##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 27, 2008
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
 For the transition period from  to
 Commission file number: 0-24663
 
 ASPECT MEDICAL SYSTEMS, INC.
  Delaware
    
    04-2985553(State or Other Jurisdiction of
    
    (I.R.S. Employer Identification No.)Incorporation or Organization)One Upland Road, Norwood, Massachusetts
    
    02062(Address of Principal Executive Offices)
    
    (Zip Code)
 (617) 559-7000
  
 þ o
  Large accelerated filer o   
    Accelerated filer þ
    Non-accelerated filer o
    Smaller reporting company o(Do not check if a smaller reporting company)
 o þ




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##### 



PagePART I
    
    FINANCIAL INFORMATION
    
    
    1Item 1.
    
    Condensed Consolidated Financial Statements (unaudited)
    
    
    1Condensed Consolidated Balance Sheets (unaudited)
as of September 27, 2008 and December 31, 2007
    
    
    1Condensed Consolidated Statements of Operations
(unaudited) for the Three and Nine Months ended
September 27, 2008 and September 29, 2007
    
    
    2Condensed Consolidated Statements of Cash Flows
(unaudited) for the Nine Months ended September 27,
2008 and September 29, 2007
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    19Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    32Item 4.
    
    Controls and Procedures
    
    
    32PART II
    
    OTHER INFORMATION
    
    
    33Item 1.
    
    Legal ProceedingsItem 1A.
    
    Risk Factors
    
    
    33Item 6.
    
    Exhibits
    
    
    51SIGNATURESEXHIBIT INDEXEX-31.1 SECTION 302 CERTIFICATION OF CEOEX-31.2 SECTION 302 CERTIFICATION OF CFOEX-32.1 SECTION 906 CERTIFICATION OF CEOEX-32.2 SECTION 906 CERTIFICATION OF CFO




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##### Table of Contents



PART I  FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS.
 ASPECT MEDICAL SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (in thousands, except share data and per share amounts)
 (unaudited)
 September 27,
    
    
    December 31,2008
    
    
    2007ASSETSCurrent assets:Cash and cash equivalents
    
    $
    36,065
    
    
    $
    19,828Short-term investments
    
    
    49,220
    
    
    
    82,134Accounts receivable, net of allowance of $210 at
September 27, 2008 and $322 at December 31, 2007
    
    
    13,252
    
    
    
    12,544Current portion of investment in sales-type leases
    
    
    1,169
    
    
    
    1,473Inventory
    
    
    7,529
    
    
    
    7,113Deferred tax assets
    
    
    4,729
    
    
    
    4,729Other current assets
    
    
    3,231
    
    
    
    2,677Total current assets
    
    
    115,195
    
    
    
    130,498Property and equipment, net
    
    
    8,121
    
    
    
    8,455Long-term restricted cash
    
    
    849
    
    
    
    1,004Long-term investments
    
    
    13,405
    
    
    
    6,518Long-term investment in sales-type leases
    
    
    1,703
    
    
    
    2,618Deferred financing fees
    
    
    2,979
    
    
    
    4,213Long-term deferred tax assets
    
    
    17,049
    
    
    
    20,171Total assets
    
    $
    159,301
    
    
    $
    173,477LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,820
    
    
    $
    1,836Accrued liabilities
    
    
    12,137
    
    
    
    9,723Current portion of obligation under capital lease
    
    
    68
    
    
    
    28Deferred revenue
    
    
    115
    
    
    
    87Total current liabilities
    
    
    14,140
    
    
    
    11,674Long-term portion of obligation under capital lease
    
    
    104
    
    
    
    89Long-term portion of deferred revenue
    
    
    89
    
    
    
    39Long-term debt
    
    
    100,000
    
    
    
    125,000Commitments and contingenciesStockholders equity:Preferred stock, $.01 par value; 5,000,000 shares
authorized, no shares issued or outstanding
    
    
    
    
    
    
    Common stock, $.01 par value; 60,000,000 shares
authorized, 17,326,968 and 17,118,037 shares issued
and outstanding at September 27, 2008 and December 31,
2007, respectively
    
    
    175
    
    
    
    174Treasury stock, at cost; 276,493 shares
    
    
    (5,008
    )
    
    
    (5,008
    )Additional paid-in capital
    
    
    185,459
    
    
    
    178,837Accumulated other comprehensive (loss) income
    
    
    (854
    )
    
    
    180Accumulated deficit
    
    
    (134,804
    )
    
    
    (137,508
    )Total stockholders equity
    
    
    44,968
    
    
    
    36,675Total liabilities and stockholders equity
    
    $
    159,301
    
    
    $
    173,477
  1




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
 (in thousands, except per share amounts)
 (unaudited)
 Three Months Ended
    
    
    Nine Months EndedSeptember 27,
    
    
    September 29,
    
    
    September 27,
    
    
    September 29,2008
    
    
    2007
    
    
    2008
    
    
    2007Product revenue
    
    $
    24,758
    
    
    $
    22,632
    
    
    $
    74,371
    
    
    $
    68,146Strategic alliance revenue
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5,246Total revenue
    
    
    24,758
    
    
    
    22,632
    
    
    
    74,371
    
    
    
    73,392Costs of revenue (1)
    
    
    6,104
    
    
    
    5,533
    
    
    
    18,943
    
    
    
    17,379Gross profit
    
    
    18,654
    
    
    
    17,099
    
    
    
    55,428
    
    
    
    56,013Operating expenses: (1)Research and development
    
    
    4,183
    
    
    
    3,820
    
    
    
    12,056
    
    
    
    12,234Sales and marketing
    
    
    12,687
    
    
    
    9,669
    
    
    
    34,561
    
    
    
    29,913General and administrative
    
    
    3,920
    
    
    
    3,656
    
    
    
    12,034
    
    
    
    11,336Total operating
expenses
    
    
    20,790
    
    
    
    17,145
    
    
    
    58,651
    
    
    
    53,483(Loss) income from operations
    
    
    (2,136
    )
    
    
    (46
    )
    
    
    (3,223
    )
    
    
    2,530Other income (expense):Interest income
    
    
    867
    
    
    
    1,517
    
    
    
    3,248
    
    
    
    3,519Interest expense
    
    
    (849
    )
    
    
    (944
    )
    
    
    (2,725
    )
    
    
    (1,059
    )Other-than-temporary
impairment of investments
    
    
    (840
    )
    
    
    
    
    
    
    (840
    )
    
    
    Gain on repurchase of debt
    
    
    5,881
    
    
    
    
    
    
    
    9,821
    
    
    
    Income before income taxes
    
    
    2,923
    
    
    
    527
    
    
    
    6,281
    
    
    
    4,990Provision for income taxes
    
    
    1,883
    
    
    
