unaudited)       |  | (Unaudited)   |    | (Unaudited)  
|                                        |               |  |                    |    |                   |  |               |    |              
|Geographic
Area by Destination
Domestic |               |  | 83                 | %  |                   |  | 81            | %  |               |  | 83  | %  |  |  | 77  | % 
|                                        | International |  |                    | 17 |                   |  |               | 19 |               |  |     | 17 |  |  |     | 23 | 
|                                        |               |  |                    |    |                   |  |               |    |               |  |     |    |  |  |     |   
|                                        |               |  | 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 28, 2002 and September
29, 2001.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

(7) Related Party Transactions

During the first quarter of 2001, the Company loaned, on a full recourse
basis, $75,000 to certain employees of the Company. In April 2001, the
Company loaned, on a full recourse basis, an aggregate of $1,081,000, to an
officer, certain employees and a consultant of the Company. In May 2002, the
Company loaned, on a full recourse basis, $50,000 to an officer of the
Company. On September 27, 2002, that officer left the employ of the Company
and the note and accrued interest became due and payable. The loans are
evidenced by promissory notes bearing interest with rates ranging from 5.00%
to 8.00% per annum. The loans, included in other assets in the accompanying
consolidated balance sheets, are payable over periods ranging from one to
five years and are in each case secured by assets of the borrower,
including shares of the Companys common stock owned by the borrower. The aggregate
outstanding balance on these loans at September 28, 2002 and December 31,
2001 was approximately $1,171,000 and $1,209,000, respectively.

In January 2002, the Company entered into a consulting agreement with
one of its directors to provide consulting, advisory and neuroscience
business planning services to the Company. As of September 28, 2002,
approximately $9,000 has been paid to this director under this consulting
agreement.

(8) Loan Agreements

In May 2001, the Company paid the outstanding principal on both the
equipment portion and term loan portion of its December 1999 loan agreement
with a commercial bank and terminated the agreement. Following the
termination of this loan agreement, the Company entered into an agreement
with another commercial bank for a revolving line of credit. The revolving
line of credit is for $5,000,000 and expires on May 14, 2003 and, subject to
annual review by the commercial bank, may be extended at the discretion of
the commercial bank. Interest on any borrowings under the revolving line of
credit is, at the election of the Company, either the prime rate or at LIBOR
plus 2.25%. Up to $1,500,000 of the $5,000,000 revolving line of credit is
available for standby letters of credit.

The revolving line of credit agreement contains restrictive covenants
that require the Company to maintain liquidity and net worth ratios and is
secured by certain investments of the Company, which are shown as restricted
cash in the accompanying consolidated balance sheets. The Company is
required to maintain restricted cash and securities with a net equity value
equal to 102% of the $5,000,000 commitment. At September 28, 2002, there was
no outstanding balance under the revolving line of credit, and the Company
was in compliance with all covenants contained in the revolving line of
credit agreement. At September 28, 2002, the interest rate on the revolving
line of credit was 4.75%.

The Company has entered into an agreement for a $5,000,000 revolving
line of credit with Boston Scientific Corporation in connection with a
strategic alliance entered into in August 2002 (see Note 9).

(9) Strategic Alliance with Boston Scientific Corporation

On August 7, 2002, the Company formed a strategic alliance with Boston
Scientific Corporation. 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 Boston Scientific Corporation pursuant to a stock
purchase agreement and granted Boston Scientific Corporation an option 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 $6,300,000 of the
aggregate purchase price was recorded as deferred revenue in the accompanying
consolidated balance sheet at September 28, 2002. This amount 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 product development and distribution agreement.

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ASPECT MEDICAL SYSTEMS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

On August 7, 2002, the Company also entered into an agreement with
Boston Scientific Corporation for a revolving line of credit. The revolving
line of credit is for $5,000,000, 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. The Companys revolving line of credit
with Boston Scientific Corporation 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 28, 2002, 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.

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

This Quarterly Report on Form 10-Q contains, in addition to historical
information, forward-looking statements within the meaning of Section 21E of
the Securities Exchange Act of 1934, as amended. These forward-looking
statements involve risks and uncertainties and are not guarantees of future
performance. Our actual results could differ significantly from the results
discussed in these forward-looking statements. In addition, subsequent events
and developments may cause our expectations to change. While we may elect to
update these forward-looking statements, we specifically disclaim any
obligation to do so, even if our expectations change. See Factors Affecting
Future Operating Results below.

Overview

We develop, manufacture and market an anesthesia monitoring system that we
call the BIS system. The BIS system is based on our patented core technology,
the 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 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 disposable BIS Sensors. We collectively refer to
our group of disposable sensors, including the BIS Standard Sensor, BIS Sensor
Plus, BIS Pediatric Sensor, BIS Quatro Sensor, which we formerly called the BIS
XP Sensor, and BIS Extend Sensor 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. The BIS XP system offers
enhanced performance capabilities and expanded benefits as compared to the
previous version of our BIS system, enabling more precise measurement of brain
activity to assess the level of consciousness. The BIS XP system is designed
to detect and filter interference from muscle artifact and is resistant to
interference from electrocautery devices. Additionally, it is able to provide
enhanced detection of near suppression, a brain wave pattern occasionally seen
during deep anesthesia and cardiac cases. Our other monitor products are the
A-1000 Monitor, the A-1050 EEG Monitor with BIS and the BIS Module Kit. After
the introduction of the A-2000 BIS Monitor, we ceased active marketing of the
A-1050 EEG Monitor with BIS domestically. In addition to the disposable BIS
Sensors, we offer the Zipprep EEG Electrode.

