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Aspect Medical Systems 10-K 2005
ASPECT MEDICAL SYSTEMS, INC. FORM 10-K
Table of Contents

 
 
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
Form 10-K
For Annual and Transaction Reports Pursuant to Sections 13 or 15(d)
of the Securities Exchange Act of 1934
     
þ
  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 
    For the fiscal year ended December 31, 2004
 
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.
(Exact name of Registrant as Specified in Its Charter)
     
Delaware   04-2985553
(State or Other Jurisdiction of
Incorporation or Organization)
  (I.R.S. Employer
Identification No.)
 
141 Needham Street
Newton, Massachusetts
(Address of Principal Executive Offices)
  02464-1505
(Zip Code)
(617) 559-7000
Registrant’s telephone number, including area code
 
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered Pursuant to Section 12(g) of the Act:
Common Stock, $0.01 Par Value
(Title Of Class)
 
     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 þ          No o
      Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.     o
      Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).     Yes þ          No o
      The aggregate market value of the voting stock held by non-affiliates of the registrant as of July 2, 2004 (based on the closing price as quoted by the Nasdaq National Market as of such date) was $254,014,822. The registrant had 20,922,737 shares of Common Stock, $0.01 par value per share, outstanding as of March 1, 2005.
DOCUMENTS INCORPORATED BY REFERENCE
      The registrant intends to file a definitive proxy statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended December 31, 2004. Portions of such proxy statement are incorporated by reference into Part III of this Form 10-K.
 
 


PART I
Item 1. Business.
Item 2. Properties.
Item 3. Legal Proceedings.
Item 4. Submission of Matters to a Vote of Security Holders.
PART II
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.
Item 6. Selected Consolidated Financial Data.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Item 7A. Qualitative and Quantitative Disclosures About Market Risk.
Item 8. Financial Statements and Supplementary Data.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Item 9A. Controls and Procedures.
Item 9B. Other Information.
PART III
Item 10. Directors and Executive Officers of the Registrant.
Item 11. Executive Compensation.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Item 13. Certain Relationships and Related Transactions.
Item 14. Principal Accountant Fees and Services.
PART IV
Item 15. Exhibits and Financial Statement Schedules.
SIGNATURES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
EXHIBIT INDEX
EX-10.39 Form of Incentive Stock Option Agreement Granted Under 2001 Stock Incentive Plan
EX-10.40 Cash Compensation for Non-Management Director Of Aspect Medical Systems, Inc.
EX-10.41 Base Salaries of Named Executive Officers of Aspect Medical Systems Inc.
EX-21.1 SUBSIDIARIES OF THE REGISTRANT
EX-23.1 CONSENT OF ERNST & YOUNG LLP
EX-31.1 CERTIFICATION BY CHIEF EXECUTIVE OFFICER
EX-31.2 CERTIFICATION BY CHIEF FINANCIAL OFFICER
EX-32.1 SECT. 1350 CERTIFICATION OF C.E.O.
EX-32.2 SECT. 1350 CERTIFICATION OF C.F.O.


Table of Contents

PART I
Item 1. Business.
Overview
      Aspect Medical Systems, Inc. was incorporated as a Delaware corporation in 1987. We develop, manufacture and market an anesthesia monitoring system that we call the BIS® system. The BIS system is based on our patented core technology, the Bispectral Index, which we refer to as the BIS index. The BIS system provides information that allows clinicians to better assess and manage a patient’s level of consciousness in the operating room and intensive care settings and administer the precise amount of anesthesia needed by each patient. We developed the BIS system over 10 years, and it is the subject of 20 issued United States patents and eight pending United States patent applications. Our proprietary BIS system includes our BIS monitor, BIS Module Kit or BISx system, which allows original equipment manufacturers to incorporate the BIS index into their monitoring products, and our disposable BIS Sensors. In January 2005, we introduced our semi-reusable sensor product in the international market, excluding Japan. We collectively refer to our group of sensor products as BIS Sensors.
      Our latest generation of stand-alone 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 observed during deep anesthesia and cardiac cases. In addition to our A-2000 BIS Monitor, we offer original equipment manufacturers our BIS Module Kit for integration into equipment sold by the original equipment manufacturers. Our BISx system, which was cleared for marketing by the FDA in February 2004, is our latest BIS monitoring system for integration into the equipment sold by original equipment manufacturers. The BISx system provides the BIS XP functionality in a single device the approximate size of a hockey puck, simplifying the incorporation of the BIS XP system into third-party patient monitoring systems.
      As of December 31, 2004, the worldwide installed base of BIS monitors and original equipment manufacturer products was approximately 24,000 units. We estimate that BIS technology is installed in approximately 36% of all domestic operating rooms, and is available in more than 160 countries. We estimate that more than 10.4 million patients worldwide have been monitored using the BIS index during surgery.
      Clinical trials and routine clinical use of the BIS system have shown that patient monitoring with the BIS system can result in:
  •  a reduction in the amount of anesthetics used,
 
  •  faster wake-up from anesthesia,
 
  •  less patient time in the operating room and the post-anesthesia care unit following surgery,
 
  •  higher rates of outpatients bypassing the post-anesthesia care unit and proceeding to a less costly step-down recovery area directly from the operating room,
 
  •  improvements in the quality of recovery, and
 
  •  a reduction in the unintentional regaining of consciousness during surgery.
      We derive our revenue primarily from sales of BIS monitors, our original equipment manufacturer products (including BIS Module Kits and BISx) and related accessories, which we collectively refer to as Equipment, and sales of BIS Sensors. In 2004, 2003 and 2002, revenue from the sale of Equipment represented approximately 29%, 31% and 33%, respectively, of our revenue, and revenue from the sale of BIS Sensors represented approximately 71%, 69% and 67%, respectively, of our revenue.

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      We maintain a website with the address www.aspectmedical.com. We are not including the information contained on our website as a part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make available free of charge through our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and amendments to these reports, as soon as reasonably practicable after we electronically file such material with, or furnish such material to, the Securities and Exchange Commission. We have posted on our website a copy of our Code of Business Conduct and Ethics. In addition, we intend to disclose on our website any amendments to, or waivers from, our code of business conduct and ethics that are required to be publicly disclosed pursuant to the rules of the Securities and Exchange Commission.
The Aspect Solution: Patient Monitoring with the BIS System
      We have developed the BIS monitoring system that is based on our proprietary BIS index. Our BIS system is composed of our BIS monitor, BIS Module Kit or BISx system and our BIS Sensors. The BIS Sensors are applied to a patient’s forehead to acquire the EEG, a measure of the electrical activity of the brain. The EEG is then analyzed by the BIS monitor, BIS Module Kit or BISx system to produce the BIS index. The BIS index is a numerical index that correlates with levels of consciousness and is displayed as a number ranging between 100, indicating that the patient is awake, and zero, indicating an absence of brain activity. In October 1996, the FDA cleared the BIS index for marketing for use as a direct measure of the effects of anesthetics and sedatives on the brain. In October 2003, the FDA cleared a new indication for use specifying that use of BIS monitoring to help guide anesthetic administration may be associated with the reduction of the incidence of awareness with recall in adults during general anesthesia and sedation.
Products
      The following chart summarizes our principal product offerings:
             
    Initial    
    Commercial    
Product   Shipment   Description
         
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 leading monitoring manufacturers.
 
BIS XP System
    2001     Latest version of BIS system offering enhanced performance capabilities and expanded benefits as compared to the previous version of the BIS system, enabling more precise measurement of brain activity to assess the level of consciousness.
 
BIS Module Kit — 4 Channel Support
    2001     Same as standard BIS Module Kit plus 4 channel EEG monitoring capability.
 
A-2000 BIS Monitor
    1998     Small, 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.

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    Initial    
    Commercial    
Product   Shipment   Description
         
 
BIS Extend Sensor
    2002     Disposable sensor with electronic memory device for use with A-2000 BIS Monitor, BIS Module Kit and BISx system that was specially designed for patients who are typically monitored for extended periods.
 
BIS Pediatric Sensor
    2001     Disposable sensor with electronic memory device for use with A-2000 BIS Monitor, 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 A-2000 BIS Monitor, BIS Module Kit and BISx system that offers 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 the A-2000 BIS Monitor and BIS Module Kit.
 
BIS Standard Sensor
    1997     Disposable sensor for use with A-2000 BIS Monitor, A-1050 EEG Monitor with BIS and BIS Module Kit
BISx System
      The BISx system is our latest original equipment manufacturer 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 leading monitoring manufacturers. BISx simplifies the incorporation of BIS technology into our partners’ monitoring systems and makes available a class of monitoring systems that has historically been out of reach due to the cost of integration. We have also maintained backwards compatibility with our existing BIS engine technology to simplify the adoption of BISx by our existing partners.
BIS XP System
      We began commercial distribution of the BIS XP system in September 2001. The BIS XP system runs on the A-2000 BIS Monitor, BIS Module Kit platform and BISx system and offers enhanced performance capabilities and expanded benefits compared with 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 observed during deep anesthesia and cardiac cases.
A-2000 BIS Monitor
      We began commercial distribution of the A-2000 BIS Monitor, our third-generation monitor, in February 1998. The A-2000 BIS Monitor is a compact, lightweight, portable monitor designed to accommodate the space limitations and positioning requirements of surgical settings. The A-2000 BIS Monitor displays the BIS index and supporting information and includes our proprietary digital signal converter. This converter is a palm-sized module that serves as the interface between the BIS monitor and the BIS Sensors. The digital signal converter acquires the EEG signal from the BIS Sensors and converts the EEG signal to digital format. The EEG signal is then processed and the BIS index is displayed on the A-2000 BIS Monitor.

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BIS Module Kit
      In 1996, we introduced our BIS Module Kit, which is designed to facilitate the integration of the BIS index into equipment marketed by our original equipment manufacturers. The BIS Module Kit consists of two pieces, our proprietary digital signal converter and a small circuit board that resides in the original equipment manufacturer’s system. The digital signal converter acquires the EEG signal from the BIS Sensors and converts the EEG signal to digital format. The circuit board then processes the EEG signal and outputs the BIS index to the original equipment manufacturer’s system.
      The common architecture of the BIS Module Kit facilitates integration of the BIS index into the original equipment manufacturer’s system. Each original equipment manufacturer is required to obtain FDA and other appropriate regulatory clearance of its BIS module product.
BIS Module Kit — 4 Channel Support
      In 2001, we introduced commercially the BIS Module Kit with 4 channel EEG monitoring capability to support a product introduction of one of our original equipment manufacturers.
BIS Sensors
      BIS Extend Sensor. We created the BIS Extend Sensor, which was introduced commercially in 2002, for patients who are typically monitored for an extended period of time, such as in intensive care unit settings. We designed the BIS Extend Sensor with a surface that allows clinicians to record in writing the date and time of application, making it easier to track when a new sensor should be applied. The BIS Extend Sensor provides resistance to electrical artifact and is designed to detect and filter interference from muscle artifact caused by sources such as eye movement. The BIS Extend Sensor contains an electronic memory device that allows information about the sensor, such as lot code, expiration date and type of sensor, to be stored on the sensor and to be retrieved by the BIS monitor, BIS Module Kit or BISx system.
      BIS Pediatric Sensor. The BIS Pediatric Sensor, which was introduced commercially in 2001, is smaller and easier to apply than our other BIS Sensors, and is designed to be visually appealing to children. The BIS Pediatric Sensor features an improved design for easy connection and enables the BIS system to automatically configure its settings for specific patient populations and applications. The BIS Pediatric Sensor contains an electronic memory device that allows information about the sensor, such as lot code, expiration date and type of sensor, to be stored on the sensor and to be retrieved by the BIS monitor, BIS Module Kit or BISx system.
      BIS Quatro Sensor. The BIS Quatro Sensor, which was introduced commercially in 2001, offers enhanced performance in deep anesthetic states and improved resistance to interference from noise sources, such as high frequency/electromyography conditions, in the operating room and intensive care unit. The BIS Quatro Sensor features an improved design compared with the BIS Standard Sensor for easy connection and enables the BIS system to automatically configure its settings for specific patient populations and applications. The BIS Quatro Sensor contains an electronic memory device that allows information about the sensor, such as lot code, expiration date and type of sensor, to be stored on the sensor and to be retrieved by the BIS monitor, BIS Module Kit or BISx system.
      BIS Sensor Plus. The BIS Sensor Plus, which was introduced commercially in 2001, is a second-generation disposable product for use with the A-2000 BIS Monitor and BIS Module Kit. The BIS Sensor Plus features an improved design compared with the BIS Standard Sensor for easy connection and enables the BIS system to automatically configure its settings for specific patient populations and applications. The BIS Sensor Plus contains an electronic memory device that allows information about the sensor, such as lot code, expiration date and type of sensor, to be stored on the sensor and to be retrieved by the BIS monitor, BIS Module Kit or BISx system.
      BIS Standard Sensor. We commenced commercial distribution of the BIS Standard Sensor in January 1997. The BIS Standard Sensor is a single-use, disposable product for use with the A-2000 BIS Monitor, the A-1050 EEG Monitor with BIS and the BIS Module Kit. The BIS Standard Sensor is not compatible with the BIS XP system because it does not contain the easy connection feature and electronic memory device of

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our other BIS Sensors. The BIS Standard Sensor provides a reliable and simple means of acquiring the EEG signal needed to generate the BIS index. The one-piece design allows quick and accurate placement on the patient’s forehead. The BIS Standard Sensor connects to the monitor by a single-point proprietary connector.
      Our Zipprep self-prepping technology is a key feature of each of our BIS Sensors. The technology is designed to minimize patient set-up time and establish effective electrical contact with the patient which enables consistent, accurate readings of the EEG signal. Prior to our development of the Zipprep technology, to obtain an EEG signal the user prepared a patient’s skin by rubbing an abrasive cream over the forehead 10 to 20 times in order to remove the top layer of skin prior to applying the electrode.
Technology
      We developed the BIS system, including our proprietary BIS index, over 10 years. The BIS index is a numerical index that quantitates the hypnotic component of anesthetic drug effect which correlates with the level of consciousness and is derived from an analysis of the EEG signal. In general, an EEG signal changes from a small-amplitude, high-frequency signal while a person is awake to a large-amplitude, low-frequency signal while a person is deeply anesthetized. Historically, researchers have used observations about these changes in the EEG signal to create mathematical algorithms to track the effects of anesthetics on the brain. However, these algorithms have not been widely adopted because studies have indicated that they generally do not provide sufficient clinically useful information to assess levels of consciousness with commonly used anesthetics and doses.
      In developing the BIS index, we sought to improve these early EEG analyses in two ways. First, by using bispectral analysis, a mathematical tool that examines signals such as the EEG, we can extract new information from the EEG signal. Second, we developed proprietary processing algorithms that extract information from bispectral analysis, power spectral analysis and time domain analysis. Geophysicists originally used bispectral analysis in the early 1960s to study ocean wave motion, atmospheric pressure changes and seismic activity. The advent of high-speed, low-cost digital signal processors has enabled the use of bispectral analysis for other applications. By using bispectral analysis, we are able to extract a distinctive fingerprint of the underlying signal structure of the EEG and represent it as a three-dimensional mathematical model.
      We created the BIS index to quantify changes in the EEG that relate to the effects of anesthetics on the brain in order to assess levels of consciousness. Over a number of years, Aspect and others collected a large database of high fidelity EEG recordings and clinical assessments from volunteers and patients receiving a wide variety of anesthetics. Researchers used clinical assessments such as a sedation rating scale, picture or word recall memory tests and response to stimuli to define levels of consciousness. Using statistical methods, we identified features within the EEG that correlated with sedation and loss of consciousness. We then used proprietary statistical methods to combine these features to generate an interpretive numerical index, which we refer to as the BIS index. The BIS index ranges from 100, indicating that the patient is awake, to zero, indicating an absence of electrical brain activity.
Clinical Development
      Our clinical research and regulatory affairs group is responsible for:
  •  establishing collaborative relationships with leading clinical researchers,
 
  •  encouraging publications related to the BIS index in scientific literature,
 
  •  monitoring compliance with the FDA and other regulatory agencies’ requirements,
 
  •  conducting clinical research with the goal of extending the application of patient monitoring with the BIS system to other settings and clinical uses, and
 
  •  collecting data for new product development.

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      We have a clinical database of over 5,000 cases for use in algorithm development and product validation based on trials that we conducted or sponsored or that third parties conducted.
      In 1996, the FDA cleared the BIS index for marketing as a measure of anesthetic effect on the brain. The regulatory approval process involved studies we conducted on over 900 volunteers and patients. These studies characterized the relationships between the BIS index value and various clinical endpoints, including movement, response to incision, response to verbal command as a measure of consciousness in volunteers and patients, memory function, drug utilization and speed of patient recovery following surgery.
      In October 2003, the FDA cleared a new indication for use specifying that use of BIS monitoring to help guide anesthetic administration may be associated with the reduction of the incidence of awareness with recall in adults during general anesthesia and sedation. This clearance was based on data that was collected in several multi-center, multinational studies to assess the incidence of awareness with recall and the impact of BIS monitoring. More than 30,000 patients were enrolled in these studies, which we conducted over a period of 18 months. Results from these studies demonstrated that awareness with recall occurs in approximately 1 to 2 cases per 1,000 patients during general anesthesia. Although our clinical research and practice experience suggests that awareness with recall is more likely to occur when BIS values are high, we do not believe that our experience demonstrates conclusively that patient monitoring with the BIS system will identify or prevent all cases of awareness with recall.
      Since the introduction of our products, clinicians have reported to us cases of possible awareness with recall during surgical procedures monitored with the BIS system. These reports may not include all cases of awareness with recall that might have occurred during procedures where patients were 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 with recall, high BIS index values were noted, indicating that the BIS index correctly identified the increased risk of awareness with recall in these patients. It is possible that, in a number of these reported cases, awareness with recall may not have been detected by monitoring with the BIS system.
      We are also collaborating with researchers that are investigating the relationship between deep anesthetic levels as measured using the BIS system and one-year morbidity and mortality. One initial report (Monk TG, Saini V, Weldon BC, Sigl JC Anesthetic management and one-year mortality after noncardiac surgery. Anesthesia Analg. 2005 Jan;100(1):4-10.) suggested that deep anesthesia is associated with increased post-operative mortality in elderly patients undergoing general anesthesia. A second study involving over 4,000 patients has reportedly confirmed this association (Lennmarken C, Lindholm, ML, Greenwald S, Sandin R. Confirmation that Low Intraoperative BIS Levels Predict Increased Risk of Post-Operative Mortality. Anesthesiology 2003, Annual Meeting A-303). Finally, a retrospective analysis of Medicare national hospital data has suggested that hospitals that routinely use intraoperative BIS monitoring may have decreased postoperative one-year mortality rates (Monk T, Sigl J, Weldon C. Intraoperative BIS Utilization is Associated with Reduced One-Year Post-Operative Mortality. Anesthesiology 2003, Annual Meeting A-1361). We believe that these preliminary findings need to be further confirmed in additional trials. The association between intraoperative anesthesia care and long term outcomes was the topic of a recent collaborative conference of medical patient safety experts (http://www.apsf.org/initiatives/outcomes.mspx).
Sales, Marketing and Customers
      Our customers include anesthesia providers, hospitals, outpatient surgical centers and individual practitioners in office-based practice. We market and sell our products to our customers through:
  •  our direct sales force,
 
  •  distributors, and
 
  •  original equipment manufacturers.
      For the years ended December 31, 2004, 2003 and 2002, no one customer accounted for 10% or more of our total revenue.

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Domestic
      We market our BIS system in the United States primarily through a combination of a direct sales force, specialty distributors and original equipment manufacturers. As of December 31, 2004, our domestic sales force was composed of 44 sales professionals, seven clinical specialists and seven inside sales representatives.
      We augment our direct sales force with medical products distributors in selected markets within the United States. We also market our products through the sales organizations of our original equipment manufacturers and contracts with hospital group purchasing organizations.
      For those healthcare organizations desiring to purchase our BIS monitors directly from us, we offer two options. Our customers have the option either to purchase BIS monitors outright or to acquire BIS monitors pursuant to a sales-type lease agreement whereby the customer contractually commits to purchase a minimum number of BIS Sensors per BIS monitor per year. Under 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. We also grant these customers an option to purchase the BIS monitors at the end of the term of the agreement, which is typically three to five years. We recognize Equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period. We believe that the sales-type lease arrangement in some cases reduces the time required for customers to adopt the BIS system because it provides them with an option to utilize their operating budget to fund the purchase.
      In addition to the two options noted above, under certain limited circumstances, we 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 typically 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 focus our marketing initiatives on the various constituencies that may be involved in the decision-making process concerning the purchase of our products. For clinical audiences, we exhibit at tradeshows, sponsor speakers at professional meetings and develop articles for publication in conjunction with industry experts. In addition, we work with hospitals to publicize their adoption of patient monitoring with the BIS system in an effort to assist them in communicating their commitment to improving the quality and efficiency of patient care.

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Group Purchasing Agreements
      We have entered into agreements with group purchasing organizations whereby the member healthcare organizations have the right to purchase BIS monitors and BIS Sensors under the pricing terms contained in the respective agreements. Under these agreements, the group purchasing organizations’ field forces have agreed to work with our sales force to facilitate the adoption of our BIS technology by their affiliated healthcare organizations. We have agreements with the following group purchasing organizations:
         
Group Purchasing Organization   Effective Date   Termination Provisions
         
Consorta, Inc. 
  November 1, 2000   Unless terminated earlier by either party by giving 90 days prior written notice, this agreement expires on October 31, 2005.
Healthtrust Purchasing Group, L.P. 
  November 1, 2004   Unless terminated earlier by either party by giving 60 days prior written notice, this agreement expires on October 31, 2007.
      We are currently in the process of renewing our agreement with Novation.
International
      In 1998, we established our international operations and opened our international headquarters in The Netherlands. In 1999, we established a subsidiary in the United Kingdom. We continue to develop our international sales and distribution program through a combination of distributors and marketing partners, including companies with which we have entered into original equipment manufacturer relationships. As of December 31, 2004, we employed 25 persons in our international organization. The majority of our international sales are denominated in United States dollars. See Note 16, “Segment Information and Enterprise Reporting,” of the Notes to Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K for domestic and international financial information.
      We are 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.