    683
    
    
    
    3,577
    
    
    
    3,142 3,142Net income (loss)
    
    $
    1,040
    
    
    $
    (156
    )
    
    $
    2,704
    
    
    $
    1,848Net income (loss) per share:Basic
    
    $
    0.06
    
    
    $
    (0.01
    )
    
    $
    0.16
    
    
    $
    0.09Diluted
    
    $
    0.06
    
    
    $
    (0.01
    )
    
    $
    0.16
    
    
    $
    0.09Weighted average shares used in
computing net income (loss) per
share:Basic
    
    
    17,317
    
    
    
    17,230
    
    
    
    17,228
    
    
    
    20,485Diluted
    
    
    23,254
    
    
    
    17,230
    
    
    
    17,373
    
    
    
    21,137(1) Stock-based compensation
included in costs and operating
expenses:Costs of revenue
    
    $
    127
    
    
    $
    145
    
    
    $
    370
    
    
    $
    430Research and development
    
    
    489
    
    
    
    502
    
    
    
    1,445
    
    
    
    1,516Sales and marketing
    
    
    627
    
    
    
    805
    
    
    
    1,972
    
    
    
    2,402General and administrative
    
    
    647
    
    
    
    727
    
    
    
    1,975
    
    
    
    2,184
  2




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in thousands)
 (unaudited)
 Nine Months EndedSeptember 27,
    
    
    September 29,2008
    
    
    2007Cash flows from operating activities:Net income
    
    
    $       2,704
    
    
    
    $       1,848Adjustments to reconcile net income to net cash provided by
operating activities Depreciation and amortization
    
    
    2,251
    
    
    
    1,856Gain on repurchase of debt
    
    
    (9,821
    )
    
    
    Loss on
other-than-temporary impairment of investments
    
    
    840
    
    
    
    Provision for doubtful accounts
    
    
    (102
    )
    
    
    91Stock-based compensation expense
    
    
    5,688
    
    
    
    6,461Tax benefit for stock option exercises
    
    
    90
    
    
    
    Deferred taxes
    
    
    3,122
    
    
    
    3,152Changes in assets and liabilities (Increase) decrease in accounts receivable
    
    
    (606
    )
    
    
    1,238Increase in inventory
    
    
    (416
    )
    
    
    (1,042
    )Increase in other current assets
    
    
    (554
    )
    
    
    (476
    )Decrease (increase) in investment in sales-type leases
    
    
    1,219
    
    
    
    (54
    )Increase in other long-term assets
    
    
    
    
    
    
    (371
    )Decrease in accounts payable
    
    
    (16
    )
    
    
    (318
    )Increase in accrued liabilities
    
    
    2,414
    
    
    
    2,105Increase (decrease) in deferred revenue
    
    
    78
    
    
    
    (5,215
    )Net cash provided by operating activities
    
    
    6,891
    
    
    
    9,275Cash flows from investing activities:Decrease in restricted cash
    
    
    155
    
    
    
    40Acquisitions of property and equipment
    
    
    (1,336
    )
    
    
    (2,400
    )Purchases of investments
    
    
    (66,072
    )
    
    
    (115,102
    )Proceeds from sales and maturities of investments
    
    
    90,275
    
    
    
    80,131Net cash provided by (used for) investing activities
    
    
    23,022
    
    
    
    (37,331
    )Cash flows from financing activities:Repurchases of common stock
    
    
    
    
    
    
    (85,041
    )Payment on deferred financing fees
    
    
    
    
    
    
    (4,556
    )Proceeds from issuance of common stock
    
    
    846
    
    
    
    1,042Proceeds from long-term debt
    
    
    
    
    
    
    125,000Repayment of long-term debt
    
    
    (14,413
    )
    
    
    Repayment of capital lease
    
    
    (59
    )
    
    
    Net cash (used for) provided by financing activities
    
    
    (13,626
    )
    
    
    36,445Effect of exchange rate changes on cash
    
    
    (50
    )
    
    
    Net increase in cash and cash equivalents
    
    
    16,237
    
    
    
    8,389Cash and cash equivalents, beginning of period
    
    
    19,828
    
    
    
    9,724Cash and cash equivalents, end of period
    
    
    $     36,065
    
    
    
    $     18,113
  3




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##### Table of Contents



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




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




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
  Accounting for
Contingencies
 Research and Development Costs
  Allowance for Doubtful Accounts
  Inventory
  Warranty
  Three Months Ended
    
    
    Nine Months EndedSeptember 27,
    
    
    September 29,
    
    
    September 27,
    
    
    September 29,2008
    
    
    2007
    
    
    2008
    
    
    2007Beginning balance
    
    $
    254
    
    
    $
    223
    
    
    $
    250
    
    
    $
    220Warranty expense
    
    
    12
    
    
    
    14
    
    
    
    42
    
    
    
    33Deductions and other
    
    
    (11
    )
    
    
    (10
    )
    
    
    (37
    )
    
    
    (26
    )Ending balance
    
    $
    255
    
    
    $
    227
    
    
    $
    255
    
    
    $
    227
 6




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 Shipping and Handling Costs
  Advertising Costs
  Property and Equipment
 Accounting for the Costs of Computer Software Developed or Obtained
for Internal Use
 Accounting For Changes and Error
Corrections
 Income Taxes
 Accounting for Income
Taxes Accounting for Uncertainty in Income
Taxes  an Interpretation of FASB Statement No. 109
 Concentration of Credit Risk
  7




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 Single or Limited Source Suppliers
  Net Income (Loss) Per Share
 Earnings Per Share
   Three Months Ended
    
    
    Nine Months EndedSeptember 27,
    
    
    September 29,
    
    
    September 27,
    
    
    September 29,2008
    
    
    2007
    
    
    2008
    
    
    2007Basic:Net income (loss)
    
    $
    1,040
    
    
    $
    (156
    )
    
    $
    2,704
    
    
    $
    1,848Weighted average shares outstanding
    
    
    17,317
    
    
    
    17,230
    
    
    
    17,228
    
    
    
    20,485Basic net income (loss) per share
    
    $
    0.06
    
    
    $
    (0.01
    )
    
    $
    0.16
    
    
    $
    0.09Diluted:Net income (loss)
    
    $
    1,040
    
    
    $
    (156
    )
    
    $
    2,704
    
    
    $
    1,848Interest expense on convertible
debt, net
    
    
    306
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss) as adjusted
    
    $
    1,346
    
    
    $
    (156
    )
    
    $
    2,704
    
    
    $
    1,848Weighted average shares outstanding
    
    
    17,317
    
    
    
    17,230
    
    
    
    17,228
    
    
    
    20,485Effect of dilutive stock options and
restricted stock
    
    
    36
    
    
    