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

We offer customers the option either to purchase the BIS monitor outright
or to acquire the BIS monitor pursuant to a sales-type lease agreement whereby
the customer contractually commits to purchase a minimum number of BIS Sensors
per BIS monitor per year. Under this agreement, customers purchase BIS Sensors
and the BIS monitor for the purchase price of the BIS Sensors plus an
additional charge per BIS Sensor to pay for the purchase price of the BIS
monitor and related financing costs over the term of the agreement. The
customer is granted an option to purchase the BIS monitor at the end of the
term of the agreement, which is typically three to five years. Revenue related
to BIS monitors sold pursuant to sales-type leases is recognized at the time of
shipment of the BIS monitors. Sales-type leases accounted for approximately 4%
of total revenue in both the three and nine months ended September 28, 2002,
and approximately 4% and 2% of total revenue in the three and nine months ended
September 29, 2001, respectively.

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

We 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 28, 2002 and September 29,
2001, revenue from the sale of Equipment represented approximately 31% and 32%,
respectively, of our revenue, and revenue from the sale of BIS Sensors
represented approximately 69% and 68%, respectively, of our revenue. In the
nine months ended September 28, 2002 and September 29, 2001, revenue from the
sale of Equipment represented approximately 34% and 31%, respectively, of our
revenue, and revenue from the sale of BIS Sensors represented approximately 66%
and 69%, respectively, of our revenue.

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Revenue from domestic sales in the three months ended September 28, 2002
and September 29, 2001 was approximately $8.3 million and $6.9 million,
respectively, which represented approximately 83% and 81%, respectively, of our
revenue for those periods. For the nine months ended September 28, 2002 and
September 29, 2001, revenue from domestic sales was approximately $24.7 million
and $20.4 million, respectively, which represented approximately 83% and 77%,
respectively, of our revenue for those periods. Revenue from international
sales in the three months ended September 28, 2002 and September 29, 2001 was
approximately $1.7 million and $1.6 million, respectively, which represented
approximately 17% and 19%, respectively, of our revenue for those periods.
Revenue from international sales in the nine months ended September 28, 2002
and September 29, 2001 was approximately $5.0 million and $5.9 million,
respectively, which represented approximately 17% and 23%, respectively, of our
revenue for those periods.

We have subsidiaries in The Netherlands and the United Kingdom, through
which we sell our products into the international market. We are developing
our international sales and distribution program through a combination of
clinical specialists to support our customers, 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 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 16% and
25%, respectively, of international revenue for the three and nine months ended
September 28, 2002 and approximately 37% and 24%, respectively, of
international revenue for the three and nine months ended September 29, 2001.

Various factors may adversely affect our quarterly operating results
through the year ending December 31, 2002. Among these factors are: first,
during this quarter we experienced a change in the management of our North
American field operations. Second, as we continue to shift the focus of our
placements from BIS monitors to BIS modules, Equipment revenue may be adversely
affected. Third, in Japan, Nihon Kohden is awaiting approval of the BIS XP
system. We believe customers may delay or reconsider purchasing decisions in
Japan pending this approval.

Application of Critical Accounting Policies

Financial Reporting Release No. 60, which was released by the Securities
and Exchange Commission, or SEC, in December 2001, 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 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 of certain
amounts included in the financial statements, giving due consideration to
materiality. 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 per 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. 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.

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Accounts Receivable

Estimates are used in determining our allowance for doubtful accounts
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, we
cannot guarantee that we will continue to experience the same credit loss rates
that we have in the past. To the extent we experience a deterioration in our
historical collections experience or increased credit losses, bad debt expense
could 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 and obsolete inventory based
primarily 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.

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. Therefore, if in any period it is determined 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
operations.

Warranty

Equipment sold 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
historical experience and an 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.

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Results of Operations

The following table presents, for the periods indicated, certain expenses
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 28,      |     | September 29,     |     | September 28, |     | September 29,
|                     |                            |                          |     | 2002               |     | 2001              |     | 2002          |     | 2001         
|                     |                            |                          |     |                    |     |                   |     |               |     |              
|Revenue              |                            |                          | 100 | %                  |     |                   | 100 | %             |     |               | 100 | %  |     |  | 100 | % 
|Costs and expenses:  |                            |                          |     |                    |     |                   |     |               |     |               |     |    |     |  |     |   
|                     | Costs of revenue           |                          |     | 28                 |     |                   |     | 36            |     |               |     | 31 |     |  |     | 33 |    
|                     | Research and development   |                          |     | 19                 |     |                   |     | 23            |     |               |     | 20 |     |  |     | 21 |    
|                     | Sales and marketing        |                          |     | 70                 |     |                   |     | 80            |     |               |     | 72 |     |  |     | 80 |    
|                     | General and administrative |                          |     | 19                 |     |                   |     | 24            |     |               |     | 19 |     |  |     | 23 |    
|                     |                            |                          |     |                    |     |                   |     |               |     |               |     |    |     |  |     |   
|                     |                            | Total costs and expenses |     |                    | 136 |                   |     |               | 163 |               |     |    | 142 |  |     |    | 157 | 
|                     |                            |                          |     |                    |     |                   |     |               |     |               |     |    |     |  |     |   
|Loss from operations |                            |                          | (36 | )                  |     |                   | (63 | )             |     |               | (42 | )  |     |  | (57 | ) 
|Interest income, net |                            |                          | 2   |                    |     |                   | 6   |               |     |               | 2   |    |     |  | 8   |   
|                     |                            |                          |     |                    |     |                   |     |               |     |               |     |    |     |  |     |   
|Net loss             |                            |                          | (34 | )%                 |     |                   | (57 | )%            |     |               | (40 | )% |     |  | (49 | )%
|                     |                            |                          |     |                    |     |                   |     |               |     |               |     |    |     |  |     |   