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Distribution Agreements
      We entered into a master distribution agreement, effective September 1, 2000, with Datex-Ohmeda Division of Instrumentarium Corporation, under which Datex-Ohmeda agreed to act as a nonexclusive distributor of our A-2000 BIS Monitor, BIS Sensors and related products in a number of territories outside the United States. The master distribution agreement expired on November 1, 2003. After the expiration of this agreement, we entered into several country-specific distribution agreements.
      We have also entered into a distribution agreement, dated January 21, 1998, with Nihon Kohden Corporation, under which Nihon Kohden has agreed to act as an exclusive distributor of our BIS monitors and related products in Japan. This agreement had an initial term of five years, and is subject to automatic renewal annually on February 21 of each year unless either party provides written notice of termination to the other party at least three months prior to expiration or any renewal period.
Original Equipment Manufacturer Relationships
      We have entered into agreements with the following patient monitoring or anesthesia equipment companies that provide for the integration of our BIS technology into their equipment:
  •  Datascope Corp
 
  •  Dixtal Biomedica Ind E Com Ltda.
 
  •  Datex-Ohmeda Division of Instrumentarium Corporation
 
  •  GE Medical Systems — Information Technologies
 
  •  Philips Medizinsysteme Boeblingen GmbH
 
  •  Dräger Medizintechnik GmbH
 
  •  Dräger Medical Systems
 
  •  Nihon Kohden Corporation
 
  •  Spacelabs Medical, Inc.
      Datascope Corp. Under an OEM Development and Purchase Agreement, dated July 24, 2003, between Aspect and Datascope Corp., Datascope agreed to integrate our BIS technology with Datascope’s patient monitors. The initial term of this agreement continues for a period of five years following the introduction of the Datascope patient monitor with our BIS technology. On each anniversary date, one additional year is added to the term of this agreement to maintain a five year rolling term unless either party provides written notice of termination to the other party at least 60 days prior to the anniversary date.
      Dixtal Biomedica Ind E Com Ltda. Under an OEM Development and Purchase Agreement, dated February 13, 2003, between Aspect and Dixtal Biomedica Ind E Com Ltda., or Dixtal, Dixtal agreed to integrate our BIS technology with Dixtal’s patient monitors. The initial term of this agreement shall commence on the effective date and shall continue for a period of three years following introduction of the Dixtal BIS Module. The term of this agreement shall be renewed automatically for successive 12 month periods unless either party provides written notice of termination to the other party at least 60 days prior to the expiration of the agreement.
      Datex-Ohmeda Division of Instrumentarium Corporation. Under an OEM Purchase Agreement, dated September 1, 2000, between Aspect and Datex-Ohmeda Division of Instrumentarium Corporation, or Datex-Ohmeda, Datex-Ohmeda agreed to integrate our BIS technology with Datex-Ohmeda’s patient monitors. Unless terminated sooner, this agreement expires on December 31, 2005. However, the term of the agreement automatically renews for one-year periods unless either party provides advanced written notice of termination to the other party (i) by April 30, 2005 for termination on December 31, 2005, and (ii) 12 months prior to the automatic renewal date, for all future periods. Under a separate agreement with Datex-Ohmeda, dated September 1, 2000, we agreed to supply certain sensor products to Datex-Ohmeda for certain monitoring

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products developed and introduced by Datex-Ohmeda. Unless terminated sooner, this agreement expires on December 31, 2005. The term of this agreement automatically renews for one-year periods unless either party provides written notice of termination to the other party, at least 12 months prior to expiration of the agreement. In October 2003, GE Medical Systems acquired Instrumentarium Corporation. We do not expect that this acquisition will have a material impact on our agreement or our operations.
      GE Medical Systems — Information Technologies. Under an OEM Development and Purchase Agreement, dated December 22, 1999, between Aspect and GE Medical Systems — Information Technologies, GE Medical Systems agreed to integrate our BIS technology with GE Medical Systems’ patient monitors. Unless terminated sooner, the agreement expires December 31, 2005. The term of the agreement automatically renews for one-year periods unless either party provides written notice of termination to the other party, at least 60 days prior to the expiration of the agreement.
      Philips Medizinsysteme Boeblingen GmbH. Under an OEM Development and Purchase Agreement, dated August 6, 1999, between Aspect and Philips Medizinsysteme Boeblingen GmbH, or Philips, Philips agreed to integrate our BIS technology with Philips’ patient monitors. Unless terminated sooner, this agreement expires on August 6, 2005. The term of the agreement automatically renews for one-year periods unless either party provides written notice of termination to the other party, at least 60 days prior to expiration of the agreement.
      Dräger Medizintechnik GmbH. Under a Product Agreement with Dräger Medizintechnik GmbH, or Dräger, dated May 5, 1999, Dräger agreed to integrate the BIS Engine technology with Dräger’s anesthesia equipment. Unless terminated sooner, this agreement will expire on December 31, 2006. This agreement automatically renews for successive one-year periods thereafter unless either party provides written notice of termination to the other party, at least 12 months prior to expiration of the renewal period.
      Dräger Medical Systems. Under a BISx Development, Purchase and License Agreement with Dräger Medical Systems, dated January 28, 2004, Draeger agreed to integrate the BISx technology with Dräger patient monitors. Unless terminated sooner, this agreement expires on December 31, 2009. This agreement automatically renews for successive one-year periods thereafter unless either party provides written notice of termination to the other party, at least 12 months prior to expiration of the renewal period.
      Nihon Kohden Corporation. Under an International License Agreement, dated January 21, 1998, between Aspect and Nihon Kohden Corporation, we have licensed our technology to Nihon Kohden on a worldwide non-exclusive basis. Nihon Kohden has the right to incorporate our technology into its patient monitoring systems. Unless terminated sooner, the agreement expires in July 2006. The Japanese Ministry of Health and Welfare approved marketing of the Nihon Kohden patient monitor integrating BIS technology in July 2002.
      Spacelabs Medical, Inc. Pursuant to the terms of a Distribution and License Agreement, dated April 1, 1996, between Aspect and Spacelabs Medical, Inc., we have granted to Spacelabs a worldwide, non-exclusive license to the BIS index to develop, manufacture, market and sell Spacelabs monitoring equipment that incorporates the BIS index. Spacelabs also has the right to distribute our BIS Sensors on a non-exclusive basis throughout the world with the exception of the United States. Unless terminated sooner, this agreement expires in April 2006. In July 2002, Instrumentarium Corporation acquired Spacelabs Medical, Inc. This acquisition did not have a material impact on our agreements and our operations. In October 2003, GE Medical Systems acquired Instrumentarium Corporation. As part of the acquisition, GE Medical Systems divested Spacelabs Medical. OSI Systems completed the acquisition of Spacelabs Medical, Inc. in March of 2004. This acquisition did not have a material impact on our agreements and our operations.
      In addition to the original equipment manufacturer agreements described above, on August 7, 2002 we entered into an agreement with Boston Scientific Corporation, a worldwide developer, manufacturer and marketer of medical devices, to introduce new sedation management technology to interventional and specialty medical procedure suites including the gastrointestinal endoscopy suite, the interventional cardiology suite and the interventional radiology suite. Our strategic alliance with Boston Scientific Corporation focuses on the development and distribution of brain monitoring technology specifically designed to enhance the

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safety, efficiency and delivery of sedation to patients undergoing less-invasive medical procedures. As part of this alliance, we granted Boston Scientific Corporation an option to distribute the newly developed technology for monitoring patients under sedation in a range of less-invasive medical specialties. Pursuant to an amendment entered into in January 2005, this option to distribute has been extended through December 31, 2006. The term of this agreement continues until such time that Boston Scientific Corporation is no longer distributing our products, but in no event will extend beyond December 31, 2014.
Research and Development
      Our research and development efforts focus primarily on continuing to improve the function and features of the BIS system and enhancing our technical leadership in signal-processing technology for use in patient care. We intend to leverage the BIS technology for the development of new monitoring products and proprietary disposable sensors for new applications and to take advantage of new opportunities such as the intensive care unit and procedural sedation markets.
      During the fiscal years ended December 31, 2004, 2003 and 2002, we spent approximately $7.5 million, $7.3 million and $7.8 million, respectively, for our research and development efforts, including clinical and regulatory expenses.
      Our research and development department has four primary areas of responsibility:
  •  algorithm research,
 
  •  product development,
 
  •  pre-production quality assurance, and
 
  •  clinical engineering.
      In 2003, we developed the BISx system which offers our original equipment manufacturer partners a 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 has been designed to integrate with a wide range of patient monitoring platforms sold by leading monitoring manufacturers. BISx simplifies the incorporation of BIS technology into our original equipment manufacturer’s monitoring systems and makes available a class of monitoring systems that has historically been out of reach due to the cost of integration. We also maintained backwards compatibility with our existing BIS engine technology to simplify the adoption of BISx by our existing partners.
      We are in the process of investigating other product areas that utilize our expertise in anesthesia delivery and monitoring of the brain. We currently have a team that is investigating the use of the BIS monitoring platform to diagnose and track neurological disorders. We believe that because the BIS index quantifies changes in patients’ brain wave activity, or EEG, and we have shown the BIS index correlates with memory function and changes in brain metabolism, it may be useful in detecting neurological disorders in patients. We are evaluating the application of the EEG-based parameters including those derived from the BIS index to measure brain function, which may assist in the detection of Alzheimer’s disease, sleep cycles, seizure detection and/or other neurological disorders, including depression. Our recent research shows a correlation between the EEG-based parameters and the severity of dementia in patients with Alzheimer’s disease and vascular dementia. This research complements our prior research demonstrating the correlation between the EEG-based parameters and the effects of pharmacological agents on the brain, changes in cerebral metabolic activity and clinical measures of cognitive and memory function. In 2003, we announced the results of studies which were done in collaboration with the Neuropsychiatric Institute and David Geffen School of Medicine at UCLA, showing that EEG-based brain monitoring technology predicts treatment response to antidepressant medications in depressed patients. We are also undertaking a clinical study working with the Depression Clinical and Research Program at Massachusetts General Hospital to explore the use of quantitative EEG-based brain monitoring technology as a predictor and correlate of treatment outcome in depressed patients. In 2004, interim results of this study demonstrated that our brain monitoring technology was able to predict the effectiveness of antidepressant medications in treating depressed patients.

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      Additionally, on July 12, 2002, we entered into an agreement with the Regents of the University of California under which the Regents of the University of California granted to us an option to enter into a license agreement conveying to Aspect an exclusive license to commercialize brain monitoring technology for depression which was developed by the Neuropsychiatric Institute and David Geffen School of Medicine at UCLA. On July 1, 2004, we exercised this option with the Regents of University of California.
Manufacturing
      We use 12,000 square feet of our 61,000 square foot facility located in Newton, Massachusetts for manufacturing purposes with the remainder used for research and development, sales and marketing, general and administrative purposes and warehouse space. In this facility, we assemble all of our BIS hardware, and we produce substantially all of our BIS Sensors. Prior to 1998, we outsourced all BIS Sensor manufacturing. We currently outsource to third parties the production of our Zipprep EEG Electrodes.
      Our production process for our BIS hardware consists of final assembly, integration and testing of standard and custom components. Our production process for our BIS Sensors consists of several manufacturing and assembly processes using custom components. Qualified sub-contractors, who have met our supplier certification process and are placed on an approved vendors list, produce certain custom components for our products. Some of the components that are necessary for the assembly of our BIS system, including some of the components used in our BIS Sensors, are currently provided to us by sole-source suppliers or a limited group of suppliers. We purchase components through purchase orders rather than long-term supply agreements and generally do not maintain large volumes of inventory. However, in February 2005, we entered into an agreement with the supplier of our electronic memory device used in the XP family of our disposable sensors to purchase a sufficient quantity of these electronic memory devices to maintain our inventory levels through at least the end of 2005. We have experienced shortages and delays in obtaining some of the components of our BIS system in the past, and we may experience similar shortages and delays in the future.
      We maintain a quality-assurance program covering our manufacturing operations. Suppliers of purchased components are required to meet stated specifications. We certify suppliers prior to use by conducting audits and product inspections. We engage in ongoing evaluations of the performance of our suppliers by evaluating the results of inspections and tests as well as the timeliness of product deliveries. We employ numerous quality-assurance procedures during our in-house manufacturing processes to ensure finished products meet specification. Quality assurance procedures include operator training, process validation, equipment calibration, inspection and testing. All manufacturing procedures and processes are formally approved and updated using established revision control procedures. Documentation of in-process and final testing results is maintained in device or lot history records. We also maintain an ongoing post-sale performance-monitoring program.
Competition
      The medical device industry is subject to intense competition. We are facing increased competition in the domestic level of consciousness market as a result of a number of competitors’ monitoring systems which have been cleared by the FDA. The competitive devices are based on signal-processing of the EEG and are marketed by well-established medical products companies with significant resources. We believe that new competition will come from companies, including patient monitoring companies, currently marketing conventional EEG monitors utilizing standard signal-processing techniques such as spectral edge frequency analyses and median frequency analyses. We also believe that new competition will come from companies that market EEG monitors utilizing novel signal-processing technologies. Several potential competitive products are currently being marketed outside the United States although we do not believe that these products provide any significant advantages relative to our BIS technology. These other products and techniques include the use of auditory evoked potentials, heart rate variability, pupillary reflexes and skin blood flow measurement techniques. Additionally, a number of academic researchers worldwide are studying the potential use of other techniques to measure the effects of anesthetics.

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      We believe that the principal competitive factors that companies competing in the market for anesthesia-monitoring products must address include:
  •  improved patient outcomes,
 
  •  cost effectiveness,
 
  •  FDA approval/clearance,
 
  •  acceptance by leading anesthesia providers,
 
  •  availability of the technology in modular patient monitoring systems,
 
  •  ease of use for anesthesia providers,
 
  •  the publication of peer reviewed clinical studies,
 
  •  sales and marketing capability,
 
  •  timing and acceptance of product innovation,
 
  •  patent protection, and
 
  •  product quality.
Patents and Proprietary Rights
      Medical technology companies place considerable importance on obtaining patent and trade secret protection for new technologies, products and processes. We consider the protection of our proprietary technologies and products to be important to the success of our business and rely on a combination of patents, licenses, copyrights and trademarks to protect our technologies and products. Our policy is to prosecute and enforce our patents and proprietary technology. We intend to continue to file United States and foreign patent applications to protect technology, inventions and improvements that are considered important to the development of our business. We also rely upon trade secrets, know-how, continuing technological innovation and licensing opportunities to develop and maintain our competitive position.
      Trade secret protection for our unpatented confidential and proprietary information is important to us. To protect our trade secrets, we generally require our employees, consultants, scientific advisors, and parties to collaboration and licensing agreements to execute confidentiality agreements upon the commencement of employment, the consulting relationship, or the collaboration or licensing arrangement with us. However, others could either develop independently the same or similar information or obtain access to our proprietary information.
      We have established a substantial proprietary position with respect to our products and our core signal processing technology, bispectral analysis, and its application to biological signals. The patent position of medical device companies is highly uncertain and involves complex legal and factual questions. There can be no assurance that any claims which are included in pending or future patent applications will be issued, that any issued patents will provide us with competitive advantage or will not be challenged by third parties, or that the existing or future patents of third parties will not have an adverse effect on our ability to commercialize our products. Furthermore, there can be no assurance that other companies will not independently develop similar products, duplicate any of our products or design around patents that may be issued to us. Litigation or administrative proceedings may be necessary to enforce any patents issued to us or to determine the scope and validity of others’ proprietary rights in court or administrative proceedings.

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      We were issued our most recent United States patent on November 25, 2003. As of December 31, 2004, we held 20 United States patents and had filed eight additional United States patent applications. We also have numerous corresponding patents and pending patent applications in certain major industrial countries, including Canada, the major European market countries, Australia, Japan, Mexico and Brazil. The following chart summarizes our United States patents and patent applications:
                     
    Number of        
    Currently        
Number of   Pending       Patent
Issued   Patent       Expiration
Patents   Applications   Technology Covered   Date
             
  2       2    
Closed loop delivery of anesthesia
  May 3, 2020
                    May 3, 2020
 
  4          
Application of Bispectral and higher order analysis and various statistical modeling technologies to EEG signals
  March 13, 2007 April 30, 2008 June 14, 2011 October 17, 2012
 
  2       2    
Methods of ensuring the reliability of the computed values
  December 24, 2016 January 30, 2018
        1    
Method of monitoring anesthetic state using changes in arterial compliance
   
  1          
Method of evaluating BIS information to facilitate clinical decision making
  August 18, 2018
 
  2          
Application of bispectral analysis to electrocardiogram signals
  May 15, 2007
June 4, 2008
        3    
Method of assessment of neurological conditions using EEG Bispectrum
   
  1          
Zipprep self-prepping disposable electrode technology
  April 26, 2011
 
  2          
Technology relating to the interface between the BIS Sensor and the BIS monitor
  October 20, 2015 October 20, 2015
 
  5          
BIS Sensor technology
  October 11, 2016 October 11, 2016 October 11, 2016 June 19, 2018
June 9, 2019
 
  1          
Signal acquisition technology for digital signal converter
  January 17, 2012
                     
  20       8          
                     
      We have also been granted a perpetual, royalty-free, non-exclusive license by Siemens Medical Systems, Inc. to a United States patent covering signal acquisition technology for digital signal converters. Additionally, on July 1, 2004, we exercised an option under an agreement with the Regents of the University of California, acquiring an exclusive license to brain monitoring technology in the field of diagnosis and management of neurological diseases and conditions which was developed at the Neuropsychiatric Institute and David Geffen School of Medicine at UCLA.
Government Regulation
      The manufacture and sale of medical diagnostic devices intended for commercial distribution and use are subject to extensive government regulation in the United States and in other countries. Our existing products are regulated in the United States as medical devices by the FDA under the Federal Food, Drug, and

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Cosmetic Act, or FDC Act. Pursuant to the FDC Act, the FDA regulates the research, testing, manufacturing, safety, labeling, storage, record keeping, advertising, distribution and production of medical devices. Noncompliance with applicable regulations can result in refusal of the government to grant clearance for devices, withdrawal of prior clearances or approvals, total or partial suspension of production, fines, injunctions, civil penalties, recall or seizure of products and criminal prosecution.
      Generally, before we can introduce a new product in the United States, we must obtain FDA clearance of a premarket notification under Section 510(k) of the FDC Act, referred to as a 510(k) notification, or approval of a premarket approval application under Section 515 of the FDC Act. To date, we have received clearance of 510(k) notification from the FDA with respect to the following products:
             
        Date of Clearance of
Product       510(k) Notification
         
Zipprep EEG Electrodes     June 1994  
A-1050 EEG Monitor with BIS     January 1996  
BIS Standard Sensor     October 1996  
BIS Clinical Utility Indication     October 1996  
A-2000 BIS Monitor     February 1998  
BIS Sensor Plus     January 2000  
BIS Pediatric Sensor     October 2000  
BIS XP Sensor family, including the BIS Quatro Sensor and BIS Extend Sensor     October 2000  
BIS Module Kit     October 2000  
BIS XP system     June 2001  
A-2000 BIS Monitor Indication for Use change (Awareness)     October 2003  
BISx system     February 2004  
      Once we have received clearance of a 510(k) notification, any products we manufacture or distribute are subject to extensive and continuing regulation by the FDA, including compliance with current Good Manufacturing Practices regulations, record keeping requirements, reporting of adverse experience with the use of the device, post-market surveillance, and other actions deemed necessary by the FDA. A new 510(k) notification is also required when a medical device manufacturer makes a change or modification to a legally marketed device that could significantly affect the safety or effectiveness of the device, or where there is a major change or modification in the intended use of the device. When any change or modification is made to a device or its intended use, the manufacturer must make the initial determination whether the change or modification is of a kind that would necessitate the filing of a new 510(k) notification. The FDA’s regulations provide only limited guidance for making this determination.
      The FDC Act regulates our quality control and manufacturing procedures by requiring us to demonstrate and maintain compliance with current Good Manufacturing Practices regulations, including quality systems regulations, as specified by the FDA. This regulation requires, among other things, that:
  •  we use written procedures to control our product development and manufacturing process,
 
  •  we validate, by extensive and detailed testing of every aspect of the process, our ability to produce devices which meet our manufacturing specifications,
 
  •  we investigate deficiencies in the manufacturing process or in the products produced, and
 
  •  we maintain detailed record keeping.
      The current Good Manufacturing Practices regulations are applicable to manufacturers that produce components specifically for use in a medical device, and require design controls and maintenance of service records.

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      The FDA monitors compliance with current Good Manufacturing Practices regulations by conducting periodic inspections of manufacturing facilities. If violations of applicable regulations are noted during FDA inspections of our manufacturing facilities, the continued marketing of our products may be adversely affected. During the last routine inspection of our manufacturing facility by the FDA, the FDA noted no adverse observations. We believe that we have continued to maintain manufacturing facilities and procedures that are fully compliant with all applicable government quality systems regulations and guidelines.
      In June 1998, we obtained ISO 9001: 1994 / EN 46001 international quality management system certification and European Medical Device Directive EC certification. These certifications show that our development, production and distribution of products comply with these standards and directives. Our continued compliance with these standards and directives has been confirmed since June 1998 in semi-annual surveillance audits. In April 2003, we obtained ISO 13485/ CMDR certification from a CMDCAS (Canadian) recognized registrar. The ISO 9001, ISO 13485 and Medical Device Directive certifications signify compliance with the requirements enabling us to affix the CE Mark to our current products. The CE Mark denotes conformity with European standards for safety and allows certified devices to be placed on the market in all European Union countries. Since June 1998, medical devices cannot be sold in European Union countries unless they display the CE Mark.
      We have established a dedicated regulatory and quality assurance group to maintain regulatory compliance and manage all of our quality-assurance activities. This group is responsible for the following activities:
  •  all regulatory submissions and communications,
 
  •  scheduling and performing company-wide internal audits,
 
  •  coordinating product update procedures and corrective actions,
 
  •  maintaining adherence to appropriate procedures and applicable requirements related to the FDA’s quality systems regulations and appropriate international regulations, and
 
  •  coordinating appropriate documentation for FDA/ ISO 9001/ ISO 13485/ CMDR/ MDD review and audits.
Third-Party Reimbursement
      Third-party payors, including Medicare, Medicaid, private health insurance carriers, managed care organizations, health care administration authorities in foreign countries and other organizations, may affect the pricing or demand for our products by regulating the maximum amount of reimbursement provided by these payors to the anesthesia providers, hospitals, outpatient surgical centers or physicians’ offices where surgical procedures are performed.
      We believe that anesthesia providers will not be separately reimbursed for patient-monitoring activities utilizing the BIS system. When facilities, such as hospitals or outpatient surgical centers, are reimbursed a fixed fee calculated on a per case, per stay, or per capita basis, the cost of monitoring with the BIS system will not be recovered by these providers unless the incremental costs of this monitoring are offset by savings in other costs, such as the costs of anesthetics or costs of the operating room or post-anesthesia care unit. This type of reimbursement policy has been adopted by Medicare, for example, for both inpatient and outpatient surgery. In such cases, patient monitoring with the BIS system may not result in sufficient savings to offset these costs. When reimbursement is based on charges or costs, patient monitoring with the BIS system may have the effect of reducing reimbursement because the charges or costs for surgical procedures, including operating room and post-anesthesia care unit charges and costs, may decline as a result of monitoring with the BIS system.
      In January 2002, the Japanese Ministry of Health, Labor and Welfare granted reimbursement approval for use of our BIS monitors. Healthcare providers in Japan will be eligible to receive partial reimbursement of 1,000 yen each time BIS monitoring is used. We believe that the BIS system is the only commercially available consciousness monitoring technology in Japan.