    
    
    
    
    145
    
    
    
    652Conversion of convertible notes
    
    
    5,901
    
    
    
    
    
    
    
    
    
    
    
    Weighted average shares assuming
dilution
    
    
    23,254
    
    
    
    17,230
    
    
    
    17,373
    
    
    
    21,137Diluted net income (loss) per share
    
    $
    0.06
    
    
    $
    (0.01
    
    
    $
    0.16
    
    
    $
    0.09
 Comprehensive Income (Loss)
  8




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
  Stock-Based Compensation
  Share Based
Payment Accounting for
Stock-Based Compensation,
   Weighted
    
    
    WeightedNumber of
    
    
    Average
    
    
    Average Remaining
    
    
    Aggregate IntrinsicShares
    
    
    Exercise Price
    
    
    Contractual Life
    
    
    ValueOutstanding at December 31, 2007
    
    
    4,266
    
    
    $
    17.31Granted
    
    
    455
    
    
    
    9.18Exercised
    
    
    (176
    )
    
    
    4.30Canceled
    
    
    (171
    )
    
    
    16.96Outstanding at September 27, 2008
    
    
    4,374
    
    
    $
    17.00
    
    
    
    5.69
    
    
    $
    298Vested or expected to vest at September 27, 2008
    
    
    4,322
    
    
    $
    17.02
    
    
    
    5.66
    
    
    $
    298Exercisable at September 27, 2008
    
    
    3,391
    
    
    $
    17.33
    
    
    
    4.92
    
    
    $
    284
   Weighted AverageNumber of
    
    
    Grant Date FairShares
    
    
    ValueUnvested at December 31, 2007
    
    
    275
    
    
    $
    16.90Granted
    
    
    306
    
    
    
    11.30Vested and cancelled
    
    
    (151
    )
    
    
    15.20Unvested at September 27, 2008
    
    
    430
    
    
    $
    13.51
 9




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
  :
  Three Months Ended
    
    Nine Months EndedSeptember 27,
    
    September 29,
    
    September 27,
    
    September 29,2008
    
    2007
    
    2008
    
    2007Options granted
    
    
    157
    
    
    
    153,387
    
    
    
    455
    
    
    
    3,393,949Weighted average exercise price
    
    $
    5.20
    
    
    $
    13.29
    
    
    $
    9.18
    
    
    $
    15.98Weighted average grant date
fair value
    
    $
    2.93
    
    
    $
    5.93
    
    
    $
    4.49
    
    
    $
    7.51Assumptions:Risk-free interest rate
    
    
    3.64
    %
    
    
    4.69
    %
    
    
    3.22
    %
    
    
    4.55
    %Expected term
    
    5.76 years
    
    
    5.2 years
    
    
    5.76 years
    
    
    5.2 yearsExpected volatility
    
    
    58
    %
    
    
    42
    %
    
    
    51
    %
    
    
    46
    %
     :
  10




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
     Use of Estimates
  Reclassifications
  Fair Value of Financial Instruments
  Recent Accounting Pronouncements
 Disclosures about Derivative Instruments and
Hedging Activities, an Amendment of FASB Statement No. 133.
 The Hierarchy of Generally Accepted Accounting
Principles The Meaning of Present Fairly in Conformity With Generally
Accepted Accounting Principles
 11




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 The Meaning of Present Fairly in Conformity With Generally Accepted Accounting
Principles
 (3) Comprehensive
Income (Loss)
  Three Months Ended
    
    
    Nine Months EndedSeptember 27,
    
    
    September 29,
    
    
    September 27,
    
    
    September 29,2008
    
    
    2007
    
    
    2008
    
    
    2007Net income (loss)
    
    $
    1,040
    
    
    $
    (156
    )
    
    $
    2,704
    
    
    $
    1,848Other
comprehensive income (loss):Foreign currency
translation
adjustments
    
    
    (50
    )
    
    
    
    
    
    
    (50
    )
    
    
    Unrealized (loss) gain
on investments, net of
reclassification
adjustment for
unrealized loss on
marketable security recognized
during the period
    
    
    (760
    )
    
    
    127
    
    
    
    (984
    )
    
    
    164Comprehensive income (loss)
    
    $
    230
    
    
    $
    (29
    )
    
    $
    1,670
    
    
    $
    2,012
 (4) Investment in Sales-Type Leases
  September 27,
    
    
    December 31,2008
    
    
    2007Total minimum lease payments receivable
    
    $
    4,263
    
    
    $
    5,655Less:Unearned interest income
    
    
    589
    
    
    
    849Allowance for lease payments
    
    
    802
    
    
    
    715Net investment in sales-type leases
    
    
    2,872
    
    
    
    4,091Less: current portion
    
    
    1,169
    
    
    
    1,473$
    1,703
    
    
    $
    2,618
 (5) Inventory
  September 27,
    
    
    December 31,2008
    
    
    2007Raw materials
    
    $
    4,421
    
    
    $
    4,027Work-in-progress
    
    
    7
    
    
    
    52Finished goods
    
    
    3,101
    
    
    
    3,034$
    7,529
    
    
    $
    7,113
 12




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 (6) Income Taxes
  Accounting for Income Taxes
 Accounting for Uncertainty in Income Taxes 
an Interpretation of FASB Statement No. 109
  (7) Fair Value Measurements
 Fair Value Measurements,
 13




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
   Balance atSeptember
    
    Fair Value Measurements at September 27, 200827, 2008
    
    Level 1
    
    Level 2
    
    Level 3Cash, cash
equivalents and
restricted cash
    
    $
    36,914
    
    
    $
    36,914
    
    
    $
    
    
    
    $
    Available for sale
securities
    
    $
    62,625
    
    
    $
    
    
    
    $
    62,625
    
    
    $
    
 (8) Segment Information and Enterprise Reporting
   Three Months Ended
    
    
    Nine Months EndedSeptember 27,
    
    
    September 29,
    
    
    September 27,
    
    
    September 29,2008
    
    
    2007
    
    
    2008
    
    
    2007Geographic Area by RegionDomestic
    
    $
    17,337
    
    
    $
    16,655
    
    
    $
    51,747
    
    
    $
    55,737International
    
    
    7,421
    
    
    
    5,977
    
    
    
    22,624
    
    
    
    17,655Total
    
    $
    24,758
    
    
    $
    22,632
    
    
    $
    74,371
    
    
    $
    73,392
 Three Months Ended
    
    Nine months endedSeptember 27,
    
    September 29,
    
    September 27,
    
    September 29,2008
    
    2007
    
    2008
    
    2007Geographic Area by RegionDomestic
    
    
    70
    %
    
    
    74
    %
    
    
    70
    %
    
    
    76
    %International
    
    
    30
    
    
    