Three and Nine Months Ended September 28, 2002 Compared to Three and Nine
Months Ended September 29, 2001

Revenue.Our revenue increased to approximately $10.0 million in the
three months ended September 28, 2002 from approximately $8.5 million in the
three months ended September 29, 2001, an increase of approximately 17%. Our
revenue increased to approximately $29.7 million in the nine months ended
September 28, 2002 from approximately $26.4 million in the nine months ended
September 29, 2001, an increase of approximately 13%.

Revenue from the sale of Equipment increased to approximately $3.1 million
in the three months ended September 28, 2002 from approximately $2.7 million in
the three months ended September 29, 2001, an increase of approximately 15%.
In the nine months ended September 28, 2002, Equipment revenue increased to
approximately $10.0 million from approximately $8.2 million in the nine months
ended September 29, 2001, an increase of approximately 22%. We believe that
the primary factor contributing to the increase in revenue from the sale of
Equipment in the three and nine months ended September 28, 2002 compared to the
three and nine months ended September 29, 2001 was the increase in revenue from
the sale of accessories, particularly sales of the BIS XP system upgrade kits,
which increased approximately 169% in the three months ended September 28, 2002
compared to the three months ended September 29, 2001 and increased
approximately 189% in the nine months ended September 28, 2002 compared to the
nine months ended September 29, 2001. Equipment revenue from the sale of
monitors and modules decreased approximately 13% in the three months ended
September 28, 2002 compared to the three months ended September 29, 2001 and
was flat in the nine months ended September 28, 2002 compared to the nine
months ended September 29, 2001. The decrease in monitor and module revenue in
the three months ended September 28, 2002 compared to the three months ended
September 29, 2001 was primarily the result of a 35% decrease in unit volume
partially offset by a 27% increase in the average unit price and a 23% increase
in module revenue. The decrease in monitor unit volume was primarily related
to a reduction of sales in Japan from 125 monitors in the three months ended
September 29, 2001 to none in the three months ended September 28, 2002 as
Nihon Kohden delays additional monitor purchases pending Japanese Ministry of
Health, Labor and Welfare approval of our BIS XP system. Revenue from the sale
of monitors and modules in the nine months ended September 28, 2002 compared to
the nine months ended September 29, 2001 was relatively flat as a result of a
decrease in monitor unit volume of approximately 7% and a decrease in module
revenue of approximately 26%, offset by an increase in the average unit price
of monitors of approximately 30%.

Revenue from the sale of BIS Sensors increased to approximately $6.9
million in the three months ended September 28, 2002 from approximately $5.8
million in the three months ended September 29, 2001, an increase of
approximately 18%. In the nine months ended September 28, 2002, revenue from
the sale of BIS Sensors increased to approximately $19.7 million from
approximately $18.1 million in the nine months ended September 29, 2001, an
increase of approximately 9%. The increase in revenue from the sale of BIS
Sensors in the three and nine months ended September 28, 2002 compared to the
three and nine months ended September 29, 2001 was primarily attributable to an
increase of approximately 16% and 8%, respectively, in the number of BIS
Sensors sold as a result of growth in the installed base of monitors and
modules and an increase in our average selling price of the BIS Sensors. Our
installed base of monitors and modules increased approximately 20% at September
28, 2002 compared to September 29, 2001, to more than 15,500 units.

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Our gross profit margin was approximately 72% and 69%, respectively, of
revenue in the three and nine months ended September 28, 2002 compared to a
gross profit margin of approximately 64% and 67%, respectively, of revenue in
the three and nine months ended September 29, 2001. The increase in gross
profit margin percentage for the three and nine months ended September 28, 2002
compared to the three and nine months ended September 29, 2001 was the result
of three factors. First, during the three and nine months ended September 28,
2002, we had a higher average selling price of our BIS Sensors. Second, we
experienced increased sales of our higher gross margin percentage BIS Sensors
compared to our Equipment as a result of the increase in our installed base of
monitors and BIS Module Kits during the third quarter. Finally, we experienced
an increase in the average worldwide selling price of monitors of approximately
27% in the three months ended September 28, 2002 compared to the three months
ended September 29, 2001 and an increase of approximately 30% in the nine
months ended September 28, 2002 compared to the nine months ended September 29,
2001.