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Employees
      As of December 31, 2004, we had 208 full-time employees worldwide in the following functional areas:
         
Number of    
Employees   Functional Area
     
  96     Sales, Marketing and Clinical Support
  35     Manufacturing and Engineering
  33     General and Administrative
  29     Research and Development
  15     Clinical and Regulatory Affairs
         
  208     Total
         
      None of our employees are covered by a collective bargaining agreement. We consider relations with our employees to be good.
Scientific Advisors
      We seek advice from a number of leading scientists and physicians on scientific and medical matters, including experts in EEG monitoring, pharmacology and anesthesia management. These individuals advise us concerning a number of matters, including:
  •  our research and development programs,
 
  •  the design and implementation of our clinical research program,
 
  •  our publication strategies,
 
  •  the identification of market opportunities from the clinical perspective, and
 
  •  specific scientific and technical issues.
Item 2. Properties.
      We currently lease approximately 61,000 square feet in Newton, Massachusetts of which approximately 12,000 square feet is used for manufacturing and approximately 49,000 square feet is used for research and development, sales and marketing, general and administrative purposes and warehouse space. This lease expires on December 31, 2006. Effective February 1, 2004, the lease on our office space in Leiden, The Netherlands expired. In October 2003, we entered into a new lease for our international organization for approximately 2,765 square feet of office space located in De Meern, The Netherlands. This lease expires in October 2008. We believe our current facilities are sufficient to meet our needs through the fiscal year ending December 31, 2005 and that additional space will be available at a reasonable cost to meet our space needs thereafter.
Item 3. Legal Proceedings.
      We are not a party to any material threatened or pending legal proceedings.
Item 4. Submission of Matters to a Vote of Security Holders.
      No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2004 through the solicitation of proxies or otherwise.

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PART II
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters.
(a)  Market for Registrant’s Common Equity
      Our common stock has been traded on the Nasdaq National Market under the symbol “ASPM” since January 28, 2000. The following table sets forth, for the years ended December 31, 2003 and 2004, the range of high and low sales prices for our common stock on the Nasdaq National Market. These prices do not include retail mark-up, mark-down or commissions and may not represent actual transactions.
                   
    High   Low
         
2003:
               
 
Quarter Ended March 29, 2003
  $ 4.63     $ 3.32  
 
Quarter Ended June 28, 2003
  $ 8.17     $ 3.50  
 
Quarter Ended September 27, 2003
  $ 10.50     $ 6.92  
 
Quarter Ended December 31, 2003
  $ 12.24     $ 8.87  
2004:
               
 
Quarter Ended April 3, 2004
  $ 18.25     $ 11.10  
 
Quarter Ended July 2, 2004
  $ 19.67     $ 14.22  
 
Quarter Ended October 2, 2004
  $ 19.42     $ 12.14  
 
Quarter Ended December 31, 2004
  $ 25.96     $ 17.00  
      On March 1, 2005, the last reported sales price of our common stock on the Nasdaq National Market was $21.22 per share. As of March 1, 2005, there were approximately 455 holders of record of our common stock.
(b)  Initial Public Offering
      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 December 31, 2004, we used approximately $10.7 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 December 31, 2004, we used approximately $43.9 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.
(c)  Dividend Policy
      We have never paid or declared any cash dividends on our common stock or other securities and do not anticipate paying cash dividends in the foreseeable future. We currently intend to retain all future earnings, if any, for use in the operation and expansion of our business. Payment of future cash dividends, if any, will be at the discretion of our board of directors after taking into account various factors, including our financial condition, operating results, current and anticipated cash needs and plans for expansion. Additionally, our revolving line of credit agreements with each of Bank of America (formerly Fleet National Bank) and Boston Scientific Corporation prohibit the declaration or payment of cash dividends without the consent of these parties.

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Item 6. Selected Consolidated Financial Data.
      The following selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes and other financial information included elsewhere in this Annual Report on Form 10-K. The consolidated statements of operations data for the years ended December 31, 2004, 2003 and 2002, and the consolidated balance sheet data as of December 31, 2004 and 2003, are derived from our audited consolidated financial statements included in this Annual Report on Form 10-K. The consolidated statements of operations data for the years ended December 31, 2001 and 2000 and the consolidated balance sheet data as of December 31, 2002, 2001, and 2000 are derived from our audited consolidated financial statements not included in this Annual Report on Form 10-K. The historical results presented here are not necessarily indicative of future results.
                                             
    Year Ended December 31,
     
    2004   2003   2002   2001   2000
                     
    (in thousands, except per share data)
Consolidated Statements of Operations Data:
                                       
 
Revenue
  $ 55,564     $ 44,091     $ 39,776     $ 35,829     $ 36,024  
 
Costs of revenue
    12,992       10,898       11,815       12,446       11,279  
                               
 
Gross profit margin
    42,572       33,193       27,961       23,383       24,745  
Operating expenses:
                                       
 
Research and development
    7,470       7,287       7,827       7,467       5,713  
 
Sales and marketing
    26,776       25,321       28,449       28,396       21,979  
 
General and administrative
    8,946       7,833       7,942       7,803       6,390  
                               
   
Total operating expenses
    43,192       40,441       44,218       43,666       34,082  
                               
Loss from operations
    (620 )     (7,248 )     (16,257 )     (20,283 )     (9,337 )
Interest income, net
    923       725       956       2,564       3,993  
                               
Net income (loss)
  $ 303     $ (6,523 )   $ (15,301 )   $ (17,719 )   $ (5,344 )
                               
Net income (loss) per share:
                                       
 
Basic
  $ 0.02     $ (0.34 )   $ (0.83 )   $ (1.01 )   $ (0.34 )
 
Diluted
  $ 0.01     $ (0.34 )   $ (0.83 )   $ (1.01 )   $ (0.34 )
Weighted average shares used in computing net income (loss) per share:
                                       
 
Basic
    20,142       19,413       18,450       17,614       15,755  
 
Diluted
    22,286       19,413       18,450       17,614       15,755  
                                         
    December 31,
     
    2004   2003   2002   2001   2000
                     
    (in thousands)
Consolidated Balance Sheet Data:
                                       
Cash, cash equivalents and marketable securities
  $ 32,213     $ 26,062     $ 31,765     $ 36,358     $ 58,489  
Restricted cash
    82       5,100       5,100       5,100        
Working capital
    34,224       30,680       36,734       41,266       58,455  
Total assets
    61,690       47,740       54,480       63,369       79,411  
Long-term debt
    186       525       1,015       964       2,617  
Total stockholders’ equity
    45,586       30,968       36,797       48,056       63,974  

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Overview
      We derive our revenue primarily from sales of BIS monitors, our original equipment manufacturer products (including BIS Module Kits and BISx) and related accessories, which we collectively refer to as Equipment, and sales of BIS Sensors. For management purposes, we segregate our revenue by sales by region and sales by product group as shown in the following table:
                           
    2004   2003   2002
             
    (in thousands)
Domestic revenue
  $ 43,638     $ 35,968     $ 33,089  
Percent of total revenue
    79 %     82 %     83 %
 
International revenue
  $ 11,926     $ 8,123     $ 6,687  
Percent of total revenue
    21 %     18 %     17 %
 
 
Total revenue
  $ 55,564     $ 44,091     $ 39,776  
 
BIS Sensor revenue
  $ 39,585     $ 30,391     $ 26,724  
 
Percent of total revenue
    71 %     69 %     67 %
 
Equipment revenue
  $ 15,979     $ 13,700     $ 13,052  
Percent of total revenue
    29 %     31 %     33 %
 
 
Total revenue
  $ 55,564     $ 44,091     $ 39,776  
      At December 31, 2004, we had cash, cash equivalents, restricted cash and short-term investments of approximately $32.3 million and working capital of approximately $34.2 million.
      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 believe our ability to grow our revenue is directly related to our ability to sell our Equipment to healthcare organizations and influence our customers after they purchase our Equipment to continue to purchase and use our BIS Sensors. We believe the increase in our installed base of Equipment resulting from the sale of BIS monitors and the sale of original equipment manufacturers’ equipment incorporating our BIS Module Kit has been the primary reason for the growth in revenue from the sale of BIS Sensors. In order to successfully grow our revenue, we need to continue to focus on both selling our Equipment and improving our per monitor and per original equipment manufacturer products sensor utilization rate. To achieve this growth, we continue to implement new sales and marketing programs. We expect that as we grow our business, revenue from the sale of BIS Sensors will continue to contribute an increasing percentage of total revenue. Additionally, we believe that, over time, revenue from the sale of BIS Module Kits and our BISx system will increase as a percentage of total Equipment revenue as healthcare organizations purchase our technology as part of an integrated solution offered by our original equipment manufacturers.
      We were profitable for the fiscal year ended December 31, 2004. We believe that maintaining our gross profit margin and controlling the growth of our operating expenses are important factors in sustaining profitability. To maintain our gross profit margin we believe we must continue to focus on maintaining our average unit sales prices of our BIS Sensors, increasing revenue from the sale of BIS Sensors as a percentage of total revenue, as BIS Sensors have a higher gross profit margin than Equipment, and continuing to reduce the costs of manufacturing our products.
      For those healthcare organizations desiring to purchase our BIS monitors directly from us, we offer two options. Our customers have the option either to purchase BIS monitors outright or to acquire BIS monitors pursuant to a sales-type lease agreement whereby the customer contractually commits to purchase a minimum number of BIS Sensors per BIS monitor per year. Under 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

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agreement. We also grant these customers an option to purchase the BIS monitors at the end of the term of the agreement, which is typically three to five years. We recognize Equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period. Sales-type leases accounted for approximately 2%, 4% and 4% of total revenue in 2004, 2003 and 2002, respectively.
      Under certain limited circumstances, we also offer customers the opportunity to use the BIS monitors under our Equipment Placement program, which we refer to as the EP program. Under the EP program, the customer is granted the right to use the BIS monitors for a mutually agreed upon period of time. During this period, the customer purchases BIS Sensors at a price that includes a premium above the list price of the BIS Sensors to cover the rental of the equipment, but without any minimum purchase commitments. At the end of the agreed upon period, the customer has the option of purchasing the BIS monitors, continuing to use them under the EP program or returning them to us.
      We have subsidiaries in The Netherlands and the United Kingdom to facilitate the sale of our products into the international market. We are continuing to develop our international sales and distribution program through a combination of distributors and marketing partners, including companies with which we have entered into original equipment manufacturer relationships.
      In January 1998, we entered into a distribution agreement with Nihon Kohden Corporation to distribute BIS monitors in Japan. In March 2000, Nihon Kohden received approval from the Japanese Ministry of Health, Labor and Welfare for marketing in Japan our A-1050 EEG Monitor with BIS and in May 2001, received approval for marketing in Japan our A-2000 BIS Monitor. Nihon Kohden has requested, but has not yet received, approval to market the BIS XP system in Japan. In January 2002, the Japanese Ministry of Health, Labor and Welfare granted reimbursement approval for use of our BIS monitors. With this approval, healthcare providers in Japan are eligible to receive partial reimbursement of 1,000 Yen each time BIS monitoring is used. In July 2002, the Japanese Ministry of Health, Labor and Welfare approved our BIS module for marketing in Japan. Sales to Nihon Kohden represented approximately 18%, 13% and 22%, respectively, of international revenue in 2004, 2003 and 2002, respectively.
      Various factors may adversely affect our quarterly operating results through the first fiscal quarter of 2005 and beyond. These factors may have a potentially adverse effect on Equipment revenue and gross profit margin on Equipment as we continue to shift the focus of our placements from BIS monitors to BIS modules and BISx systems. In addition, in Japan, Nihon Kohden is awaiting approval of the BIS XP system, and we believe customers in Japan may continue to delay purchases of our products or may choose not to purchase our products pending this approval.
Critical Accounting Policies
      Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. Note 2 of the Notes to Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K includes a summary of our significant accounting policies and methods used in the preparation of our financial statements. In preparing these financial statements, we have made estimates and judgments in determining certain amounts included in the financial statements. The application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates. We do not believe there is a significant likelihood that materially different amounts would be reported under different conditions or using different assumptions. We believe that our critical accounting policies and estimates are as follows:
Revenue Recognition
      We sell our BIS monitors primarily through a combination of a direct sales force and distributors. Our original equipment manufacturer products are sold to original equipment manufacturers who in turn sell them to the end-user. BIS Sensors are sold through a combination of a direct sales force, distributors and original

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equipment manufacturers. Direct product sales are structured as sales, sales-type lease arrangements or sales under our EP program. We recognize revenue from product sales when earned in accordance with Staff Accounting Bulletin, or SAB, No. 104, Revenue Recognition, and Emerging Issues Task Force, or EITF, 00-21, Revenue Arrangements with Multiple Deliverables. Revenue is recognized when persuasive evidence of an arrangement exists, product delivery has occurred or services have been rendered, the price is fixed or determinable and collectibility is reasonably assured. For product sales, revenue is not recognized until title and risk of loss have transferred to the customer.
      We also recognize revenue from prepaid license and royalty fees. This revenue is deferred until product shipment or delivery in accordance with the terms of the agreement and license and royalty fees are earned in accordance with the terms of the respective agreements. In August 2002, we recorded approximately $6,300,000 of deferred revenue related to an OEM product development and distribution agreement with Boston Scientific Corporation. The deferred revenue is being recognized ratably over the term of the OEM product development and distribution agreement, as amended, which represents our best estimate of our period of significant continuing obligation to provide Boston Scientific Corporation exclusive distribution rights to newly developed technology. We amended the OEM product development and distribution agreement in January 2005 and extended the estimate of our period of significant continuing obligation by two years. This will reduce the revenue that we record on a quarterly basis by approximately $31,000 in 2005 and beyond. If our estimate of the period of significant continuing obligation is revised, this may have an impact on our revenue recognition of the deferred revenue related to the Boston Scientific Corporation agreement.
      We follow Statement of Financial Accounting Standards, or SFAS, No. 13, Accounting For Leases, for our sales-type lease agreements. 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. 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 the net investment in sales-type leases. We recognize Equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period. We review and assess the net realizability of our investment in sales-type leases at each reporting period. This review includes determining, on a customer specific basis, if a customer is significantly underperforming relative to the customer’s cumulative level of committed BIS Sensor purchases as required by the sales-type lease agreement. If a customer is underperforming, we record an allowance for lease payments as a charge to revenue to reflect the lower estimate of the net realizable investment in sales-type lease balance.
      We recognize revenue either at shipment or delivery in accordance with the agreed upon contract terms with distributors and original equipment manufacturers in accordance with SAB No. 104. Sales to distributors and original equipment manufacturers include a clause in the contracts that indicates that customer acceptance is limited to confirmation that our products function in accordance with our applicable product specifications in effect at the time of delivery. Formal acceptance by the distributor or original equipment manufacturer is not necessary to recognize revenue provided that we objectively demonstrate that the criteria specified in the acceptance provisions are satisfied. Each product is tested prior to shipment to ensure that it meets the applicable product specifications in effect at the time of delivery. Additionally, we have historically had a minimal number of defective products shipped to distributors and original equipment manufacturers and any defective products are subject to repair or replacement under warranty as distributors and original equipment manufacturers do not have a right of return.
Allowance for Doubtful Accounts
      We determine our allowance for doubtful accounts by using estimates based on our historical collections experience, current trends, historical write-offs of our receivables, credit policy and a percentage of our accounts receivable by aging category. We also review the credit quality of our customer base as well as changes in our credit policies. We continuously monitor collections and payments from our customers. While credit losses have historically been within our expectations and the provisions established, our credit loss rates

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in the future may not be consistent with our historical experience. To the extent we experience a deterioration in our historical collections experience or increased credit losses, bad debt expense would likely increase in future periods.
Inventories
      We value inventory at the lower of cost or estimated market, and determine cost on a first-in, first-out basis. We regularly review inventory quantities on hand and record a provision for excess or obsolete inventory primarily based on production history and on our estimated forecast of product demand. The medical industry in which we market our products is characterized by rapid product development and technological advances that could result in obsolescence of inventory. Additionally, our estimates of future product demand may prove to be inaccurate, in which case we would need to change our estimate of the provision required for excess or obsolete inventory. If revisions are deemed necessary, we would recognize the adjustments in the form of a charge to costs of revenue at the time of the determination. Therefore, although we continually update our forecasts of future product demand, any significant unanticipated declines in demand or technological developments, such as the introduction of new products by our competitors, could have a significant negative impact on the value of our inventory, results of operations and cash flows in future periods.
Warranty
      Equipment that we sell generally is covered by a warranty period of one year. We accrue a warranty reserve for estimated costs to provide warranty services. Our estimate of costs to service our warranty obligations is based on our historical experience and expectation of future conditions. While our warranty costs have historically been within our expectations and the provisions established, to the extent we experience an increased number of warranty claims or increased costs associated with servicing those claims, our warranty expenses will increase, and we may experience decreased gross profit margin and cash flow.
Results of Operations
      The following tables present, for the periods indicated, information expressed as a percentage of revenue and a summary of our total revenue. This information has been derived from our consolidated statements of operations included elsewhere in this Annual Report on Form 10-K. You should not draw any conclusions about our future results from the results of operations for any period.
                             
    Year Ended
    December 31,
     
    2004   2003   2002
             
Revenue
    100 %     100 %     100 %
Costs of revenue
    23       25       30  
                   
Gross profit margin
    77       75       70  
Operating expenses:
                       
 
Research and development
    14       17       20  
 
Sales and marketing
    48       57       71  
 
General and administrative
    16       18       20  
                   
   
Total operating expenses
    78       92       111  
                   
Loss from operations
    (1 )     (17 )     (41 )
Interest income, net
    2       2       2  
                   
Net income (loss)
    1 %     (15 )%     (39 )%
                   

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Year Ended December 31, 2004 Compared to Year Ended December 31, 2003
                           
            Percentage
            Increase
    2004   2003   (Decrease)
             
    (in thousands except unit    
    amounts)    
Revenue — Worldwide
                       
BIS Sensor
  $ 39,585     $ 30,391       30 %
 
BIS monitor
    9,551       6,942       38 %
 
Original equipment manufacturer products
    3,008       3,229       (7 )%
 
Other equipment and accessories
    3,420       3,529       (3 )%
                   
Total Equipment
    15,979       13,700       17 %
                   
Total revenue
  $ 55,564     $ 44,091       26 %
                   
Unit Analysis — Worldwide
                       
BIS Sensors
    2,820,000       2,244,000       26 %
BIS monitors
    1,948       1,340       45 %
Original equipment manufacturer products
    2,239       2,259       (1 )%
Installed base
    24,133       19,517       24 %
      Revenue. The increase in revenue from the sale of BIS Sensors from 2003 to 2004 was primarily attributable to an increase of approximately 26% in the number of BIS Sensors sold as a result of growth in the installed base of BIS monitors and original equipment manufacturer products. The increase in the number of BIS Sensors sold was complemented by an increase in the average selling price of BIS Sensors of approximately 4%. Our installed base of BIS monitors and original equipment manufacturer products increased approximately 24% to 24,133 units at December 31, 2004 compared with 19,517 units at December 31, 2003.
      The increase in revenue from the sale of Equipment from 2003 to 2004 was primarily the result of an increase of approximately 38% in BIS monitor revenue, which resulted from an increase in unit sales volume of approximately 45% as we shipped 1,948 BIS monitors in 2004 compared with 1,340 BIS monitors in 2003. The 45% increase in unit volume relates primarily to BIS monitor shipments to Japan. For the year ended December 31, 2004, we shipped 320 BIS monitors to Japan compared with no shipments in 2003. The shipments to our distributor in Japan during 2004 were in response to increased demand for our BIS technology as Nihon Kohden continues to await approval from the Japanese Ministry of Health, Labor and Welfare to market the BIS XP system in Japan. The increase in BIS monitor revenue was offset by a decrease of approximately 7% in original equipment manufacturer product revenue. The number of original equipment manufacturer products shipped to our original equipment manufacturers decreased slightly in 2004 compared with 2003. In 2004, the number of original equipment manufacturer products shipped to our original equipment manufacturers decreased approximately 1%, from 2,259 original equipment manufacturer products shipped in 2003 to 2,239 original equipment manufacturer products shipped in 2004.
      Our gross profit margin was approximately 77% of revenue in 2004 compared with a gross profit margin of approximately 75% of revenue in 2003. The increase in the gross profit margin in 2004 compared with 2003 was primarily attributable to increased sales of our BIS Sensors as a percentage of total revenue. BIS Sensors have a higher gross profit margin than Equipment. BIS Sensors accounted for approximately 71% of our total revenue in 2004 compared with approximately 69% of our total revenue in 2003. The increased unit volume of BIS Sensors, combined with an increase in the BIS Sensor average unit selling price contributed to the increase in our gross profit margin in 2004 compared with 2003. The increase in the average unit selling price of our BIS Sensors resulted primarily from increased sales of our BIS XP family of sensors as our BIS XP technology continues to represent a growing percentage of our installed base.

