item 14 exhibits financial statement schedules reports form 8k documents filed part report 1 financial statements following financial statements nettaxicom included separate section annual report form 10k commencing pages referenced report independent certified public accountants consolidated financial statements consolidated balance sheets consolidated statements operations consolidated statements shareholders deficiency equity consolidated statements cash flows notes consolidated financial statements 2 financial statement schedules financial statement schedules nettaxicom omitted applicable required information included consolidated financial statements notes thereto 3 exhibits following exhibits attached hereto incorporated herein reference exhibit number description exhibit 21 agreement plan reorganization dated september 24 1998 among nettaxi online communities inc owners outstanding shares common stock nettaxi online communities inc company 22 merger agreement plan reorganization dated april 1 1999 plus net inc company 31 articles incorporation company 32 certificate amendment articles incorporation company 33 bylaws company 34 certificate amendment articles incorporation 41 specimen common stock certificate company 42 see exhibits 31 32 33 provisions articles incorporation bylaws company defining rights holders common stock company 43 convertible debenture dated march 31 1999 favor rgc international investors ldc 44 1999 stock option plan company 45 form stock option agreement options issued pursuant 1999 stock option plan company 101 asset purchase sale agreement dated october 1 1997 ssn properties llc company 102 sub lease dated september 3 1997 execustaff company 103 intentionally blankupdated form agreement filed exhibit 1042 104 intentionally blankupdated form agreement filed exhibit 1043 105 stock option agreement dated march 20 1998 robert rositano jr company 106 stock option agreement dated march 20 1998 dean rositano company 107 intentionally blankupdated form agreement filed exhibit 1044 108 intentionally blankupdated form agreement filed exhibit 1045 109 employment agreement dated august 1 1998 dean rositano company 1010 employment agreement dated august 1 1998 robert rositano jr company 1011 stock option agreement dated august 1 1998 robert rositano jr company 1012 stock option agreement dated august 1 1998 dean rositano company 1013 intentionally blankupdated form agreement filed exhibit 1046 1014 letter agreement dated september 3 1998 bay tree capital associates llc company 1015 intentionally blankupdated form agreement filed exhibit 1047 1016 intentionally blankupdated form agreement filed exhibit 1048 1017 1998 stock option plan company 1018 form stock option agreement options issued pursuant 1998 stock option plan company 1019 stock option agreement 1998 stock option plan dean rositano company 1020 stock option agreement 1998 stock option plan robert rositano jr company 1021 intentionally blankupdated form agreement filed exhibit 1049 1022 technology licensing agreement dated february 3 1999 go hip inc company 1023 first amendment technology licensing agreement dated april 1 1999 go hip inc company 1024 intentionally blankupdated form agreement filed exhibit 1050 1025 intentionally blankupdated form agreement filed exhibit 1040 1026 intentionally blankupdated form agreement filed exhibit 1051 1027 intentionally blankupdated form agreement filed exhibit 1052 1028 settlement agreement dated march 2 1999 among michael gardner bay tree capital associates llp wall street trading group bruce k dorfman robert rositano jr dean rositano company 1029 common stock purchase option purchase common shares nettaxi inc dated march 4 1999 wall street trading group company 1030 securities purchase agreement dated march 31 1999 among rgc international investors ldc company 1031 stock purchase warrant dated march 31 1999 among rgc international investors ldc company 1032 registration rights agreement dated march 31 1999 among rgc international investors ldc company 1033 oppenheimer funds 401k plan 1034 standard office lease gross dated march 1999 south bay construction development co iii south bay construction development co vii company 1035 form indemnification agreement company directors executive officers 1036 intentionally blankupdated form agreement filed exhibit 1053 1037 employment agreement dated april 1 1999 mr glenn goelz company 1038 consulting agreement dated may 10 1999 fontenelle llc company 1039 intentionally blankupdated form agreement filed exhibit 1054 1040 intentionally blankupdated form agreement filed exhibit 1055 1041 lease agreement dated may 27 1999 hl realty management company agent owners flamingo fountains registrant 1042 master software license bundling distribution agreement dated november 13 1997 apple computer inc company 1043 master software license bundling distribution agreement dated march 14 1997 fountain technologies inc company 1044 web advertising services agreement dated june 3 1998 fly cast communications corporation company 1045 sales representation contract dated july 7 1998 michael weiner dba unique media services company 1046 merchant services agreement dated august 3 1998 echarge corporation company 1047 conversion agreement dated september 4 1998 ssn properties llc company 1048 internet infospace content world wide web site distribution agreement dated october 8 1998 infospacecom inc delaware corporation company 1049 agreement terminal facility colocation space dated january 18 1999 alchemy communications inc company 1050 letter agreement dated january 15 1999 babenet ltd company 1051 license distribution agreement dated march 30 1999 netopia inc company 1052 website linking promotion agreement dated march 5 1999 pi graphix inc company 1053 development agreement dated december 16 1998 big network inc company 1054 development license agreement dated may 1999 ebay inc company 1055 internet services suite agreement dated may 5 1999 wired digital inc lycos inc company 1056 financial consulting agreement dated june 29 1999 phoenix group international llc company 1057 master services agreement dated september 15 1997 exodus communications inc company 1058 gigabit data center services agreement dated july 1 1999 alchemy communications inc company 1059 advertising impression network contract dated july 1 1999 white sand communications inc company 1060 advertising impression network contract dated july 1 1999 multinet communications worldwide limited company 1061 data center service agreement dated july 15 1999 babenet ltd company 1062 data center service agreement dated july 15 1999 whitehorn ventures limited company 1063 data center service agreement dated august 15 1999 white sand communications inc company 1064 cobranded free isp agreement dated november 30 1999 spin media network inc company 1065 internet content distribution agreement dated december 30 1999 infospacecom company 1066 sinclair davis trading group agreement dated december 8 1999 sinclair davis trading corp company 1067 form subscription agreement company 211 subsidiaries company 231 intentionally blank updated exhibit 233 232 consent silicon valley law group included exhibit 51 233 intentionally blank updated exhibit 234 intentionally blank updated exhibit 235 consent bdo seidman llp 241 powers attorney included signature pages registration statement 271 financial data schedule incorporated reference exhibits filed registrants registration statement form s1 file 33378129 declared effective august 13 1999 incorporated reference exhibits filed registrants quarterly report form 10q period ending september 30 1999 incorporated reference exhibits filed registrants registration statement form s1 file 33330074 filed february 10 2000 incorporated reference exhibits filed registrants registration statement form s8 file 33332678 filed march 17 2000 b reports form 8k reports form 8k filed year ended december 31 1999 signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized nettaxicom date march 30 2000 glenn goelz glenn goelz chief financial officer principal accounting financial officer power attorney undersigned officers directors nettaxicom hereby severally constitute appoint glenn goelz true lawful attorneyinfact agent full power substitution resubstitution name place stead capacities sign amendments report file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneyinfact agent full power authority perform every act thing requisite necessary done connection therewith fully intents purposes might could person hereby ratifying confirming said attorneyinfact agent substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated signature title date robert rositano jr chief executive officer march 30 2000 robert rositano jr secretary director principal executive officer dean rositano president director march 30 2000 dean rositano glenn goelz vice president chief march 30 2000 financial officer principal glenn goelz accounting officer andrew garroni director march 30 2000 andrew garroni ron goldie director march 30 2000 ron goldie nettaxicom report independent certified public accountants board directors shareholders nettaxicom audited accompanying consolidated balance sheets nettaxicom december 31 1999 1998 related consolidated statements operations shareholders deficiency equity cash flows two years period ended december 31 1999 period october 23 1997 date inception december 31 1997 financial statements responsibility companys management responsibility express opinion financial statements based audits conducted audits accordance generally accepted auditing standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements referred present fairly material respects financial position nettaxicom december 31 1999 1998 results operations cash flows two years period ended december 31 1999 period october 23 1997 date inception december 31 1997 conformity generally accepted accounting principles san jose california february 15 2000 except matters discussed note 13 date march 9 2000 see accompanying notes consolidated financial statements nettaxicom consolidated balance sheets see accompanying notes consolidated financial statements see accompanying notes consolidated financial statements see accompanying notes consolidated financial statements nettaxicom consolidated statements cash flows note 11 see accompanying notes consolidated financial statements nettaxicom notes consolidated financial statements 1 summary accounting policies company nettaxicom formerly nettaxi inc formerly swan valley snowmobiles inc company nevada corporation incorporated october 26 1995 september 29 1998 company completed acquisition 100 outstanding common stock nettaxi online communities inc delaware corporation changed name nettaxi inc nettaxicom accounting purposes acquisition treated acquisition company nettaxi online communities inc nettaxi online communities inc acquiror shares per share data prior acquisition restated reflect stock issuance related stock split note 7 former shareholders nettaxi online communities inc received 85 shares company immediately acquisition financial statements periods prior reorganization nettaxi online communities inc effective may 7 1999 company completed merger single transaction plus net inc exchanging 7 million shares common stock common stock plus net inc share plus net exchanged 1000 shares nettaxi common stock merger constituted taxfree reorganization accounted pooling interest accounting principles board opinion 16 periods proceeding merger intercompany transactions require elimination combined consolidated results operations adjustments necessary conform accounting practices two companies merger plus net inc allowed company provide customers web based email program robust meta search engine plus net inc also ecommerce processing engine enabled acceptance processing online credit card transactions plus net inc reported revenues net loss 200 period ended december 31 1998 period january 1 may 7 1999 plus net inc revenues approximately 700000 net income approximately 413600 subsequent merger company ceased evaluation processing online credit card transactions business 1999 line business accounted approximately 1285000 companys revenues nettaxi online communities inc incorporated october 23 1997 capitalize significant opportunity exists today convergence media entertainment industries vast communications power internet companys web site httpwwwnettaxicom online community designed seamlessly integrate content ecommerce services companys subscribers providing comprehensive information news sports entertainment health politics finances lifestyle areas interest growing number internet users companys mission establish nettaxicom entry point portal internet continuing develop premium online communities contentrich subscribers provide easytouse ecommerce services businesses reside online communities companys principal executive offices located campbell california consolidation accompanying consolidated financial statements include accounts nettaxicom formerly nettaxi inc formerly swan valley snowmobile inc whollyowned subsidiary nettaxi online communities inc intercompany accounts transactions eliminated consolidated financial statements nettaxicom notes consolidated financial statements use estimates preparation consolidated financial statements conformity generally accepted accounting principles requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date consolidated financial statements reported amounts revenues expenses reporting period actual results could differ estimates nettaxicom notes consolidated financial statements cash equivalents company considers highly liquid investments original maturities 90 days less cash equivalents accounts receivable allowances doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews losses adjustment history current economic conditions factors deserve recognition estimating potential losses management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond managements control property equipment property equipment stated cost depreciation provided using straightline method estimated economic useful lives assets follows assets held capital leases amortized straightline basis shorter lease term estimated useful lives related assets nettaxicom notes consolidated financial statements purchased technology intangibles company amortizes straightline basis cost purchased technology intangibles shorter five 5 years useful life related technology underlying asset software development costs accordance statement financial accounting standards 86 accounting costs computer software sold leased otherwise marketed software development costs expensed incurred technological feasibility established time costs capitalized product available general release customers date establishments technological feasibility companys products general release software substantially coincided result software development costs qualifying capitalization insignificant therefore company capitalized software development costs revenue recognition deferred revenue companys revenues derived principally sale banner advertisements web hosting services products online malls advertising revenues recognized period advertisement delivered provided collection resulting receivable probable advertisers charged per impression delivery basis maximum specified contract date duration companys advertising commitments exceeded one year company guarantees minimum number impressions deliveries revenue recognized ratably proportion number impressions deliveries recorded minimum number impressions deliveries guaranteed deferred revenue resulting advertising agreements aggregated 0 47000 december 31 1999 1998 amortized straightline basis advertising agreement web hosting revenues recognized period services provided product revenue recognized upon shipment provided significant obligations remain collectability probable nettaxicom notes consolidated financial statements advertising revenue include barter revenues exchange nettaxicom advertising space nettaxicoms web sites reciprocal advertising space web sites revenues barter transactions recorded advertising revenues lower estimated fair value advertisements received delivered recognized advertisements run nettaxicoms web sites barter expenses recorded nettaxicoms advertisements run reciprocal web sites typically period advertisements run nettaxicoms web sites 1999 barter revenues represented 7 net revenues barter revenue year ended december 31 1998 period ended december 31 1997 november 1999 financial accounting standards board fasb issued emerging issues task force eitf issue 9917 accounting advertising barter transactions eitf 9917 revenues expenses recognized advertising barter transactions fair value advertising surrendered received company historical practice receiving paying cash transactions december 31 1999 company compliance eitf 9917 income taxes company accounts income taxes accordance statement financial accounting standards sfas 109 accounting income taxes requires asset liability approach results recognition deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent future tax return consequences differences either deductible taxable assets liabilities recovered settled future tax benefits subject valuation allowance management believes likely deferred tax assets realized nettaxicom notes consolidated financial statements advertising costs cost advertising expensed incurred advertising costs year ended december 31 1999 1998 period ended december 31 1997 approximately 2831300 3100 300 respectively longlived assets company periodically reviews longlived assets impairment events changes circumstances indicate carrying amount asset may recoverable company writes asset net realizable value fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments cash equivalents carrying amount reported consolidated balance sheets cash equivalents approximates fair value shortterm debt fair value shortterm debt approximates cost short period time maturity longterm debt fair value longterm debt estimated based current interest rates available company debt instruments similar terms remaining maturities related party notes receivable payable fair value notes receivable notes payable shareholders based armslength transactions bear interest rates comparable similar debt obligations nettaxicom notes consolidated financial statements december 31 1999 1998 fair values companys debt instruments approximate historical carrying amounts stockbased incentive program sfas 123 accounting stockbased compensation encourages entities recognize compensation costs stockbased employee compensation plans using fair value based method accounting defined sfas 123 allows continued use intrinsic value based method accounting prescribed accounting principles board apb opinion 25 accounting stock issued employees company continues use accounting prescribed apb opinion 25 required disclose pro forma net income loss earnings loss per share fair value based method accounting applied note 7 basic diluted loss per common share february 1997 fasb issued sfas 128 earnings per share effective december 28 1997 conforming sfas 128 company changed method computing earnings per share restated prior periods included consolidated financial statements basic loss per common share determined dividing loss available common shareholders weighted average number common shares outstanding diluted percommonshare amounts assume issuance common stock potentially dilutive equivalent shares outstanding antidilution provisions sfas 128 require consistency diluted percommonshare amounts basic percommonshare amounts loss periods reported differences basic diluted earnings per share number potential common shares included diluted earnigns per share due antidilutive 3838679 280000 0 years ended december 31 1999 1998 period ended december 31 1997 respectively share per share information adjusted shares exchanged common stock plus net inc nettaxicom notes consolidated financial statements adoption new