In the fourth fiscal quarter of 2002, we believe that our gross margin
percentage will be comparable to the third fiscal quarter of 2002 because of
the effect of the continuing transition of our existing installed base to the
BIS XP system through the sale of low gross margin percentage upgrade kits and
a slight increase in Equipment revenue as a percentage of total revenue.

Research and Development.Research and development expenses decreased
slightly to approximately $1.9 million in the three months ended September 28,
2002 from approximately $2.0 million in the three months ended September 29,
2001, a decrease of approximately 4%. Research and development expenses
increased to approximately $5.8 million in the nine months ended September 28,
2002 from approximately $5.6 million in the nine months ended September 29,
2001, an increase of approximately 5%. The decrease in research and
development expenses for the three months ended September 28, 2002 compared to
the three months ended September 29, 2001, was primarily attributable to
decreases in product development expenses of approximately $107,000 as a result
of the completion of the development of our BIS XP system, research and
development personnel and related payroll and other expenses of approximately
$25,000 and clinical studies expense of approximately $25,000. These decreases
were offset by increases of approximately $59,000 in consulting expenses and
approximately $29,000 in patent related expenses.

The increase in research and development expenses for the nine months
ended September 28, 2002 compared to the nine months ended September 29, 2001,
was primarily attributable to an increase in personnel and related payroll and
other expenses of approximately $448,000, offset by decreases in product
development expenses of approximately $223,000, approximately $31,000 in
clinical studies expense and approximately $66,000 in consulting expenses. We
expect research and development expenses to increase slightly in the fourth
fiscal quarter of 2002 as compared to the third fiscal quarter of 2002 as we
continue to invest in the development of product improvements and extensions
for our current products, clinical studies, including our three multi-center,
multinational studies to determine the incidence of awareness during BIS
monitoring that we are sponsoring, and new applications for our technology,
including our initiatives into neuroscience.

Sales and Marketing.Sales and marketing expenses increased to
approximately $7.0 million in the three months ended September 28, 2002 from
approximately $6.9 million in the three months ended September 29, 2001, an
increase of approximately 2%. Sales and marketing expenses increased to
approximately $21.3 million in the nine months ended September 28, 2002 from
approximately $21.0 million in the nine months ended September 29, 2001, an
increase of approximately 1%. The slight increase in sales and marketing
expenses in the three months ended September 28, 2002 compared to the three
months ended September 29, 2001, was attributable to an increase in market
research and development expenses of approximately $99,000, an increase in
operating expenses associated with our international subsidiaries of
approximately $480,000 and an increase in clinical education initiatives of
approximately $64,000. These increases were offset by decreases in expenses
associated with efforts to improve our name and brand awareness through
advertising, public relations, tradeshows and the Internet of approximately
$92,000 and consulting expenses of approximately $103,000.

The increase in sales and marketing expenses for the nine months ended
September 28, 2002 compared to the nine months ended September 29, 2001 was
primarily attributable to an increase in expenses associated with increasing
our name and brand awareness through advertising, public relations, tradeshows
and the Internet of approximately $330,000, an increase in operating expenses
associated with our international subsidiaries of approximately $1.1 million
and an increase in clinical education initiatives of approximately $164,000.
These increases were offset by decreases in consulting expenses of
approximately $883,000 and in sales and marketing personnel and related payroll
and other expenses of approximately $353,000. We expect sales and marketing
expenses in the fourth fiscal quarter of 2002 to increase as compared to the
third fiscal quarter of 2002 as we continue to complement our existing sales
and marketing programs with additional programs.

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General and Administrative.General and administrative expenses were
approximately $2.0 million in both the three month periods ended September 28,
2002 and September 29, 2001. General and administrative expenses decreased to
approximately $5.7 million in the nine months ended September 28, 2002 from
approximately $6.1 million in the nine months ended September 29, 2001, a
decrease of approximately 6%. In the three months ended September 28, 2002
compared to the three months ended September 29, 2001, there was an increase of
approximately $101,000 of insurance expense and an increase of approximately
$71,000 in professional and consulting expenses. These increases were offset
by decreases in general and administrative personnel and related payroll and
other expenses of approximately $146,000 and investor relations expenses of
approximately $36,000. The decrease in general and administrative expenses for
the nine months ended September 28, 2002 compared to the nine months ended
September 29, 2001 was primarily attributable to a decrease in general and
administrative personnel and related payroll and other expenses of
approximately $418,000 and a decrease in investor relations expenses of
approximately $111,000. These decreases were offset by increases in
professional and consulting expenses of approximately $205,000 and insurance
expense of approximately $207,000. We expect general and administrative
expenses in the fourth fiscal quarter of 2002 to be comparable to the third
fiscal quarter of 2002.