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Expense Overview
                         
            Percentage
            Increase
    2004   2003   (Decrease)
             
    (in thousands)    
Expenses
                       
Research and development
  $ 7,470     $ 7,287       3 %
Sales and marketing
  $ 26,776     $ 25,321       6 %
General and administrative
  $ 8,946     $ 7,833       14 %
      Research and Development. The increase in research and development expenses in 2004 compared with 2003 was primarily attributable to an increase of approximately $280,000 in compensation and benefits relating to an increase in headcount during the year and an increase in patent related expenses of approximately $61,000 as we continue to strengthen our intellectual property rights with respect to certain products in the countries in which we distribute our products. These increases were partially offset by a decrease in consulting expenses of approximately $155,000 for various ongoing projects. We expect research and development expenses in 2005 to increase compared with 2004 as we continue to invest in clinical studies and expand applications for our technology, including our initiatives into neuroscience.
      Sales and Marketing. The increase in sales and marketing expenses in 2004 compared with 2003 was primarily attributable to an increase of approximately $1.3 million in operating expenses associated with our international subsidiaries and an increase in sales commission expense of approximately $1.2 million. The $1.3 million increase in expenses associated with our international subsidiaries was driven by an increase of approximately $1.0 million in compensation and benefits as a result of increased headcount and an increase of approximately $156,000 in consulting expenses. The increases in sales and marketing expenses were partially offset by a decrease of approximately $273,000 in trade show expenses, a decrease in commissions paid to group purchasing organizations of approximately $216,000, a decrease in advertising expenses of approximately $199,000, a decrease of approximately $170,000 in travel and entertainment expenses and a decrease in market research and development expenses of approximately $79,000. We expect sales and marketing expenses in 2005 to increase compared with 2004.
      General and Administrative. The increase in general and administrative expenses in 2004 compared with 2003 was attributable to an increase of approximately $324,000 in compensation and benefits, an increase of approximately $389,000 in professional and consulting fees, primarily related to services in connection with Section 404 of the Sarbanes-Oxley Act of 2002 and an increase in our commercial insurance expenses of approximately $65,000. We expect general and administrative expenses in 2005 to increase compared with 2004.
      Interest Income. Interest income increased to approximately $1.0 million in 2004 from approximately $924,000 in 2003, an increase of approximately 11%. The increase in interest income from 2003 to 2004 was primarily attributable to higher cash and investment balances throughout 2004 and a slight increase in interest rates. We expect interest income to increase in 2005 compared with 2004 due to the increase in our cash and investment balances.
      Interest Expense. Interest expense decreased to approximately $106,000 in 2004 from approximately $199,000 in 2003, a decrease of approximately 47%. The decrease in interest expense in 2004 was a result of lower average outstanding debt obligations. We expect interest expense to decrease slightly in 2005 compared with 2004 as a result of continuing lower average outstanding debt obligations.
      Net Income (Loss). As a result of the factors discussed above, in 2004 we had net income of approximately $303,000 compared with a net loss of approximately $6.5 million in 2003. We did not record a provision for income taxes for the year ended December 31, 2004 as we have significant deferred tax assets available to offset any income tax liabilities and expenses. At December 31, 2004, we had a full valuation allowance against these gross deferred tax assets as we have determined that it is more likely than not that some portion or all of the deferred tax assets will not be realized.

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Year Ended December 31, 2003 Compared to Year Ended December 31, 2002
                           
            Percentage
            Increase
    2003   2002   (Decrease)
             
    (in thousands except unit    
    amounts)    
Revenue — Worldwide
                       
BIS Sensor
  $ 30,391     $ 26,724       14 %
 
BIS monitor
    6,942       8,181       (15 )%
 
BIS Module Kit
    3,229       1,479       118 %
 
Other equipment and accessories
    3,529       3,392       4 %
                   
Total Equipment
    13,700       13,052       5 %
                   
Total revenue
  $ 44,091     $ 39,776       11 %
                   
Unit Analysis — Worldwide
                       
BIS Sensors
    2,244,000       2,055,000       9 %
BIS monitors
    1,340       1,714       (22 )%
Original equipment manufacturer BIS modules
    2,259       1,066       112 %
Installed base
    19,517       16,210       20 %
      Revenue. The increase in revenue from the sale of BIS Sensors from 2002 to 2003 was primarily attributable to an increase of approximately 9% in the number of BIS Sensors sold as a result of growth in the installed base of BIS monitors and BIS modules. The increase in the number of BIS Sensors sold was complemented by an increase in the average selling price of BIS Sensors of approximately 4%. Our installed base of BIS monitors and BIS modules increased approximately 20% to 19,517 units at December 31, 2003 compared to 16,210 units at December 31, 2002.
      The increase in revenue from the sale of Equipment from 2002 to 2003 was primarily driven by an increase in BIS Module Kit revenue of approximately 118%. The increase in module revenue for this period was due to an increase of approximately 112% in the number of BIS Module Kits shipped to our original equipment manufacturers, from 1,066 BIS Module Kits in 2002 to 2,259 BIS Module Kits in 2003. The increase in BIS Module Kit revenue in this period was partially offset by a decrease in BIS monitor revenue of approximately 15%. The decrease in BIS monitor revenue resulted from a decrease of approximately 22% in unit volume, as we shipped 1,714 BIS monitors in 2002 compared to 1,340 BIS monitors in 2003. The decrease in monitor unit volume was a result of a decrease of approximately 25% in international BIS monitors shipped, particularly relating to units shipped to Japan. Sales of BIS monitor units in Japan decreased from 200 units shipped in 2002 to none in 2003 as Nihon Kohden delayed additional BIS monitor purchases pending the Japanese Ministry of Health, Labor and Welfare approval of the BIS XP technology.
      Our gross profit margin was approximately 75% of revenue in 2003 as compared to a gross profit margin of approximately 70% of revenue in 2002. The increase in gross profit margin for the year ended December 31, 2003 was a result of four factors. First, we experienced increased sales of our BIS Sensors as a percentage of total revenue during the year ended December 31, 2003. BIS Sensors accounted for approximately 69% of total revenue for the year ended December 31, 2003 as compared to 67% for the year ended December 31, 2002. BIS Sensors have a higher gross profit margin than Equipment. Second, we had an increase in the worldwide average unit price on BIS monitors of approximately 8% in 2003 compared to 2002. Third, we have had a reduction in depreciation expense related to BIS monitors used in the EP program as the existing pool of BIS monitors becomes fully depreciated and we substantially reduce our focus and reliance on the EP program. Finally, we recognized approximately $615,000 of deferred revenue in the year ended December 31, 2003 related to the strategic alliance with Boston Scientific Corporation without any corresponding costs of revenue, increasing the gross profit margin by approximately 2%.

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Expense Overview
                         
            Percentage
            Increase
    2003   2002   (Decrease)
             
    (in thousands)    
Expenses
                       
Research and development
  $ 7,287     $ 7,827       (7 )%
Sales and marketing
  $ 25,321     $ 28,449       (11 )%
General and administrative
  $ 7,833     $ 7,942       (1 )%
      Research and Development. The decrease in research and development expenses in 2003 compared with 2002 was primarily attributable to a decrease in research and development personnel and related payroll and other expenses of approximately $659,000. This decrease was offset by an increase in consulting expenses of approximately $138,000 for various ongoing projects.
      Sales and Marketing. The decrease in sales and marketing expenses in 2003 compared with 2002 was attributable to decreases of approximately $757,000 in travel and entertainment expenses, approximately $987,000 in operating expenses associated with our international subsidiaries, approximately $739,000 in expenses related to advertising, public relations, tradeshows and the internet, approximately $339,000 in recruiting expenses and approximately $748,000 in payroll expense. The $987,000 decrease in expenses associated with our international subsidiaries was driven by a decrease of approximately $573,000 in personnel and related payroll expenses. The decreases in sales and marketing expenses were offset by an increase in commissions expense of approximately $1.2 million.
      General and Administrative. The decrease in general and administrative expenses in 2003 compared with 2002 was attributable to a decrease of approximately $388,000 in professional services and a decrease of approximately $137,000 in our provision for doubtful accounts due to improvements in our historical collection experience. These decreases were offset by increases of approximately $302,000 in personnel related payroll and other expenses and approximately $101,000 primarily as a result of an increase in the annual premium for our directors and officers liability insurance coverage.
      Interest Income, Net. Net interest income decreased to approximately $725,000 in 2003 from approximately $956,000 in 2002, a decrease of approximately 24%. Interest income decreased to approximately $924,000 in 2003 from approximately $1.2 million in 2002, a decrease of approximately 23%. The decrease in interest income was primarily attributable to lower cash and investment balances resulting from 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 $198,000 in 2003 from approximately $243,000 in 2002, a decrease of approximately 18%. The decrease in interest expense in 2003 was a result of lower average outstanding debt obligations because we did not draw down on our lines of credit in 2003 as we did in 2002.
      Net Loss. As a result of the factors discussed above, in 2003 we had a net loss of approximately $6.5 million as compared with a net loss of approximately $15.3 million in 2002.

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Quarterly Results of Operations
      The following table sets forth unaudited selected operating results for each of the eight fiscal quarters in the two years ended December 31, 2004. We believe that the following selected quarterly information includes all adjustments (consisting only of normal, recurring adjustments) that we consider necessary to present this information fairly. This financial information should be read in conjunction with the financial statements and related notes included elsewhere in this Annual Report on Form 10-K. Our results of operations have fluctuated in the past and are likely to continue to fluctuate significantly from quarter to quarter in the future. Therefore, results of operations for any previous periods are not necessarily indicative of results of operations to be recorded in the future.
                                                                 
    Quarter Ended
     
    March 29,   June 28,   September 27,   December 31,   April 3,   July 3,   October 2,   December 31,
    2003   2003   2003   2003   2004   2004   2004   2004
                                 
                (in thousands)            
Revenue
  $ 10,127     $ 10,709     $ 11,189     $ 12,066     $ 12,797     $ 13,426     $ 13,625     $ 15,716  
Gross profit margin
    7,578       7,992       8,428       9,195       9,932       10,249       10,380       12,011  
Operating expenses
    10,296       9,972       9,982       10,191       10,908       10,818       10,118       11,349  
Net (loss) income
    (2,524 )     (1,795 )     (1,387 )     (817 )     (796 )     (376 )     520       955  
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 convertible preferred stock. Through December 31, 2004, we raised approximately $85.7 million from private equity financings, received approximately $3.4 million in equipment financing and received approximately $5.1 million of financing related to our investment 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 completed 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 Bank of America (formerly Fleet National Bank), for a $5.0 million revolving line of credit, which expires in May 2005. The revolving line of credit with Bank of America contains restrictive covenants that require us to maintain liquidity and net worth ratios and is secured by certain investments, which are shown as restricted cash on our consolidated balance sheets. In connection with the extension of our revolving line of credit agreement in May 2004, we are now required to maintain restricted cash in an amount equal to 102% of the outstanding amounts under the revolving line of credit. Prior to the extension in May 2004, we were required to maintain restricted cash in an amount equal to 102% of the $5.0 million commitment. At December 31, 2004, we were in compliance with all covenants contained in the revolving line of credit agreement. 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 December 31, 2004, the interest rate on the line of credit was 5.25%. Up to $1.5 million of the $5.0 million revolving line of credit is available for standby letters of credit. At December 31, 2004, there was no amount outstanding under this line of credit and we had standby letters of credit outstanding in the amount of $80,000.
      In August 2002, we entered into a strategic alliance with Boston Scientific Corporation whereby we sold 1,428,572 shares of our common stock at a purchase price per share of $7.00 to Boston Scientific Corporation. Gross cash proceeds from this sale of common stock were approximately $10.0 million. Note 19 of our Notes to Consolidated Financial Statements included elsewhere in this Annual Report on Form 10-K includes additional information relating to the strategic alliance with Boston Scientific Corporation.
      In connection with our strategic alliance with Boston Scientific Corporation, we also entered into an agreement with Boston Scientific Corporation for a revolving line of credit under which we are entitled to borrow up to $5.0 million. The revolving line of credit 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

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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 December 31, 2004, there was no outstanding balance under this revolving line of credit and we were in compliance with all covenants contained in the revolving line of credit agreement.
      On April 7, 2004, in order to raise cash for working capital and other general corporate purposes, we entered into another stock purchase agreement with Boston Scientific Corporation to issue and sell to Boston Scientific Corporation an aggregate of 500,000 shares of our common stock at a purchase price of $16.21 per share. We completed the sale on June 8, 2004. Gross cash proceeds from this sale of common stock were approximately $8.1 million.
      We expect to meet our short-term liquidity needs through the use of cash and short-term investments on hand at December 31, 2004. We believe that the financial resources available to us, including our current working capital, our long-term investments and available revolving lines of credit will be sufficient to finance our planned operations and capital expenditures through at least the end of 2005. However, our future liquidity and capital requirements will depend upon numerous factors, including the resources required to further develop our marketing and sales organization domestically and internationally, to finance our research and development programs, to implement new marketing programs, to finance our sales-type lease program and to meet market demand for our products.
      Working capital at December 31, 2004 was approximately $34.2 million compared with approximately $30.7 million at December 31, 2003. The increase in working capital from December 31, 2003 to December 31, 2004 was primarily attributable to an increase in our short-term investments which resulted from the sale of common stock to Boston Scientific Corporation in June 2004 and an increase in our accounts receivable.
      Cash from Operations. We used approximately $530,000 of cash for operations in 2004. Cash used for operations during this period was primarily driven by an increase in accounts receivable of approximately $2.0 million due to increased sales offset by depreciation and amortization of approximately $1.5 million.
      We used approximately $10.4 million of cash for operations during the three years ended December 31, 2004, which was primarily driven by net operating losses of approximately $21.5 million. The operating losses were partially offset by approximately $6.1 million in depreciation and amortization expense, a net increase in deferred revenue of approximately $4.3 million primarily related to proceeds received in connection with the strategic alliance entered into in August 2002 and a net decrease in inventory of approximately $2.9 million.
      Cash from Investing Activities. We used approximately $10.7 million of cash from investing activities in 2004. The cash used for investing activities was the result of net purchases of investments of approximately $15.2 million in 2004 offset by a decrease in restricted cash of approximately $5.0 million. The reduction in restricted cash resulted from the amendment of our revolving line of credit with Bank of America in May 2004.
      We used approximately $3.9 million for investing activities during the three years ended December 31, 2004 primarily as a result of net purchases of investments of approximately $7.0 million and acquisition of property, plant and equipment of approximately $3.1 million, partially offset by a decrease in restricted cash of approximately $5.0 million.
      Cash from Financing Activities. We received approximately $13.6 million of cash from financing activities in 2004 primarily as a result of proceeds from the issuance of our common stock to Boston Scientific Corporation of approximately $8.1 million and approximately $6.1 million of proceeds from the issuance of our common stock upon the exercise of stock options granted under our stock option plans, partially offset by payments of principal on debt related to our investment in sales-type leases of approximately $706,000.

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      We received approximately $14.7 million of cash from financing activities during the three years ended December 31, 2004. Cash provided by financing activities during this period was primarily the result of proceeds from the sale of shares of our common stock in connection with a strategic alliance entered into in August 2002, and the additional sale of 500,000 shares to Boston Scientific Corporation in June 2004.
      In July 1999, we entered into an agreement under which we can sell a portion of our existing and future investment in sales-type leases to Americorp Financial, Inc. Through December 31, 2004, we sold approximately $5.1 million of our investment in sales-type leases under this agreement. 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 investment At December 31, 2004, approximately $497,000 is recorded as debt on our consolidated balance sheet.
      We had capital expenditures of approximately $1.2 million for the year ended December 31, 2004, which related primarily to the purchase of manufacturing equipment for use in the production of our BIS Sensors and the purchase of computer hardware and third-party software. At December 31, 2004, we did not have any commitments for capital expenditures, however, we anticipate that the level of capital expenditures in 2005 will increase from the level of capital expenditures during the year ended December 31, 2004.
      We have summarized below our contractual cash obligations as of December 31, 2004:
                                         
    Payments Due By Period
     
        Less Than   One to Three   Three to Five   After Five
Contractual Obligations   Total   One Year   Years   Years   Years
                     
Operating leases
  $ 2,812     $ 1,258     $ 1,460     $ 94     $  
Debt related to the sale of investment in sales type leases
    497       311       186              
Purchase commitment
    1,400       1,400                    
                               
Total contractual cash obligations
  $ 4,709     $ 2,969     $ 1,646     $ 94     $  
                               
      In February 2005, we entered into an agreement with the supplier of our electronic memory device used in the XP family of our disposable sensors to purchase a sufficient quantity of these electronic memory devices to maintain our inventory levels through at least the end of 2005. This commitment is expected to be approximately $1.4 million.
Off-Balance Sheet Arrangements
      We do not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.
Income Taxes
      We have net operating loss carryforwards for federal and state income tax purposes of approximately $92,195,000 and $34,654,000, respectively, and tax credits for federal and state income tax purposes of approximately $2,469,000 and $1,457,000, respectively. These tax attributes began expiring in 2002 and will continue to expire through 2024 if not utilized. Additionally, the net operating loss and tax credit carryforwards are subject to review by the Internal Revenue Service. Ownership changes, as defined under Sections 382 and 383 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 the Company’s value immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years. We have substantial net operating loss carryforwards that have generated significant deferred tax assets. We have provided a full valuation allowance against these

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deferred tax assets as we have determined that it is more likely than not that we will not be able to fully utilize these net operating loss carryforwards.
Effects of Inflation
      We believe that inflation and changing prices over the past three years have not had a significant impact on our revenue or on our results of operations.
Recent Accounting Pronouncements
      On December 16, 2004, the Financial Accounting Standards Board, or FASB, issued Statement No. 123 (revised 2004), Share Based Payment, or SFAS No. 123R, which is a revision of Statement No. 123, Accounting for Stock-Based Compensation, or SFAS 123. SFAS 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Under SFAS No. 123R, we must calculate and record in the income statement the cost of equity instruments, such as stock options or restricted stock, awarded to employees for services received; pro forma disclosure is not longer permitted. The cost of the equity instruments is to be measured based on fair value of the instruments on the date they are granted (with certain exceptions) and is required to be recognized over the period during which the employees are required to provide services in exchange for the equity instruments. The statement is effective in the first interim or annual reporting period beginning after June 15, 2005.
      SFAS No. 123R provides two alternatives for adoption: (1) a “modified prospective” method in which compensation cost is recognized for all awards granted subsequent to the effective date of this statement as well as for the unvested portion of awards outstanding as of the effective date; or (2) a “modified retrospective” method which follows the approach in the “modified prospective” method, but also permits entities to restate prior periods to record compensation cost calculated under SFAS No. 123 for the pro forma disclosure. We plan to adopt SFAS No. 123R as of July 3, 2005, the beginning of our third fiscal quarter of 2005. Since we currently account for stock options granted to employees and shares issued under our employee stock purchase plan in accordance with the intrinsic value method permitted under APB Opinion No. 25, no compensation expense generally is recognized. Management expects that the adoption of SFAS No. 123R will have a significant impact on our results of operations, although it will have no impact on our overall financial position. The impact of adopting SFAS No. 123R on periods after adoption cannot be accurately estimated at this time, as it will depend on the market value and the amount of share based awards granted in future periods. However, had we adopted SFAS No. 123R in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income (loss) and earnings (loss) per share in Note 2 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K.
Factors Affecting Future Operating Results
      This Annual Report on Form 10-K 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 each fiscal quarter in 2005 and for the year ending December 31, 2005. These forward-looking statements involve risks and uncertainties and are not guarantees of future performance. Words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” and variations of these words and similar expressions are intended to identify forward-looking statements. Our actual results could differ significantly from the results discussed in these forward-looking statements. The following important factors represent some of the current challenges to us that create risk and uncertainty. Failure to adequately overcome any of the following challenges could have a material adverse effect on our results of operations, business or financial condition. In addition, subsequent events and developments may cause our expectations to change.

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While we may elect to update these forward-looking statements we specifically disclaim any obligation to do so, even if our expectations change.
We will not continue to be profitable if hospitals and anesthesia providers do not buy and use our BIS system in sufficient quantities.
      Our customers may determine that the cost of the BIS system exceeds cost savings in drugs, personnel and post-anesthesia care recovery resulting from use of the BIS system. In addition, hospitals and anesthesia providers may not accept the BIS system as an accurate means of assessing a patient’s level of consciousness during surgery or in the intensive care unit. If extensive or frequent malfunctions occur, healthcare 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 continue to be profitable.
      The success of our business also depends in a large part on continued use of the BIS system by our customers and, accordingly, sales by us of BIS Sensors. We expect that over time, sales of BIS Sensors will increase as a percentage of our revenue as compared to sales of Equipment as we build our installed base of monitors and modules. If use of our BIS system, and accordingly, sales of our BIS Sensors, do not increase, our ability to grow our revenue could be adversely affected.
We depend on our BIS system for substantially all of our revenue, and if the BIS system does not gain widespread market acceptance, then our revenue will not grow.
      We began selling our current BIS system in early 1998 and introduced the latest version, the BIS XP system, at the end of the third fiscal quarter of 2001. In 2002, we introduced commercially the BIS Extend Sensor for patients who are monitored over an extended period of time, such as in intensive care unit settings. To date, we have not achieved widespread market acceptance of the BIS system for use in the operating room or in the intensive care unit from healthcare providers or professional anesthesia organizations. Because we depend on our BIS system for substantially all of our revenue and we have no other significant products, if we fail to achieve widespread market acceptance for the BIS system, we will not be able to sustain or grow our product revenue.
Various market factors may adversely affect our quarterly operating results through the first fiscal quarter of 2005.
      Various factors may adversely affect our quarterly operating results through the first fiscal quarter of 2005. First, we continue to shift the focus of our placements from BIS monitors to original equipment manufacturer products which may lead to a reduction in Equipment revenue and gross margin on Equipment. Second, in Japan, Nihon Kohden is awaiting approval of the BIS XP system from the Japanese Ministry of Health, Labor and Welfare which may cause delays in purchasing decisions by customers in Japan, or these potential customers may choose not to purchase our products. The continuation of difficult worldwide economic conditions, reductions in hospital purchasing programs and the cost of transitioning our installed base to the BIS XP system may also adversely impact our revenue and operating results through the first fiscal quarter of 2005. Additionally, on October 7, 2004, the Joint Commission on Accreditation of Healthcare Organizations, or JCAHO, issued a Sentinel Event Alert aimed at preventing and managing the impact of anesthesia awareness. The Alert identifies the incidence of awareness, describes common underlying causes and suggests steps for healthcare professionals and institutions to take in order to manage and prevent future occurrences and recommends healthcare organizations develop and implement policies to address anesthesia awareness. While we believe this report is favorable to our business, industry organizations and others in the anesthesia community may not agree with the position taken in the Alert and, accordingly, potential benefits to our business that could have resulted from this Alert may not be realized.