accounting pronouncements february 1998 financial accounting standards board fasb issued sfas 132 employers disclosure pensions postretirement benefits standardizes disclosure requirements pension postretirement benefits adoption sfas 132 impact companys current disclosures june 1998 fasb issued sfas 133 accounting derivative instruments hedging activities sfas 133 requires companies recognize derivatives contracts either assets liabilities balance sheet measure fair value certain conditions met derivative may specifically designated hedge objective match timing gain loss recognition hedging derivative recognition changes fair value hedged asset liability attributable hedged risk ii earnings effect hedged forecasted transaction derivative designated hedging instrument gain loss recognized income period change june 1999 fasb issued sfas 137 accounting derivative instruments hedging activities deferral effective date fasb statement 133 amends sfas 133 effective fiscal quarters fiscal years beginning june 15 2000 historically company entered derivative contracts either hedge existing risks speculative purposes accordingly company expect adoption new standard material impact companys results operations financial position cash flows nettaxicom notes consolidated financial statements 2 property equipment property equipment consisted following equipment capital lease obligations aggregated 14700 december 31 1999 1998 related accumulated amortization 1500 500 respectively 3 purchased technology intangibles november 1997 company issued convertible secured promissory note amount 1020000 note 6 2475066 shares common stock valued 980000 related party exchange certain fixed assets liabilities technology core technology acquired web database software application underlying technology companys internet city products based fair market value consideration exchanged determined independent appraisal service aggregate purchase price 2000000 allocated following respective assets liabilities based fair market value time transaction nettaxicom notes consolidated financial statements 1998 company experienced several functional problems portions purchased technology namely web database software application due components incompatibility subsequent releases upgraded versions operating system following attempts make components compatible company decided december 1998 spend additional monies components replace approximately 50 components acquired technology longer technically viable upgraded versions companys operating system provided alternative future use company wrote unamortized portion impaired technology resulting charge expense 667000 purchased technology intangibles consisted following nettaxicom notes consolidated financial statements 4 accrued expenses accrued expenses consisted following 5 lease commitments company leases facility operating lease expires may 31 2003 facility lease requires company pay certain maintenance operating expenses taxes insurance utilities rent expense years ended december 31 1999 1998 period ended december 31 1997 178000 35500 6800 respectively 1999 company entered operating leases certain vehicles year ended december 31 1999 rent expense related vehicle leases aggregated 2600 summary future minimum lease payments capitalized leases together present value minimum lease payments future minimum payments required noncancelable operating leases terms excess one year follows nettaxicom notes consolidated financial statements 6 convertible notes payable related party november 1 1997 company issued 10 fiveyear convertible secured promissory note amount 1020000 september 1998 note accrued interest 85800 converted 2792763 shares common stock interest expense note aggregated 68800 1998 17000 period ended december 31 1997 march 31 1999 company entered 5000000 convertible debt financing agreement rgc international investors ldc rgc convertible debenture bears interest 5 matures march 31 2004 debentures convertible option holder number shares common stock equal principal amount debentures converted including accrued interest divided conversion price specified debentures conversion price lesser variable fixed conversion price variable conversion price based trading price companys common stock fixed period conversion debentures fixed conversion price 1188 fixed conversion price represents 120 average three lowest trades ten days prior effective date agreement november december 1999 rgc converted 1800000 debentures accrued interest 63300 802223 shares common stock december 31 1999 accrued interest remaining debentures aggregated 125500 nettaxicom notes consolidated financial statements 7 shareholders equity preferred stock october 1997 company offered shares preferred stock private placement offering established maximum 150000 shares series preferred stock 075 per share convertible 505 shares companys common stock time year ended december 31 1998 period ended december 31 1997 company issued 11400 134000 shares series preferred stock offering net cash proceeds 8600 100500 respectively shares issued discount fair market value stock company recorded deemed preferred stock dividends 14300 167500 year ended december 31 1998 period ended december 31 1997 respectively september 1998 shares series preferred stock converted 734438 shares companys common stock common stock october 1997 company offered shares common stock private placement offering established maximum 1262650 shares common stock 040 per share 1998 company issued 506378 shares common stock offering net proceeds 200500 year ended december 31 1998 period ended december 31 1997 company issued 252045 88395 shares common stock ascribed values 120000 35000 payments services respectively shares issued connection payments services performed valued fair market value share issued october 1997 private placement offering nettaxicom notes consolidated financial statements year ended december 31 1998 period ended december 31 1997 company issued 76087 99442 shares common stock ascribed values 22800 17500 officers employees company lieu salaries respectively september 1998 companys board directors declared 253 1 stock split connection acquisition discussed note 1 references number shares common stock per share data consolidated financial statements adjusted reflect stock split retroactive basis september 1998 connection acquisition company offered shares common stock private placement offering established maximum 1250000 shares common stock 080 per share placement agent received 200000 shares common stock fair market value 160000 company issued 1250000 shares common stock offering net proceeds 999600 may 1999 company completed merger single transaction plus net inc exchanging 7000000 shares common stock common stock plus net inc share plus net exchanged 1000 shares nettaxi common stock accordance convertible debt financing agreement entered company rgc international investors ldc march 31 1999 rgc option purchase one additional share common stock every share common stock issuable result conversion debenture price equal applicable conversion price november december 1999 rgc exercised investment option right purchased 802223 shares companys common stock proceeds 1863300 december 1999 company issued 350000 shares common stock consulting group exchange twoyear agreement provide company consulting services based fair market value shares issued price services determined 1060800 nettaxicom notes consolidated financial statements included prepaid expenses deferred expenses december 31 1999 1026600 representing unamortized portion consulting services warrants 1998 prior adoption stock option plan discussed company granted warrants officers employees consultants company purchase 2399298 shares common stock 004 september 1998 warrants exchanged 2399298 shares common stock via issuance promissory notes 95000 concurrent reorganization company promissory notes accounted common stock subscribed offset shareholders equity notes collected accordance apb opinion 25 accounting stock issued employees company recorded 855000 compensation costs associated warrants conjunction agreement entered company rgc march 31 1999 company issued warrants vested immediately purchase 150000 shares common stock 12375 company recognized additional 115500 interest expense associated warrants august 1999 company entered agreement rgc pursuant exercised warrants consideration early exercise warrants exercise price warrants decreased 12375 7875 company issued rgc warrants purchase additional 150000 shares common stock 7875 company recognize additional 245700 interest expense associated warrants 1999 company recognized 86700 amount interest expense nettaxicom notes consolidated financial statements stock option program september 29 1998 company adopted stock option plan restricted employees officers consultants company options granted plan generally vest three years exercisable ten years nonstautory options granted prices less 85 estimated fair value stock date grant determined board directors incentive options granted prices less 100 estimated fair value stock date grant however options granted shareholders greater 10 outstanding stock established less 110 estimated fair value stock date grant company reserved three million shares common stock issuance plan nettaxicom notes consolidated financial statements summary status companys stock option plan december 31 1999 december 31 1998 changes years ended presented following table following table summarizes information stock options outstanding december 31 1999 nettaxicom notes consolidated financial statements connection grant certain stock options 1999 company recorded deferred compensation 702700 representing difference deemed fair market value exercise price options determined board directors date grant deferred compensation amortized vesting period underlying options amount recognized compensation expense 1999 amounted 211300 sfas 123 accounting stockbased compensation requires company provide pro forma information regarding net loss income loss earnings per share compensation cost companys stock option plan determined accordance fair value based method prescribed sfas no123 company estimates fair value stock options grant date using blackscholes option pricingmodel following weighted average assumptions used grants 1999 1998 dividend yield 0 expected volatility 112 180 riskfree interest rate 62 57 expected lives three years plan options company adopted stock option plan september 1998 consequently stock options granted 1997 accounting provisions sfas 123 companys net loss basic diluted net loss per common share would adjusted pro forma amounts nettaxicom notes consolidated financial statements 8 income taxes provision income taxes year ended december 31 1999 relates earnings plus net inc prior merger provision income taxes year ended december 31 1998 period ended december 31 1997 consisted minimum state taxes following summarizes differences income tax expense amount computed applying federal income tax rate 34 years ended december 31 1999 1998 period ended december 31 1997 deferred income taxes benefits result temporary timing differences recognition certain expenses income items tax financial reporting purposes follows company net operating loss carryforwards available reduce future taxable income approximately 11200000 federal income tax purposes benefits carryforwards expire 2019 december 31 1999 management cannot determine likely carryforwards deferred tax assets realized accordingly fully reserved deferred tax assets nettaxicom notes consolidated financial statements pursuant change ownership provisions tax reform act 1986 utilization companys net operating loss research development tax credit carryforwards may limited cumulative change ownership 50 occurs within threeyear period company determined ownership change occurred 9 concentration credit risk financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade receivables company places cash equivalents high quality financial institutions policy limits amounts credit exposure one financial institution companys accounts receivable derived many customers various industries company believes risk accounting loss significantly reduced due diversity endcustomers geographic sales areas company performs credit evaluation customers financial condition whenever necessary generally require cash collateral security support customer receivables 10 major customers year ended december 31 1999 one customer accounted approximately 17 revenues related account receivable december 31 1999 250000 year ended december 31 1998 four customers accounted approximately 28 21 13 12 revenues respectively related accounts receivable december 31 1998 52100 38100 0 23800 respectively period ended december 31 1997 one customer accounted approximately 84 revenues related account receivable december 31 1997 59100 nettaxicom notes consolidated financial statements 11 supplemental disclosure cash flow information following supplemental disclosure statements cash flows 12 contingencies company involved litigation arising ordinary course business opinion management consulting legal counsel matters without merit resolved without material adverse effect companys financial position results operations cash flows 13 subsequent events january february 2000 rgc converted 800000 debentures accrued interest 35000 631932 shares common stock conjunction conversions rgc also exercised investment option right purchased 631932 shares companys common stock proceeds 835000 january 2000 company adopted new stock option plan addition plan adopted 1998 company reserved 3300000 shares common stock issuance new plan nettaxicom notes consolidated financial statements january 2000 company granted options new stock option plan purchase 1508800 shares common stock exercise price 244 per share certain members board directors employees company november 1999 company retained services investment banking firm assist securing private placement additional capital march 9 2000 company issued 300000 shares proceeds 450000 additional 6700000 held escrow agent release company upon issuance common stock sold 150 per share subscribers private placement services investment bank receive 350000 shares companys common stock valued 525000 14 valuation qualifying accounts additions balance charged balance beginning costs end description period expenses deductions period 1999 allowance doubtful accounts 31200 52400 83600 1998 allowance doubtful accounts 31200 1997 allowance doubtful accounts index exhibits exhibit number description exhibit 21 agreement plan reorganization dated september 24 1998 among nettaxi online communities inc owners outstanding shares common stock nettaxi online communities inc company 22 merger agreement plan reorganization dated april 1 1999 plus net inc company 31 articles incorporation company 32 certificate amendment articles incorporation company 33 bylaws company 34 certificate amendment articles incorporation 41 specimen common stock certificate company 42 see exhibits 31 32 33 provisions articles incorporation bylaws company defining rights holders common stock company 43 convertible debenture dated march 31 1999 favor rgc international investors ldc 44 1999 stock option plan company 45 form stock option agreement options issued pursuant 1999 stock option plan company 101 asset purchase sale agreement dated october 1 1997 ssn properties llc company 102 sub lease dated september 3 1997 execustaff company 103 intentionally blankupdated form agreement filed exhibit 1042 104 intentionally blankupdated form agreement filed exhibit 1043 105 stock option agreement dated march 20 1998 robert rositano jr company 106 stock option agreement dated march 20 1998 dean rositano company 107 intentionally blankupdated form agreement filed exhibit 1044 108 intentionally blankupdated form agreement filed exhibit 1045 109 employment agreement dated august 1 1998 dean rositano company 1010 employment agreement dated august 1 1998 robert rositano jr company 1011 stock option agreement dated august 1 1998 robert rositano jr company 1012 stock option agreement dated august 1 1998 dean rositano company 1013 intentionally blankupdated form agreement filed exhibit 1046 1014 letter agreement dated september 3 1998 bay tree capital associates llc company 1015 intentionally blankupdated form agreement filed exhibit 1047 1016 intentionally blankupdated form agreement filed exhibit 1048 1017 1998 stock option plan company 1018 form stock option agreement options issued pursuant 1998 stock option plan company 1019 stock option agreement 1998 stock option plan dean rositano company 1020 stock option agreement 1998 stock option plan robert rositano jr company 1021 intentionally blankupdated form agreement filed exhibit 1049 1022 technology licensing agreement dated february 3 1999 go hip inc company 1023 first amendment technology licensing agreement dated april 1 1999 go hip inc company 1024 intentionally blankupdated form agreement filed exhibit 1050 1025 intentionally blankupdated form agreement filed exhibit 1040 1026 intentionally blankupdated form agreement filed exhibit 1051 1027 intentionally blankupdated form agreement filed exhibit 1052 1028 settlement agreement dated march 2 1999 among michael gardner bay tree capital associates llp wall street trading group bruce k dorfman robert rositano jr dean rositano company 1029 common stock purchase option purchase common shares nettaxi inc dated march 4 1999 wall street trading group company 1030 securities purchase agreement dated march 31 1999 among rgc international investors ldc company 1031 stock purchase warrant dated march 31 1999 among rgc international investors ldc company 1032 registration rights agreement dated march 31 1999 among rgc international investors ldc company 1033 oppenheimer funds 401k plan 1034 standard office lease gross dated march 1999 south bay construction development co iii south bay construction development co vii company 1035 form indemnification agreement company directors executive officers 1036 intentionally blankupdated form agreement filed exhibit 1053 1037 employment agreement dated april 1 1999 mr glenn goelz company 1038 consulting agreement dated may 10 1999 fontenelle llc company 1039 intentionally blankupdated form agreement filed exhibit 1054 1040 intentionally blankupdated form agreement filed exhibit 1055 1041 lease agreement dated may 27 1999 hl realty management company agent owners flamingo fountains registrant 1042 master software license bundling distribution agreement dated november 13 1997 apple computer inc company 1043 master software license bundling distribution agreement dated march 14 1997 fountain technologies inc company 1044 web advertising services agreement dated june 3 1998 fly cast communications corporation company 1045 sales representation contract dated july 7 1998 michael weiner dba unique media services company 1046 merchant services agreement dated august 3 1998 echarge corporation company 1047 conversion agreement dated september 4 1998 ssn properties llc company 1048 internet infospace content world wide web site distribution agreement dated october 8 1998 infospacecom inc delaware corporation company 1049 agreement terminal facility colocation space dated january 18 1999 alchemy communications inc company 1050 letter agreement dated january 15 1999 babenet ltd company 1051 license distribution agreement dated march 30 1999 netopia inc company 1052 website linking promotion agreement dated march 5 1999 pi graphix inc company 1053 development agreement dated december 16 1998 big network inc company 1054 development license agreement dated may 1999 ebay inc company 1055 internet services suite agreement dated may 5 1999 wired digital inc lycos inc company 1056 financial consulting agreement dated june 29 1999 phoenix group international llc company 1057 master services agreement dated september 15 1997 exodus communications inc company 1058 gigabit data center services agreement dated july 1 1999 alchemy communications inc company 1059 