Interest Income, Net.Net interest income decreased to approximately
$229,000 in the three months ended September 28, 2002 from approximately
$509,000 in the three months ended September 29, 2001, a decrease of
approximately 55%. Net interest income decreased to approximately $732,000 in
the nine months ended September 28, 2002 from approximately $2.2 million in the
nine months ended September 29, 2001, a decrease of approximately 66%.
Interest income decreased to approximately $290,000 in the three months ended
September 28, 2002 from approximately $587,000 in the three months ended
September 29, 2001, a decrease of approximately 51%. Interest income decreased
to approximately $918,000 in the nine months ended September 28, 2002 from
approximately $2.5 million in the nine months ended September 29, 2001, a
decrease of approximately 63%. The decrease in interest income was primarily
attributable to lower cash and investments 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 to approximately $60,000 in the three months
ended September 28, 2002 from approximately $78,000 in the three months ended
September 29, 2001, a decrease of approximately 22%. Interest expense
decreased to approximately $186,000 in the nine months ended September 28, 2002
from approximately $301,000 in the nine months ended September 29, 2001, a
decrease of approximately 38%. The decrease in interest expense in the three
and nine months ended September 28, 2002 was a result of the repayment of our
equipment and term loans in May 2001, lower average outstanding debt
obligations resulting from payments under our other debt obligations, and lower
interest rates on our working capital line of credit as compared to the
equipment and term loans. We expect net interest income to remain consistent
in the fourth fiscal quarter of 2002 compared to net interest income in the
third fiscal quarter of 2002 as a result of slightly higher average cash and
investment balances resulting from the sale of our common stock in August 2002,
offset by a continued decline in general interest rates and a reduction in
interest expense as we continue to repay our outstanding debt obligations.

Net Loss.As a result of the factors discussed above, for the three and
nine months ended September 28, 2002 we had a net loss of approximately $3.4
million and $11.8 million, respectively, as compared to a net loss of
approximately $4.8 million and $12.9 million for the three and nine months
ended September 29, 2001.

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 28, 2002, we raised
approximately $67.6 million from private equity financings and have received
approximately $3.4 million in equipment financing and approximately $4.5
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
on May 14, 2003. 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 sheets. 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 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. Approximately $6,300,000 of the aggregate purchase price was
recorded as deferred revenue in the accompanying consolidated balance sheet at
September 28, 2002. This amount represents the portion of the purchase price
in excess of the

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closing price of our common stock on the date of the sale.
This deferred revenue will be recognized ratably over the term of the OEM
product development and distribution agreement.

In August 2002, we also entered into an agreement with Boston Scientific
Corporation for a revolving line of credit. The revolving line of credit is
for $5.0 million, 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 28, 2002, 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 28, 2002.

We believe that the financial resources available to us, including our
current working capital and availability under our 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
EP program and to meet market demand for our products.

Working capital at September 28, 2002 was approximately $40.3 million
compared to approximately $41.3 million at December 31, 2001. The decrease in
working capital from December 31, 2001 to September 28, 2002 was primarily
attributable to our continued net loss of approximately $11.8 million, offset
by proceeds of approximately $10.0 million received from the sale of our common
stock in connection with the strategic alliance entered into in August 2002.

We used approximately $2.6 million of cash for operations in the nine
months ended September 28, 2002 as compared to approximately $12.7 million in
the nine months ended September 29, 2001. Cash used for operations in the nine
months ended September 28, 2002 was primarily driven by operating losses, a
decrease in accounts payable of approximately $301,000, a decrease in accrued
liabilities of approximately $700,000, an increase in other assets of
approximately $186,000 and an increase in our investment in sales-type leases
of approximately $607,000, offset by decreases in accounts receivable of
approximately $329,000, inventory of approximately $2.3 million due to improved
inventory management, and an increase in deferred revenue of approximately $6.2
million. The increase in deferred revenue is related to proceeds received in
connection with the strategic alliance entered into in August 2002. This
amount 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.

We received approximately $12.6 million of cash from investing activities
in the nine months ended September 28, 2002 as compared to approximately $5.6
million in the nine months ended September 29, 2001. The cash received from
investing activities in the nine months ended September 28, 2002 was primarily
the result of the sales and maturities of our investments in marketable
securities. 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 in the
nine months ended September 28, 2002. In the nine months ended September 29,
2001, we received approximately $13.1 million, net, of proceeds from sales and
maturities of marketable securities, invested approximately $1.3 million
primarily for improvements to our information systems and additions to
demonstration equipment, approximately $1.1 million, net, in loans to related
parties and increased restricted cash by $5.1 million.

We received approximately $893,000 of cash from financing activities in
the nine months ended September 28, 2002 primarily as a result of proceeds from
the sale of our common stock in connection with a strategic alliance entered
into in August 2002, proceeds from the sale of our investment in sales-type
leases and the issuance of shares of our common stock upon the exercise of
stock options, partially offset by payments of principal on debt and the pay
down of our working capital line of credit. In the nine months ended September
29, 2001, we received approximately $2.4 million as a result of proceeds from
our working capital line of credit and the issuance of shares of our common
stock upon the exercise of stock options, offset by payments of principal on
debt.

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In May 2001, we paid the outstanding principal on both the equipment
portion and term loan portion of our loan agreement with Imperial Bank and
terminated the agreement. Following this termination, we entered into an
agreement with Fleet National Bank for a revolving line of credit. The
revolving line of credit is for $5.0 million and expires on May 14, 2003 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 28, 2002, the interest rate on the line of credit was 4.75%. 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 28, 2002. At September 28, 2002, we had standby letters of credit
outstanding in the amount of approximately $295,000.