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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,
 
  •  implementation of, and our subsequent reduction on the focus of, our EP program,
 
  •  use of and demand for our BIS Sensors,
 
  •  transition of sales focus from BIS monitors to original equipment manufacturer products,
 
  •  customer cancellations,
 
  •  introduction of competitive products,
 
  •  regulatory approvals,
 
  •  changes in management,
 
  •  turnover in our direct sales force,
 
  •  effectiveness of new marketing and sales programs,
 
  •  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 fall below the expectations of securities analysts or investors. If our quarterly operating results are below expectations in the future, the market price of our common stock would likely decrease. In addition, because we do not have a substantial 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 continue to experience 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 debt allowances in any quarter.
If the estimates we make, and the assumptions on which we rely in preparing our financial statements prove inaccurate, our actual results may vary from those reflected in our financial statements.
      Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. 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 and related disclosure of contingent assets and liabilities. This includes estimates on warranty reserves, inventory valuations and allowances for doubtful accounts. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. There can be no assurance, however, that our estimates, or the assumptions underlying them, will be correct.
If approval of our BIS XP system is not obtained in Japan, our revenue and operating results could be adversely affected.
      In Japan, Nihon Kohden is awaiting approval of the BIS XP system from the Japanese Ministry of Health, Labor and Welfare. Until approval is obtained, customers in Japan may delay their purchasing decisions with respect to our products or may decide not to purchase our products at all. As a result, if approval for this product is not obtained in Japan in the near future, or at all, it could limit the growth of our international revenue.

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We may need additional financing for our future capital needs and may not be able to raise additional funds on terms acceptable to us, or at all.
      We believe that the financial resources available to us, including our current working capital and available revolving lines of credit, will be sufficient to finance our planned operations and capital expenditures through at least the end of 2005. If we are unable to increase our revenue and maintain positive cash flow, we will need to raise additional funds. We may also need additional financing if:
  •  the research and development costs of our products currently under development increase,
 
  •  we decide to expand faster than currently planned,
 
  •  we develop new or enhanced services or products ahead of schedule,
 
  •  we decide to undertake new sales and/or marketing initiatives,
 
  •  we are required to defend or enforce our intellectual property rights,
 
  •  sales of our products do not meet our expectations domestically or internationally,
 
  •  we need to respond to competitive pressures, or
 
  •  we decide to acquire complementary products, businesses or technologies.
      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 operations which would significantly limit our ability to implement our business plan. In addition, we may have to issue securities that may have rights, preferences and privileges senior to our common stock.
Cases of awareness with recall during monitoring with the BIS system could limit market acceptance of BIS systems and could expose us to product liability claims.
      Clinicians have reported to us cases of possible awareness with recall during surgical procedures monitored with the BIS system. In most of the cases that were reported to us, when BIS index values were recorded at the time of awareness, high BIS index values were noted, indicating that the BIS index correctly identified the increased risk of awareness with recall in these patients. However, in a small number of these reported cases, awareness with recall may not have been detected by monitoring with the BIS system. We have not systematically solicited reports of awareness with recall. It is possible that additional cases of awareness with recall during surgical procedures monitored with the BIS system have not been reported to us. Anesthesia providers and hospitals may elect not to purchase and use BIS systems if there is adverse publicity resulting from the report of cases of awareness with recall that were not detected during procedures monitored with the BIS 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 our multi-center, multinational clinical studies have demonstrated that the use of BIS monitoring to help guide anesthetic administration may be associated with the reduction of the incidence of awareness with recall in adults using general anesthesia and sedation, we may be subject to product liability claims for cases of awareness with recall 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. Moreover, if the patient safety benefits of BIS monitoring are not persuasive enough to lead to wider adoption of our BIS technology, our business could be adversely affected.
We may not be able to compete with new products or alternative techniques developed by others, which could impair our ability to remain competitive and achieve future growth.
      The medical device industry in which we market our products is characterized by rapid product development and technological advances. Our competitors have introduced commercially anesthesia monitoring products which have been cleared by the United States Food and Drug Administration, or FDA. If we do

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not compete effectively with these monitoring products, our revenue will be adversely affected. Our current or planned products are at risk of obsolescence from:
  •  other new monitoring products, based on new or improved technologies,
 
  •  new products or technologies used on patients or in the operating room during surgery in lieu of monitoring devices,
 
  •  electrical or mechanical interference from new or existing products or technologies,
 
  •  alternative techniques for evaluating the effects of anesthesia,
 
  •  significant changes in the methods of delivering anesthesia, and
 
  •  the development of new anesthetic agents.
      We may not be able to improve our products or develop new products or technologies quickly enough to maintain a competitive position in our markets and continue to grow our business.
If we do not successfully develop and introduce enhanced or new products we could lose revenue opportunities and customers.
      As the market for our BIS system matures, we need to develop and introduce new products for anesthesia monitoring or other applications. In 2002, we introduced commercially the BIS Extend Sensor for patients who are typically monitored for an extended period of time, such as in intensive care unit settings. We do not know whether the use of the BIS system in the intensive care unit will achieve market acceptance. In addition, we have begun to research the use of BIS monitoring to diagnose and track neurological diseases, and face at least the following two related risks:
  •  we may not successfully adapt the BIS system to function properly for procedural sedation, when used with anesthetics we have not tested or with patient populations we have not studied, such as infants, and
 
  •  our technology is complex, and we may not be able to develop it further for applications outside anesthesia monitoring, such as the diagnosis and tracking of neurological diseases.
      If we do not successfully adapt the BIS system for new products and applications both within and outside the field of anesthesia monitoring, or if such products and applications are developed but not successfully commercialized, then we could lose revenue opportunities and customers.
If we do not develop and implement a successful sales and marketing strategy, we will not expand our business.
      In the past, we have experienced high turnover in our direct sales force. It is possible that high turnover may occur in the future. If new sales representatives do not acquire the technological skills to sell our products in a timely and successful manner or we experience high turnover in our direct sales force, we may not be able to sustain and grow our product revenue. In addition, in order to increase our sales, we need to continue to strengthen our relationships with our international distributors and continue to add international distributors. Also, we need to continue to strengthen our relationships with our original equipment manufacturers and other sales channels and increase sales through these channels. On an ongoing basis, we develop and introduce new sales and marketing programs and clinical education programs to promote the use of the BIS system by our customers. If we do not implement these new sales and marketing and education programs in a timely and successful manner, we may not be able to achieve the level of market awareness and sales required to expand our business. We have only limited sales and marketing experience both in the United States and internationally and may not be successful in developing and implementing our strategy. Among other things, 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,

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  •  promote frequent use of the BIS system so that sales of our disposable BIS Sensors increase,
 
  •  establish and implement successful sales and marketing and education programs that encourage our customers to purchase our products or the products that are made by original equipment manufacturers incorporating our technology,
 
  •  manage geographically dispersed operations, and
 
  •  modify our products and marketing and sales programs for foreign markets.
Our third-party distribution and original equipment manufacturer relationships could negatively affect our profitability, cause sales of our products to decline and be difficult to terminate if we are dissatisfied.
      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. In addition, 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 international markets. We conduct international business primarily in Europe and Japan and we are attempting to increase the number of countries in which we do business. It is costly to establish international facilities and operations and to promote the BIS system in international markets. We have encountered barriers to the sale of our BIS system outside the United States, including less acceptance by anesthesia providers for use of disposable products, such as BIS Sensors, delays in regulatory approvals outside of the United States, particularly in Japan, and difficulties selling through indirect sales channels. In addition, we have little experience in marketing and distributing products in these markets. Revenue from international activities may not offset the expense of establishing and maintaining these international operations.
We may not be able to meet the unique operational, legal and financial challenges that we will encounter in our international operations, which may limit the growth of our business.
      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 adequate protection against infringement of our intellectual property,
 
  •  protectionist laws and business practices that favor local competitors, which could slow our growth in international markets,
 
  •  difficulties in terminating or modifying distributor arrangements because of restrictions in markets outside the United States,
 
  •  less acceptance by foreign anesthesia providers of the use of disposable products, such as BIS Sensors,
 
  •  delays in regulatory approval of our products,

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  •  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 and could adversely impact our results of operations.
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, original equipment manufacturer products 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 for any reason, including damage or destruction of our facility, or experience a termination or modification of any manufacturing arrangement with a third party, we may be unable to deliver products to our customers on a timely basis. Our failure to deliver products on a timely basis could lead to customer dissatisfaction and damage our reputation.
Our reliance on sole-source suppliers could adversely affect our ability to meet our customers’ demands for our products in a timely manner or within budget.
      Some of the components that are necessary for the assembly of our BIS system, including some of the components used in our BIS Sensors, are currently provided to us by sole-source suppliers or a limited group of suppliers. We purchase components through purchase orders rather than long-term supply agreements and generally do not maintain large volumes of inventory. We have experienced shortages and delays in obtaining some of the components of our BIS systems in the past, and we may experience similar shortages or delays in the future. The disruption or termination of the supply of components could cause a significant increase in the costs of these components, which could affect our profitability. A disruption or termination in the supply of components could also result in our inability to meet demand for our products, which could lead to customer dissatisfaction and damage our reputation. If a supplier is no longer willing or able to manufacture components that we purchase and integrate into the BIS system, we may attempt to design replacement components ourselves that would be compatible with our existing technology. In doing so, we would incur additional research and development expenses, and there can be no assurance that we would be successful in designing or manufacturing any replacement components. 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.
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

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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 may be costly and time-consuming.
We could be exposed to significant product liability claims which could divert management attention and adversely affect our cash balances, our ability to obtain and maintain insurance coverage at satisfactory rates or in adequate amounts and our reputation.
      The manufacture and sale of our products expose us to product liability claims and product recalls, including those which may arise from misuse or malfunction of, or design flaws in, our products or use of our products with components or systems not manufactured or sold by us. Product liability claims or product recalls, regardless of their ultimate outcome, could require us to spend significant time and money in litigation or to pay significant damages. We currently maintain product liability insurance; however, it may not cover the costs of any product liability claims made against us. Furthermore, we may not be able to obtain insurance in the future at satisfactory rates or in adequate amounts. In addition, publicity pertaining to the misuse or malfunction of, or design flaws in, our products could impair our ability to successfully market and sell our products.
Several class action lawsuits have been filed against the underwriters of our initial public offering which may result in negative publicity and potential litigation against us that would be costly to defend and the outcome of which is uncertain and may harm our business.
      The underwriters of our initial public offering are named as defendants in several class action complaints which have been filed allegedly on behalf of certain persons who purchased shares of our common stock between January 28, 2000 and December 6, 2000. These complaints allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934. Primarily they allege that there was undisclosed compensation received by our underwriters in connection with our initial public offering. While we and our officers and directors have not been named as defendants in these suits, based on comparable lawsuits filed against other companies, there can be no assurance that we and our officers and directors will not be named in similar complaints in the future. In addition, the underwriters may assert that we are liable for some or all of any liability that they are found to have to the plaintiffs, pursuant to the indemnification provisions of the underwriting agreement we entered into as part of the initial public offering, or otherwise.
      We can provide no assurance as to the outcome of these complaints or any potential suit against us or our officers and directors. Any conclusion of these matters in a manner adverse to us could have a material adverse affect on our financial position and results of operations. In addition, the costs to us of defending any litigation or other proceeding, even if resolved in our favor, could be substantial. Such litigation could also substantially divert the attention of our management and our resources in general. Even if we are not named as defendants

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in these lawsuits, we may also be required to incur significant costs and our management may be distracted by being required to provide information, documents or testimony in connection with the actions against our underwriters. Uncertainties resulting from the initiation and continuation of any litigation or other proceedings and the negative publicity associated with this litigation could harm our ability to compete in the marketplace.
Boston Scientific Corporation may be able to affect 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 could be adversely affected.
      As of March 1, 2005, Boston Scientific Corporation owned approximately 24% of our outstanding common stock, which includes 500,000 shares of our common stock that we sold to Boston Scientific Corporation on June 8, 2004. If Boston Scientific Corporation maintains or increases its ownership of our outstanding common stock, it may have the ability to affect corporate actions requiring stockholder approval. On August 7, 2002, we formed a strategic alliance with Boston Scientific Corporation. In connection with this strategic alliance, we entered into an agreement pursuant to which we granted Boston Scientific Corporation an option to distribute newly developed technology for monitoring patients under sedation in a range of less-invasive medical specialties. If such products are not successfully developed, marketed and sold under the agreement in a manner consistent with our expectations, the growth of our business and our operating results will be adversely affected. Even if we successfully develop new sedation management technology for less-invasive medical procedures, Aspect and Boston Scientific Corporation may not successfully market and sell this new technology.
We may not reserve amounts adequate to cover product obsolescence, claims and returns, which could result in unanticipated expenses and fluctuations in operating results.
      Depending on factors such as the timing of our introduction of new products which utilize our BIS technology, as well as warranty claims and product returns, we may need to reserve amounts in excess of those currently reserved for product obsolescence, excess inventory, warranty claims and product returns. These reserves may not be adequate to cover all costs associated with these items. If these reserves are inadequate, we would be required to incur unanticipated expenses which could result in unexpected fluctuations in quarterly operating results.
We may not be able to compete effectively, which could result in price reductions and decreased demand for our products.
      We are facing increased competition in the domestic level of consciousness monitoring market as a result of a number of competitors’ monitoring systems which have been cleared by the FDA. These products are marketed by well-established medical products companies with significant resources. We may not be able to compete effectively with these and other potential competitors. We may also face substantial competition from companies which may develop sensor products that compete with our proprietary BIS Sensors for use with our BIS monitors or with third-party monitoring systems or anesthesia delivery systems that incorporate the BIS index. We also expect to face competition from companies currently marketing conventional electroencephalogram, or EEG, monitors using standard and novel signal-processing techniques. Other companies may develop anesthesia-monitoring systems that perform better than the BIS system and/or sell for less. In addition, one or more of our competitors may develop products that are substantially equivalent to our FDA-approved products, in which case they may be able to use our products as predicate devices to more quickly obtain FDA approval of their competing products. Medical device companies developing these and other competitive products may have greater financial, technical, marketing and other resources than we do. Competition in the sale of anesthesia-monitoring systems could result in price reductions, fewer orders, reduced gross margins and loss of market share.

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Our ability to market and sell our products and generate revenue depends upon receipt of domestic and foreign regulatory approval of our products and manufacturing operations.
      Before we can market new products in the United States, we must obtain clearance from the FDA. If the FDA concludes that any of our products do not meet the requirements to obtain clearance of a premarket notification under Section 510(k) of the Food, Drug and Cosmetic Act, then we would be required to file a premarket approval application. The premarket approval application process 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.
      The FDA also requires us to adhere to current Good Manufacturing Practices regulations, which include production design controls, testing, quality control, storage and documentation procedures. The FDA may at any time inspect our facilities to determine whether adequate compliance has been achieved. Compliance with current Good Manufacturing Practices regulations for medical devices is difficult and costly. In addition, we may not continue to be compliant as a result of future changes in, or interpretations of, regulations by the FDA or other regulatory agencies. If we do not achieve continued compliance, the FDA may withdraw marketing clearance or require product recall. When any change or modification is made to a device or its intended use, the manufacturer may be required to reassess compliance with current Good Manufacturing Practices regulations, which may cause interruptions or delays in the marketing and sale of our products.
      Sales of our products outside the United States are subject to foreign regulatory requirements that vary from country to country. The time required to obtain approvals from foreign countries may be longer than that required for FDA approval, and requirements for foreign licensing may differ from FDA requirements.
      The federal, state and foreign laws and regulations regarding the manufacture and sale of our products are subject to future changes, as are administrative interpretations of regulatory agencies. If we fail to comply with applicable federal, state or foreign laws or regulations, we could be subject to enforcement actions, including product seizures, recalls, withdrawal of clearances or approvals and civil and criminal penalties.
If we do not retain our senior management and other key employees, we may not be able to successfully implement our business strategy.
      Our president and chief executive officer, Nassib Chamoun, joined us at our inception in 1987. Our chairman, J. Breckenridge Eagle, began serving as a director in 1988. Many other members of our management and key employees have extensive experience with us and other companies in the medical device industry. Our success is substantially dependent on the ability, experience and performance of these members of our senior management and other key employees. Because of their ability and experience, if we lose one or more of the members of our senior management or other key employees, our ability to successfully implement our business strategy could be seriously harmed.
If we do not attract and retain skilled personnel, we will not be able to expand our business.
      Our products are based on complex signal-processing technology. Accordingly, we require skilled personnel to develop, manufacture, sell and support our products. Our future success will depend largely on our ability to continue to hire, train, retain and motivate additional skilled personnel, particularly sales representatives who are responsible for customer education and training and post-installation customer support. Consequently, if we are not able to attract and retain skilled personnel, we will not be able to expand our business.

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Failure of users of the BIS system to obtain adequate reimbursement from third-party payors could limit market acceptance of the BIS system, which could prevent us from sustaining profitability.
      Anesthesia providers are generally not reimbursed separately for patient monitoring activities utilizing the BIS system. For hospitals and outpatient surgical centers, when reimbursement is based on charges or costs, patient monitoring with the BIS system may reduce reimbursements for surgical procedures, because charges or costs may decline as a result of monitoring with the BIS system. Failure by hospitals and other users of the BIS system to obtain adequate reimbursement from third-party payors, or any reduction in the reimbursement by third-party payors to hospitals and other users as a result of using the BIS system could limit market acceptance of the BIS system, which could prevent us from achieving profitability.
Item 7A. Qualitative and Quantitative Disclosures About Market Risk.
Interest Rate Exposure
      Our investment portfolio consists primarily of high-grade commercial paper, high grade corporate bonds and debt obligations of various governmental agencies. We manage our investment portfolio in accordance with our investment policy. The primary objectives of our investment policy are to preserve principal, maintain a high degree of liquidity to meet operating needs, and obtain competitive returns subject to prevailing market conditions. Investments are made with an average maturity of 12 months or less and a maximum maturity of 24 months. These investments are subject to risk of default, changes in credit rating and changes in market value. These investments are also subject to interest rate risk and will decrease in value if market interest rates increase. Due to the conservative nature of our investments and relatively short effective maturities of the debt instruments, we believe interest rate risk is mitigated. Our investment policy specifies the credit quality standards for our investments and limits the amount of exposure from any single issue, issuer or type of investment.
      Our investment in sales-type leases, line of credit agreements and sales-type lease debt agreements are also subject to market risk. The interest rates implicit in our sales-type leases and on our sales-type lease debt agreements are fixed and not subject to interest rate risk. The interest rates on our line of credit agreements are variable and subject to interest rate risk. The interest rate risk related to the lines of credit is mitigated primarily by the fact that the lines of credit, when drawn on, are generally outstanding for short periods of time in order to fund short-term cash requirements.
Foreign Currency Exposure
      Most of our revenue, expenses and capital spending are transacted in U.S. dollars. The expenses and capital spending of our two international subsidiaries are transacted in the respective country’s local currency and subject to foreign currency exchange rate risk. Our foreign currency transactions are translated into U.S. dollars at prevailing rates. Gains or losses resulting from foreign currency transactions are included in current period income or loss as incurred. Currently, all material transactions are denominated in U.S. dollars, and we have not entered into any material transactions that are denominated in foreign currencies.
Item 8. Financial Statements and Supplementary Data.
      The information required by this item may be found on pages F-1 through F-28 of this Annual Report on Form 10-K.

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Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
      None.
Item 9A. Controls and Procedures.
1.     Evaluation of Disclosure Controls and Procedures
      Our management, with the participation of our chief executive officer and chief financial officer, evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2004. The term “disclosure controls and procedures,” as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act are recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of December 31, 2004, our chief executive officer and chief financial officer concluded that, as of such date, our disclosure controls and procedures were effective at the reasonable assurance level.
      No change in our internal controls over financial reporting occurred during the fiscal quarter ended December 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
      2. Internal Control over Financial Reporting.
  (a)  Management’s Report on the Effectiveness of Internal Control over Financial Reporting
      Our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) or 15d-15(f) promulgated under the Securities Exchange Act of 1934 as a process designed by, or under the supervision of, our principal executive and principal financial officers and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
  •  Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect our transactions and dispositions of our assets;
 
  •  Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and
 
  •  Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
      Our management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2004. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.

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      Based on our assessment, management believes that, as of December 31, 2004, our internal control over financial reporting is effective based on those criteria.
      Our independent registered public accounting firm has issued an audit report on our assessment of the company’s internal control over financial reporting. This report appears below.
      (b) Attestation Report of the Independent Registered Public Accounting Firm.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of Aspect Medical Systems, Inc.
      We have audited management’s assessment, included in the accompanying Management’s Report on the Effectiveness of Internal Control Over Financial Reporting, that Aspect Medical Systems, Inc. (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Aspect Medical Systems Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
      We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
      A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
      Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
      In our opinion, management’s assessment that Aspect Medical Systems, Inc. maintained effective internal control over financial reporting as of December 31, 2004 is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Aspect Medical Systems, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.

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      We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Aspect Medical Systems, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004 and our report dated March 10, 2005 expressed an unqualified opinion thereon.
  /s/ Ernst & Young LLP
Boston, Massachusetts
March 10, 2005

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      (c) Changes in Internal Control over Financial Reporting.
      No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred during the fiscal quarter ended December 31, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
Item 9B.     Other Information.
      Not applicable.