advertising impression network contract dated july 1 1999 white sand communications inc company 1060 advertising impression network contract dated july 1 1999 multinet communications worldwide limited company 1061 data center service agreement dated july 15 1999 babenet ltd company 1062 data center service agreement dated july 15 1999 whitehorn ventures limited company 1063 data center service agreement dated august 15 1999 white sand communications inc company 1064 cobranded free isp agreement dated november 30 1999 spin media network inc company 1065 internet content distribution agreement dated december 30 1999 infospacecom company 1066 sinclair davis trading group agreement dated december 8 1999 sinclair davis trading corp company 1067 form subscription agreement company 211 subsidiaries company 231 intentionally blank updated exhibit 233 232 consent silicon valley law group included exhibit 51 233 intentionally blank updated exhibit 234 intentionally blank updated exhibit 235 consent bdo seidman llp 241 powers attorney included signature pages registration statement 271 financial data schedule incorporated reference exhibits filed registrants registration statement form s1 file 33378129 declared effective august 13 1999 incorporated reference exhibits filed registrants quarterly report form 10q period ending september 30 1999 incorporated reference exhibits filed registrants registration statement form s1 file 33330074 filed february 10 2000 incorporated reference exhibits filed registrants registration statement form s8 file 33332678 filed march 17 2000item 14 exhibits financial statement schedules reports form 8k documents filed part report 1 financial statements following financial statements nettaxicom included separate section annual report form 10k commencing pages referenced 2 financial statement schedules financial statement schedules nettaxicom omitted applicable required information included consolidated financial statements notes thereto 3 exhibits following exhibits attached hereto incorporated herein reference exhibit number description exhibit 21 agreement plan reorganization dated september 24 1998 among nettaxi online communities inc owners outstanding shares common stock nettaxi online communities inc company incorporated reference exhibit 21 filed registrants registration statement form s1 file 33378129 declared effective august 13 1999 22 merger agreement plan reorganization dated april 1 1999 plus net inc company incorporated reference exhibit 22 filed registrants registration statement form s1 file 33378129 31 articles incorporation company incorporated reference exhibit 31 filed registrants registration statement form s1 file 33378129 32 certificate amendment articles incorporation company incorporated reference exhibit 32 filed registrants registration statement form s1 file 33378129 33 bylaws company incorporated reference exhibit 33 filed registrants registration statement form s1 file 33378129 34 certificate amendment articles incorporation company incorporated reference exhibit 34 filed registrants quarterly report form 10q quarter ended september 30 1999 35 certificate amendment articles incorporation company previously filed registration statement 41 specimen common stock certificate company incorporated reference exhibit 41 filed registrants registration statement form s1 file 33378129 42 see exhibits 31 32 33 provisions articles incorporation bylaws company defining rights holders common stock company 43 convertible debenture dated march 31 1999 favor rgc international investors ldc incorporated reference exhibit 43 filed registrants registration statement form s1 file 33378129 44 1999 stock option plan company incorporated reference exhibit 44 filed registrants registration statement form s8 file 33332678 filed march 17 2000 45 form stock option agreement options issued pursuant 199 stock option plan company incorporated reference exhibit 45 filed registrants registration statement form s8 file 33332678 101 asset purchase sale agreement dated october 1 1997 ssn properties llc company incorporated reference exhibit 101 filed registrants registration statement form s1 file 33378129 102 sub lease dated september 3 1997 execustaff company incorporated reference exhibit 102 filed registrants registration statement form s1 file 33378129 103 stock option agreement dated march 20 1998 robert rositano jr company incorporated reference exhibit 105 filed registrants registration statement form s1 file 33378129 104 stock option agreement dated march 20 1998 dean rositano company incorporated reference exhibit 106 filed registrants registration statement form s1 file 33378129 105 employment agreement dated august 1 1998 dean rositano company incorporated reference exhibit 109 filed registrants registration statement form s1 file 33378129 106 employment agreement dated august 1 1998 robert rositano jr company incorporated reference exhibit 1010 filed registrants registration statement form s1 file 33378129 107 stock option agreement dated august 1 1998 robert rositano jr company incorporated reference exhibit 1011 filed registrants registration statement form s1 file 33378129 108 stock option agreement dated august 1 1998 dean rositano company incorporated reference exhibit 1012 filed registrants registration statement form s1 file 33378129 109 letter agreement dated september 3 1998 bay tree capital associates llc company incorporated reference exhibit 1014 filed registrants registration statement form s1 file 33378129 1010 1998 stock option plan company incorporated reference exhibit 1017 filed registrants registration statement form s1 file 33378129 1011 form stock option agreement options issued pursuant 1998 stock option plan company incorporated reference exhibit 1018 filed registrants registration statement form s1 file 33378129 1012 stock option agreement 1998 stock option plan dean rositano company incorporated reference exhibit 1019 filed registrants registration statement form s1 file 33378129 1013 stock option agreement 1998 stock option plan robert rositano jr company incorporated reference exhibit 1020 filed registrants registration statement form s1 file 33378129 1014 technology licensing agreement dated february 3 1999 go hip inc company incorporated reference exhibit 1022 filed registrants registration statement form s1 file 33378129 1015 first amendment technology licensing agreement dated april 1 1999 go hip inc company incorporated reference exhibit 1023 filed registrants registration statement form s1 file 33378129 1016 settlement agreement dated march 2 1999 among michael gardner bay tree capital associates llp wall street trading group bruce k dorfman robert rositano jr dean rositano company incorporated reference exhibit 1028 filed registrants registration statement form s1 file 33378129 1017 common stock purchase option purchase common shares nettaxi inc dated march 4 1999 wall street trading group company incorporated reference exhibit 1029 filed registrants registration statement form s1 file 33378129 1018 securities purchase agreement dated march 31 1999 among rgc international investors ldc company incorporated reference exhibit 1030 filed registrants registration statement form s1 file 33378129 1019 stock purchase warrant dated march 31 1999 among rgc international investors ldc company incorporated reference exhibit 1031 filed registrants registration statement form s1 file 33378129 1020 registration rights agreement dated march 31 1999 among rgc international investors ldc company incorporated reference exhibit 1032 filed registrants registration statement form s1 file 33378129 1021 oppenheimer funds 401k plan incorporated reference exhibit 1033 filed registrants registration statement form s1 file 33378129 1022 standard office lease gross dated march 1999 south bay construction development co iii south bay construction development co vii company incorporated reference exhibit 1034 filed registrants registration statement form s1 file 33378129 1023 form indemnification agreement company directors executive officers incorporated reference exhibit 1035 filed registrants registration statement form s1 file 33378129 1024 employment agreement dated april 1 1999 mr glenn goelz company incorporated reference exhibit 1037 filed registrants registration statement form s1 file 33378129 1025 consulting agreement dated may 10 1999 fontenelle llc company incorporated reference exhibit 1038 filed registrants registration statement form s1 file 33378129 1026 lease agreement dated may 27 1999 hl realty management company agent owners flamingo fountains registrant incorporated reference exhibit 1041 filed registrants registration statement form s1 file 33378129 1027 master software license bundling distribution agreement dated november 13 1997 apple computer inc company incorporated reference exhibit 1042 filed registrants registration statement form s1 file 33378129 1028 master software license bundling distribution agreement dated march 14 1997 fountain technologies inc company incorporated reference exhibit 1043 filed registrants registration statement form s1 file 33378129 1029 web advertising services agreement dated june 3 1998 fly cast communications corporation company incorporated reference exhibit 1044 filed registrants registration statement form s1 file 33378129 1030 sales representation contract dated july 7 1998 michael weiner dba unique media services company incorporated reference exhibit 1045 filed registrants registration statement form s1 file 33378129 1031 merchant services agreement dated august 3 1998 echarge corporation company incorporated reference exhibit 4046 filed registrants registration statement form s1 file 33378129 1032 conversion agreement dated september 4 1998 ssn properties llc company incorporated reference exhibit 1047 filed registrants registration statement form s1 file 33378129 1033 internet infospace content world wide web site distribution agreement dated october 8 1998 infospacecom inc delaware corporation company incorporated reference exhibit 1048 filed registrants registration statement form s1 file 33378129 1034 agreement terminal facility colocation space dated january 18 1999 alchemy communications inc company incorporated reference exhibit 1049 filed registrants registration statement form s1 file 33378129 1035 letter agreement dated january 15 1999 babenet ltd company incorporated reference exhibit 1050 filed registrants registration statement form s1 file 33378129 1036 license distribution agreement dated march 30 1999 netopia inc company incorporated reference exhibit 1051 filed registrants registration statement form s1 file 33378129 1037 website linking promotion agreement dated march 5 1999 pi graphix inc company incorporated reference exhibit 1052 filed registrants registration statement form s1 file 33378129 1038 development agreement dated december 16 1998 big network inc company incorporated reference exhibit 1053 filed registrants registration statement form s1 file 33378129 1039 development license agreement dated may 1999 ebay inc company incorporated reference exhibit 1054 filed registrants registration statement form s1 file 33378129 1040 internet services suite agreement dated may 5 1999 wired digital inc lycos inc company incorporated reference exhibit 1055 filed registrants registration statement form s1 file 33378129 1041 financial consulting agreement dated june 29 1999 phoenix group international llc company incorporated reference exhibit 1056 filed registrants registration statement form s1 file 33378129 1042 cobranded free isp agreement dated november 30 1999 spin media network inc company incorporated reference exhibit 1057 filed registrants registration statement form s1 file 33378129 1043 internet content distribution agreement dated december 30 1999 infospacecom company incorporated reference exhibit 1058 filed registrants registration statement form s1 file 33378129 1044 advertising impression network contract dated july 1 1999 white sand communications inc company incorporated reference exhibit 1059 filed registrants quarterly report form 10q period ending september 30 1999 1045 advertising impression network contract dated july 1 1999 multinet communications worldwide limited companyincorporated reference exhibit 1060 filed registrants quarterly report form 10q period ending september 30 1999 1046 data center service agreement dated july 15 1999 babenet ltd company incorporated reference exhibit 1061 filed registrants quarterly report form 10q period ending september 30 1999 1047 data center service agreement dated july 15 1999 whitehorn ventures limited company incorporated reference exhibit 1062 filed registrants quarterly report form 10q period ending september 30 1999 1048 data center service agreement dated august 15 1999 white sand communications inc company incorporated reference exhibit 1063 filed registrants quarterly report form 10q period ending september 30 1999 1049 cobranded free isp agreement dated november 30 1999 spin media network inc company incorporated reference exhibit 1064 filed registrants registration statement form s1 file 33378129 1050 internet content distribution agreement dated december 30 1999 infospacecom company incorporated reference exhibit 1065 filed registrants registration statement form s1 file 33378129 1051 sinclair davis trading group agreement dated december 8 1999 sinclair davis trading corp company incorporated reference exhibit 1066 filed registrants annual report form 10k period ending december 31 1999 1052 form subscription agreement company incorporated reference exhibit1067 filed registrants annual report form 10k period ending december 31 1999 1053 letter intent agreement dated february 29 2000 ppc racing company previously filed registration statement 1054 registration rights agreement dated april 28 2000 rgc international investors ldc company incorporated reference exhibit 1054 filed registrants registration statement form s1 filed june 2 2000 1055 warrant agreement dated april 28 2000 rgc international investors ldc company incorporated reference exhibit 1054 filed registrants registration statement form s1 filed june 2 2000 1056 settlement agreement mutual general release dated april 28 2000 rgc international investors ldc rose glen capital management lp rgc general partner corporation steve katznelson gerald stahlecker chris hinkel company incorporated reference exhibit 1054 filed registrants registration statement form s1 filed june 2 2000 1057 consulting agreement dated october 29 2000 company michael gardner 1058 online advertising insertion order dated april 3 2000 company hearmecom 1059 content license agreement dated april 27 2000 company screamingmedia 1060 development revenue sharing agreement dated august 23 2000 company activeworldscom inc 1061 gotocom search services order dated september 1 2000 company gotocom 1062 webmall cobranded web page agreement dated september 7 2000 company storerunner network inc 1063 software license agreement dated september 29 2000 company annuncio software inc 1064 consulting services agreement dated october 11 2000 company annuncio software inc 1065 online advertising services contract dated february 1 2001 company fastclickcom inc 1066 gigabit data services agreement dated march 2001 company alchemy communications inc 1067 exit traffic agreement dated january 1 2000 company internet fuelcom inc 211 subsidiaries company incorporated reference exhibit 1057 filed registrants registration statement form s1 file 33378129 231 consent bdo seidman llp b reports form 8k none signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized nettaxicom date april 3 2001 dean rositano dean rositano chief financial officer principal accounting financial officer pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated signature title date robert rositano jr chief executive officer april 3 2001 secretary director robert rositano jr principal executive officer dean rositano president chief financial officer april 3 2001 director dean rositano principal accounting officer andrew garroni director april 3 2001 andrew garroni nettaxicom consolidated financial statements december 31 2000 1999 nettaxicom consolidated financial statements december 31 2000 1999 report independent certified public accountants board directors shareholders nettaxicom audited accompanying consolidated balance sheets nettaxicom december 31 2000 1999 related consolidated statements operations shareholders equity deficiency cash flows three years period ended december 31 2000 financial statements responsibility companys management responsibility express opinion financial statements based audits conducted audits accordance auditing standards generally accepted united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements referred present fairly material respects financial position nettaxicom december 31 2000 1999 results operations cash flows three years period ended december 31 2000 conformity accounting principles generally accepted united states bdo seidman llp san jose california march 8 2001 nettaxicom consolidated balance sheets see accompanying notes consolidated financial statements nettaxicom consolidated statements operations see accompanying notes consolidated financial statements nettaxicom consolidated statements shareholders equity deficiency notes 6 7 see accompanying notes consolidated financial statements nettaxicom consolidated statements cash flows note 11 see accompanying notes consolidated financial statements nettaxicom notes consolidated financial statements 1 summary company accounting policies nettaxicom formerly nettaxi inc formerly swan valley snowmobiles inc company nevada corporation incorporated october 26 1995 september 29 1998 company completed acquisition 100 outstanding common stock nettaxi online communities inc delaware corporation changed name nettaxi inc nettaxicom accounting purposes acquisition treated acquisition company nettaxi online communities inc nettaxi online communities inc acquiror shares per share data prior acquisition restated reflect stock issuance related stock split note 7 former shareholders nettaxi online communities inc received 85 shares company immediately acquisition financial statements periods prior reorganization nettaxi online communities inc effective may 7 1999 company completed merger single transaction plus net inc exchanging 7 million shares common stock common stock plus net inc share plus net exchanged 1000 shares nettaxi common stock merger constituted taxfree reorganization accounted pooling interest accounting principles board opinion 16 periods proceeding merger intercompany transactions require elimination combined consolidated results operations adjustments necessary conform accounting practices two companies merger plus net inc allowed company provide customers web based email program robust meta search engine plus net inc also ecommerce processing engine enabled acceptance processing online credit card transactions nettaxicom notes consolidated financial statements plus net inc reported revenues net loss 200 period ended december 31 1998 period january 1 may 7 1999 plus net inc revenues approximately 700000 net income approximately 413600 subsequent merger company ceased evaluation processing online credit card transactions business 1999 line business accounted approximately 1285000 companys revenues nettaxi online communities inc incorporated october 23 1997 capitalize significant opportunity exists today convergence media entertainment industries vast communications power internet companys web site httpwwwnettaxicom online community designed seamlessly integrate content ecommerce services companys subscribers providing comprehensive information news sports entertainment health politics finances lifestyle areas interest growing number internet users companys mission establish nettaxicom entry point portal internet continuing develop premium online communities contentrich subscribers provide easytouse ecommerce services