    26
    
    
    
    30
    
    
    
    24Total
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
  14




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 (9) Commitments and Contingencies
 Leases
    Legal
Proceedings
   15




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
 (10) Loan Agreements
   (11) Termination and Repurchase Agreement with Boston Scientific Corporation
  
    
    the OEM Product Development Agreement dated as of August 7, 2002 (as amended January
31, 2005 and February 5, 2007, the 2002 Agreement), pursuant to which the Company was to
develop certain products that Boston Scientific Corporation would then commercialize in
the area of monitoring patients under sedation in a range of less invasive medical
specialties, and pursuant to which the Company granted Boston Scientific Corporation an
exclusive option to become the distributor for a period of time of certain products;
    
    the Product Development and Distribution Agreement dated as of May 23, 2005 (the 2005
Agreement), pursuant to which the Company was to develop new applications of its
brain-monitoring technology in the area of the diagnosis and treatment of neurological,
psychiatric and pain disorders and Boston Scientific was appointed the exclusive
distributor of such products; and
    
    the Letter Agreement dated August 7, 2002, and Security Agreement dated August 7, 2002,
pursuant to which Boston Scientific Corporation agreed to make revolving interest-bearing
loans to Aspect from time to time at the request of Aspect, such revolving loans being
evidenced by a promissory note in the original principal amount of $5,000,000 dated August
7, 2002.
  16




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##### Table of Contents



ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
   (12) Convertible Debt
   
    
    during the five business day period after any five consecutive trading day period
(the measurement period) in which the price per note for each trading day of that
measurement period was less than 97% of the product of the last reported sale price of
the Companys common stock and the conversion rate on each such day;
    
    during any calendar quarter (and only during such quarter) after the calendar
quarter ending September 30, 2007, if the last reported sale price of the Companys
common stock for 20 or more trading days in a period of 30 consecutive trading days
ending on the last trading day of the immediately preceding calendar quarter exceeds
120% of the applicable conversion price in effect on the last trading day of the
immediately preceding calendar quarter; or
    
    upon the occurrence of specified corporate events.
    17




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ASPECT MEDICAL SYSTEMS, INC.
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(tabular amounts in thousands, except percentages and per share amounts)
(unaudited)
      (13) Stock Repurchase Program
  18




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS.
 Overview
 ®
  InitialCommercialProduct
    
    Shipment
    
    DescriptionEQUIPMENTBIS VIEW
    
    2007
    
    Basic-featured standalone monitor which has fewer optional user configurations compared with the BIS VISTA monitor.BIS VISTA
    
    2006
    
    Monitor that offers an enhanced display and user interface as well as greater processing capability compared to our other monitors.BISx system
    
    2004
    
    BIS monitoring solution that provides the processing technology required to obtain BIS information from a single device the approximate size of a hockey puck. The BISx system is designed to integrate with a wide range of patient monitoring platforms sold by original equipment manufacturers.BIS XP System
    
    2001
    
    BIS system offering enhanced performance capabilities and expanded benefits as compared to the previous version of the BIS system, designed to enable more precise measurement of brain activity to assess the level of consciousness.BIS Module Kit
    
    2001
    
    Same as standard BIS Module Kit plus 4 channel EEG monitoring capability. 4 ChannelSupportA-2000 BIS Monitor
    
    1998
    
    Compact, lightweight, portable third-generation BIS monitor.BIS Module Kit
    
    1998
    
    Components of BIS monitoring technology that are integrated into equipment sold by original equipment manufacturers.SENSORSSemi-Reusable
(SRS) Sensor
    
    2005
    
    Semi-reusable version of a BIS Sensor that uses the same algorithm and hardware as our disposable sensors. Currently available only in markets outside the United States, excluding Japan.BIS Extend Sensor
    
    2002
    
    Disposable sensor with electronic memory device for use with our BIS Monitors, BIS Module Kit and BISx System that was designed for patients who are typically monitored for extended periods.
 19




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##### Table of Contents



InitialCommercialProduct
    
    Shipment
    
    DescriptionBIS Pediatric Sensor
    
    2001
    
    Disposable sensor with electronic memory device for use with our BIS Monitors, BIS Module Kit and BISx System that is smaller and easier to apply to children.BIS Quatro Sensor
    
    2001
    
    Disposable sensor with electronic memory device for use with our BIS Monitors, BIS Module Kit and BISx System that is designed to offer enhanced performance in deep anesthetic states and enhanced resistance to interference from noise sources.BIS Sensor Plus
    
    2001
    
    Second-generation disposable sensor for use with our BIS Monitors and BIS Module Kit.BIS Standard Sensor
    
    1997
    
    Disposable sensor for use with our BIS Monitors and BIS Module Kit.
  Three Months Ended
    
    Nine Months EndedSeptember 27,
    
    September 29,
    
    September 27,
    
    September 29,2008
    
    2007
    
    2008
    
    2007(dollars in thousands)Domestic revenue
    
    $
    17,337
    
    
    $
    16,655
    
    
    $
    51,747
    
    
    $
    55,737Percent of total revenue
    
    
    70
    %
    
    
    74
    %
    
    
    70
    %
    
    
    76
    %International revenue
    
    $
    7,421
    
    
    $
    5,977
    
    
    $
    22,624
    
    
    $
    17,655Percent of total revenue
    
    
    30
    %
    
    
    26
    %
    
    
    30
    %
    
    
    24
    %Total revenue
    
    $
    24,758
    
    
    $
    22,632
    
    
    $
    74,371
    
    
    $
    73,392BIS Sensor revenue
    
    $
    20,788
    
    
    $
    19,031
    
    
    $
    62,819
    
    
    $
    55,148Percent of total revenue
    
    
    84
    %
    
    
    84
    %
    
    
    84
    %
    
    
    75
    %Equipment revenue
    
    $
    3,970
    
    
    $
    3,601
    
    
    $
    11,552
    
    
    $
    12,998Percent of total revenue
    
    
    16
    %
    
    
    16
    %
    
    
    16
    %
    
    
    18
    %Strategic alliance revenue
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    5,246Percent of total revenue
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7
    %Total revenue
    
    $
    24,758
    
    
    $
    22,632
    
    
    $
    74,371
    
    
    $
    73,392
    20




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Share-Based Payment Accounting for Stock Issued to Employees
 New England Journal of Medicine
 21




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Critical Accounting Policies and Estimates
  Revenue Recognition
 Revenue
Recognition, Revenue Arrangements with Multiple
Deliverables
 Accounting For Leases
  22




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Stock-Based Compensation
        Allowance for Doubtful Accounts
  Inventories
  23




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Warranty
  Income Taxes
  Accounting for Uncertainty in Income Taxes  an Interpretation of FASB
Statement No. 109
 Results of Operations
  Three Months Ended
    