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PART III
Item 10. Directors and Executive Officers of the Registrant.
      The information with respect to directors and executive officers required under this item is incorporated by reference to the information set forth under the section entitled “Election of Directors” in our proxy statement for our 2005 Annual Meeting of Stockholders to be held on May 25, 2005. Information relating to certain filings of Forms 3, 4 and 5 is contained in our 2005 proxy statement under the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” and is incorporated herein by reference.
      The information required under this item pursuant to Item 401(h) and 401(i) of Regulation S-K relating to an Audit Committee financial expert and identification of the Audit Committee of our Board of Directors is contained in our 2005 proxy statement under the caption “Corporate Governance” and is incorporated herein by reference.
      We have adopted a written code of business conduct and ethics that applies to our principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. Our Code of Business Conduct and Ethics is posted on our website. We intend to disclose any amendments to, or waivers from, our code of business conduct and ethics on our website which is located at www.aspectmedical.com.
Item 11. Executive Compensation.
      The information required under this item is incorporated by reference to the sections entitled “Information About Executive Compensation,” “Compensation of Directors” and “Compensation Committee Interlocks and Insider Participation” in our 2005 proxy statement.
      The sections entitled “Report of the Compensation Committee” and “Comparative Stock Performance Graph” in our 2005 proxy statement are not incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
      The information required under this item is incorporated by reference to the section entitled “Stock Ownership Information” and “Securities Authorized for Issuance Under Equity Compensation Plans” in our 2005 proxy statement.
Item 13. Certain Relationships and Related Transactions.
      The information required under this item is incorporated by reference to the section entitled “Certain Relationships and Related Transactions” in our 2005 proxy statement.
Item 14. Principal Accountant Fees and Services.
      The information required under this item is incorporated by reference to the section entitled “Independent Auditors Fees and Other Matters” in our 2005 proxy statement.

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PART IV
Item 15. Exhibits and Financial Statement Schedules.
      (a) Consolidated Financial Statements.
        For a list of the consolidated financial information included herein, see Index to the Consolidated Financial Statements on page F-1 of this Annual Report on Form 10-K.
      (b) List of Exhibits.
        The exhibits listed in the Exhibit Index immediately preceding the exhibits are filed as part of this Annual Report on Form 10-K.
      (c) Financial Statement Schedules.
        All schedules have been omitted because the information required to be set forth therein is not applicable or is shown in the accompanying Consolidated Financial Statements or notes thereto.

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SIGNATURES
      Pursuant to the requirements of Section 13 or 15(d) 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: March 15, 2005
  By:  /s/ Michael Falvey
 
 
  Michael Falvey
  Vice President and Chief Financial Officer
      Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
             
Signature   Title   Date
         
 
/s/ Nassib G. Chamoun
 
Nassib G. Chamoun
  President, Chief Executive Officer and Director (Principal Executive Officer)   March 15, 2005
 
/s/ J. Breckenridge Eagle
 
J. Breckenridge Eagle
  Chairman of the Board of Directors   March 15, 2005
 
/s/ Michael Falvey
 
Michael Falvey
  Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)   March 15, 2005
 
/s/ Boudewijn L.P.M. Bollen
 
Boudewijn L.P.M. Bollen
  President of International Operations and Director   March 15, 2005
 
/s/ David W. Feigal, Jr., M.D.
 
David W. Feigal, Jr., M.D.
  Director   March 15, 2005
 
/s/ Edwin M. Kania
 
Edwin M. Kania
  Director   March 15, 2005
 
/s/ James J. Mahoney, Jr.
 
James J. Mahoney, Jr.
  Director   March 15, 2005
 
/s/ Richard J. Meelia
 
Richard J. Meelia
  Director   March 15, 2005
 
/s/ Donald R. Stanski, M.D.
 
Donald R. Stanski, M.D.
  Director   March 15, 2005

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ASPECT MEDICAL SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
         
    Page
     
Report of Independent Registered Public Accounting Firm
    F-2  
Consolidated Balance Sheets as of December 31, 2004 and 2003
    F-3  
Consolidated Statements of Operations for the Years Ended December 31, 2004, 2003 and 2002
    F-4  
Consolidated Statements of Stockholders’ Equity for the Years Ended December 31, 2004, 2003
and 2002
    F-5  
Consolidated Statements of Cash Flows for the Years Ended December 31, 2004, 2003 and 2002
    F-7  
Notes to Consolidated Financial Statements
    F-8  

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of
Aspect Medical Systems, Inc.
      We have audited the accompanying consolidated balance sheets of Aspect Medical Systems Inc. as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
      We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
      In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Aspect Medical Systems, Inc. at December 31, 2004 and 2003, and the consolidated results of its operations and cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
      We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Aspect Medical Systems, Inc.’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2005 expressed an unqualified opinion thereon.
  /s/ Ernst & Young LLP
Boston, Massachusetts
March 10, 2005

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ASPECT MEDICAL SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
                     
    December 31,   December 31,
    2004   2003
         
ASSETS
               
Current assets:
               
 
Cash and cash equivalents
  $ 14,761     $ 12,344  
 
Restricted cash
    82       5,100  
 
Short-term investments
    17,452       13,718  
 
Accounts receivable, net of allowances of $41 and $150 at December 31, 2004 and 2003, respectively
    7,835       5,773  
 
Current portion of investment in sales-type leases
    1,698       1,797  
 
Inventory, net
    2,224       1,515  
 
Other current assets
    1,192       1,147  
             
   
Total current assets
    45,244       41,394  
Property and equipment, net
    2,662       2,996  
Long-term investments
    11,439        
Long-term investment in sales-type leases
    2,320       2,613  
Long-term portion of notes receivable from related parties
    25       737  
             
   
Total assets
  $ 61,690     $ 47,740  
             
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Current liabilities:
               
 
Current portion of long-term debt
  $ 311     $ 679  
 
Accounts payable
    1,920       1,189  
 
Accrued liabilities
    7,832       7,871  
 
Deferred revenue
    957       975  
             
   
Total current liabilities
    11,020       10,714  
Long-term portion of deferred revenue
    4,898       5,533  
Long-term debt
    186       525  
Commitments and contingencies (Note 13)
               
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, 20,838,611 and 19,502,079 shares issued and outstanding at December 31, 2004 and 2003, respectively
    208       195  
 
Additional paid-in capital
    145,429       131,131  
 
Notes receivable from employees and directors
          (78 )
 
Accumulated other comprehensive loss
    (78 )     (4 )
 
Accumulated deficit
    (99,973 )     (100,276 )
             
   
Total stockholders’ equity
    45,586       30,968  
             
   
Total liabilities and stockholders’ equity
  $ 61,690     $ 47,740  
             
The accompanying notes are an integral part of these consolidated financial statements.

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ASPECT MEDICAL SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
                             
    Year Ended December 31,
     
    2004   2003   2002
             
Revenue
  $ 55,564     $ 44,091     $ 39,776  
Costs of revenue
    12,992       10,898       11,815  
                   
Gross profit margin
    42,572       33,193       27,961  
Operating expenses:
                       
 
Research and development
    7,470       7,287       7,827  
 
Sales and marketing
    26,776       25,321       28,449  
 
General and administrative
    8,946       7,833       7,942  
                   
   
Total operating expenses
    43,192       40,441       44,218  
                   
Loss from operations
    (620 )     (7,248 )     (16,257 )
Interest income
    1,029       924       1,199  
Interest expense
    (106 )     (199 )     (243 )
                   
Net income (loss)
  $ 303     $ (6,523 )   $ (15,301 )
                   
Net income (loss) per share:
                       
 
Basic
  $ 0.02     $ (0.34 )   $ (0.83 )
 
Diluted
  $ 0.01     $ (0.34 )   $ (0.83 )
Weighted average shares used in computing net income (loss) per share:
                       
 
Basic
    20,142       19,413       18,450  
 
Diluted
    22,286       19,413       18,450  
The accompanying notes are an integral part of these consolidated financial statements.

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ASPECT MEDICAL SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)
                                                                           
                Notes       Accumulated        
        Common Stock       Receivable       Other        
    Comprehensive       Additional   From       Comprehensive       Total
    Income       Par   Paid-in   Employees   Deferred   Income   Accumulated   Stockholders’
    (Loss)   Shares   Value   Capital   and Directors   Compensation   (Loss)   Deficit   Equity
                                     
Balance, December 31, 2001
            17,792     $ 178     $ 126,656     $ (336 )   $ (23 )   $ 34     $ (78,452 )   $ 48,057  
 
Issuance of common stock in connection with strategic alliance, net of issuance costs of approximately $170,000
          1,429       14       3,516                               3,530  
 
Issuance of common stock upon exercise of common stock options
          150       2       427                               429  
 
Payments on notes receivable from employees and directors
                            65                         65  
 
Deferred compensation related to stock options
                      8             (8 )                  
 
Amortization of deferred compensation related to stock options
                                  31                   31  
Comprehensive loss:
                                                                       
 
Net loss
    (15,301 )                                         (15,301 )     (15,301 )
 
Other comprehensive loss — Unrealized loss on marketable securities
    (13 )                                   (13 )           (13 )
                                                         
Comprehensive loss:
  $ (15,314 )                                                
                                                                       
Balance, December 31, 2002
            19,371     $ 194     $ 130,607     $ (271 )   $     $ 21     $ (93,753 )   $ 36,798  
 
Issuance of common stock upon exercise of common stock options
          131       1       497                               498  
 
Payments on notes receivable from employees and directors
                            193                         193  
 
Deferred compensation related to stock options
                      27             (27 )                  
 
Amortization of deferred compensation related to stock options
                                  27                   27  
Comprehensive loss:
                                                                       
 
Net loss
    (6,523 )                                         (6,523 )     (6,523 )
 
Other comprehensive loss — Unrealized loss on marketable securities
    (25 )                                   (25 )           (25 )
                                                         
Comprehensive loss:
  $ (6,548 )                                                
                                                                       
Balance, December 31, 2003
            19,502     $ 195     $ 131,131     $ (78 )   $     $ (4 )   $ (100,276 )   $ 30,968  

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ASPECT MEDICAL SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY — (Continued)
(in thousands)
                                                                             
                Notes       Accumulated        
        Common Stock       Receivable       Other        
    Comprehensive       Additional   From       Comprehensive       Total
    Income       Par   Paid-in   Employees   Deferred   Income   Accumulated   Stockholders’
    (Loss)   Shares   Value   Capital   and Directors   Compensation   (Loss)   Deficit   Equity
                                     
 
Issuance of common stock in connection with strategic alliance
  $       500     $ 5     $ 8,100     $     $  —     $     $  —     $ 8,105  
 
Issuance of common stock upon exercise of common stock options
          836       8       6,116                               6,124  
 
Issuance of common stock awards
          1             16                                       16  
 
Payments on notes receivable from employees and directors
                            78                         78  
 
Deferred compensation related to stock options
                      61             (61 )                  
 
Amortization of deferred compensation related to stock options
                      5             61                   66  
 
Comprehensive income:
                                                                       
   
Net income
    303                                           303       303  
   
Other comprehensive loss — Unrealized loss on marketable securities
    (74 )                                   (74 )           (74 )
                                                         
Comprehensive income:
  $ 229                                                  
                                                                       
Balance, December 31, 2004
            20,839     $ 208     $ 145,429     $     $  —     $ (78 )   $ (99,973 )   $ 45,586  
                                                                       
The accompanying notes are an integral part of these consolidated financial statements.

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ASPECT MEDICAL SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
                               
    Year Ended December 31,
     
    2004   2003   2002
             
Cash flows from operating activities:
                       
 
Net income (loss)
  $ 303     $ (6,523 )   $ (15,301 )
 
Adjustments to reconcile net income (loss) to net cash used for operating activities:
                       
   
Depreciation and amortization
    1,509       1,993       2,620  
   
Credit to allowance for doubtful accounts
    (39 )     (237 )     (100 )
   
Compensation expense related to stock options
    66       27       31  
 
Changes in assets and liabilities —
                       
   
(Increase) decrease in accounts receivable
    (2,023 )     (870 )     829  
   
(Increase) decrease in inventory
    (709 )     819       2,775  
   
(Increase) decrease in other assets
    (67 )     89       (96 )
   
Decrease (increase) in investment in sales-type leases
    392       (268 )     (734 )
   
Increase (decrease) in accounts payable
    731       (58 )     (318 )
   
(Decrease) increase in accrued liabilities
    (39 )     744       (309 )
   
(Decrease) increase in deferred revenue
    (654 )     (898 )     5,888  
                   
     
Net cash used for operating activities
    (530 )     (5,182 )     (4,715 )
                   
Cash flows from investing activities:
                       
 
Loans to related parties
                (50 )
 
Payments on loans to related parties
    734       379       99  
 
Acquisition of property and equipment
    (1,175 )     (868 )     (1,046 )
 
Decrease in restricted cash
    5,018              
 
Purchases of marketable securities
    (40,056 )     (17,346 )     (21,601 )
 
Proceeds from sales and maturities of marketable securities
    24,810       23,825       23,399  
                   
     
Net cash (used for) provided by investing activities
    (10,669 )     5,990       801  
                   
Cash flows from financing activities:
                       
 
Payment on working capital line of credit
                (3,000 )
 
Proceeds from sale of investment in sales-type leases
          266       1,073  
 
Principal payments on debt related to investment in sales-type leases
    (707 )     (965 )     (964 )
 
Proceeds from issuance of common stock
    14,245       499       3,958  
 
Payments received on notes receivable from employees and directors
    78       193       65  
                   
     
Net cash provided by (used for) financing activities
    13,616       (7 )     1,132  
                   
Net increase (decrease) in cash and cash equivalents
    2,417       801       (2,782 )
Cash and cash equivalents, beginning of period
    12,344       11,543       14,325  
                   
Cash and cash equivalents, end of period
  $ 14,761     $ 12,344     $ 11,543  
                   
Supplemental disclosure of cash flow information:
                       
 
Interest paid
  $ 105     $ 192     $ 242  
                   
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
(tabular amounts in thousands, except per share amounts)
(1)  Description of Operations
      Aspect Medical Systems, Inc. and its subsidiaries (the “Company”) develop, manufacture and market an anesthesia monitoring system called the BIS® system. 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. The Company’s BIS system incorporates the Company’s proprietary disposable BIS Sensors and the Company’s BIS monitor or original equipment manufacturers’ products, including the BIS Module Kit and BISx. The Company’s latest generation BIS monitor, the A-2000® BIS Monitor, was cleared for marketing by the United States Food and Drug Administration (“FDA”) in February 1998. The Company’s latest version of the BIS system, the BIS XP system, was cleared for marketing by the FDA in June 2001. The BIS system is based on the Company’s patented core technology, the BIS index.
      The Company had net income of approximately $303,000 for the year ended December 31, 2004 and incurred net losses of approximately $6,523,000 and $15,301,000 for the years ended December 31, 2003, and 2002, respectively. At December 31, 2004, the Company had an accumulated deficit of approximately $99,974,000. The principal risks that may affect the business, results of operations and financial condition of the Company include the Company’s ability to effectively market and sell the Company’s products, market acceptance of the Company’s technology and products, the Company’s ability to raise sufficient capital to fund operations, limited sales and marketing experience, the reliance on a single product family, manufacturing risks, the dependence on single source or limited suppliers, technological risks and other risks.
(2)  Summary of Significant Accounting Policies
      A summary of the significant accounting policies used by the Company in the preparation of its consolidated financial statements follows:
Principles of Consolidation
      The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All intercompany accounts and transactions have been eliminated.
Foreign Currency
      The functional currency of the Company’s international subsidiaries is the U.S. dollar. Foreign currency transaction gains and losses are recorded in the consolidated statements of operations and have not been material.
Cash, Cash Equivalents and Marketable Securities
      The Company invests its excess cash in money market accounts, certificates of deposit, high-grade commercial paper, high grade corporate bonds and debt obligations of various government agencies. The Company considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.
      The Company accounts for its investments in 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 as available-for-sale at December 31, 2004 and 2003. The investments are reported at fair value, with any unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’ equity as accumulated other comprehensive income (loss). Investments that have contractual maturities of more than twelve months are included in long-term investments in the accompanying consolidated balance sheets.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
Revenue Recognition
      The Company sells its BIS monitors primarily through a combination of a direct sales force and distributors. The Company sells its BIS Module Kits to original equipment manufacturers who in turn sell them to the end-user. BIS Sensors are sold through a combination of a direct sales force, distributors and original equipment manufacturers. Direct product sales are structured as sales, sales-type lease arrangements or sales under the Company’s Equipment Placement (“EP”) program. Sales, sales-type lease agreements and sales under the EP program are subject to the Company’s standard terms and conditions of sale and do not include any customer acceptance criteria, installation or other post shipment obligations (other than warranty) or any rights of return. The Company’s BIS monitor is a standard product and does not require installation as it can be operated with the instructions included in the operator’s manual.
      The Company recognizes revenue from product sales when earned in accordance with Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition, and Emerging Issues Task Force (“EITF”) 00-21, Revenue Arrangements with Multiple Deliverables. Revenue is recognized when persuasive evidence of an arrangement exists, product delivery has occurred or services have been rendered, the price is fixed or determinable and collectibility is reasonably assured. For product sales, revenue is not recognized until title and risk of loss have transferred to the customer. The Company’s revenue arrangements with multiple elements are divided into separate units of accounting if specified criteria are met, including whether the delivered element has stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. The consideration received is allocated among the separate units based on their respective fair values, and the applicable revenue recognition criteria are applied to each of the separate units.
      The Company follows SFAS No. 13, Accounting For Leases, for its sales-type lease agreements. 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 the net investment in sales-type leases. The Company recognizes equipment revenue under sales-type lease agreements either at shipment or delivery in accordance with the agreed upon contract terms with interest income recognized over the life of the sales-type lease. The cost of the BIS monitor acquired by the customer is recorded as costs of revenue in the same period.
      In addition, the Company reviews and assesses the net realizability of its investment in sales-type leases at each reporting period. This review includes determining, on a customer specific basis, if a customer is significantly underperforming relative to the customer’s cumulative level of committed BIS Sensor purchases as required by the sales-type lease agreement. If a customer is underperforming, the Company records an allowance for lease payments as a charge to revenue to reflect the lower estimate of the net realizable investment in sales-type lease balance.
      As of December 31, 2004, the Company does not consider any sales-type lease agreement, against which an allowance for lease payments has been established, an impaired asset.
      Under the Company’s 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 typically 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 the Company. Under the EP program, no equipment revenue is recognized as the equipment remains the Company’s property and title does not pass to the customer, and the criteria for sales-type leases under

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
SFAS No. 13 are not met. The BIS monitors under the EP program are depreciated over two years and the depreciation is charged to costs of revenue. BIS Sensor revenue is recognized either at shipment or delivery of the BIS Sensors in accordance with the agreed upon contract terms.
      The Company’s obligations under warranty are limited to repair or replacement of any product that the Company reasonably determines to be covered by the warranty. The Company records an estimate for its total warranty obligation in accordance with SFAS No. 5, Accounting for Contingencies.
      In connection with the Stock Purchase Agreement and OEM Product Development Agreement with Boston Scientific Corporation (“BSC”) discussed in Note 19, the Company recorded approximately $6,300,000 of deferred revenue in August 2002. The deferred revenue is being recognized ratably over the term of the OEM product development and distribution agreement with BSC, which represents the Company’s best estimate of its period of significant continuing obligation to provide BSC exclusive distribution rights to newly developed technology. The term of the OEM product development and distribution agreement continues until such time that BSC is no longer distributing the Company’s products, but in no event will extend beyond December 31, 2014.
Research and Development Costs
      The Company charges research and development costs to operations as incurred. Research and development costs include costs associated with new product development, product improvements and extensions, clinical studies and project consulting expenses.
Allowance for Doubtful Accounts
      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 its credit policies. The Company continually monitors collections and payments from its customers.
Inventory
      The Company values inventory at the lower of cost or estimated market, and determines cost on a first-in, first-out basis. The Company regularly reviews inventory quantities on hand and records a provision for excess or obsolete inventory primarily based on production history and on its estimated forecast of product demand. The medical device 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 would 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 the form of a charge to its costs of revenue at the time of the determination.
Warranty
      Equipment that the Company sells is generally covered by a warranty period of one year. The Company accrues a warranty reserve for estimated costs to provide such warranty services. The Company’s estimate of costs to service its warranty obligations is based on historical experience and an expectation of future conditions. Warranty expense for the years ended December 31, 2004, 2003 and 2002, and accrued warranty

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
cost, included in accrued liabilities in the consolidated balance sheet at December 31, 2004 and 2003, was as follows:
           
Balance as of December 31, 2001
  $ 1,090  
 
Warranty expense
    (600 )
 
Deductions and other
    (122 )
       
Balance as of December 31, 2002
    368  
 
Warranty expense
    (150 )
 
Deductions and other
    (71 )
       
Balance as of December 31, 2003
    147  
 
Warranty expense
    87  
 
Deductions and other
    (97 )
       
Balance as of December 31, 2004
  $ 137  
       
Shipping and Handling Costs
      Shipping and handling costs are included in costs of revenue. Shipping and handling costs for the years ended December 31, 2004, 2003 and 2002 were approximately $527,000, $400,000 and $392,000, respectively.
Advertising Costs
      Advertising costs are expensed as incurred. These costs are included in sales and marketing expense in the consolidated statements of operations. Advertising costs for the years ended December 31, 2004, 2003 and 2002 were approximately $231,000, $360,000 and $672,000, respectively.
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 using the straight-line method 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. The Company does not develop software for internal use and the costs of software acquired for internal use are accounted for in accordance with the American Institute of Certified Public Accountant’s Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.
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.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
Concentration of Credit Risk
      Financial instruments that potentially expose the Company to concentrations of credit risk primarily consist of cash, cash equivalents, investments, accounts receivable and investment in sales-type lease receivables. To minimize the financial statement risk with respect to accounts receivable and investment in sales-type lease receivables, the Company maintains reserves for potential credit losses and such losses, in the aggregate, have not exceeded management’s expectations. The Company maintains cash, cash equivalents and investments 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.
Single or Limited Source Suppliers
      The Company currently obtains certain key components of its products from single or limited sources. The Company purchases components pursuant to purchase orders rather than long-term supply agreements and generally does not maintain large volumes of inventory. The Company has experienced shortages and delays in obtaining certain components of its products in the past. The Company may experience similar shortages and delays in the future. The disruption or termination of the supply of components or a significant increase in the costs of these components from these sources could have a material adverse effect on the Company’s business, financial position and results of operations and cash flows.
Net Income (Loss) Per Share
      In accordance with SFAS No. 128, Earnings Per Share, basic net income (loss) per share amounts for the three years ended December 31, 2004, 2003 and 2002 were computed by dividing the net income (loss) available to common stockholders by the weighted average number of common shares outstanding during those periods and diluted net income (loss) per share was computed using the weighted average number of common shares outstanding and other dilutive securities as applicable, during those periods.
      For the year ended December 31, 2004, the Company has included in the calculation of the Company’s diluted net income per share approximately 2,144,000 shares related to common stock issuable pursuant to the exercise of stock options and warrants. The Company has excluded from the calculation of the Company’s diluted net income per share approximately 22,000 share of common stock issuable pursuant to the exercise of stock options because the inclusion of these shares would have been anti-dilutive.
      For the years ended December 31, 2003 and 2002, the Company has excluded from the calculation of the Company’s diluted net loss per share approximately 989,000 and 590,000 shares, respectively, related to restricted common stock subject to repurchase and common stock issuable pursuant to the exercise of stock options and warrants because the inclusion of these shares would have been antidilutive as a result of the Company’s net loss position.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
      Basic and diluted net income (loss) per share for the years ended December 31, 2004, 2003 and 2002 were determined as follows:
                           
    2004   2003   2002
             
Basic:
                       
 
Net income (loss)
  $ 303     $ (6,523 )   $ (15,301 )
                   
 
Weighted average shares outstanding
    20,142       19,413       18,450  
                   
Basic net income (loss) per share
  $ 0.02     $ (0.34 )   $ (0.83 )
                   
 
Diluted:
                       
 
Net income (loss)
  $ 303     $ (6,523 )   $ (15,301 )
                   
 
Weighted average shares outstanding
    20,142       19,413       18,450  
 
Effect of dilutive stock options
    2,144              
                   
 
Weighted average shares assuming dilution
    22,286       19,413       18,450  
                   
Diluted net income (loss) per share
  $ 0.01     $ (0.34 )   $ (0.83 )
                   
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 income (loss), the only other element of comprehensive income (loss) impacting the Company is the unrealized gains (losses) on its investments for all periods presented.
Stock-Based Compensation
      SFAS No. 123, Accounting for Stock-Based Compensation, requires the measurement of the fair value of stock options or warrants to be included in the statement of income or disclosed in the notes to financial statements. The Company accounts for stock-based compensation for employees using the intrinsic value method under APB Opinion No. 25 and has adopted the fair value disclosure-only alternative under SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. The Company has computed the weighted-average fair value of options granted in 2004, 2003 and 2002 using the Black-Scholes option-pricing model pursuant to SFAS No. 123. The following table shows the weighted average assumptions used in the applicable periods and the weighted average fair market value of the options granted in each period.
                         