businesses reside online communities companys principal executive offices located campbell california consolidation accompanying consolidated financial statements include accounts nettaxicom formerly nettaxi inc formerly swan valley snowmobile inc whollyowned subsidiary nettaxi online communities inc intercompany accounts transactions eliminated consolidated financial statements nettaxicom notes consolidated financial statements use estimates preparation consolidated financial statements conformity generally accepted accounting principles requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date consolidated financial statements reported amounts revenues expenses reporting period actual results could differ estimates cash equivalents company considers highly liquid investments original maturities 90 days less cash equivalents accounts receivable allowances doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews losses adjustment history current economic conditions factors deserve recognition estimating potential losses management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond managements control property equipment property equipment stated cost depreciation provided using straightline method estimated economic useful lives assets follows estimated useful lives furniture fixtures 5 years office equipment 5 years computers equipment 3 years nettaxicom notes consolidated financial statements assets held capital leases amortized straightline basis shorter lease term estimated useful lives related assets purchased technology intangibles company amortizes straightline basis cost purchased technology intangibles shorter five 5 years useful life related technology underlying asset revenue recognition deferred revenue companys revenues derived principally sale banner advertisements web hosting services products online malls advertising revenues recognized period advertisement delivered provided collection resulting receivable probable advertisers charged per impression delivery basis maximum specified contract date duration companys advertising commitments exceeded one year company guarantees minimum number impressions deliveries revenue recognized ratably proportion number impressions deliveries recorded minimum number impressions deliveries guaranteed web hosting revenues recognized period services provided product revenue recognized upon shipment provided significant obligations remain collectability probable advertising revenue include barter revenues exchange nettaxicom advertising space nettaxicoms web sites reciprocal advertising space web sites revenues barter transactions recorded advertising revenues lower estimated fair value advertisements received delivered recognized advertisements run nettaxicoms web sites barter expenses recorded nettaxicoms advertisements run reciprocal web sites typically period advertisements run nettaxicoms web sites barter revenues related expenses years ended december 31 2000 1999 1998 approximately 2224800 343400 0 respectively representing 28 7 0 net revenues respectively nettaxicom notes consolidated financial statements november 1999 financial accounting standards board fasb issued emerging issues task force eitf issue 9917 accounting advertising barter transactions eitf 9917 revenues expenses recognized advertising barter transactions fair value advertising surrendered received company historical practice receiving paying cash transactions december 1999 staff securities exchange commission sec issued staff accounting bulletin sab 101 revenue recognition sab 101 provides sec staffs views applying generally accepted accounting principles selected revenue recognition issues sab 101 effective fourth fiscal quarter fiscal years beginning december 15 1999 company believes current revenue recognition policies comply provisions sab 101 income taxes company accounts income taxes accordance statement financial accounting standards sfas 109 accounting income taxes requires asset liability approach results recognition deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent future tax return consequences differences either deductible taxable assets liabilities recovered settled future tax benefits subject valuation allowance management believes likely deferred tax assets realized advertising costs cost advertising expensed incurred advertising costs years ended december 31 2000 1999 1998 approximately 2365600 2831300 3100 respectively nettaxicom notes consolidated financial statements longlived assets company periodically reviews longlived assets impairment events changes circumstances indicate carrying amount asset may recoverable company writes asset fair value fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments cash equivalents carrying amount reported consolidated balance sheets cash equivalents approximates fair value shortterm debt fair value shortterm debt approximates cost short period time maturity longterm debt fair value longterm debt estimated based current interest rates available company debt instruments similar terms remaining maturities related party notes receivable payable fair value notes receivable notes payable shareholders based armslength transactions bear interest rates comparable similar debt obligations nettaxicom notes consolidated financial statements december 31 2000 1999 fair values companys debt instruments approximate historical carrying amounts stockbased incentive program sfas 123 accounting stockbased compensation encourages entities recognize compensation costs stockbased employee compensation plans using fair value based method accounting defined sfas 123 allows continued use intrinsic value based method accounting prescribed accounting principles board apb opinion 25 accounting stock issued employees company continues use accounting prescribed apb opinion 25 stockbased compensation employees required disclose pro forma net income loss earnings loss per share fair value based method accounting applied note 7 company accounts stockbased compensation nonemployees sfas 123 march 2000 financial accounting standards board issued interpretation 44 accounting certain transactions involving stock compensation interpretation abp opinion 25 became effective july 1 2000 interpretation 44 clarifies definition employee purposes applying opinion 25 b criteria determining whether stock compensation plan qualifies noncompensatory plan c accounting consequences various modifications terms previously fixed stock option award accounting exchange stock compensation awards business combination adoption provisions interpretation significant impact companys financial statements nettaxicom notes consolidated financial statements basic diluted loss per common share february 1997 fasb issued sfas 128 earnings per share effective december 28 1997 conforming sfas 128 company changed method computing earnings per share restated prior periods included consolidated financial statements basic loss per common share determined dividing loss available common shareholders weighted average number common shares outstanding diluted percommonshare amounts assume issuance common stock potentially dilutive equivalent shares outstanding antidilution provisions sfas 128 require consistency diluted percommonshare amounts basic percommonshare amounts loss periods reported differences basic diluted earnings per share number potential common shares included diluted earnings per share due antidilutive 23994732 3838679 280000 years ended december 31 2000 1999 1998 respectively share per share information adjusted shares exchanged common stock plus net inc adoption new accounting pronouncements june 1998 fasb issued sfas 133 accounting derivative instruments hedging activities sfas 133 amended sfas 138 requires companies recognize derivatives contracts either assets liabilities balance sheet measure fair value certain conditions met derivative may specifically designated hedge objective match timing gain loss recognition hedging derivative recognition changes fair value hedged asset liability attributable hedged risk ii earnings effect hedged forecasted transaction derivative designated hedging instrument gain loss recognized income period change june 1999 fasb issued sfas 137 accounting derivative instruments hedging activities deferral effective date fasb statement 133 amends sfas 133 effective fiscal quarters fiscal years beginning june 15 2000 historically company entered derivative contracts either hedge existing risks speculative purposes accordingly company expect adoption new standard material impact companys results operations financial position cash flows nettaxicom notes consolidated financial statements 2 property equipment consisted following equipment december 31 2000 1999 furniture fixtures 203600 196200 office equipment 55100 59700 computers equipment 2721100 2134400 2979800 2390300 less accumulated depreciation 1231500 421700 1748300 1968600 depreciation expense amounted 903400 361800 59800 years ended december 31 200 1999 1998 respectively 3 purchased november 1997 company issued convertible secured technology promissory note amount 1020000 note 6 2475066 shares common stock valued 980000 intangibles related party exchange certain fixed assets liabilities technology core technology acquired web database software application underlying technology companys internet city products based fair market value consideration exchanged determined independent appraisal service aggregate purchase price 2000000 allocated following respective assets liabilities based fair market value time transaction purchased technology 1740000 intangibles 150000 computers equipment 100000 office equipment 45000 furniture fixtures 5000 contracts payable accrued expenses 40000 2000000 nettaxicom notes consolidated financial statements 1998 company experienced several functional problems portions purchased technology namely web database software application due components incompatibility subsequent releases upgraded versions operating system following attempts make components compatible company decided december 1998 spend additional monies components replace approximately 50 components acquired technology longer technically viable upgraded versions companys operating system provided alternative future use company wrote unamortized portion impaired technology resulting charge expense 667000 purchased technology intangibles consisted following december 31 2000 1999 purchased technology 870000 less accumulated amortization 551000 377000 319000 493000 intangibles 150000 less accumulated amortization 95000 65000 55000 85000 4 accrued expenses accrued expenses consisted following december 31 2000 1999 payroll related expenses 97800 216200 professional fees 157300 135000 marketing 83800 93000 accrued interest related party 125500 59000 89400 397900 659100 nettaxicom notes consolidated financial statements 5 lease company leases facility operating lease commitments expires may 1 2002 facility lease requires company pay certain maintenance operating expenses taxes insurance utilities rent expense years ended december 31 2000 1999 1998 281600 178000 35500 respectively 1999 company entered operating leases certain vehicles years ended december 31 2000 1999 rent expense related vehicle leases aggregated 5300 2600 summary future minimum payments required noncancelable operating leases terms excess one year follows operating years ending december 31 leases 2001 284400 2002 98400 382800 6 convertible november 1 1997 company issued 10 fiveyear notes payable convertible secured promissory note amount related party 1020000 september 1998 note accrued interest 85800 converted 2792763 shares common stock interest expense note aggregated 68800 1998 nettaxicom notes consolidated financial statements march 31 1999 company entered 5000000 convertible debt financing agreement rgc international investors ldc rgc convertible debenture bears interest 5 matures march 31 2004 debentures convertible option holder number shares common stock equal principal amount debentures converted including accrued interest divided conversion price specified debentures conversion price lesser variable fixed conversion price variable conversion price based trading price companys common stock fixed period conversion debentures fixed conversion price 1188 fixed conversion price represents 120 average three lowest trades ten days prior effective date agreement accordance terms debt agreement rgc converted november december 1999 1800000 debentures accrued interest 63300 802223 shares common stock january february 2000 800000 debentures accrued interest 34900 632472 shares common stock april 28 2000 company reached settlement agreement rgc 2400000 remaining principal amount convertible debentures plus accrued interest thereon approximately 85000 whereby company agreed issue aggregate 1750000 shares common stock settlement shares warrants purchase aggregate 2200000 shares common stock exercise price 150 per share discussed note 7 also agreed beginning date agreement prior delivery settlement shares debentures would convertible fixed conversion price 142 per share fair market value companys stock april 28 2000 300 company recognized deemed noncash interest expense 2400000 resulting implied beneficial conversion feature 7 shareholders october 1997 company offered shares preferred equity stock private placement offering preferred established maximum 150000 shares series stock preferred stock 075 per share convertible 505 shares companys common stock time nettaxicom notes consolidated financial statements year ended december 31 1998 period ended december 31 1997 company issued 11400 134000 shares series preferred stock offering net cash proceeds 8600 100500 respectively shares issued discount fair market value stock company recorded deemed preferred stock dividends 14300 167500 year ended december 31 1998 period ended december 31 1997 respectively september 1998 shares series preferred stock converted 734438 shares companys common stock common stock october 1997 company offered shares common stock private placement offering established maximum 1262650 shares common stock 040 per share 1998 company issued 506378 shares common stock offering net proceeds 200500 year ended december 31 1998 company issued 252045 shares common stock ascribed value 120000 payment services shares issued services performed valued fair market value share issued october 1997 private placement offering year ended december 31 1998 company issued 76087 shares common stock ascribed value 22800 officers employees company lieu salaries september 1998 companys board directors declared 253 1 stock split connection acquisition discussed note 1 references number shares common stock per share data consolidated financial statements adjusted reflect stock split retroactive basis nettaxicom notes consolidated financial statements september 1998 connection acquisition company offered shares common stock private placement offering established maximum 1250000 shares common stock 080 per share placement agent received 200000 shares common stock fair market value 160000 company issued 1250000 shares common stock offering net proceeds 999600 may 1999 company completed merger single transaction plus net inc discussed note 1 exchanging 7000000 shares common stock common stock plus net inc share plus net exchanged 1000 shares nettaxi common stock accordance convertible debt financing agreement entered company rgc international investors ldc march 31 1999 rgc option purchase one additional share common stock every share common stock issuable result conversion debenture price equal applicable conversion price november december 1999 rgc exercised investment option right purchased 802223 shares companys common stock proceeds 1863300 january february 2000 additional 632472 shares common stock proceeds 834900 december 1999 company issued 350000 shares common stock consulting group exchange twoyear agreement provide company consulting services based fair market value shares issued price services determined 1060800 february 2000 company issued additional 175000 shares common stock fair market value 574200 consideration extending agreement additional six months company amortizes aggregate consideration given 30 months term agreement included prepaid expenses deferred expenses december 31 2000 1999 926500 1026600 respectively representing unamortized portion consideration given consulting services nettaxicom notes consolidated financial statements september 2000 company issued 75000 additional shares common stock consulting group consideration failure execute demand registration rights timely manner pursuant agreements based fair market value shares issued company recognized 37500 consulting expense transaction february 2000 company offered shares common stock valued 150 per share warrants expiring january 31 2003 entitling holder right purchase one share common stock exercise price 400 per share private placement offering company issued 15416633 shares common stock warrants purchase 15416633 shares common stock offering net proceeds 21142600 february 2000 company issued 6250 shares common stock fair market value 9700 settlement cancellation letter intent provide sponsorship march april 2000 company issued 778982 shares common stock warrants purchase 389491 shares common stock exercise price 276 per share discussed exchange conversion 1558000 trade payables july august 2000 company issued aggregate 430000 shares common stock fair market value 327100 consideration consulting services company amortizes aggregate consideration given term underlying agreements included prepaid expenses december 31 2000 29200 representing unamortized portion consideration given consulting services may 2000 companys certificate incorporation amended increase number shares authorized common stock 200000000 nettaxicom notes consolidated financial statements warrants 1998 prior adoption stock option plan discussed company granted warrants directors employees company purchase 2399298 shares common stock 004 exercise price warrants less market price common stock grant date company recorded accordance apb opinion 25 accounting stock issued employees 855000 compensation costs associated warrants september 1998 warrants exchanged 2399298 shares common stock via issuance promissory notes 95000 concurrent reorganization company promissory notes accounted common stock subscribed offset shareholders equity notes collected years ended december 31 2000 1999 company issued warrants connection financing consulting services conversion trade payables purchase 3139491 475000 shares common stock respectively company estimates fair value warrants grant date using blackscholes valuation model following weightedaverage assumptions used grants 2000 1999 dividend yield 0 expected volatility 138 69 riskfree interest rate 62 expected contractual lives warrant computed value charged operations interest term related agreements march 1999 company issued warrants vested immediately purchase 125000 shares common stock 800 per share warrants issued connection dispute settlement expire march 2001 conjunction agreement entered company rgc march 31 1999 company issued warrants vested immediately purchase 150000 shares common stock 12375 company recognized additional 115500 interest expense associated warrants august 1999 company entered agreement rgc pursuant exercised warrants nettaxicom notes consolidated financial statements consideration early exercise warrants exercise price warrants decreased 12375 7875 company issued rgc warrants purchase additional 150000 shares common stock 7875 warrants subsequently due antidilution provisions issued execise price 438 per share resulting increase number shares issuable upon exercise warrants 269692 company recognized additional 245700 interest expense associated warrants 2000 1999 company recognized 159000 86700 amount interest expense respectively june 2000 company issued warrants vested immediately purchase 2200000 shares common stock 150 per share exercisable five years accordance