    Nine Months EndedSeptember 27,
    
    September 29,
    
    September 27,
    
    September 29,2008
    
    2007
    
    2008
    
    2007Revenue
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %
    
    
    100
    %Costs of revenue
    
    
    25
    
    
    
    24
    
    
    
    25
    
    
    
    24Gross margin
    
    
    75
    
    
    
    76
    
    
    
    75
    
    
    
    76Operating expenses:Research and development
    
    
    17
    
    
    
    17
    
    
    
    16
    
    
    
    17Sales and marketing
    
    
    51
    
    
    
    43
    
    
    
    46
    
    
    
    41General and administrative
    
    
    16
    
    
    
    16
    
    
    
    16
    
    
    
    15Total operating expenses
    
    
    84
    
    
    
    76
    
    
    
    78
    
    
    
    73(Loss) income from operations
    
    
    (9
    )
    
    
    
    
    
    
    (3
    )
    
    
    3Interest income, net
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    3Impairment loss on investments
    
    
    (3
    )
    
    
    
    
    
    
    (1
    )
    
    
    Gain on repurchase of debt
    
    
    24
    
    
    
    
    
    
    
    13
    
    
    
    Income before income taxes
    
    
    12
    
    
    
    2
    
    
    
    9
    
    
    
    6Provision for incomes taxes
    
    
    8
    
    
    
    3
    
    
    
    5
    
    
    
    4Net income (loss)
    
    
    4
    %
    
    
    (1
    )%
    
    
    4
    %
    
    
    2
    %
 24




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Three and Nine Months Ended September 27, 2008 Compared with the Three and Nine Months Ended
September 29, 2007
 Three Months Ended
    
    
    Nine Months EndedPercentage
    
    
    
    
    
    
    
    
    
    
    PercentageSeptember 27,
    
    
    September 29,
    
    
    Increase
    
    
    September 27,
    
    
    September 29,
    
    
    Increase2008
    
    
    2007
    
    
    (Decrease)
    
    
    2008
    
    
    2007
    
    
    (Decrease)(in thousands, except
    
    
    
    
    
    

    (in thousands, exceptunit amounts)
    
    
    
    
    
    
    unit amounts)Revenue  WorldwideBIS Sensors
    
    $
    20,788
    
    
    $
    19,031
    
    
    
    9
    %
    
    $
    62,819
    
    
    $
    55,148
    
    
    
    14
    %BIS monitors
    
    
    1,847
    
    
    
    2,090
    
    
    
    (12
    )%
    
    
    5,888
    
    
    
    7,969
    
    
    
    (26
    )%Original equipment manufacturer products
    
    
    1,227
    
    
    
    833
    
    
    
    47
    %
    
    
    3,194
    
    
    
    2,806
    
    
    
    14
    %Other equipment and accessories
    
    
    896
    
    
    
    678
    
    
    
    32
    %
    
    
    2,470
    
    
    
    2,223
    
    
    
    11
    %Total Equipment
    
    
    3,970
    
    
    
    3,601
    
    
    
    10
    %
    
    
    11,552
    
    
    
    12,998
    
    
    
    (11
    )%Total product revenue
    
    
    24,758
    
    
    
    22,632
    
    
    
    9
    %
    
    
    74,371
    
    
    
    68,146
    
    
    
    9
    %Strategic alliance
    
    
    
    
    
    
    
    
    
    
    
    %
    
    
    
    
    
    
    5,246
    
    
    
    (100
    )%Total revenue
    
    $
    24,758
    
    
    $
    22,632
    
    
    
    9
    %
    
    $
    74,371
    
    
    $
    73,392
    
    
    
    1
    %Unit Analysis  WorldwideBIS Sensors
    
    
    1,514,000
    
    
    
    1,377,000
    
    
    
    10
    %
    
    
    4,575,000
    
    
    
    3,945,000
    
    
    
    16
    %BIS monitors
    
    
    599
    
    
    
    741
    
    
    
    (19
    )%
    
    
    1,986
    
    
    
    2,548
    
    
    
    (22
    )%Original equipment manufacturer
BIS products
    
    
    1,510
    
    
    
    1,017
    
    
    
    48
    %
    
    
    4,294
    
    
    
    3,547
    
    
    
    21
    %Installed base
    
    
    53,630
    
    
    
    45,344
    
    
    
    18
    %
    
    
    53,630
    
    
    
    45,344
    
    
    
    18
    %
 Revenue.
 New England Journal of Medicine
  25




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##### Table of Contents



Expense Overview
 Three Months Ended
    
    Percentage
    
    Nine Months Ended
    
    
    PercentageSeptember 27,
    
    September 29,
    
    Increase
    
    September 27,
    
    September 29,
    
    Increase2008
    
    2007
    
    (Decrease)
    
    2008
    
    2007
    
    (Decrease)(in thousands)
    
    
    
    
    
    (in thousands)ExpensesResearch and development
    
    $
    4,183
    
    
    $
    3,820
    
    
    
    10
    %
    
    $
    12,056
    
    
    $
    12,234
    
    
    
    (1
    )%Sales and marketing
    
    $
    12,687
    
    
    $
    9,669
    
    
    
    31
    %
    
    $
    34,561
    
    
    $
    29,913
    
    
    
    16
    %General and administrative
    
    $
    3,920
    
    
    $
    3,656
    
    
    
    7
    %
    
    $
    12,034
    
    
    $
    11,336
    
    
    
    6
    %
 Research and Development.
  Sales and Marketing.
  General and Administrative.
  27




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##### Table of Contents



Interest Income.
 Interest Expense.
 Other Income (expense).
 Income Taxes.
 Accounting for Income Taxes
 28




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##### Table of Contents



Liquidity and Capital Resources
  
    
    net proceeds of approximately $54.6 million from our initial public offering of
common stock in February 2000;
    
    approximately $3.4 million in equipment financing;
    
    approximately $5.1 million related to our investment in sales-type leases;
    
    proceeds of approximately $10.0 million related to our 2002 OEM product development
and distribution agreement with Boston Scientific Corporation;
    
    proceeds of approximately $8.1 million from the sale of our common stock to Boston
Scientific Corporation in 2004;
    
    $10.0 million in installment payments from Boston Scientific Corporation received in
May 2005 and May 2006 pursuant to the 2005 product development and distribution
agreement with Boston Scientific Corporation; and
    
    net proceeds of $121.0 million received from the issuance of our 2.5% convertible
senior notes in June 2007.
     29