We guarantee approximately $238,000 of operating lease obligations of our
subsidiaries for the lease of office space and automobiles.

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 28, 2002, we sold approximately
$4.5 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 28, 2002,
approximately $1.8 million is recorded as debt on our consolidated balance
sheet.

We had capital expenditures of approximately $855,000 for the nine months
ended September 28, 2002. At September 28, 2002, we did not have any
commitments for capital expenditures. We anticipate that the level of capital
expenditures in the fourth fiscal quarter of 2002 will remain comparable to the
level of capital expenditures during the third fiscal quarter of 2002. Capital
expenditures in the third fiscal quarter of 2002 were approximately $250,000.

We have summarized below our contractual cash obligations as of September
28, 2002:

|                                        |  |                        |           |          |  |           |           |              |  |              |           |            |  |   |           |  |  |   |   |  |  |  |  | 
|--------------------------------------- |  | ---------------------- | --------- | -------- |  | --------- | --------- | ------------ |  | ------------ | --------- | ---------- |  | - | --------- |  |  | - | - |  |  |  |  | 
|                                        |  | Payments Due By Period
|                                        |  |                       
|                                        |  |                        |           |          |  | Less Than |           | One to Three |  | Four to Five |           | After Five |  |   |           | 
|Contractual Obligations                 |  | Total                  |           | One Year |  | Years     |           | Years        |  | Years        |           |            |  |  
|                                        |  |                        |           |          |  |           |           |              |  |              |           |            |  |  
|Operating leases                        |  | $                      | 4,574,748 |          |  | $         | 1,196,749 |              |  | $            | 2,141,705 |            |  | $ | 1,236,294 |  |  | $ |  | 
|Sale of investment in sales type leases |  |                        | 1,780,554 |          |  |           | 834,251   |              |  |              | 901,920   |            |  |   | 44,383    |  |  |   |  | 
|                                        |  |                        |           |          |  |           |           |              |  |              |           |            |  |   |           |  |  |   |   | 
|Total contractual cash obligations      |  | $                      | 6,355,302 |          |  | $         | 2,031,000 |              |  | $            | 3,043,625 |            |  | $ | 1,280,677 |  |  | $ |  | 
|                                        |  |                        |           |          |  |           |           |              |  |              |           |            |  |   |           |  |  |   |   | 

Income Taxes

We have net operating loss and research and development tax credit
carryforwards for federal income tax purposes that will expire commencing in
the year 2002 through the year 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.

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Conversion to Euro

Eleven of the 15 members of the European Union have adopted the Euro as
their legal currency. Our current information systems allow us to currently
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 United
States dollars. We do not believe the Euro will have a significant effect on
our business, financial condition or results of operations.

Recent Accounting Pronouncements

In August 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. This statement supercedes FASB
Statement No. 121, Accounting for the Impairment of Long-Lived Assets to Be
Disposed of, and the accounting and reporting provisions of APB Opinion No. 30,
Reporting the Results of Operations  Reporting the Effects of Disposal of a
Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions. Under this statement it is required that one
accounting model be used for long-lived assets to be disposed of by sale,
whether previously held and used or newly acquired, and it broadens the
presentation of discontinued operations to include more disposal transactions.
The provisions of this statement are effective for financial statements issued
for fiscal years beginning after December 15, 2001, and interim periods within
those fiscal years, with early adoption permitted. Effective January 1, 2002,
we adopted SFAS No. 144. The adoption of SFAS No. 144 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 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, 2002. The following factors represent current challenges to us that create
risk and uncertainty. Failure to adequately overcome any of the following
challenges could have a material adverse effect on our results of operations,
business or financial condition.

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

Customers may determine that the cost of the BIS system exceeds cost
savings in drugs, personnel and post-anesthesia care recovery resulting from
use of the BIS system. In addition, hospitals and anesthesia providers may not
accept the BIS system as an accurate means of assessing a patients level of
consciousness during surgery 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. Nevertheless, sales of BIS Sensors as
a percentage of revenue did not increase significantly over the last year. If
use of our BIS system, and accordingly, sales of our BIS Sensors, do not
increase, it could adversely affect our revenue.

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
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.

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Various market factors may adversely affect our quarterly operating results
through the fourth fiscal quarter of 2002.

In addition to the factors identified herein, various other factors may
adversely affect our quarterly operating results through the fourth fiscal
quarter of 2002. First, during the third quarter we experienced a change in
the management of our North American field operations. Second, we continue to
shift the focus of our placements from BIS monitors to BIS modules. Third, in
Japan, Nihon Kohden is awaiting approval of the BIS XP system. These factors
may adversely impact our revenue through the fourth fiscal quarter of 2002,
depending in part on the successful transition to new management in our sales
organization and the timing and effectiveness of our new sales, marketing and
clinical education programs. The continuation of difficult worldwide economic
conditions, reductions in hospital purchasing programs, possible delays in
purchasing decisions by customers in Japan 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 2002.

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 availability under our 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 surgical awareness during monitoring with the BIS system could limit
market acceptance of BIS systems and could expose us to product liability
claims.