settlement agreement entered company rgc april 28 2000 company recognized additional 1496000 deemed interest expense associated warrants february 2000 company issued warrants vested immediately purchase 200000 shares common stock exercise price 400 addition previously issued warrants purchase 50000 shares common stock exercise price 12375 finders fee connection private placement march april 2000 company issued warrants purchase 389491 shares common stock exercise price 276 conjunction conversion trade payables company recognized 541400 interest expense associated warrants october 2000 company issued warrants consulting services vested immediately purchase 350000 shares common stock exercise price 035 per share aggregate value warrants 84000 amortized four months period included prepaid expenses december 31 2000 42000 representing unamortized portion consideration given consulting services nettaxicom notes consolidated financial statements stock option program september 1998 company adopted 1998 stock option plan january 2000 board directors adopted 1999 stock option plan collectively plans subject ratification stockholders plans authorizes grant options purchase shares common stock employees directors consultants company affiliates options combination incentive nonstatutory options incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest three years exercisable ten years company reserved 3000000 shares common stock issuance 1998 stock option plan 8900000 shares common stock issuance 1999 stock option plan nettaxicom notes consolidated financial statements summary status companys stock option plan december 31 2000 1999 1998 changes years ended presented following table nettaxicom notes consolidated financial statements following table summarizes information stock options outstanding december 31 2000 years ended december 31 2000 1999 company recorded deferred compensation approximately 512200 702700 respectively relating issuance 380000 285000 consultant options respectively administrative sales marketing services amounts computed using blackscholes option valuation model related amortization charged operations term related consulting agreements 2000 1999 amortization amounted approximately 573700 211300 respectively weightedaverage assumptions used compute value options granted 2000 1999 follows dividend yield 0 expected volatility 110 82 riskfree interest rate 62 expected lives two years nettaxicom notes consolidated financial statements sfas 123 accounting stockbased compensation requires company provide pro forma information regarding net loss income loss earnings per share compensation cost companys stock option plan determined accordance fair value based method prescribed sfas no123 company estimates fair value stock options grant date using blackscholes option valuation model following weighted average assumptions used grants 2000 1999 1998 dividend yield 0 expected volatility 124 112 180 riskfree interest rate 62 57 expected lives three years plan options accounting provisions sfas 123 companys net loss basic diluted net loss per common share would adjusted pro forma amounts 8 income provision income taxes year ended december taxes 31 1999 relates earnings plus net inc prior merger provision income taxes years ended december 31 2000 1998 consisted minimum state taxes nettaxicom notes consolidated financial statements following summarizes differences income tax expense amount computed applying federal income tax rate 34 years ended december 31 2000 1999 1998 companys effective tax rate differs statutory federal income tax principally result federal state net operating losses deferred benefit recognized due full valuation allowance provided resulting deferred tax asset temporary differences carryforwards gave rise significant portions deferred tax assets liabilities december 31 2000 1999 1998 follows nettaxicom notes consolidated financial statements december 31 2000 company federal net operating loss nol carryforward amount 25143000 may applied future taxable income benefits begin expire 2017 company also california nol carryforward amount 13395000 may applied future taxable income benefits begin expire 2002 companys ability utilize nol carryforwards dependent upon companys ability generate taxable income future periods may limited due restrictions imposed federal state laws upon change ownership 9 concentration financial instruments potentially subject company credit risk concentration credit risk consist principally cash equivalents trade receivables company places cash equivalents high quality financial institutions policy limits amounts credit exposure one financial institution companys accounts receivable derived many customers various industries company believes risk accounting loss significantly reduced due diversity endcustomers geographic sales areas company performs credit evaluation customers financial condition whenever necessary generally require cash collateral security support customer receivables 10 major 2000 four customers accounted approximately 20 customers 13 11 10 revenues respectively related account receivable december 31 2000 294000 0 95200 0 respectively 1999 one customer accounted approximately 17 revenues related account receivable december 31 1999 250000 1998 four customers accounted approximately 28 21 13 12 revenues respectively related accounts receivable december 31 1998 52100 38100 0 23800 respectively nettaxicom notes consolidated financial statements 11 supplemental following supplemental disclosure statements disclosure cash flows cash flow information 12 contingencies nettaxicom acquired certain technology ssn properties turn acquired assets foreclosure convertible notes issued simply interactive inc certain minority shareholders simply interactive inc disputing transfer assets ultimately nettaxicom management believes groups claims without merit therefore settlement relating claims material adverse effect financial position company nettaxicom notes consolidated financial statements time normal course business various claims made company time opinion management pending claims outcome expected result material adverse effect financial position company 13 subsequent march 1 2001 company signed asset purchase events agreement via newly formed wholly owned subsidiary lookup guide acquisition corporation california corporation issue 2200000 shares common stock exchange substantially assets lookupguidecom california corporation 14 valuation qualifying accounts nettaxicom notes consolidated financial statements 15 quarterly summarized quarterly financial data presented information reflect adjustments opinion unaudited management normal recurring nature necessary present fairly results operations periods presenteditem 14 exhibits financial statement schedules reports form 8k documents filed part report 1 financial statements following financial statements nettaxicom included separate section annual report form 10k commencing pages referenced contents report independent certified public accountants consolidated financial statements consolidated balance sheets consolidated statements operations consolidated statements shareholders equity consolidated statements cash flows notes consolidated financial statements 2 financial statement schedules financial statement schedules nettaxicom omitted applicable required information included consolidated financial statements notes thereto 3 exhibits following exhibits attached hereto incorporated herein reference exhibit number description exhibit 21 agreement plan reorganization dated september 24 1998 among nettaxi online communities inc owners outstanding shares common stock nettaxi online communities inc company incorporated reference exhibit 21 filed registrants registration statement form s1 file 33378129 declared effective august 13 1999 22 merger agreement plan reorganization dated april 1 1999 plus net inc company incorporated reference exhibit 22 filed registrants registration statement form s1 file 33378129 23 merger agreement plan reorganization dated january 9 2002 rae systems inc raes acquisition corporation company incorporated reference exhibit 21filed registrants periodic report form 8k filed january 10 2002 31 articles incorporation company incorporated reference exhibit 31 filed registrants registration statement form s1 file 33378129 32 certificate amendment articles incorporation company incorporated reference exhibit 32 filed registrants registration statement form s1 file 33378129 33 bylaws company incorporated reference exhibit 33 filed registrants registration statement form s1 file 33378129 34 certificate amendment articles incorporation company incorporated reference exhibit 34 filed registrants quarterly report form 10q quarter ended september 30 1999 35 certificate amendment articles incorporation company previously filed registration statement 41 specimen common stock certificate company incorporated reference exhibit 41 filed registrants registration statement form s1 file 33378129 42 see exhibits 31 32 33 provisions articles incorporation bylaws company defining rights holders common stock company 44 1999 stock option plan company incorporated reference exhibit 44 filed registrants registration statement form s8 file 33332678 filed march 17 2000 45 form stock option agreement options issued pursuant 199 stock option plan company incorporated reference exhibit 45 filed registrants registration statement form s8 file 33332678 103 stock option agreement dated march 20 1998 robert rositano jr company incorporated reference exhibit 105 filed registrants registration statement form s1 file 33378129 104 stock option agreement dated march 20 1998 dean rositano company incorporated reference exhibit 106 filed registrants registration statement form s1 file 33378129 105 employment agreement dated august 1 1998 dean rositano company incorporated reference exhibit 109 filed registrants registration statement form s1 file 33378129 106 employment agreement dated august 1 1998 robert rositano jr company incorporated reference exhibit 1010 filed registrants registration statement form s1 file 33378129 107 stock option agreement dated august 1 1998 robert rositano jr company incorporated reference exhibit 1011 filed registrants registration statement form s1 file 33378129 108 stock option agreement dated august 1 1998 dean rositano company incorporated reference exhibit 1012 filed registrants registration statement form s1 file 33378129 109 letter agreement dated september 3 1998 bay tree capital associates llc company incorporated reference exhibit 1014 filed registrants registration statement form s1 file 33378129 1010 1998 stock option plan company incorporated reference exhibit 1017 filed registrants registration statement form s1 file 33378129 1011 form stock option agreement options issued pursuant 1998 stock option plan company incorporated reference exhibit 1018 filed registrants registration statement form s1 file 33378129 1012 stock option agreement 1998 stock option plan dean rositano company incorporated reference exhibit 1019 filed registrants registration statement form s1 file 33378129 1013 stock option agreement 1998 stock option plan robert rositano jr company incorporated reference exhibit 1020 filed registrants registration statement form s1 file 33378129 1019 stock purchase warrant dated march 31 1999 among rgc international investors ldc company incorporated reference exhibit 1031 filed registrants registration statement form s1 file 33378129 1020 registration rights agreement dated march 31 1999 among rgc international investors ldc company incorporated reference exhibit 1032 filed registrants registration statement form s1 file 33378129 1021 oppenheimer funds 401k plan incorporated reference exhibit 1033 filed registrants registration statement form s1 file 33378129 1023 form indemnification agreement company directors executive officers incorporated reference exhibit 1035 filed registrants registration statement form s1 file 33378129 1034 agreement terminal facility colocation space dated january 18 1999 alchemy communications inc company incorporated reference exhibit 1049 filed registrants registration statement form s1 file 33378129 1035 letter agreement dated january 15 1999 babenet ltd company incorporated reference exhibit 1050 filed registrants registration statement form s1 file 33378129 1046 data center service agreement dated july 15 1999 babenet ltd company incorporated reference exhibit 1061 filed registrants quarterly report form 10q period ending september 30 1999 1047 data center service agreement dated july 15 1999 whitehorn ventures limited company incorporated reference exhibit 1062 filed registrants quarterly report form 10q period ending september 30 1999 1048 data center service agreement dated august 15 1999 white sand communications inc company incorporated reference exhibit 1063 filed registrants quarterly report form 10q period ending september 30 1999 1049 cobranded free isp agreement dated november 30 1999 spin media network inc company incorporated reference exhibit 1064 filed registrants registration statement form s1 file 33378129 1052 form subscription agreement company incorporated reference exhibit1067 filed registrants annual report form 10k period ending december 31 1999 1053 letter intent agreement dated february 29 2000 ppc racing company previously filed registration statement 1054 registration rights agreement dated april 28 2000 rgc international investors ldc company incorporated reference exhibit 1054 filed registrants registration statement form s1 filed june 2 2000 1055 warrant agreement dated april 28 2000 rgc international investors ldc company incorporated reference exhibit 1054 filed registrants registration statement form s1 filed june 2 2000 1056 settlement agreement mutual general release dated april 28 2000 rgc international investors ldc rose glen capital management lp rgc general partner corporation steve katznelson gerald stahlecker chris hinkel company incorporated reference exhibit 1054 filed registrants registration statement form s1 filed june 2 2000 1057 consulting agreement dated october 29 2000 company michael gardner incorporated reference exhibit 1057 filed registrants annual report form 10k year ended december 31 2000 1058 online advertising insertion order dated april 3 2000 company hearmecom incorporated reference exhibit 1058 filed registrants annual report form 10k year ended december 31 2000 1059 content license agreement dated april 27 2000 company screamingmedia incorporated reference exhibit 1059 filed registrants annual report form 10k year ended december 31 2000 1060 development revenue sharing agreement dated august 23 2000 company activeworldscom inc incorporated reference exhibit 1060 filed registrants annual report form 10k year ended december 31 2000 1061 gotocom search services order dated september 1 2000 company gotocom incorporated reference exhibit 1061 filed registrants annual report form 10k year ended december 31 2000 1062 webmall cobranded web page agreement dated september 7 2000 company storerunner network inc incorporated reference exhibit 1062 filed registrants annual report form 10k year ended december 31 2000 1063 software license agreement dated september 29 2000 company annuncio software inc incorporated reference exhibit 1063 filed registrants annual report form 10k year ended december 31 2000 1064 consulting services agreement dated october 11 2000 company annuncio software inc incorporated reference exhibit 1064 filed registrants annual report form 10k year ended december 31 2000 1065 online advertising services contract dated february 1 2001 company fastclickcom inc incorporated reference exhibit 1065 filed registrants annual report form 10k year ended december 31 2000 1066 gigabit data services agreement dated march 2001 company alchemy communications inc incorporated reference exhibit 1066 filed registrants annual report form 10k year ended december 31 2000 1067 exit traffic agreement dated january 1 2000 company internet fuelcom inc incorporated reference exhibit 1067 filed registrants annual report form 10k year ended december 31 2000 1068 consulting agreement dated april 7 2001 company innovative networks inc incorporated reference exhibit 1068 filed registrants quarterly report form 10q quarterly period ended june 30 2001 1069 letter agreement dated august 1 2001 among company baytree capital associates llc incorporated reference exhibit 1069 filed registrants quarterly report form 10q quarterly period ended june 30 2001 211 subsidiaries company incorporated reference exhibit 1057 filed registrants registration statement form s1 file 33378129 231 consent bdo seidman llp b reports form 8k december 11 2001 filed report form 8k announce entered nonbinding letter intent merger rae systems inc january 10 2002 filed report form 8k announce entered agreement merge rae systems inc signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized nettaxicom date february 21 2002 dean rositano dean rositano chief financial officer principal accounting financial officer pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated nettaxicom contents report independent certified public accountants consolidated financial statements consolidated balance sheets consolidated statements operations consolidated statements shareholders equity consolidated statements cash flows notes consolidated financial statements report independent certified public accountants board directors shareholders nettaxicom audited accompanying consolidated balance sheets nettaxicom december 31 2001 2000 related consolidated statements operations shareholders equity cash flows three years period ended december 31 2001 financial statements responsibility companys management responsibility express opinion financial statements based audits conducted audits accordance auditing standards generally accepted united states america standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion discussed note 1 financial statements january 9 2002 nettaxicom entered merger agreement nettaxicom subject shareholder approval agreed merge rae systems inc merger consummated nettaxicom abandon business model adopt business model rae systems inc opinion consolidated financial statements referred present fairly material respects financial position nettaxicom december 31 2001 2000 results operations cash flows three years period ended december 31 2001 conformity accounting principles generally accepted united states america bdo seidman llp san jose california january 11 2002 nettaxicom notes consolidated financial statements 1 summary company accounting policies nettaxicom formerly nettaxi inc formerly swan valley snowmobiles inc company nevada corporation incorporated october 26 1995 september 29 1998 company completed acquisition 100 outstanding common stock nettaxi online communities inc delaware corporation changed name nettaxi inc nettaxicom accounting purposes acquisition treated acquisition company nettaxi online communities inc nettaxi online communities inc acquiror nettaxicom internet marketing portal provides wide range content internet based services consumers businesses subscribers companys web site wwwnettaxicom also provided access enhanced content broadband video clips email accounts 1999 company developed diversified revenue model provided subscribers access web site hosting services broad range content provided affiliated businesses access large population internet users advertising promotional purposes company also provided web site hosting internet connectivity services corporate customers companys principal executive offices located campbell california beginning april 2001 bankruptcy liquidation many companys internet based customers suppliers caused management reevaluate companys business model since internet infrastructure unstable customer base financially weak management began take corrective action significantly decrease cash burn determine best course action maintain enhance value company regard management