    Year Ended December 31,
     
    2004   2003   2002
             
Risk-free interest rate
    3.23 %     2.99 %     4.40 %
Expected dividend yield
                 
Expected life of options
    5 years       5 years       5 years  
Expected volatility
    55 %     57 %     75 %
Weighted average fair value of options granted
  $ 7.90     $ 3.14     $ 6.10  

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
      If the Company had recognized compensation cost for these awards consistent with SFAS No. 123, the Company’s net loss and pro forma net loss per common share would have been increased to the following pro forma amounts:
                               
    Year Ended December 31,
     
    2004   2003   2002
             
Net loss:
                       
 
Net income (loss) as reported
  $ 303     $ (6,523 )   $ (15,301 )
   
Add: Stock-based employee compensation expense included in reported net loss
                 
   
Deduct: Stock-based employee compensation expense determined under fair value based method for all awards
    (5,945 )     (7,112 )     (7,744 )
                   
 
Pro forma net loss
  $ (5,642 )   $ (13,635 )   $ (23,045 )
                   
Net income (loss) per share:
                       
   
Basic:
                       
     
As reported
  $ 0.02     $ (0.34 )   $ (0.83 )
     
Pro forma
  $ (0.28 )   $ (0.70 )   $ (1.25 )
   
Diluted:
                       
     
As reported
  $ 0.01     $ (0.34 )   $ (0.83 )
     
Pro forma
  $ (0.25 )   $ (0.70 )   $ (1.25 )
      Compensation expense for non-employee stock options was approximately $66,000, $26,000 and $31,000 for the years ended December 31, 2004, 2003 and 2002, respectively.
      The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. Also, because options vest over several years and the Company expects to grant options in future years, the above pro forma results of applying the provisions of SFAS No. 123 are not necessarily representative of the pro forma results in future years.
Use of Estimates
      The preparation of financial statements in conformity with generally accepted accounting principles 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, investments, accounts receivable, investment in sales-type leases, accounts payable and long-term debt, approximate their carrying values.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
Reclassifications
      Certain amounts in the prior years’ financial statements have been reclassified to conform with the current-year presentation.
Recent Accounting Pronouncements
      On December 16, 2004, the Financial Accounting Standards Board, or FASB, issued Statement No. 123 (revised 2004), Share Based Payment, or SFAS No. 123R, which is a revision of Statement No. 123, Accounting for Stock-Based Compensation, or SFAS 123. SFAS 123R supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends SFAS No. 95, Statement of Cash Flows. Under SFAS No. 123R, companies must calculate and record in the income statement the cost of equity instruments, such as stock options or restricted stock, awarded to employees for services received; pro forma disclosure is not longer permitted. The cost of the equity instruments is to be measured based on fair value of the instruments on the date they are granted (with certain exceptions) and is required to be recognized over the period during which the employees are required to provide services in exchange for the equity instruments. The statement is effective in the first interim or annual reporting period beginning after June 15, 2005.
      SFAS No. 123R provides two alternatives for adoption: (1) a “modified prospective” method in which compensation cost is recognized for all awards granted subsequent to the effective date of this statement as well as for the unvested portion of awards outstanding as of the effective date; or (2) a “modified retrospective” method which follows the approach in the “modified prospective” method, but also permits entities to restate prior periods to record compensation cost calculated under SFAS No. 123 for the pro forma disclosure. The Company plans to adopt SFAS No. 123R as of July 3, 2005, the beginning of our third fiscal quarter of 2005. Since the Company currently accounts for stock options granted to employees and shares issued under its employee stock purchase plan in accordance with the intrinsic value method permitted under APB Opinion No. 25, no compensation expense generally is recognized. The Company expects that the adoption of SFAS No. 123R will have a significant impact on the Company’s results of operations, although it will have no impact on the Company’s overall financial position. The impact of adopting SFAS No. 123R on periods after adoption cannot be accurately estimated at this time, as it will depend on the market value and the amount of share based awards granted in future periods. However, had the Company adopted SFAS No. 123R in prior periods, the impact of that standard would have approximated the impact of SFAS No. 123 as described in the disclosure of pro forma net income (loss) and earnings (loss) per share included in Note 2 to the Company’s consolidated financial statements.
(3)  Comprehensive Income (Loss)
      The Company’s total comprehensive income (loss) is as follows:
                           
    Year Ended December 31,
     
    2004   2003   2002
             
Net income (loss)
  $ 303     $ (6,523 )   $ (15,301 )
Other comprehensive income (loss):
                       
 
Unrealized loss on marketable securities
    (74 )     (25 )     (13 )
                   
Comprehensive income (loss)
  $ 229     $ (6,548 )   $ (15,314 )
                   

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
(4)  Cash Equivalents, Restricted Cash and Marketable Securities
      Cash and cash equivalents consist of the following:
                 
    December 31,
     
    2004   2003
         
Cash
  $ 13,009     $ 11,344  
Commercial paper
    1,752       1,000  
             
    $ 14,761     $ 12,344  
             
      At December 31, 2004, the Company maintained $82,000 of restricted cash as part of its revolving line of credit agreement with a commercial bank (see Note 18).
      Available-for-sale marketable securities at December 31, 2004 and 2003 consist of the following:
                                   
    Amortized   Unrealized   Unrealized    
    Cost   Gains   Losses   Fair Value
                 
December 31, 2004 —
                               
 
U.S. Government debt securities
  $ 2,734     $ 6     $ (2 )   $ 2,738  
 
Corporate obligations
    26,094       4       (443 )     25,655  
 
Commercial paper
    495       3             498  
                         
    $ 29,323     $ 13     $ (445 )   $ 28,891  
                         
December 31, 2003 —
                               
 
U.S. Government debt securities
  $ 508     $     $  —     $ 508  
 
Corporate obligations
    11,717       48       (52 )     11,713  
 
Commercial paper
    1,497                   1,497  
                         
    $ 13,722     $ 48     $ (52 )   $ 13,718  
                         
      All available-for-sale marketable securities have contractual maturities of one to two years.
      The aggregate fair value of investments with unrealized losses was approximately $24,413,000 and $9,769,000 at December 31, 2004 and 2003, respectively. All such investments have been in an unrealized loss position for less than a year.
      The Company reviews investments in U.S. Government debt securities and corporate obligations for other-than-temporary impairment whenever the fair value of an investment is less than amortized cost and evidence indicates that an investment’s carrying amount is not recoverable within a reasonable period of time. To determine whether an impairment is other-than-temporary, the Company considers whether it has the ability and intent to hold the investment until a market price recovery and considers whether evidence indicating the cost of the investment is recoverable outweighs evidence to the contrary.
      The cost of securities sold is determined based on the specific identification method for purposes of recording realized gains and losses. Gross realized gains and losses on the sales of investments have not been material.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
(5)  Investment in Sales-Type Leases
      The Company leases equipment to customers under sales-type leases. The components of the Company’s net investment in sales-type leases are as follows:
                     
    December 31,
     
    2004   2003
         
Total minimum lease payments receivable
  $ 5,815     $ 6,493  
 
Less:
               
   
Unearned interest income
    842       985  
   
Allowance for lease payments
    955       1,098  
                 
Net investment in sales-type leases
    4,018       4,410  
 
Less — current portion
    1,698       1,797  
                 
    $ 2,320     $ 2,613  
                 
      Future minimum lease payments due under non-cancelable leases as of December 31, 2004 are as follows:
         
Year Ending December 31,    
     
2005
  $ 1,965  
2006
    1,400  
2007
    876  
2008
    444  
2009
    175  
       
    $ 4,860  
       
(6)  Inventory
      Inventory consists of the following:
                 
    December 31,
     
    2004   2003
         
Raw materials
  $ 959     $ 739  
Work-in-progress
    66       62  
Finished goods
    1,199       714  
             
    $ 2,224     $ 1,515  
             
      For the years ended December 31, 2004, 2003 and 2002, approximately $275,000, $48,000 and $30,000, respectively, of raw material components of monitors were written down to zero cost and subsequently scrapped or used for repair and service.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
(7)  Property and Equipment
      Property and equipment consist of the following:
                     
        December 31,
    Useful Life    
    in Years   2004   2003
             
Construction in progress
    $ 545     $ 340  
Computer equipment
  3     5,731       5,262  
Demonstration, evaluation and rental equipment
  2     60       61  
Machinery and equipment
  3 to 5     5,021       4,555  
Furniture and fixtures
  3     2,012       1,934  
Leasehold improvements
  Shorter of the
lease or useful life
of the asset
    1,630       1,630  
                 
          14,999       13,782  
Accumulated depreciation and amortization
        (12,337 )     (10,786 )
                 
        $ 2,662     $ 2,996  
                 
(8)  Income Taxes
      The Company’s effective income tax rate as of December 31, 2004 differed from the expected US federal statutory income tax rate as set forth below:
         
    December 31,
    2004
     
Expected federal tax expense
  $ 103  
Permanent differences
    124  
Previously unbenefitted net operating losses
    (227 )
         
Income tax expense
  $  
         
      Deferred income tax assets consist of the following:
                   
    December 31,
     
    2004   2003
         
Net operating loss carryforwards
  $ 33,061     $ 29,433  
Tax credit carryforwards
    3,431       3,315  
Deferred revenue
    2,280       2,535  
Other
    3,146       3,949  
             
 
Gross deferred tax assets
    41,918       39,232  
 
Valuation allowance
    (41,918 )     (39,232 )
             
 
Net deferred tax asset
  $     $  
             
      The Company accounts for income taxes under the provision of SFAS No. 109 which, requires recognition of future tax benefits (NOLs and other temporary differences), subject to a valuation allowance based on the “more-likely-than-not” standard of realizing such benefit. In determining whether it is “more-likely-than-not” that the Company will realize such benefits, SFAS No. 109 requires that all negative and positive evidence be considered in making the determination. SFAS No. 109 also indicates that “forming a

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
conclusion that a valuation allowance is not needed is difficult when there is negative evidence such as cumulative losses in recent years;” therefore, the Company has determined that it is required by the provision of SFAS No. 109 to maintain a valuation allowance for all of the recorded net deferred tax assets. This determination is based primarily on historical losses without considering the impact of any potential upturn in the business. Accordingly, future favorable adjustments to the valuation allowance may be required if and when circumstances change. During 2004, the valuation allowance increased by $2,686,000.
      As of December 31, 2004, the Company has net operating loss carryforwards for federal and state income tax purposes of approximately $92,195,000 and $34,654,000, respectively, and tax credits for federal and state income tax purposes of approximately $2,469,000 and $1,457,000, respectively. These tax attributes began expiring in 2002 and will continue to expire through 2024 if not utilized. Additionally, the net operating loss and tax credit carryforwards are subject to review by the Internal Revenue Service. Ownership changes, as defined under Sections 382 and 383 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 the Company’s value immediately prior to the ownership change. Subsequent ownership changes may further affect the limitation in future years.
      As of December 31, 2004, the Company has deferred tax assets of approximately $3,362,000 that pertain to net operating loss carryforwards resulting from the exercise of employee stock options. If recognized, the tax benefit of these losses will be accounted for as a credit to stockholders’ equity.
(9)  Stockholders’ Equity
Warrants
      In December 1998, the Company issued warrants to purchase approximately 193,000 shares of common stock in association with the issuance of convertible preferred stock. The warrants had an exercise price of $12.50 per share and warrants to purchase approximately 160,000 shares of common stock expired unexercised on February 2, 2003. The Company allocated the proceeds received between the preferred stock and the warrants based on the estimated fair market values of the convertible preferred stock and the warrants.
Common Stock
      At December 31, 2004, the Company has reserved approximately 7,032,000 shares of common stock for issuance under the Company’s stock option plans and approximately 120,352 shares of common stock for issuance under the Company’s 1999 Employee Stock Purchase Plan.
(10)  Stock Option Plans
      The Company’s stock option plans provide for the grant, at the discretion of the Board of Directors, of options for the purchase of up to 10,560,000 shares of common stock to employees, directors and advisors. Option exercise prices are determined by the Board of Directors. Stock options and restricted common stock generally vest over two to four years and provide for the acceleration of vesting upon a change of control of the Company. At December 31, 2004, approximately 2,447,000 shares of common stock were available for future grant under the Company’s stock option plans.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
      A summary of stock option activity is as follows:
                           
            Weighted
    Number of       Average Option
    Shares   Option Exercise Prices   Price per Share
             
Outstanding, December 31, 2001
    3,409,778     $ .20-47.88       11.16  
 
Granted
    1,323,700       2.51-10.55       7.40  
 
Exercised
    (90,694 )     .20-10.20       2.39  
 
Canceled
    (543,672 )     2.80-28.63       10.52  
                   
Outstanding, December 31, 2002
    4,099,112       .20-47.88       10.23  
 
Granted
    740,725       3.62-10.12       5.25  
 
Exercised
    (83,560 )     .20-10.00       3.30  
 
Canceled
    (282,109 )     2.51-47.88       11.81  
                   
Outstanding, December 31, 2003
    4,474,168       .20-47.88       9.43  
 
Granted
    1,040,750       12.50-23.62       15.71  
 
Exercised
    (810,201 )     .20-23.63       7.17  
 
Canceled
    (120,284 )     2.51-45.83       11.42  
                   
Outstanding, December 31, 2004
    4,584,433     $ .20-47.88     $ 11.20  
                   
 
Exercisable, December 31, 2004
    3,071,455     $ .20-47.88     $ 11.15  
Exercisable, December 31, 2003
    2,973,255     $ .20-47.88     $ 10.20  
Exercisable, December 31, 2002
    2,327,699     $ .20-47.88     $ 10.03  
      During 1997 and 1998, the Company accelerated the vesting of certain employees’ and directors’ stock options. These employees and directors exercised options to acquire 1,495,470 shares of common stock. The option exercise price was paid in the form of cash of $45,735 and by delivery to the Company of full recourse promissory notes of $336,580. These promissory notes bear interest at 5.28% per annum and are payable over periods ranging up to five years. The shares of common stock were subject to a repurchase right by the Company. As of December 31, 2004, no shares remained subject to repurchase and there were no amounts outstanding on these loans.
      During 2000, an employee exercised stock options to purchase 143,511 shares of common stock with a full recourse promissory note of $234,420. The loan was payable over five years and bore interest at a rate of 8% per annum. As of December 31, 2004, there was no outstanding amount on this loan.

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Table of Contents

ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
      A summary of outstanding and exercisable options as of December 31, 2004 is as follows:
                                         
    Outstanding   Exercisable
         
        Weighted        
        Average   Weighted       Weighted
        Remaining   Average       Average
        Contractual   Exercise       Exercise
Exercise Price   Number   Life   Price   Number   Price
                     
$ 0.20 – $ 3.68
    732,135       5.55     $ 2.56       483,491     $ 2.02  
3.85 –   4.20
    494,661       5.22       4.04       387,666       4.09  
4.96 –   9.80
    502,192       5.42       7.73       381,840       7.86  
10.00 –  10.12
    510,700       7.22       10.03       305,381       10.01  
10.19 –  11.69
    526,618       5.55       10.78       505,829       10.79  
12.40 –  14.91
    496,923       7.56       13.23       309,961       12.72  
15.00 –  15.23
    46,450       5.79       15.16       7,200       15.00  
15.66 –  15.66
    675,754       9.09       15.66       176,330       15.66  
17.00 –  23.63
    474,450       6.36       22.71       389,207       23.60  
24.50 –  47.88
    124,550       5.34       33.43       124,550       33.43  
                               
$ 0.20 – $47.88
    4,584,433                       3,071,455          
                               
1991 Amended and Restated Stock Option Plan
      The Company’s 1991 Amended and Restated Stock Option Plan provides for the granting, at the discretion of the Board of Directors, of options for the purchase of up to 3,360,000 shares of common stock to employees, directors and advisors. Options granted under the 1991 Amended and Restated Stock Option Plan terminate ten years from the date of grant. Option exercise prices are determined by the Board of Directors.
1998 Stock Incentive Plan
      The Company’s 1998 Stock Incentive Plan (the “1998 Incentive Plan”) was adopted by the Board of Directors on July 8, 1998. The Board of Directors has authorized the Compensation Committee to administer the 1998 Incentive Plan, including the granting of options to executive officers. At December 31, 2004, the 1998 Incentive Plan provided for the granting, at the discretion of the Compensation Committee, of options for the purchase of up to 3,000,000 shares of common stock (subject to adjustment in the event of stock splits and other similar events) to employees, directors and advisors. Options granted under the 1998 Incentive Plan terminate ten years from the date of grant. Option exercise prices are determined by the Compensation Committee, but cannot be less than 100% of fair market value for incentive stock options.
1998 Director Stock Option Plan
      In February 1998, the Company adopted the 1998 Director Stock Option Plan (the “Director Plan”). Under the terms of this plan, directors of the Company who are not employees of the Company are eligible to receive nonstatutory options to purchase shares of common stock. At December 31, 2004, a total of 200,000 shares of common stock could be issued upon exercise of options under this plan. The initial options granted under the Director Plan are exercisable as to 50% of the shares pursuant to the option as of the date of grant and as to one-sixth of the shares on the first, second and third anniversaries of the date of grant, provided that the optionee continues to serve as a director and provide for the acceleration of vesting upon a change of control of the Company. Additional options, which are granted annually, will be exercisable in three equal annual installments on each of the first, second and third anniversaries of the date of grant, provided that the

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Table of Contents

ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
optionee continues to serve as a director. Options granted under the Director Plan terminate on the earlier of (i) ten years from the date of grant, or (ii) sixty days after the optionee ceases to serve as a director.
1999 Employee Stock Purchase Plan
      In December 1999, the Company adopted its 1999 Employee Stock Purchase Plan (the “Purchase Plan”). The Purchase Plan allows eligible employees the right to purchase shares of common stock at the lower of 85% of the closing price per share of common stock on the first or last day of an offering period. Each offering period is six months. An aggregate of 300,000 shares of common stock have been reserved for issuance pursuant to the Purchase Plan. As of December 31, 2004, 179,648 shares of the Company’s common stock had been issued under the Purchase Plan.
2001 Stock Incentive Plan
      The Company’s 2001 Stock Incentive Plan (the “2001 Incentive Plan”) was adopted by the Company’s Board of Directors on March 19, 2001 and approved by the Company’s stockholders on May 22, 2001. The Board of Directors has authorized the Compensation Committee to administer the 2001 Incentive Plan, including the granting of options to executive officers. At December 31, 2004, the 2001 Incentive Plan provided for the granting, at the discretion of the Compensation Committee, of options for the purchase of up to 4,000,000 shares of common stock (subject to adjustment in the event of stock splits and other similar events) to employees, directors and advisors. Options granted under the 2001 Incentive Plan terminate ten years from the date of grant. Option exercise prices are determined by the Compensation Committee, but cannot be less than 100% of fair market value for incentive stock options.
(11)  Distribution and Licensing Agreements
      The Company has entered into various distribution, licensing and royalty agreements relating to its products with distributors and original equipment manufacturers covering both the domestic and international markets. These agreements have original terms ranging from two to ten years. In connection with these agreements, approximately $5,650,000 and $6,485,000 of payments received were classified as deferred revenue as of December 31, 2004 and 2003, respectively. The deferred revenue includes prepaid license and royalty fees. The deferred revenue is recognized either at shipment or delivery in accordance with the agreed upon contract terms and as license and royalty fees are earned. License and royalty fees are related to future technological developments and will be recognized upon shipment or delivery of units incorporating the technology in accordance with the agreed upon contract terms. For the years ended December 31, 2004 and 2003, the Company had approximately $205,000 and $23,000, respectively, in deferred revenue related to revenue arrangements, which had been deferred until the revenue recognition criteria in SAB No. 104 and other authoritative accounting literature have been met.
(12)  401(k) Savings Plan
      The Company has a 401(k) savings plan in which substantially all domestic employees can participate. Employer contributions are at the discretion of the Board of Directors and vest ratably over five years. The Company made no contributions to the plan during the years ended December 31, 2004, 2003 and 2002.
(13)  Commitments and Contingencies
Leases
      The Company leases approximately 61,000 square feet of research and development, sales and marketing, production and general and administrative space in Newton, Massachusetts under an operating lease that