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

We are currently sponsoring three multi-center, multinational studies to
assess the incidence of awareness during BIS monitoring. If these studies do
not demonstrate that patient monitoring with the BIS system will reduce the
incidence of surgical awareness, our business could be adversely affected.

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

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



| |  |  | other new monitoring products, based on new or improved technologies,                                               
| |  | - | --------------------------------------------------------------------------------------------------------------------
|
| |  |  | new products or technologies used on patients or in the operating
room during surgery in lieu of monitoring devices,
|
| |  |  | electrical or mechanical interference from new or existing products
or technologies,                                
|
| |  |  | alternative techniques for evaluating the effects of anesthesia,                                                    
|
| |  |  | significant changes in the methods of delivering anesthesia, and                                                    
|
| |  |  | the development of new anesthetic agents.                                                                           

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

If we do not successfully develop and introduce enhanced or new products we
could lose revenue opportunities and customers.

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

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If we do not develop and implement a successful sales and marketing strategy,
we will not expand our business.

In the third quarter of 2002, we experienced a change in the management of
our North American field operations. If the transition to new management is
not efficient and effective, or if new sales representatives do not acquire the
technological skills to sell our products in a timely and successful manner and
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 implement new sales and marketing programs. If these new sales and
marketing programs are not implemented 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. In addition, we recently completed the transition to new
management in our international operations, including the combination of our
international commercial and clinical groups. If this international
reorganization is not successful, we may not be able to expand our
international 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. In addition, due to the
high turnover in our direct sales force we need to hire and train more sales
representatives. 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 organization
and new sales and marketing programs and clinical education programs that
encourage our customers to purchase and use our products, we will not reach the
level of sales necessary to achieve profitability.

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

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

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

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

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

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 suppliers could adversely affect our ability to meet our
customers demands for our products in a timely manner or within budget.

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

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

We 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 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.

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

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

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



| |  |  |  the timing and volume of customer orders for our BIS system,                      
| |  |  | ------------------------------------------------------------------------------------
|
| |  |  |  the introduction of the BIS XP system,                                            
|
| |  |  |  implementation of our EP program,                                                 
|
| |  |  |  use of and demand for our BIS Sensors,                                            
|
| |  |  |  customer cancellations,                                                           
|
| |  |  |  introduction of competitive products,                                             
|
| |  |  |  changes in management,                                                            
|
| |  |  |  turnover in our direct sales force,                                               
|
| |  |  |  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 stock would also be likely
to decrease. In addition, because we do not have a significant backlog of
customer orders for our BIS system, revenue in any quarter depends on orders
received in that quarter. Our quarterly results may also be adversely affected
because some customers may have inadequate financial resources to purchase our
products or may fail to pay for our products after receiving them. In
particular, hospitals are increasingly experiencing financial constraints,
consolidations and reorganizations as a result of cost containment measures and
declining third-party reimbursement for services, which may result in decreased
product orders or an increase in bad debts in any quarter.

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 October 25, 2002, Boston Scientific Corporation owned approximately
17% 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 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 specialities. 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.

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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.

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 another companys monitoring system approved
by the FDA in 2002. This product is marketed by a well-established medical
products company with significant resources. We may not be able to compete
effectively with this and other potential competitors. We may also face
substantial competition from companies which may develop sensor products that
compete with our proprietary BIS Sensors for use with our BIS monitors or with
third-party monitoring systems or anesthesia delivery systems that incorporate
the BIS index. We also expect to face competition from companies currently
marketing conventional electroencephalogram, or EEG, monitors using standard
and novel signal-processing techniques. Other companies may develop
anesthesia-monitoring systems that perform better than the BIS system and/or
sell for less. In addition, one or more of our competitors may develop
products that are substantially equivalent to our FDA-approved products, in
which case they may be able to use our products as predicate devices to more
quickly obtain FDA approval of their competing products. Medical device
companies developing these and other competitive products may have greater
financial, technical, marketing and other resources than we do. Competition in
the sale of anesthesia-monitoring systems could result in price reductions,
fewer orders, reduced gross margins and loss of market share.

Our ability to market and sell our products and generate revenue depends upon
receipt of domestic and foreign regulatory approval of our products and
manufacturing operations.

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

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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 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 or reconsider their purchasing decisions with
respect to our products. 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.

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

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

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

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

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.

27



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##### Table of Contents






Item 3. Qualitative and Quantitative 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 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 risk exposure.




Item 4. Controls and Procedures.



| | (a) |  | Evaluation of disclosure controls and procedures.Based on their
evaluation of our disclosure controls and procedures (as defined in
Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934)
as of a date within 90 days of the filing date of this Quarterly Report
on Form 10-Q, our chief executive officer and chief financial officer
have concluded that our disclosure controls and procedures are designed
to ensure that information required to be disclosed by us in the reports
that we file or submit under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the SECs
rules and forms and are operating in an effective matter.
| | --- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | (b) |  | Changes in internal controls.There were no significant changes in our
internal controls or in other factors that could significantly affect
these controls subsequent to the date of their most recent evaluation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

28



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##### 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 28, 2002, we used approximately $8.5
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 28, 2002, we used
approximately $25.8 million of the net proceeds for general corporate
purposes, including working capital, product development, increasing
our sales and marketing capabilities and expanding our international
operations. As of September 28, 2002, we had approximately $20.3
million of proceeds remaining from the offering, and pending use of the
proceeds, we have invested these funds in short-term, interest-bearing,
investment-grade securities.



| |                                                                                                                                                                                                                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On August 7, 2002, we issued 1,428,572 shares of our common stock
to Boston Scientific Corporation for an aggregate price of $10,000,004.
The common stock was issued in reliance upon the exemptions from
registration under Section 4(2) of the Securities Act of 1933 or
Regulation D promulgated thereunder, relative to sales by an issuer not
involving a public offering.