implemented acquisition strategy pursuant seeking identify appropriate entity merge acquire restructure companys current business nettaxicom notes consolidated financial statements beginning may 2001 management reduced companys overhead burn rate reducing salaries employees reducing number personnel marketing expenses costs associated companys hosting activities effective july 7 2001 company terminated significant cohosting customer contracts connection also discontinued purchase bandwidth premium services third party provider terminations reduced operating expenses materially affected companys revenues beginning third quarter 2001 company continues operate website however following implementation acquisition strategy company pursued revenue generating activities last six months 2001 companys current management team consisting finance administrative employees place maintain operations enable ongoing review analysis acquisition candidates assist consummation appropriate transaction management also engaged services investment banker assist process see note 12 current developments january 9 2002 nettaxicom executed definitive merger agreement contemplates merger raes acquisition corporation california corporation wholly owned subsidiary nettaxicom rae systems inc california corporation designs manufacturers portable gas detection instruments wireless monitoring communications equipment terms merger agreement unanimously approved boards directors rae systems shareholders receive approximately 80 outstanding shares combined entity subject approval shareholders nettaxicom shares reverse split ratio 567 1 prior closing merger management board directors nettaxi resign closing merger replaced board directors management team rae systems understanding respective parties upon completion merger goingforward operating activities combined company rae systems inc transaction expected taxfree shareholders companies us federal income tax purposes subject approval partys shareholderssee note 12 upon completion merger new company known rae systems inc nettaxicom notes consolidated financial statements consolidation accompanying consolidated financial statements include accounts nettaxicom whollyowned subsidiaries nettaxi online communities inc raes acquisition corporation intercompany accounts transactions eliminated consolidated financial statements use estimates preparation consolidated financial statements conformity generally accepted accounting principles requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date consolidated financial statements reported amounts revenues expenses reporting period actual results could differ estimates cash equivalents company considers highly liquid investments original maturities 90 days less cash equivalents accounts receivable allowances doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews losses adjustment history current economic conditions factors deserve recognition estimating potential losses management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond managements control nettaxicom notes consolidated financial statements property equipment property equipment stated cost depreciation provided using straightline method estimated economic useful lives assets follows estimated useful lives furniture fixtures 5 years office equipment 5 years computers equipment 3 years assets held capital leases amortized straightline basis shorter lease term estimated useful lives related assets purchased technology intangibles company amortizes straightline basis cost purchased technology intangibles shorter five 5 years useful life related technology underlying asset revenue recognition deferred revenue companys revenues derived principally sale banner advertisements web hosting services products online malls advertising revenues recognized period advertisement delivered provided collection resulting receivable probable advertisers charged per impression delivery basis maximum specified contract date duration companys advertising commitments exceeded one year company guarantees minimum number impressions deliveries revenue recognized ratably proportion number impressions deliveries recorded minimum number impressions deliveries guaranteed web hosting revenues recognized period services provided product revenue recognized upon shipment provided significant obligations remain collectability probable nettaxicom notes consolidated financial statements advertising revenue include barter revenues exchange nettaxicom advertising space nettaxicoms web sites reciprocal advertising space web sites revenues barter transactions recorded advertising revenues lower estimated fair value advertisements received delivered recognized advertisements run nettaxicoms web sites barter expenses recorded nettaxicoms advertisements run reciprocal web sites typically period advertisements run nettaxicoms web sites barter revenues related expenses years ended december 31 2001 2000 1999 approximately 0 2224800 343400 respectively representing 0 28 7 net revenues respectively november 1999 financial accounting standards board fasb issued emerging issues task force eitf issue 9917 accounting advertising barter transactions eitf 9917 revenues expenses recognized advertising barter transactions fair value advertising surrendered received company historical practice receiving paying cash transactions royalty revenues earned sales company developed cdrom internet city thirdparty distributors thirdparty distributors package cdrom products sale enduser distributor remits payments company 90 days sales product enduser right return company recognizes revenues upon receipt payment distributor company contract several partners revenue expense sharing agreements provide company earn revenues based sale thirdparty suppliers products transactions company receives either percentage transaction fixed fee revenues recorded net nettaxicom notes consolidated financial statements company charges cohosting customers onetime installation fees prior january 31 2001 company recognized fees upon completion installation accordance staff accounting bulletin sab 101 revenue recognition onetime installation fees deferred systematically recognized products andor services delivered andor performed term arrangement expected period performance fees earned company recognize onetime installation fees 2001 premium subscribers charged website development fees develop website upon request fees charged costs develop sites company nominal company defers recognition fees charged period contract december 1999 staff securities exchange commission sec issued staff accounting bulletin sab 101 revenue recognition sab 101 provides sec staffs views applying generally accepted accounting principles selected revenue recognition issues sab 101 effective fourth fiscal quarter fiscal years beginning december 15 1999 company believes current revenue recognition policies comply provisions sab 101 income taxes company accounts income taxes accordance statement financial accounting standards sfas 109 accounting income taxes requires asset liability approach results recognition deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent future tax return consequences differences either deductible taxable assets liabilities recovered settled future tax benefits subject valuation allowance management believes likely deferred tax assets realized advertising costs cost advertising expensed incurred advertising costs years ended december 31 2001 2000 1999 approximately 74700 2365600 2831300 respectively nettaxicom notes consolidated financial statements longlived assets company periodically reviews longlived assets impairment events changes circumstances indicate carrying amount asset may recoverable company writes asset fair value company periodically reviews intangible assets evaluate whether events changes occurred would suggest impairment carrying value impairment would recognized expected future operating cash flows lower carrying value fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments cash equivalents carrying amount reported consolidated balance sheets cash equivalents approximates fair value shortterm debt fair value shortterm debt approximates cost short period time maturity stockbased incentive program sfas 123 accounting stockbased compensation encourages entities recognize compensation costs stockbased employee compensation plans using fair value based method accounting defined sfas 123 allows continued use intrinsic value based method accounting prescribed accounting principles board apb opinion 25 accounting stock issued employees company continues use accounting prescribed apb opinion 25 required disclose pro forma net income loss earnings loss per share fair value based method accounting applied note 7 nettaxicom notes consolidated financial statements march 2000 financial accounting standards board fasb issued interpretation 44 accounting certain transactions involving stock compensation interpretation apb opinion 25 became effective july 1 2000 interpretation 44 clarifies definition employee purposes applying opinion 25 b criteria determining whether stock compensation plan qualifies noncompensatory plan c accounting consequences various modifications terms previously fixed stock option award accounting exchange stock compensation awards business combination adoption provisions interpretation significant impact companys financial statements basic diluted loss per common share february 1997 fasb issued sfas 128 earnings per share effective december 28 1997 conforming sfas 128 company changed method computing earnings per share restated prior periods included consolidated financial statements basic loss per common share determined dividing loss available common shareholders weighted average number common shares outstanding diluted percommonshare amounts assume issuance common stock potentially dilutive equivalent shares outstanding antidilution provisions sfas 128 require consistency diluted percommonshare amounts basic percommonshare amounts loss periods reported differences basic diluted earnings per share number potential common shares included diluted earnings per share due antidilutive 25953816 23994732 3838679 years ended december 31 2001 2000 1999 respectively share per share information adjusted shares exchanged common stock plus net inc nettaxicom notes consolidated financial statements adoption new accounting pronouncements june 1999 fasb issued sfas 137 accounting derivative instrument hedging activities deferral effective date fasb statement 133 amends sfas 133 effective fiscal years beginning june 15 2000 june 2000 sfas 133 amended sfas 138 accounting certain derivative instruments hedging activities amended modified certain issues discussed sfas 133 sfas 138 also effective fiscal years beginning june 15 2000 sfas 133 sfas 138 establish accounting reporting standards requiring every derivative instrument recorded balance sheet either asset liability measured fair value statements also require changes derivatives fair value recognized currently earnings unless specific hedge accounting criteria met company engage derivative instruments hedging activities accordingly impact companys financial statements adoption sfas 133 sfas 138 july 2001 fasb issued sfas 141 sfas 141 business combinations supersedes accounting principles board apb opinion 16 business combinations sfas 141 eliminates pooling ofinterests method accounting business combinations modifies application purchase accounting method elimination poolingofinterests method effective transactions initiated june 30 2001 remaining provision sfas 141 effective transactions accounted using purchase method completed june 30 2001 july 2001 fasb also issued sfas 142 sfas 142 goodwill intangible assets supersedes apb opinion 17 intangible assets sfas 142 goodwill intangible assets indefinite lives amortized tested impairment annually using fair value approach except certain circumstances whether impairment indicator intangible assets continue valued amortized estimated lives inprocess research development continue written immediately acquired goodwill must assigned reporting units purposes impairment testing segment reporting existing goodwill longer subject amortization provisions sfas 142 required applied starting fiscal years beginning december 15 2001 nettaxicom notes consolidated financial statements august 2001 fasb issued sfas 143 sfas 143 accounting obligations associated retirement longlived assets sfas 143 addresses financial accounting reporting retirement obligation asset sfas 143 states companies recognize asset retirement cost fair value part cost asset classify accrued amount liability balance sheet asset retirement liability accreted ultimate payout interest expense initial measurement liability would subsequently updated revised estimates discounted cash outflows sfas 143 effective fiscal years beginning june 15 2002 company yet determined effect sfas 143 financial position results operations cash flows october 2001 fasb issued sfas 144 sfas 144 accounting impairment disposal longlived assets sfas 144 supersedes sfas 121 requiring one accounting model used longlived assets disposed sale whether previously held used newly acquired broadening presentation discontinued operation include disposal transactions sfas 144 effective fiscal years beginning december 15 2001 company yet determined effect sfas 144 financial position results operations cash flows 2 property equipment consisted following equipment fourth quarter 2001 company thirdparty appraisal carried property equipment result appraisal company recorded asset impairment charges 551000 nettaxicom notes consolidated financial statements 3 purchased technology intangibles consisted technology following intangibles december 31 2001 2000 purchased technology 870000 less accumulated amortization 870000 551000 319000 intangibles 150000 less accumulated amortization 150000 95000 55000 result decision taken management mid2001 implement acquisition strategy terminate companys significant cohosting customer contracts projected undiscounted cash flows support value purchased technology intangibles longer deemed adequate 2001 company wrotedown purchased technology intangibles 232000 40000 respectively 4 accrued expenses consisted following expenses 5 lease company leases facility operating lease commitments expires may 31 2002 facility lease requires company pay certain maintenance operating expenses taxes insurance utilities rent expense years ended december 31 2001 2000 1999 245300 281600 178000 respectively nettaxicom notes consolidated financial statements 1999 company entered operating leases certain vehicles years ended december 31 2001 2000 1999 rent expense related vehicle leases aggregated 5300 2600 summary future minimum payments required noncancelable operating leases terms excess one year follows 6 convertible march 31 1999 company entered 5000000 notes payable convertible debt financing agreement related party rgc international investors ldc rgc convertible debenture bears interest 5 matures march 31 2004 debentures convertible option holder number shares common stock equal principal amount debentures converted including accrued interest divided conversion price specified debentures conversion price lesser variable fixed conversion price variable conversion price based trading price companys common stock fixed period conversion debentures fixed conversion price 1188 fixed conversion price represents 120 average three lowest trades ten days prior effective date agreement accordance terms debt agreement rgc converted november december 1999 1800000 debentures accrued interest 63300 802223 shares common stock january february 2000 800000 debentures accrued interest 34900 632472 shares common stock nettaxicom notes consolidated financial statements april 28 2000 company reached settlement agreement rgc 2400000 remaining principal amount convertible debentures plus accrued interest thereon approximately 85000 whereby company agreed issue aggregate 1750000 shares common stock settlement shares warrants purchase aggregate 2200000 shares common stock exercise price 150 per share discussed note 7 also agreed beginning date agreement prior delivery settlement shares debentures would convertible fixed conversion price 142 per share fair market value companys stock april 28 2000 300 company recognized deemed noncash interest expense 2400000 resulting implied beneficial conversion feature 7 shareholders common stock equity may 1999 company completed merger single transaction plus net inc discussed note 1 exchanging 7000000 shares common stock common stock plus net inc share plus net exchanged 1000 shares nettaxi common stock merger constituted taxfree reorganization accounted pooling interest accounting principles board opinion 16 periods proceeding merger intercompany transactions require elimination combined consolidated results operations adjustments necessary conform accounting practices two companies plus net inc reported revenues net loss 200 period ended december 31 1998 period january 1 may 7 1999 plus net inc revenues approximately 700000 net income approximately 413600 subsequent merger company ceased evaluation processing online credit card transactions business 1999 line business accounted approximately 1285000 companys revenues accordance convertible debt financing agreement entered company rgc international investors ldc march 31 1999 rgc option purchase one additional share common stock every share common stock issuable result conversion debenture price equal applicable conversion price nettaxicom notes consolidated financial statements november december 1999 rgc exercised investment option right purchased 802223 shares companys common stock proceeds 1863300 january february 2000 additional 632472 shares common stock proceeds 834900 december 1999 company issued 350000 shares common stock consulting group exchange twoyear agreement provide company consulting services based fair market value shares issued price services determined 1060800 february 2000 company issued additional 175000 shares common stock fair market value 574200 consideration extending agreement additional six months company amortized aggregate consideration given term agreement fully recognized unamortizated portion second quarter 2001 included prepaid expenses deferred expenses december 31 2000 926500 representing unamortized portion consideration given consulting services september 2000 company issued 75000 additional shares common stock consulting group consideration failure execute demand registration rights timely manner pursuant agreements based fair market value shares issued company recognized 37500 consulting expense transaction february 2000 company offered shares common stock valued 150 per share warrants expiring january 31 2003 entitling holder right purchase one share common stock exercise price 400 per share private placement offering company issued 15416633 shares common stock warrants purchase 15416633 shares common stock offering net proceeds 21142600 february 2000 company issued 6250 shares common stock fair market value 9700 settlement cancellation letter intent provide sponsorship march april 2000 company issued 778982 shares common stock warrants purchase 389491 shares common stock exercise price 276 per share discussed exchange conversion 1558000 trade payables nettaxicom notes consolidated financial statements july august 2000 company issued aggregate 430000 shares common stock fair market value 327100 consideration consulting services company amortizes aggregate consideration given term underlying agreements included prepaid expenses december 31 2000 29200 representing unamortized portion consideration given consulting services may 2000 companys certificate incorporation amended increase number shares authorized common stock 200000000 warrants 1998 prior adoption stock option plan discussed company granted warrants directors employees company purchase 2399298 shares common stock 004 exercise