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##### Table of Contents



Cash provided by operations.
 Cash
used for investing activities.
 30




---



##### Table of Contents



Cash provided by financing activities.
 Off-Balance Sheet Arrangements
  Effects of Inflation
  Recent Accounting Pronouncements
 Disclosures about Derivative Instruments and
Hedging Activities an Amendment of FASB Statement No. 133
 The Hierarchy of Generally Accepted Accounting
Principles The Meaning of Present Fairly in Conformity With Generally
Accepted Accounting Principles The Meaning
of Present Fairly in Conformity With Generally Accepted Accounting Principles
 Forward-Looking Statements
 This Quarterly Report on Form 10-Q contains, in addition to historical information,
forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of
1934, including information relating to our ability to maintain profitability, information with
respect to market acceptance of our BIS system, continued growth in sales of our BIS monitors,
original equipment manufacturer products and BIS Sensors, our dependence on the BIS system,
regulatory approvals for our products, our ability to remain competitive and achieve future growth,
information with respect to other plans and strategies for our business and factors that may
influence our revenue for the fiscal quarter ending December 31, 2008 and thereafter. These
forward-looking statements involve risks and uncertainties and are not guarantees of future
performance. Words such as expect, anticipate, intend, plan, believe, seek, estimate
and variations of these words and similar expressions are intended to identify forward-looking
statements. Our actual results could differ significantly from the results discussed in these
forward-looking statements. The important factors discussed under Part II  Item 1A. Risk Factors
below represent some of the current challenges to us that create risk and uncertainty. In addition,
subsequent events and developments may cause our expectations to change. While we may elect to
update these forward-looking statements we specifically disclaim any obligation to do so, even if
our expectations change.
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##### Table of Contents



Item 3. Quantitative and Qualitative Disclosures About Market Risk.
 Interest Rate Exposure
    Foreign Currency Exposure
  
 Item 4. Controls and Procedures.
 Evaluation of Disclosure Controls and Procedures.
  Changes in Internal Controls.
  32




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##### Table of Contents



PART II  OTHER INFORMATION
 
 Item 1. Legal Proceedings
  
 Item 1A. Risk Factors
  We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our
BIS system and purchase our BIS Sensors in sufficient quantities.
  New England Journal of Medicine
  33




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We depend on our BIS system for substantially all of our revenue, and if the BIS system does not
gain widespread market acceptance, then our revenue will not grow.
  Various factors may adversely affect our quarterly operating results through the fourth fiscal
quarter of 2008 and beyond.
  
    
    a third party study published in March 2008 in the New England Journal
of Medicine compared BIS monitoring with a protocol based on end-tidal gas
anesthetic in a patient population considered to be at high risk of awareness
and concluded that, based upon a similar occurrence of awareness in both
groups, no benefit of BIS monitoring was demonstrated. We believe
that the publication of this
study has had, and may continue to have an adverse effect on the rate at which existing or potential new
customers purchase and use our products, which could adversely affect our
operating results;
    
    we are expanding our sales force and expect that such expansion will
continue to increase our operating expenses in future periods and that such an
increase would not be offset at least initially by an increase in revenue; as a
result our operating results in such periods could be adversely affected;
    
    we continue to shift the focus of our sales and marketing efforts from
expanding our customer base to deepening our relationships with our existing
customers and increasing their sensor utilization and procedure penetration.
As a result of this shift in focus, we expect our revenue from the sale of
equipment to continue to decrease. As such, if we do not increase revenue from
sales of our BIS Sensors as quickly as we plan, or at all, our operating
results could be adversely affected;
    
    we may not realize expected benefits of favorable industry
pronouncements on anesthesia awareness, including the position statements
issued by the Joint Commission on Accreditation of Healthcare Organizations,
the American Society of Anesthesiologists House of Delegates, and the American
Association of Nurse Anesthetists;
    
    we have recently repurchased a portion of our 2.5% convertible senior
notes due 2014, referred to as our notes, and we may make additional
repurchases in the future. If any such repurchases are made at a discount to
the face value of the note, we expect to record a gain on such transaction,
which could affect our operating results in the quarter in which any such
repurchase is made; and
    
    we face risks beyond our control with respect to the continued
challenges of the U.S. and worldwide economies including without limitation the
effects of domestic inflation, declines in the value of our investments and the
global rise in energy costs.
  Fluctuations in our quarterly operating results could cause our stock price to decrease.
  
    
    the timing and volume of customer orders for our BIS system;
    
    market acceptance of our BIS VISTA monitor;
 34




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##### Table of Contents




    
    use of and demand for our BIS Sensors;
    
    transition of sales focus from expanding our customer base to developing our existing
customers and increasing their sensor utilization and procedure penetration;
    
    customer cancellations;
    
    introduction of competitive products;
    
    regulatory approvals;
    
    changes in management;
    
    turnover in our direct sales force;
    
    we are expanding our sales force and expect that such expansion will increase our
operating expenses in future periods and that such an increase would not be offset at
least initially by an increase in revenue;
    
    effectiveness of new marketing and sales programs;
    
    communications published by industry organizations or other professional entities in
the anesthesia community that are unfavorable to our business, including publications
of the results of clinical studies;
    
    trading in our convertible debt instruments;
    
    repurchases of shares of our common stock or our 2.5% notes;
    
    the amount of our outstanding indebtedness and interest payments under debt obligations;
    
    reductions in orders by our distributors and original equipment manufacturers; and
    
    the timing and amount of our expenses.
  If the estimates we make, and the assumptions on which we rely, in preparing our financial
statements prove inaccurate, our actual results may vary from those reflected in our financial
statements.
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##### Table of Contents



Compliance with changing regulation of corporate governance and public disclosure as well as
potential new accounting pronouncements are likely to impact our future financial position or
results of operations.
 Share-Based Payment,
  Failure to maintain effective internal controls in accordance with section 404 of the
Sarbanes-Oxley act could have a material adverse effect on our business and stock price.
  We may need additional financing for our future capital needs and may not be able to raise
additional funds on terms acceptable to us, or at all.
  
    
    the research and development costs of our products or technology currently under development, including costs to fund
our neuroscience program following termination in June 2007 of our alliance with Boston Scientific Corporation,
increase beyond current estimates;
    
    we decide to expand faster than currently planned;
    
    we develop new or enhanced services or products ahead of schedule;
    
    we decide to undertake new sales and/or marketing initiatives;
    
    we are required to defend or enforce our intellectual property rights, or respond to other legal challenges with
respect to our products, including product liability claims;
    
    sales of our products do not meet our expectations domestically or internationally, including sales of our BIS Sensors;
    
    we are required or elect to pay the principal under our 2.5% notes in cash at or prior to maturity or we determine to
repurchase any portion of our 2.5% notes;
    
    we experience unexpected losses in our cash investments or are otherwise unable to liquidate these investments due to
unfavorable conditions in the capital markets;
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##### Table of Contents




    
    we need to respond to competitive pressures; or
    
    we decide to acquire complementary products, businesses or technologies.
   Cases of awareness with recall during monitoring with the BIS system could limit market acceptance
of the BIS system and could expose us to product liability claims.
  We may not be able to compete with new products or alternative techniques developed by others,
which could impair our ability to remain competitive and achieve future growth.
  