Item 3. Defaults Upon Senior Securities.



| |      
| | -----
| | None.




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



| |      
| | -----
| | None.




Item 5. Other Information.



| |      
| | -----
| | None.

29



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##### Table of Contents






Item 6. Exhibits and Report on Form 8-K.

(a)  Exhibits

|      |  |                                                                                                                                                   
|----- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|10.1 |  | OEM Product Development Agreement, dated as of August 7, 2002, by
and between the Registrant and Boston Scientific Corporation.                   
|     
|99.1  |  | 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.
|     
|99.2  |  | 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.



---

| |  | 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.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

(b)  Reports on Form 8-K



| |                                                                                                                                                                                                                                                                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | On August 8, 2002, we filed a Current Report on Form 8-K with
the SEC reporting a strategic alliance with Boston Scientific
Corporation, including the grant of an option to Boston Scientific
Corporation to distribute newly developed technology for monitoring
patients under sedation in a range of less-invasive medical
specialties. The date of this Current Report on Form 8-K is August
7, 2002.

30



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##### 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 12, 2002 | By: /s/ J. Neal Armstrong                   
|----------------------- | --------------------------------------------
|                        |                                             
|                        | Vice President and Chief Financial Officer  
|                        | (Principal Financial and Accounting Officer)

31



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##### Table of Contents






CERTIFICATIONS

I, Nassib G. Chamoun, certify that:



| | 1. |  | I have reviewed this quarterly report on Form 10-Q of Aspect
Medical Systems, Inc.;                                                                                                                                                                                                                                           
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | 2. |  | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
|
| | 3. |  | Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present
in all material respects the financial condition, results of operations
and cash flows of the registrant as of, and for, the periods presented
in this quarterly report;                   
|
| | 4. |  | The registrants other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:                                                                                                     



|
|
|
|
|
|
|



|
|
|



| | a) |  | all significant deficiencies in the design or
operation of internal controls which could adversely affect
the registrants ability to record, process, summarize and
report financial data and have identified for the registrants
auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves
management or other employees who have a significant role in
the registrants internal controls; and                                                                                                                                        



| | 6. |  | The registrants other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                         | /s/ Nassib G. Chamoun                    
|------------------------ | -----------------------------------------
|Dated: November 12, 2002 | Nassib G. Chamoun
Chief Executive Officer

32



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##### Table of Contents



I, J. Neal Armstrong, certify that:



| | 1. |  | I have reviewed this quarterly report on Form 10-Q of Aspect Medical
Systems, Inc.;                                                                                                                                                                                                                                           
| | -- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | 2. |  | Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
|
| | 3. |  | Based on my knowledge, the financial statements, and other
financial information included in this quarterly report, fairly present
in all material respects the financial condition, results of operations
and cash flows of the registrant as of, and for, the periods presented
in this quarterly report;                   
|
| | 4. |  | The registrants other certifying officers and I are responsible
for establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:                                                                                                     



| | a) |  | designed such disclosure controls and procedures to
ensure that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us by
others within those entities, particularly during the period in
which this quarterly report is being prepared;
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | evaluated the effectiveness of the registrants
disclosure controls and procedures as of a date within 90 days
prior to the filing date of this quarterly report (the
Evaluation Date); and                                                                                                  
|
| | c) |  | presented in this quarterly report our conclusions
about the effectiveness of the disclosure controls and
procedures based on our evaluation as of the Evaluation Date;                                                                                                                        



| | 5. |  | The registrants other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrants auditors and
the audit committee of registrants board of directors (or persons
performing the equivalent function):
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | a) |  | all significant deficiencies in the design or
operation of internal controls which could adversely affect
the registrants ability to record, process, summarize and
report financial data and have identified for the registrants
auditors any material weaknesses in internal controls; and
| | -- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| | b) |  | any fraud, whether or not material, that involves
management or other employees who have a significant role in
the registrants internal controls; and                                                                                                                                        



| | 6. |  | The registrants other certifying officers and I have indicated in
this quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
| | -- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                         | /s/ J. Neal Armstrong                    
|------------------------ | -----------------------------------------
|Dated: November 12, 2002 | J. Neal Armstrong
Chief Financial Officer

33



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##### Table of Contents



EXHIBIT INDEX

|        |  |                                                                                                                                                   
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------
|EXHIBIT |  |                                                                                                                                                   
|NUMBER  |  | EXHIBIT                                                                                                                                           
|        |  |                                                                                                                                                   
|10.1   |  | OEM Product Development Agreement, dated as of August 7, 2002, by
and between the Registrant and Boston Scientific Corporation.                   
|       
|99.1    |  | 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.
|       
|99.2    |  | 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.



---

| |  | 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.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------