price warrants less market price common stock grant date company recorded accordance apb opinion 25 accounting stock issued employees 855000 compensation costs associated warrants september 1998 warrants exchanged 2399298 shares common stock via issuance promissory notes 95000 concurrent reorganization company promissory notes accounted common stock subscribed offset shareholders equity notes collected years ended december 31 2000 1999 company issued warrants connection financing consulting services conversion trade payables purchase 3139491 475000 shares common stock respectively company estimates fair value warrants grant date using blackscholes valuation model following weightedaverage assumptions used grants 2001 2000 1999 dividend yield 0 expected volatility 94 138 69 riskfree interest rate 55 62 expected contractual lives warrant computed value charged operations interest term related agreements nettaxicom notes consolidated financial statements conjunction agreement entered company rgc march 31 1999 company issued warrants vested immediately purchase 150000 shares common stock 12375 company recognized additional 115500 interest expense associated warrants august 1999 company entered agreement rgc pursuant exercised warrants consideration early exercise warrants exercise price warrants decreased 12375 7875 company issued rgc warrants purchase additional 150000 shares common stock 7875 warrants subsequently due antidilution provisions issued exercise price 438 per share resulting increase number shares issuable upon exercise warrants 269692 company recognized additional 245700 interest expense associated warrants 2000 1999 company recognized 159000 86700 amount interest expense respectively june 2000 company issued warrants vested immediately purchase 2200000 shares common stock 150 per share exercisable five years accordance settlement agreement entered company rgc april 28 2000 company recognized additional 1496000 deemed interest expense associated warrants february 2000 company issued warrants vested immediately purchase 200000 shares common stock exercise price 400 addition previously issued warrants purchase 50000 shares common stock exercise price 12375 finders fee connection private placement march april 2000 company issued warrants purchase 389491 shares common stock exercise price 276 conjunction conversion trade payables company recognized 541400 interest expense associated warrants nettaxicom notes consolidated financial statements october 2000 company issued warrants consulting services vested immediately purchase 350000 shares common stock exercise price 035 per share aggregate value warrants 84000 amortized four months period 2001 2000 company recognized 42000 amount respectively april 2001 company issued warrants vested immediately purchase 1500000 shares common stock exercise price 013 financial consulting services aggregate value warrants amounted 165000 included prepaid expenses december 31 2001 41200 representing unamortized portion consideration given consulting services stock option program september 1998 company adopted 1998 stock option plan january 2000 board directors adopted 1999 stock option plan collectively plans subject ratification shareholders plans authorizes grant options purchase shares common stock employees directors consultants company affiliates options combination incentive nonstatutory options incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest three years exercisable ten years company reserved 3000000 shares common stock issuance 1998 stock option plan 8900000 shares common stock issuance 1999 stock option plan nettaxicom notes consolidated financial statements summary status companys stock option plan december 31 2001 2000 1999 changes years ended presented following table following table summarizes information stock options outstanding december 31 2001 nettaxicom notes consolidated financial statements years ended december 31 2001 2000 1999 company recorded deferred compensation approximately 0 512200 702700 respectively relating issuance 0 380000 285000 consultant options respectively administrative sales marketing services amounts computed using blackscholes option valuation model related amortization charged operations term related consulting agreements 2001 2000 1999 amortization amounted approximately 429900 573700 211300 respectively weightedaverage assumptions used compute value options granted 2000 1999 follows dividend yield 0 expected volatility 110 82 riskfree interest rate 62 expected lives two years sfas 123 accounting stockbased compensation requires company provide pro forma information regarding net loss income loss earnings per share compensation cost companys stock option plan determined accordance fair value based method prescribed sfas no123 company estimates fair value stock options grant date using blackscholes option valuation model following weighted average assumptions used grants 2001 2000 1999 dividend yield 0 expected volatility 96 124 112 riskfree interest rate 50 62 expected lives three years plan options accounting provisions sfas 123 companys net loss basic diluted net loss per common share would adjusted pro forma amounts nettaxicom notes consolidated financial statements 8 income taxes provision income taxes year ended december 31 1999 relates earnings plus net inc prior merger provision income taxes years ended december 31 2001 2000 consisted minimum state taxes following summarizes differences income tax expense amount computed applying federal income tax rate 34 years ended december 31 2001 2000 1999 companys effective tax rate differs statutory federal income tax principally result federal state net operating losses deferred benefit recognized due full valuation allowance provided resulting deferred tax asset nettaxicom notes consolidated financial statements temporary differences carryforwards gave rise significant portions deferred tax assets liabilities december 31 2001 2000 1999 follows december 31 2001 company federal net operating loss nol carryforward amount 26754000 may applied future taxable income benefits begin expire 2017 company also california nol carryforward amount 14200600 may applied future taxable income benefits begin expire 2002 companys ability utilize nol carryforwards dependent upon companys ability generate taxable income future periods may limited due restrictions imposed federal state laws upon change ownership 9 concentration financial instruments potentially subject company credit risk concentration credit risk consist principally cash equivalents trade receivables company places cash equivalents high quality financial institutions policy limits amounts credit exposure one financial institution nettaxicom notes consolidated financial statements companys accounts receivable derived many customers various industries company believes risk accounting loss significantly reduced due diversity endcustomers geographic sales areas company performs credit evaluation customers financial condition whenever necessary generally require cash collateral security support customer receivables 10 major 2001 three customers accounted approximately 47 customers 25 19 revenues respectively related account receivable december 31 2001 0 respectively 2000 four customers accounted approximately 20 13 11 10 revenues respectively related account receivable december 31 2000 294000 0 95200 0 respectively 1999 one customer accounted approximately 17 revenues related account receivable december 31 1999 250000 11 supplemental following supplemental disclosure statements disclosure cash flows cash flow information nettaxicom notes consolidated financial statements 12 commitments may 1 2001 seven shareholders nettaxi filed action contingencies company complaint also names companys chief executive officer president former chief financial officer additional defendants complaint alleged company violated securities laws connection february 2000 private placement complaint amended may 23 2001 amendment addressed factual matters added three new plaintiffs lawsuit shortly filing amended complaint company pursuant rules district court met plaintiffs pointed factual inaccuracies deficiencies plaintiffs chose attempt amend complaint second time six plaintiffs purchased shares nettaxi common stock february 2000 private placement prior filing complaint plaintiffs demanded refund money invested nettaxi demanded exercise price warrants issued private placement reduced 400 025 per share additionally prior filing complaint nettaxi asked invest capital company affiliated one plaintiffs complaint plaintiffs seek compensatory damages injunctive relief fees interest october 1 2001 company filed motion dismiss complaint filed plaintiffs response plaintiffs given notice intend seek court permission file third amended complaint attempt recharacterize claims remove claims plaintiffs concede contrary law management believes allegations made complaint without merit lawsuit reflects shareholder frustration recent downturn stock market defend action vigorously time normal course business various claims made company time opinion management pending claims outcome expected result material adverse effect financial position company nettaxicom notes consolidated financial statements may 2001 company entered agreement investment banker provide semiexclusive basis services connection identifying potential merger candidate assist negotiating effecting transaction terms agreement provide compensation paid investment banker upon successful closing transaction amount 5 total amount transaction 3 million 2 remaining amount transaction payable election investment banker cash common stock company warrant exercisable purchase 5 companys common stock purchase price defined agreement january 9 2002 company entered merger agreement company subject shareholder approval agreed merge rae systems inc companys shareholders approve merger company shall pay rae systems inc within five days date termination merger agreement amount equal 250000 merger consummated change control company result two officers company entitled receive severance package consisting cash payment 150000 accelerated vesting outstanding options purchase 67020 shares common stock taking account 567 1 reverse split exercise price 0737 per share cash bonus amount necessary exercised price 0737 per share cash bonus amount necessary exercise options warrants purchase 176366 shares common stock taking account 567 1 reverse split exercise price 1134 per share nettaxicom notes consolidated financial statements 14 quarterly summarized quarterly financial data presented information reflect adjustments opinion unaudited management normal recurring nature necessary present fairly results operations periods presented effective july 7 2001 company terminated significant cohosting customer contracts effectively ceased revenue generating activitiesitem 14 controls procedures supervision participation management including principal executive officer principal financial officer conducted evaluation disclosure controls procedures term defined rule 13a14c promulgated securities exchange act 1934 amended “exchange act” within 90 days filing date report based evaluation principal executive officer principal financial officer concluded disclosure controls procedures effective b significant changes including corrective actions regard significant deficiencies material weaknesses internal controls factors could significantly affect controls subsequent date evaluation referenced paragraph part iv item 15item 14 principal accounting fees services information required item set forth proxy statement 2004 annual meeting stockholders heading proposal 2ratification appointment independent auditors incorporated herein reference part iv item 15item 14 principal accounting fees services information required item set forth proxy statement 2005 annual meeting stockholders heading “proposal 2ratification appointment independent auditors” incorporated herein reference part iv item 15item 14 principal accounting fees services information required item set forth proxy statement 2005 annual meeting stockholders heading “proposal 2ratification appointment independent auditors” incorporated herein reference part iv item 15item 14 principal accounting fees services information required item set forth proxy statement 2007 annual meeting stockholders heading “proposal 2 ratification appointment independent auditors” incorporated herein reference part iv item 15item 14 principal accounting fees services information required item set forth proxy statement 2009 annual meeting stockholders heading “proposal 2 ratification appointment independent auditors” incorporated herein reference part iv item 15item 14 principal accounting fees services information required item incorporated herein reference information contained company’s 2010 proxy statement part iv item 15item 14 principal accounting fees services information required item incorporated herein reference information contained company’s 2011 proxy statement part iv item 15item 14 principal accounting fees services information required item set forth proxy statement 2008 annual meeting stockholders heading “proposal 2 ratification appointment independent auditors” incorporated herein reference part iv item 15 item 7 managements discussion analysis financial condition results operations following discussion financial condition results operations nettaxi read conjunction consolidated financial statements related notes included elsewhere form discussion contains forwardlooking statements involve risks uncertainties actual results may differ mat erially anticipated forwardlooking statements result various factors including limited set forth risk factors item 1a elsewhere form overview incorporated october 1997 launched web site july 1998 located campbell california developer commerceenabled contentrich communities offer subscribers citizens place build home pages businesses internet nettaxicom website httpwwwnettaxicom structured virtual urban environment populated subscribers referred citizens divided thematic communities streets homes nettaxicom provides access news entertainment sports financial travel information services free email personal home pages chat messages date revenues derived principally sale advertisements sell variety advertising packages clients including banner advertisements event sponsorships targeted direct response advertisements currently advertising revenues derived principally shortterm advertising arrangements averaging one six months guarantee minimum number impressions fixed fee advertising revenues recognized ratably period advertisement displayed provided significant remaining obligations collection resulting receivable probable payments received advertisers prior displaying advertisements site recorded deferred revenues recognized revenue ratably advertisement displayed extent minimum guaranteed impression levels met defer recognition corresponding revenues guaranteed levels achieved expect continue derive majority revenue foreseeable future sale advertising space web site third quarter 1999 company began providing website hosting internet connectivity services corporate customers services delivered stateoftheart internet data center located southern california using highperformance internet backbone network customers pay monthly fees professional services utilized onetime installation fees connectivity charges hosting revenues recognized period services provided addition advertising revenues derive revenues royalties distribution cdrom tutorial product premium account membership subscriptions royalty revenues result relationships computer manufacturers bundle distribute cdrom product products membership programs offer premium services monthly fee providing additional services unlimited personal email accounts family friends unlimited nettaxi site builder web pages themed web page templates personal event calendar discussion groups options customize personal homepages pictures colors content may 1999 completed merger plus net inc california corporation allowed us provide users web based email program robust meta search engine plus net also ecommerce processing engine enables acceptance processing online credit card transactions believe merger also enhances electronic commerce advertising opportunities result merger plus net inc may 1999 received revenues credit card processing fees first half 1999 minimal revenues earned third quarter 1999 contract fees derived terminated december 1999 anticipate revenues type minimal foreseeable future also receive revenues ecommerce transactions recent ecommerce arrangements generally provide us share sales resulting direct links site revenues programs recognized month service provided date revenues ecommerce arrangements material however expect ecommerce derived revenues become significant portion total revenues foreseeable future increase number contractual relationships parties offering ecommerce related products services made available subscribers parties seeking make online sales subscribers visitors site date entered business technology license arrangements order build website community provide communityspecific content generate additional traffic provide subscribers additional products services including ecommerce tools intend continue investigate potential acquisitions seek additional relationships content providers fall within scope business strategy serve increase subscriber base overall site traffic acquisitions carry numerous risks uncertainties cannot guarantee able successfully integrate businesses products technologies personnel might acquired future results operations comparison twelve months ended december 31 1999 1998 net revenues net revenues year ended december 31 1999 increased 1851 approximately 503 million 258000 year ended december 31 1998 absolute dollar increase result increase number advertisers average contract duration value result higher web site traffic nettaxicom web pages increase revenues corporate web hosting transaction processing fee revenue lesser extent increases royalties customization fees associated distribution cd rom product barter revenues accounted approximately 7 total revenues twelve months ended december 31 1999 one customer accounted approximately 17 total revenues twelve months ended december 13 1999 year ended december 31 1998 four customers accounted approximately 28 21 13 12 revenues advertising revenues advertising revenues year ended december 31 1999 1998 approximately 267 million approximately 177000 respectively represented 53 69 respectively total net revenues year increase absolute dollars resulted increase number advertisers well increase average contract commitments advertisers result increased web traffic web site transaction processing fees transaction processing fees approximately 129 million year ended december 31 1999 represented 19 total net revenues transaction processing fees 1998 transactions fees consist revenue derived credit card evaluations processing online credit card transactions 1999 revenue attributable merger plus net inc may 1999 contract fees derived terminated december 1999 expect revenues type significant future periods hosting revenues hosting revenues approximately 945000 year ended december 31 1999 represented 19 total net revenues hosting revenues 1998 third quarter 1999 company began providing internet hosting connectivity services corporate customers services delivered stateoftheart internet data center located southern california using highperformance internet backbone network customers pay monthly fees professional services utilized onetime installation fees monthly connectivity charges hosting revenues recognized period services provided cost operations cost operations approximately 400 million 240000 years ended december 31 1999 1998 respectively substantial absolute dollar increases twelve month period 1999 1998 result increased costs colocation expenses internet connection charges equipment costs depreciation