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
expires in December 2006. Effective February 1, 2004, the lease on the Company’s office space in Leiden, The Netherlands expired. A new operating lease for the Company’s international organization was entered into for approximately 2,765 square feet of office space in De Meern, The Netherlands. This lease expires in October 2008. Rent expense was approximately $998,000, $936,000 and $966,000 in 2004, 2003 and 2002, respectively. Future gross minimum lease commitments for all non-cancelable operating leases as of December 31, 2004 are as follows:
         
Year Ending December 31,    
     
2005
  $ 1,258  
2006
    1,238  
2007
    222  
2008
    94  
       
Total minimum lease payments
  $ 2,812  
       
(14)  Other Related Party Transactions
      Through May 2002, the Company loaned, on a full recourse basis, an aggregate of $1,491,000, to certain officers, employees and a consultant of the Company. All loans are evidenced by promissory notes bearing interest with rates ranging from 5.00% to 8.00% per annum. The loans are payable over periods ranging from one to five years and in each case are secured by certain assets of the borrower, including shares of the Company’s common stock owned by the borrower. At December 31, 2004 and 2003, the aggregate outstanding balance on these loans was approximately $47,000 and $781,000, respectively. The long-term portion of the loans is included in long-term notes receivable from related parties, and the short-term portion of approximately $22,000 and $128,000 at December 31, 2004 and 2003, respectively, is included in other current assets in the accompanying consolidated balance sheets.
(15)  Accrued Liabilities
      Accrued liabilities consist of the following:
                   
    December 31,
     
    2004   2003
         
Payroll and payroll-related
  $ 5,614     $ 5,492  
Professional services
    281       223  
Warranty
    137       147  
Accrued research and development expenses
    133       105  
Accrued sales and marketing expenses
    165       486  
Accrued general and administrative expenses
    164       223  
Deferred rent expense
    128       177  
Taxes payable
    527       615  
Unvouchered invoices
    683       403  
             
 
Total accrued liabilities
  $ 7,832     $ 7,871  
             

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
(16)  Segment Information and Enterprise Reporting
      The Company operates in one reportable segment as it markets and sells one family of anesthesia monitoring systems. The Company does not disaggregate financial information by product or geographically, other than export sales by region and sales by product, for management purposes. Substantially all of the Company’s assets are located within the United States. All of the Company’s products are manufactured in the United States.
      Revenue by geographic destination and as a percentage of total revenue is as follows:
                             
    Year Ended December 31,
     
    2004   2003   2002
             
Geographic Area by Destination
                       
 
Domestic
  $ 43,638     $ 35,968     $ 33,089  
 
International
    11,926       8,123       6,687  
                   
   
Total
  $ 55,564     $ 44,091     $ 39,776  
                   
                             
    Year Ended December 31,
     
    2004   2003   2002
             
Geographic Area by Destination
                       
 
Domestic
    79%       82%       83%  
 
International
    21          18          17     
                   
   
Total
    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 years ended December 31, 2004, 2003 and 2002.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
(17)  Valuation and Qualifying Accounts
      The following tables set forth activity in the Company’s valuation and qualifying accounts:
                                           
        Additions        
                 
    Balance at   Charges (Credits)   Charges       Balance at
    Beginning of   to Expenses and   (Credits) to       End of
    Period   Costs of Revenue   Revenue   Deductions   Period
                     
Allowance for Doubtful Accounts
Year Ended —
                                       
 
December 31, 2002
  $ 522,000     $ (100,000 )   $     $ 14,000     $ 408,000  
 
December 31, 2003
    408,000       (237,000 )           21,000       150,000  
 
December 31, 2004
    150,000       (39,000 )             70,000       41,000  
Reserve for Excess or Obsolete Inventory
Year Ended —
                                       
 
December 31, 2002
  $ 296,000     $ (80,000 )   $     $ 30,000     $ 186,000  
 
December 31, 2003
    186,000       70,000             48,000       208,000  
 
December 31, 2004
    208,000       279,000             275,000       212,000  
Allowance for Lease Payments
Year Ended —
                                       
 
December 31, 2002
  $ 957,000     $     $ 209,000     $     $ 1,166,000  
 
December 31, 2003
    1,166,000             186,000       254,000       1,098,000  
 
December 31, 2004
    1,098,000             (122,000 )     (21,000 )     955,000  
(18)  Loan Agreements
      In May 2001, the Company entered into an agreement with a commercial bank for a revolving line of credit. The Company is entitled to borrow up to $5,000,000 under the revolving line of credit, which expires in May 2005 and, subject to annual review by the commercial bank, may be extended at the discretion of the commercial bank. Interest on any borrowings under the revolving line of credit is, at the election of the Company, either the prime rate or at LIBOR plus 2.25%. Up to $1,500,000 of the $5,000,000 revolving line of credit is available for standby letters of credit. At December 31, 2004, the Company had outstanding standby letters of credit with the commercial bank of approximately $80,000. At December 31, 2004, there was no outstanding balance under this revolving line 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. In connection with the extension of the revolving line of credit in May 2004, the Company is required to maintain restricted cash in an amount equal to 102% of the outstanding amounts under the revolving line of credit agreement. Prior to the amendment in May 2004, the Company was required to maintain restricted cash in an amount equal to 102% of the $5,000,000 commitment, or $5,100,000. At December 31, 2004, the Company was in compliance with all covenants contained in the revolving line of credit agreement. At December 31, 2004, the interest rate on the revolving line of credit was 5.25%.
      In August 2002, the Company entered into an agreement for a $5,000,000 revolving line of credit with BSC in connection with a strategic alliance (see Note 19).

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
      In July 1999, the Company entered into an agreement under which it can sell a portion of its existing and future investment in sales-type leases to a third-party finance company. Through December 31, 2004, the Company sold approximately $5.1 million of its investment 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 have been classified as debt in the accompanying consolidated balance sheets. This debt bears interest at rates ranging from 10.25% to 12.50%. Payments on the outstanding principal under this debt match the timing of the payments due on the underlying investment in sales-type leases.
      Future principal payments under the Company’s sales-type lease debt agreements are as follows:
         
Year Ending December 31,    
     
2005
  $ 311  
2006
    126  
2007
    56  
2008
    4  
       
Total principal payments
  $ 497  
       
(19)  Strategic Alliance with Boston Scientific Corporation
      On August 7, 2002, the Company formed a strategic alliance with BSC. In connection with this strategic alliance, the Company sold 1,428,572 shares of the Company’s common stock at a purchase price per share of $7.00 to BSC pursuant to a stock purchase agreement. Gross cash proceeds from this sale of common stock were $10,000,004. In addition, the Company granted BSC an option under an OEM product development and distribution agreement to distribute newly developed technology for monitoring patients under sedation in a range of less-invasive medical specialties. The Company allocated the fair market value between the common stock and the option to be the exclusive distributor. The excess of $4.41 per share paid by BSC over the closing price of the Company’s common stock on August 7, 2002, or approximately $6,300,000 in total, was attributed to the value of the rights provided to BSC under the OEM product development and distribution agreement.
      Approximately $4,917,000 of the aggregate purchase price is recorded as deferred revenue in the accompanying consolidated balance sheet at December 31, 2004, which represents the unamortized portion of the purchase price in excess of the closing price of the Company’s common stock on August 7, 2002. The deferred revenue is being recognized ratably over the term of the OEM product development and distribution agreement, which represents the Company’s best estimate of its period of significant continuing obligation to provide BSC exclusive distribution rights to newly developed technology. The term of the agreement continues until such time that BSC is no longer distributing the Company’s products, but in no event will extend beyond December 31, 2014 pursuant to an amendment to the OEM product development agreement with Boston Scientific Corporation entered into in January 2005. On January 31, 2005, the Company amended its OEM product development agreement with Boston Scientific Corporation to provide a two year extension to the period during which Boston Scientific Corporation may exercise an option to distribute sedation management technology for interventional and specialty medical procedure suites. The amendment extends until December 31, 2006, Boston Scientific Corporation’s right to exercise its option and also extends until the end of 2014 the term of Boston Scientific Corporation’s distribution rights. This amendment will reduce the revenue that the Company records on a quarterly basis by approximately $31,000. Approximately $615,000 was recognized as revenue for the years ended December 31, 2004 and 2003.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
      As part of the strategic alliance with BSC, the Company also entered into an agreement pursuant to which BSC has agreed to provide the Company a $5,000,000 revolving line of credit, which expires in August 2007 and may be extended at the discretion of BSC. Interest on any borrowings under this revolving line of credit is at a rate equal to the LIBOR rate at which BSC, under its own revolving credit facility, is entitled to borrow funds, plus any additional amounts payable thereon by BSC under such revolving credit facility, plus eighty basis points. The Company’s revolving line of credit with BSC is secured by the Company’s inventory and certain of the Company’s accounts receivable and contains certain restrictive covenants covering the collateral. At December 31, 2004, 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.
      On April 7, 2004, the Company entered into an agreement with BSC to issue and sell 500,000 shares of the Company’s common stock to BSC pursuant to a stock purchase agreement. The Company completed the sale on June 8, 2004. The purchase price per share was $16.21 and the aggregate gross proceeds from the transaction were $8,105,000. In connection with this sale of common stock, the Company has granted BSC the right to require the Company to register these shares for resale under the Securities Act of 1933.
(20)  Shareholder Rights Plan
      On November 29, 2004, the Company adopted a shareholder rights plan. In connection with the adoption of this plan, the Company’s Board of Directors declared a dividend of one right for each outstanding share of the Company’s Common Stock, $0.01 par value per share, to stockholders of record at the close of business on December 10, 2004. Pursuant to the Rights Agreement, each Right entitles the registered holder to purchase from the Company one one-thousandth of a share of the Company’s Series A Junior Participating Preferred Stock, $0.01 par value per share, at a purchase price of $150.00 per share in cash. The Rights are not exercisable until the Distribution Date as defined in the Rights Agreement filed with the Securities and Exchange Commission on December 1, 2004 and will expire upon the close of business on November 29, 2014 unless earlier redeemed or exchanged as defined in the Rights Agreement.

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ASPECT MEDICAL SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)
(tabular amounts in thousands, except per share amounts)
(21)  Summarized Quarterly Financial Data (Unaudited)
      The tables that follow summarize unaudited quarterly financial data for the years ended December 31, 2004 and December 31, 2003:
                                   
    For the Quarter Ended
     
    April 3,   July 3,   October 2,   December 31,
    2004   2004   2004   2004
                 
Revenue
  $ 12,797     $ 13,426     $ 13,625     $ 15,716  
Gross profit margin
    9,932       10,249       10,380       12,011  
Operating expenses
    10,908       10,818       10,118       11,349  
Net income (loss)
  $ (796 )   $ (376 )   $ 520     $ 955  
Net income (loss) per share
                               
 
Basic
  $ (0.04 )   $ (0.02 )   $ 0.03     $ 0.05  
 
Diluted
  $ (0.04 )   $ (0.02 )   $ 0.02     $ 0.04  
                                 
    For the Quarter Ended
     
    March 29,   June 28,   September 27,   December 31,
    2003   2003   2003   2003
                 
Revenue
  $ 10,127     $ 10,709     $ 11,189     $ 12,066  
Gross profit margin
    7,578       7,992       8,428       9,194  
Operating expenses
    10,296       9,972       9,982       10,191  
Net loss
  $ (2,524 )   $ (1,795 )   $ (1,387 )   $ (817 )
Basic and diluted net loss per share
  $ (0.13 )   $ (0.09 )   $ (0.07 )   $ (0.04 )

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EXHIBIT INDEX
         
Exhibit    
No.   Exhibit
     
  3(i) .1   Restated Certificate of Incorporation is incorporated herein by reference to Exhibit 3.1 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
  3(ii) .1   Amended and Restated By-Laws are incorporated herein by reference to Exhibit 3.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended March 31, 2001 (File No. 0-24663).
 
  3 .2   Certificate of Designations of Series A Junior Participating Preferred Stock is incorporated herein by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K as filed with the Commission on November 29, 2004 (File No. 333-86295).
 
  4 .1   Specimen common stock certificate is incorporated herein by reference to Exhibit 4.1 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  4 .2   See Exhibits 3(i).1 and 3(ii).1 for provisions of the Registrant’s certificate of incorporation and by-laws defining the rights of holders of common stock.
 
  4 .3   Rights Agreement, dated as of November 29, 2004, between Aspect Medical Systems, Inc. and EquiServe Trust Company, N.A., which includes as Exhibit A the form of Certificate of Designations of Series A Junior Participating preferred Stock, as Exhibit B the form of Rights Certificate and as Exhibit C the Summary of Rights to Purchase Preferred Stock is incorporated herein by reference to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K as filed with the Commission on November 29, 2004 (File No. 333-86295).
 
  10 .1   1998 Director Stock Option Plan, as amended, is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .2†   International Distribution Agreement, dated as of January 21, 1998, by and between the Registrant and Nihon Kohden Corporation is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .3†   International License Agreement, dated as of January 21, 1998, by and between the Registrant and Nihon Kohden Corporation is incorporated herein by reference to Exhibit 10.3 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .4   License Agreement, dated as of October 31, 1995, by and between the Registrant and Siemens Medical Systems, Inc. is incorporated herein by reference to Exhibit 10.5 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .5†   Product Agreement, dated May 5, 1999, by and between the Registrant and Drager Medizintechnik GmbH is incorporated herein by reference to Exhibit 10.6 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .6†   OEM Development and Purchase Agreement, dated August 6, 1999, by and between the Registrant and Philips Medizinsysteme Boeblingen GmbH (formerly Agilent Technologies, Inc.) is incorporated herein by reference to Exhibit 10.7 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .7†   Letter Agreement, dated August 27, 1999, by and between the Registrant and Philips Medizinsysteme Boeblingen GmbH (formerly Agilent Technologies, Inc.) is incorporated herein by reference to Exhibit 10.8 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .8†   Distribution and License Agreement, dated as of April 1, 1996, between SpaceLabs Medical, Inc. and the Registrant is incorporated herein by reference to Exhibit 10.9 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .9   Form of Promissory Note made in favor of the Registrant by certain directors and executive officers, together with Form of Pledge Agreement, by and between the Registrant and certain directors and executive officers, together with a schedule of material terms are incorporated herein by reference to Exhibit 10.16 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).

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Table of Contents

         
Exhibit    
No.   Exhibit
     
 
  10 .10   Promissory Note, dated April 10, 1998, made in favor of the Registrant by Jeffrey Barrett, together with Pledge Agreement, dated as of April 10, 1998, by and between the Registrant and Jeffrey Barrett are incorporated herein by reference to Exhibit 10.18 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .11   Fourth Amended and Restated Registration Rights Agreement, dated December 17, 1998, by and among the Registrant and the several purchasers named on the signature pages thereto is incorporated herein by reference to Exhibit 10.21 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .12†   Supplier Agreement, dated August 13, 1999, between Novation, LLC and the Registrant is incorporated herein by reference to Exhibit 10.24 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .13†   OEM Development and Purchase Agreement, dated December 22, 1999, by and between the Registrant and GE Marquette Medical Systems, Inc. is incorporated herein by reference to Exhibit 10.26 to the Registrant’s Registration Statement on Form S-1 (File No. 333-86295).
 
  10 .14†   Master Distribution Agreement, dated September 1, 2000, by and between the Registrant and Datex-Ohmeda Division of Instrumentarium Corporation is incorporated herein by reference to Exhibit 10.21 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2000 (File No. 0-24663).
 
  10 .15   Sublease Agreement, dated as of October 15, 1999, by and between Newton Technology Park LLC and the Registrant is incorporated herein by reference to Exhibit 10.24 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2000 (File No. 0-24663 Iomega).
 
  10 .16   Revolving Credit Facility, dated as of May 16, 2001, by and between the Registrant and Fleet National Bank, together with Promissory Note, dated May 16, 2001, by and between the Registrant and Fleet National Bank and Pledge Agreement, dated as of May 16, 2001, by and between the Registrant and Fleet National Bank is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended June 30, 2001 (File No. 0-24663).
 
  10 .17   First Amendment, dated December 21, 2001, to Loan Agreement, dated as of May 16, 2001, by and between the Registrant and Fleet National Bank is incorporated herein by reference to Exhibit 10.26 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2001 (File No. 0-24663).
 
  10 .18†   Addendum No. 1, effective January 1, 2002, to OEM Development and Purchase Agreement, dated December 22, 1999, by and between the Registrant and GE Medical Systems, Inc. is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended March 30, 2002 (File No. 0-24663).
 
  10 .19   Advisory Board Agreement, dated as of January 23, 2002, by and between Stephen E. Coit and the Registrant is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q for the period ended March 30, 2002 (File No. 0-24663).
 
  10 .20   Stock Purchase Agreement, dated as of August 7, 2002, by and between the Registrant and Boston Scientific Corporation is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated August 7, 2002 (File No. 0-24663).
 
  10 .21   Registration Rights Agreement, dated as of August 7, 2002, by and between the Registrant and Boston Scientific Corporation is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Current Report on Form 8-K dated August 7, 2002 (File No. 0-24663).
 
  10 .22   Loan Agreement, dated August 7, 2002, by and between the Registrant and Boston Scientific Corporation, together with Security Agreement, dated August 7, 2002, by and between the Registrant and Boston Scientific Corporation and Promissory Note dated as of August 7, 2002, made by the Registrant in favor of Boston Scientific Corporation are incorporated herein by reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K dated August 7, 2002 (File No. 0-24663).

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Table of Contents

         
Exhibit    
No.   Exhibit
     
 
  10 .23†   OEM Product Development Agreement, dated as of August 7, 2002, by and between the Registrant and Boston Scientific Corporation is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended September 28, 2002 (File No. 0-24663).
 
  10 .24   Third Amendment, dated March 21, 2003, to Loan Agreement, dated as of May 16, 2001, by and between the Registrant and Fleet National Bank is incorporated herein by reference to Exhibit 10.33 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2002 (File No. 0-24663).
 
  10 .25†   OEM Development and Purchase Agreement, dated February 13, 2002, by and between the Registrant and Dixtal Biomedica Ind E Com Ltda. is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended March 29, 2003 (File No. 0-24663).
 
  10 .26   Special Bonus Program for Nassib G. Chamoun dated April 24, 2003 is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q for the period ended March 29, 2003 (File No. 0-24663).
 
  10 .27†   OEM Development and Purchase Agreement, dated July 24, 2003, by and between the Registrant and Datascope Corp. is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended September 27, 2003 (File No. 0-24663).
 
  10 .28†   Addendum 1, effective January 1, 2003, to the OEM Purchase Agreement, dated September 1, 2000, by and between the Registrant and Datex-Ohmeda Division of Instrumentarium Corporation is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q for the period ended September 27, 2003 (File No. 0-24663).
 
  10 .29†   Addendum 1, Effective January 1, 2003, to the OEM Development and Purchase Agreement, dated August 6, 1999, by and between the Registrant and Philips Medizinsysteme Boeblingen GmbH (formerly Agilent Technologies, Inc.) is incorporated herein by reference to Exhibit 10.35 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2003 (File No. 0-24663).
 
  10 .30†   Addendum 3, effective March 13, 2003, to the OEM Development and Purchase Agreement, dated December 22, 1999, by and between the Registrant and GE Marquette Medical Systems, Inc is incorporated herein by reference to Exhibit 10.36 to the Registrant’s Annual Report on Form 10-K for the year ended December 31, 2003 (File No. 0-24663).
 
  10 .31†   BISx Development, Purchase and License Agreement dated January 28, 2004, by and between the Registrant and Draeger Medical Systems, Inc. is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 2004 (File No. 0-24663).
 
  10 .32†   Addendum 2, effective January 1, 2004, to the OEM Development and Purchase Agreement, dated August 6, 1999, by and between the Registrant and Philips Medizinsysteme Boeblingen GmbH (formerly Agilent Technologies, Inc.) is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 2004 (File No. 0-24663).
 
  10 .33   Stock Purchase Agreement, dated as of April 7, 2004, by and between the Registrant and Boston Scientific Corporation is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K dated April 7, 2004 (File No. 0-24663) is incorporated herein by reference to Exhibit 10.3 to the Registrant’s Quarterly Report on Form 10-Q for the period ended April 3, 2004 (File No. 0-24663).
 
  10 .34   Fifth Amendment, dated May 14, 2004, to Loan Agreement, dated as of May 16, 2001, by and between the Registrant and Fleet National Bank, together with Deposit Pledge Agreement, dated May 14, 2004, by and between the Registrant and Fleet National Bank is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended July 3, 2004 (File No. 0-24663).

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Table of Contents

         
Exhibit    
No.   Exhibit
     
 
  10 .35†   Exclusive License Agreement, dated July 1, 2004, by and between the Registrant and The Regents of the University of California is incorporated herein by reference to Exhibit 10.2 to the Registrant’s Quarterly Report on Form 10-Q for the period ended July 3, 2004 (File No. 0-24663).
 
  10 .36   Sixth Amendment, dated October 8, 2004, to Loan Agreement, dated May 16, 2001, by and between the Registrant and Fleet National Bank is incorporated herein by reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-Q for the period ended October 2, 2004 (File No. 0-24663).
 
  10 .37   2001 Stock Incentive Plan, is incorporated herein by reference to the Registrant’s Definitive Proxy Statement filed on April 18, 2001 (File No. 0-24663).
 
  10 .38   Executive Officer 2005 Bonus Plan is incorporated herein by reference to the Registrants Current Report on Form 8-K dated February 17, 2005 (File No. 0-24663).
 
  10 .39   Form of Stock Option Agreement Granted Under 2001 Stock Incentive Plan.
 
  10 .40   Cash Compensation for Non-Management Directors of Aspect Medical Systems, Inc.
 
  10 .41   Base Salaries of Named Executive Officers of Aspect Medical Systems, Inc.
 
  21 .1   Subsidiaries of the Registrant.
 
  23 .1   Consent of Ernst & Young LLP.
 
  31 .1   Certification by Chief Executive Officer Pursuant to Rule 13a-14(a) and 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) and 15d-14(a) of the Securities Exchange Act of 1934, as amended.
 
  32 .1   Certification by Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
  32 .2   Certification by Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
†  Confidential treatment has been requested as to certain portions of this Exhibit. Such portions have been omitted and filed separately with the Securities and Exchange Commission.

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