    
    other new monitoring products, based on new or improved technologies;
    
    new products or technologies used on patients or in the operating room during surgery in lieu of monitoring devices;
    
    electrical or mechanical interference from new or existing products or technologies;
    
    alternative techniques for evaluating the effects of anesthesia;
    
    significant changes in the methods of delivering anesthesia; and
    
    the development of new anesthetic agents.
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If we do not maintain our relationships with the anesthesia community and if anesthesiologists and
other healthcare providers do not recommend and endorse our products, our sales may decline or we
may be unable to increase our sales and profits.
  New England Journal of Medicine
 Negative publicity or unfavorable media coverage could damage our reputation and harm our
operations.
  If we do not successfully develop or acquire and introduce enhanced or new products we could lose
revenue opportunities and customers.
  
    
    identify and respond, in a timely manner, to new market trends or opportunities;
    
    assess customer needs;
    
    successfully develop or acquire competitive products;
    
    complete regulatory clearance in a timely manner;
    
    successfully develop cost effective manufacturing processes;
    
    introduce such products to our customers in a timely manner; and
    
    achieve market acceptance of the BIS system.
  38




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
    
    we may not successfully adapt the BIS system to function properly for
procedural sedation, when used with anesthetics we have not tested or
with patient populations we have not studied, such as infants; and
    
    our technology is complex, and we may not be able to develop it
further for applications outside anesthesia monitoring, such as the
diagnosis and tracking of neurological diseases.
   If our clinical trials are delayed or unsuccessful, our business could be adversely affected.
    
    
    delays or the inability to obtain required approvals from institutional review boards or other governing
entities at clinical sites selected for participation in our clinical trials;
    
    delays in enrolling patients and volunteers into clinical trials;
    
    lower than anticipated retention rates of patients and volunteers in clinical trials;
    
    negative results from clinical trials for any of our potential products, including those involving the
management of depression and the early diagnosis and tracking of Alzheimers disease; and
    
    failure of our clinical trials to demonstrate the efficacy or clinical utility of our potential products.
  If we do not develop and implement a successful sales and marketing strategy, we will not expand
our business.
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
    
    provide or assure that distributors and original equipment manufacturers provide the
technical and educational support customers need to use the BIS system successfully;
    
    promote frequent use of the BIS system so that sales of our disposable BIS Sensors increase;
    
    establish and implement successful sales and marketing and education programs that
encourage our customers to purchase our products or the products that are made by original
equipment manufacturers incorporating our technology;
    
    manage geographically dispersed operations; and
    
    modify our products and marketing and sales programs for foreign markets.
 We encourage our direct sales force, distributors and original equipment manufacturers to maximize
the amount of our products they sell and they may engage in aggressive sales practices that may
harm our reputation.
 
 Our third-party distribution and original equipment manufacturer relationships could negatively
affect our profitability, cause sales of our products to decline and be difficult to terminate if
we are dissatisfied.
  We may not be able to generate enough additional revenue from our international expansion to offset
the costs associated with establishing and maintaining foreign operations.
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We may not be able to meet the unique operational, legal and financial challenges that we encounter
in our international operations, which may limit the growth of our business.
  
    
    failure of local laws to provide adequate protection against infringement of our intellectual property;
    
    protectionist laws and business practices that favor local competitors, which could slow or prohibit our
growth in international markets;
    
    difficulties in terminating or modifying distributor arrangements because of restrictions in markets
outside the United States;
    
    less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors;
    
    delays in regulatory approval of our products;
    
    currency conversion issues arising from sales denominated in currencies other than the United States dollar;
    
    foreign currency exchange rate fluctuations;
    
    longer sales cycles to sell products like the BIS system to hospitals and outpatient surgical centers,
which could slow our revenue growth from international sales; and
    
    longer accounts receivable payment cycles and difficulties in collecting accounts receivable.
  We may experience customer dissatisfaction and our reputation could suffer if we fail to
manufacture enough products to meet our customers demands.
  Our reliance on sole-source suppliers could adversely affect our ability to meet our customers
demands for our products in a timely manner or within budget.
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We may be required to bring litigation to enforce our intellectual property rights, which may
result in substantial expense and may divert our attention from the implementation of our business
strategy.
  We may be sued by third parties which claim that our products infringe on their intellectual
property rights, particularly because there is substantial uncertainty about the validity and
breadth of medical device patents.
  
    
    cease selling, incorporating or using any of our products that incorporate the
challenged intellectual property, which would adversely affect our revenue;
    
    obtain a license from the holder of the infringed intellectual property right, which
license may not be available on reasonable terms, if at all; and
    
    redesign our products, which may be costly, time-consuming and may not be successful.
 We could be exposed to significant product liability claims which could divert management attention
and adversely affect our cash balances, our ability to obtain and maintain insurance coverage at
satisfactory rates or in adequate amounts and our reputation.
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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.
   We and Boston Scientific recently jointly terminated our strategic alliance and other agreements
and, as a result, we may not have sufficient funding to finance our neuroscience programs.
  
    
    the original equipment manufacturer product development agreement dated as of
August 7, 2002, pursuant to which we were seeking to develop certain products that
Boston Scientific Corporation would then commercialize in the area of monitoring
patients under sedation in a range of less invasive medical specialties, and pursuant to
which we granted Boston Scientific Corporation an exclusive option to become the
distributor for a period of time of certain of our products;
    
    the product development and distribution agreement dated as of May 23, 2005,
pursuant to which we were seeking to develop new applications of its brain-monitoring
technology in the area of the diagnosis and treatment of neurological, psychiatric and
pain disorders and Boston Scientific Corporation was appointed the exclusive distributor
of such products. Under this agreement, which we refer to as the neuroscience alliance,
Boston Scientific Corporation had agreed to provide $25.0 million of funding over a five
year period. We received $10.0 million under this agreement; and
    
    the letter agreement dated August 7, 2002, and the security agreement dated August 7,
2002, pursuant to which Boston Scientific Corporation agreed to make revolving
interest-bearing loans to us from time to time at our request, such revolving loans
being evidenced by a promissory note in the original principal amount of $5.0 million
dated August 7, 2002 made by us in favor of Boston Scientific Corporation.
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We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could
result in unanticipated expenses and fluctuations in operating results.
  We may not be able to compete effectively, which could result in price reductions and decreased
demand for our products.
  Our ability to market and sell our products and generate revenue depends upon receipt of domestic
and foreign regulatory approval of our products and manufacturing operations.
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Even if we obtain the necessary FDA clearances or approvals, if we or our suppliers fail to comply
with ongoing regulatory requirements our products could be subject to restrictions or withdrawal
from the market.
  
    
    untitled letters, warning letters, fines, injunctions and civil penalties;
    
    administrative detention, which is the detention by the FDA of medical devices believed to be
adulterated or misbranded;
    
    customer notification, or orders for repair, replacement or refund;
    
    voluntary or mandatory recall or seizure of our products;
    
    operating restrictions, partial suspension or total shutdown of production;
    
    refusal to review pre-market notification or pre-market approval submissions;
    
    rescission of a substantial equivalence order or suspension or withdrawal of a pre-market approval; and
    
    criminal prosecution.
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We may be subject, directly or indirectly, to federal and state healthcare fraud and abuse laws and
regulations and, if we are unable to fully comply with such laws, could face substantial penalties.
  If we do not retain our senior management and other key employees, we may not be able to
successfully implement our business strategy.
  If we do not attract and retain skilled personnel, or if we do not maintain good relationships with
our employees, we will not be able to expand our business.
   If we make any acquisitions, we will incur a variety of costs and may never successfully integrate
the acquired business into ours.
  Our employees may engage in misconduct or other improper activities, including insider trading.
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Failure of users of the BIS system, or users of future products we may develop, to obtain adequate
reimbursement from third-party payors could limit market acceptance of the BIS system and other
products, which could prevent us from sustaining profitability.
   The market price of our stock is highly volatile, and this volatility could cause your investment
in our stock to suffer a decline in value and cause us to incur significant costs from class action
litigation.
  
    
    variations in our quarterly operating results or those of companies that are perceived
to be similar to us;
    
    third-party sales of large blocks of our common stock;
    
    rumors relating to us or our competitors;
    
    changes to our research and development plans and/or announcements regarding new
technologies by us or our competitors;
    
    adverse results in clinical trials of our BIS monitoring system products and products
under development;
    
    lawsuits involving us;
    
    sales by us of equity or debt to fund our operations;
    
    the loss of any of our key scientific or management personnel;
    
    FDA or international regulatory actions or lawsuits concerning the safety of our
products; and
    
    market conditions, both in the medical device sector and generally.
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Transactions engaged in by our largest stockholders, our directors or executives involving our
common stock may have an adverse effect on the price of our stock.
   We have various mechanisms in place to discourage takeover attempts, which may reduce or eliminate
our stockholders ability to sell their shares for a premium in a change of control transaction.
  
    
    preferred stock that could be issued by our board of directors to make it more difficult for a third
party to acquire, or to discourage a third party from acquiring, a majority of our outstanding voting
stock;
    
    classification of our directors into three classes with respect to the time for which they hold office;
    
    non-cumulative voting for directors;
    
    control by our board of directors of the size of our board of directors;
    
    limitations on the ability of stockholders to call special meetings of stockholders;
    
    inability of our stockholders to take any action by written consent; and
    
    advance notice requirements for nominations of candidates for election to our board of directors or
for proposing matters that can be acted upon by our stockholders at stockholder meetings.
 Risks Related to our Issuance of $125 Million Principal Amount of
2.5% Convertible Senior Notes due 2014
 Our increased indebtedness as a result of the issuance of $125 million principal amount of 2.5%
convertible senior notes, or the notes, may harm our financial condition and results of operations.
  
    
    it could adversely affect our ability to satisfy our obligations under the notes;
    
    a substantial portion of our cash flows from operations will have to be dedicated to
interest payments, principal payments and, if we irrevocably elect to net share settle the
notes, conversion payments and may not be available for operations, working capital,
capital expenditures, expansion, acquisitions or general corporate or other purposes;
    
    it may impair our ability to obtain additional financing in the future;
    
    it may limit our flexibility in planning for, or reacting to, changes in our business
and industry; and
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
    
    it may make us more vulnerable to downturns in our business, our industry or the economy
in general.
  We may not have the cash necessary to pay interest on the notes, to settle conversions of the notes
(if we have obtained stockholder approval to elect net share settlement of the notes, and we
irrevocably elect such settlement method) or to repurchase the notes upon a fundamental change.
  
    
    pay cash in an amount equal to the lesser of one-fortieth of the principal amount of the
notes being converted and the daily conversion value (the product of the conversion rate
and the current trading price) of the notes being converted; and
    
    issue shares of our common stock only to the extent that the daily conversion value of
the notes exceeded one-fortieth of the principal amount of the notes being converted for
each trading day of the relevant 40 trading day observation period.
  The net share settlement feature of the notes, if available, may have adverse consequences.
  
    
    result in holders receiving no shares of our common stock
upon conversion or fewer shares of our common stock relative to the conversion value of the notes;
    
    reduce our liquidity because we will be required to pay the principal portion in cash;
    
    delay holders receipt of the proceeds upon conversion; and
    
    subject holders to market risk before receiving any shares upon conversion.
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If we repurchase any portion of the notes, such repurchases could adversely affect the holders of
the notes and our common stock and could also adversely affect our financial condition and
operating results.
  Future sales of our common stock in the public market or the issuance of securities senior to our
common stock could adversely affect the trading price of our common stock and the value of the
notes and our ability to raise funds in new securities offerings.
   Conversion of the notes will dilute the ownership interest of existing stockholders, including
holders who had previously converted their notes.
  Provisions in the indenture for the notes may deter or prevent a business combination that may be
favorable to note holders.
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The notes may not be rated or may receive a lower rating than anticipated.
  The effective subordination of the notes to our secured indebtedness to the extent of the
collateral securing such indebtedness may limit our ability to satisfy our obligations under the
notes.
  The structural subordination of the notes to our secured liabilities and all liabilities and
preferred equity of our subsidiaries may limit our ability to satisfy our obligations under the
notes.
  
 Item 6. Exhibits.
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SIGNATURE
  ASPECT MEDICAL SYSTEMS, INC.Date: November 6, 2008
    By:
    /s/ Michael FalveyMichael FalveyVice President and Chief Financial Officer
(Principal Financial and Accounting
Officer) 52




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EXHIBIT INDEX
 EXHIBITNUMBER
    
    EXHIBIT10.1
    
    Key Employee Change in Control Severance Benefits Plan is
incorporated herein by reference to Exhibit 10.1 to the
Registrants Current Report on Form 8-K dated September 18, 2008.31.1
    
    Certification by Chief Executive Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.31.2
    
    Certification by Chief Financial Officer Pursuant to Rule
13a-14(a)/15d-14(a) of the Securities Exchange Act of 1934, as
amended.32.1
    
    Certification by Chief Executive Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.32.2
    
    Certification by Chief Financial Officer Pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.