equipment amortization intangible assets expenses third party content development third quarter 1999 began providing internet connectivity services corporate customers required purchases additional bandwidth service customers costs expected continue increase web traffic increases corporate customer require additional bandwidth citizens sales marketing expenses sales marketing expenses consisted primarily salaries sales marketing personnel marketing promotion advertising related costs sales marketing expenses approximately 479 million 746000 twelve month periods ended december 31 1999 1998 respectively absolute dollar increases twelve month period 1999 comparable period 1998 sales marketing expenses primarily attributable expansion online print advertising public relations promotional expenditures well increased sales marketing personnel related expenses required implement marketing strategy third quarter 1999 company began implement aggressive marketing campaigns online traditional media promote nettaxicom brand attract increasing number visitors web site expect sales marketing expenses increase significantly future periods increases principally related hiring additional sales marketing personnel increased spending advertising variety media increase brand awareness attract additional visitors web site assurance increased expenditures result increased visitors web site additional revenues research development expenses research development expenses approximately 219 million 635000 twelve month periods ended december 31 1999 1998 respectively absolute dollar increases twelve month period 1999 1998 primarily attributable ongoing updating infrastructure technological development web site increase also includes increased salaries associated hiring costs result highly competitive nature hiring internet software marketplace experienced substantial costs engineer consultants twelve month period ended december 31 1999 expects increased costs continue recruit retain personnel meet research development requirements general administrative expenses general administrative expenses consisted primarily salaries related costs executive administrative finance personnel well legal accounting professional service fees general administrative expenses approximately 346 million 105 million respective twelve month periods ended december 31 1999 1998 respectively increase absolute dollars twelve month period 1999 1998 primarily due increases number general administrative personnel increase fees professional services amortization deferred compensation expenses related issuance common stock option sot consultants expect general administrative expenses grow hire additional personnel incur additional expenses related growth business operation public company asset impairment year ended december 31 1998 operating expenses includes one time adjustment 667000 asset impairment asset impairment write adjust carrying amount portions purchased technology namely web database software application net realizable value period ended december 31 1999 asset impairment writedown recorded interest expense net interest expense approximately 351100 59000 respective twelve month period ended december 31 1999 1998 net interest expense twelve month periods ended december 31 1999 1998 related convertible promissory note issued march 31 1999 amortization deferred interest related warrants issued conjunction convertible promissory note income twelve months ended december 31 1998 realized gain 28500 disposal capital equipment gain realized 1999 income taxes december 31 1999 net operating loss carry forwards available reduce future taxable income aggregate approximately 11200000 federal income tax purposes benefits expire 2019 pursuant change ownership defined provisions tax reform act 1986 utilization net operating loss carry forwards may limited cumulative change ownership 50 occurs threeyear period determined ownership change occurred twelve months ended december 31 1999 recorded tax provision relates earnings made plus net inc fiscal period merger results operations comparison period october 23 1997 date incorporation december 31 1997 twelve months ended december 31 net revenues net revenues twelve months ended december 31 1998 approximately 258000 period ended december 31 1997 approximately 144900 revenues 1997 period principally derived royalties distribution cdrom tutorial product revenues twelve months ended december 31 1998 reflect shift initial startup phase company current business model derives majority revenue sale banner advertisements advertising revenues advertising revenues twelve months ended december 31 1998 approximately 177000 approximately 69 total revenues advertising revenues period ended december 31 1997 company began sale banner advertising internet third quarter 1998 royalty revenues royalty revenues approximately 61700 twelve months ended december 31 1998 represented approximately 24 total revenues approximately 132300 period ended december 31 1997 represented approximately 91 total revenues company initially derived revenues distribution cdrom tutorial product cost operations cost operations approximately 239800 twelve months ended december 31 1998 87400 period ended december 31 1997 substantial absolute dollar result increased costs colocation expenses internet connection charges software equipment costs depreciation equipment result buildout web site sales marketing expenses sales marketing expenses consisted primarily salaries sales marketing personnel sales marketing expenses approximately 745600 3100 twelve month period ended december 31 1998 period ended december 31 1997 respectively absolute dollar increase represents shift early research development stages company current business model online community generating revenues sales advertising required shift resources focus sales marketing efforts promote brand awareness company increased traffic web site expect sales marketing expenses increase significantly future periods increases principally related hiring additional sales marketing personnel increased spending advertising variety media increase brand awareness attract additional visitors web site assurance increased expenditures result increased visitors web site additional revenues research development expenses research development expenses approximately 634700 36500 twelve month period ended december 31 1998 period ended december 31 1997 respectively absolute dollar increases research development expenses primarily attributable ongoing updating infrastructure technological development web site increased salaries result highly competitive nature hiring internet software marketplace expect increased costs continue recruit retain personnel meet research development requirements company general administrative expenses general administrative expenses consisted primarily salaries related costs executive administrative finance personnel well legal accounting professional service fees general administrative expenses approximately 105 million 160000 twelve month period ended december 31 1998 period ended december 31 1997 respectively increase absolute dollars general administrative expenses primarily due increases number general administrative personnel increase fees professional services expect general administrative expenses grow hire additional personnel incur additional expenses related growth business operation public company asset impairment twelve months ended december 31 1998 operating expenses includes one time adjustment 667000 asset impairment asset impairment write adjust carrying amount portions purchased technology namely web database software application net realizable value period ended december 31 1997 asset impairment writedown recorded interest incomeexpense net interest expense twelve months ended december 31 1998 approximately 59000 17000 period ended december 31 1997 net interest expense periods related convertible promissory note issued november 1 1997 converted shares common stock september 1998 income taxes provision income taxes year ended december 31 1998 period ended december 31 1997 consisted minimum state taxes december 31 1998 net operating loss carryforwards available reduce future taxable income aggregate approximately 1227000 federal income tax purposes liquidity capital resources december 31 1999 company cash equivalents approximately 988000 compared approximately 466000 december 31 1998 net cash used operating activities equaled approximately 536 million 665800 twelvemonth periods ended december 31 1999 1998 respectively significant negative cash flows operating activities twelve month periods primarily net operating losses adjusted noncash items increases accounts receivable balances due time lag revenue recognition receipt payments advertisers factors offset significant increases accounts payable accrued expenses net cash used investing activities approximately 216 million 124600 twelve month periods ended december 31 1999 1998 respectively substantially cash used investing activities periods primarily related purchase capital equipment connection build web site infrastructure net cash provided financing activities approximately 804 million 121 million twelve month periods ended december 31 1999 1998 respectively net cash provided financing activities 1998 consisted primarily net proceeds issuance common stock net cash provided financing activities 1999 consisted net proceeds issuance common stock issuance convertible promissory note incurred net losses approximately 988 million 313 million year ended december 31 1999 1998 respectively december 31 1999 accumulated deficit approximately 1334 million net losses accumulated deficit resulted significant operational infrastructure costs incurred development marketing services fact revenues failed keep pace costs result expansion plans expectation operating expenses especially areas sales marketing continue increase significantly expect incur additional losses operations foreseeable future extent increases operating expenses precede subsequently followed commensurate increases revenues unable adjust operating expense levels accordingly business results operations financial condition would materially adversely affected assurance ever achieve sustain profitability operating losses increase future currently believe sufficient cash fund operations december 2000 time required seek additional capital sustain operations expect generate portion necessary cash flow advertising hosting revenues also need obtain capital sources equity debt financing recently completed private placement common stock result raised approximately 236 million exchange approximately 158 million shares common stock issued investors also received warrants purchase equal number shares common stock exercisable exercise price 400 per share investors completed subscription agreements represented company accredited investors purchasing shares account currently negotiating prospective investors however date agreements additional financing consummated cannot assure able achieve sustain positive cash flow profitability sources available provide financial resources necessary continue operations unsuccessful generating resources one anticipated sources unable replace shortfall resources another source may able extend period available resources would adequate deferring creation satisfaction various commitments deferring expansion introduction various services otherwise scaling back operations unable generate required resources ability meet obligations continue operations would adversely affected given limited resources history losses operations need raise additional funds order fund expansion business develop new enhanced services products respond competitive pressures acquire complementary products businesses technologies assurances given however able obtain additional resources unsuccessful generating anticipated resources one anticipated sources unable replace shortfall resources another source may able extend period available resources would adequate deferring creation satisfaction various commitments deferring introduction various services entry various markets otherwise scaling back operations unable generate required resources ability meet obligations continue operations would adversely affected impact year 2000 many currently installed computer systems software products coded accept recognize two digit entries date code field systems may therefore recognize date using 00 year 1900 rather year 2000 result computer systems andor software used many companies governmental agencies may need upgraded comply year 2000 requirements risk system failure miscalculations causing disruptions normal business activities state readiness third party vendors upon materially rely exodus communications alchemy communications inc house service web equipment provide connection internet exodus alchemy informed us believe systems year 2000 compliant although february 28 2000 experienced material technical problems related year 2000 continue seek verification key vendors distributors suppliers year 2000 compliant presently compliant provide description plans become extent vendors failed provide certification year 2000 compliant terminated replaced relationships conducted internal assessment material information technology noninformation technology systems headquarters year 2000 compliance experienced problems systems january 1 2000 since time believe material systems currently year 2000 compliant costs date yet incurred material costs identifying evaluating year 2000 compliance issues costs related expected continue relate upgrades replacements necessary software hardware well costs associated time spent employees evaluation process year 2000 compliance matters generally expenses included operating capital expenditures budget expected exceed 100000 however costs significantly higher expected could material adverse effect business results operations financial condition risks although february 28 2000 experienced material technical problems related year 2000 assurance discover year 2000 compliance problems systems require substantial revisions replacements event operational facilities support business webhosting facilities year 2000 compliant may unable deliver goods services customers portions web site may become unavailable addition assurance third party software hardware services incorporated material systems need revised replaced could timeconsuming expensive inability fix replace third party software hardware services timely basis could result lost revenues increased operating costs business interruptions could material adverse effect business results operations financial condition moreover failure adequately address year 2000 compliance issues software hardware systems could result claims mismanagement misrepresentation breach contract related litigation could costly timeconsuming defend addition assurance governmental agencies utility companies internet access companies others outside control year 2000compliant failure entities year 2000compliant could result systemic failure beyond control including example prolonged internet telecommunications electrical failure could also prevent us delivering services users decrease use internet prevent users accessing services would material adverse effect business results operations financial condition contingency plan currently contingency plan deal worst case scenario might occur technologies depend year 2000compliant fail operate effectively year 2000 taken consideration results year 2000 compliance evaluation responses received distributors suppliers third parties conduct business determining need nature extent contingency plans present efforts address year 2000 compliance issues discussed successful distributors suppliers third parties conduct business successfully address issues users could seek alternate suppliers products services material year 2000 problem could require us incur significant unanticipated expenses remedy could divert managements time attention either could material adverse effect business operating results financial condition year 2000 readiness disclosure statement within meaning year 2000 information readiness disclosure act pl 105271 however disclosures made herein affect liabilities federal securities laws recent accounting pronouncements june 1997 financial accounting standards board issued statement financial accounting standards 131 disclosure segments enterprise related information effective fiscal years beginning december 15 1997 statement financial accounting standards no131 requires public companies report information operating segments annual financial statements subsequent condensed financial statements interim periods issued shareholders statement also requires public companies report information products services geographic areas operate major customers reportable operating segments determined based management approach defined statement financial accounting standards 131 management approach based way chief operating decisionmaker organizes segments within enterprise making operating decisions assessing performance determined separately reportable business segments february 1998 financial accounting standards board issued statement financial accounting standards 132 employers disclosure pension post retirement benefits standardized disclosure requirements pension post retirement benefits adoption statement financial accounting standards 132 impact companys current disclosures june 1998 financial accounting standards board issued statement financial accounting standards 133 accounting derivative instruments hedging activities statement financial accounting standards no133 establishes accounting reporting standards requiring every derivative instrument recorded balance sheet either asset liability measured fair value statement financial accounting standards 133 requires changes derivatives fair value recognized currently earnings unless specific hedge accounting criteria met june 1999 fasb issued sfas 137 accounting derivative instruments hedging activities deferral effective date fasb statement 133 amends sfas 133 effective fiscal quarters fiscal years beginning june 15 2000 historically entered derivatives contracts either hedge existing risks speculative purposes accordingly expect adoption new standard material impact results operations financial position cash flows march 1998 american institute certified public accountants issued statement position 981 software internal use provides guidance accounting cost computer software developed obtained internal use statement position 981 effective financial statements fiscal years beginning december 13 1998 expect adoption statement position 981 material impact consolidated financial statements item 7aitem 7 managements discussion analysis financial condition results operations report contains forwardlooking statements within meaning section 27a securities act 1933 section 21e securities exchange act 1934 including without limitation statements regarding companys expectations beliefs intentions future strategies signified words expects anticipates intends believes similar language forwardlooking statements involve risks uncertainties factors forwardlooking statements included document based information available company date hereof speak date hereof factors discussed risk factors elsewhere annual report form 10k among factors cases affected companys results could cause actual results differ materially projected forwardlooking statements following discussion read conjunction condensed consolidated financial statements notes thereto overview nettaxicom internet marketing portal provides wide range content internet based services consumers businesses web site wwwnettaxicom serves gathering place people shared topics interest well entry point referred portal internet web site provide content addressing large number targeted categories content organized affinity categories news sports entertainment health politics finances lifestyle areas interest visitors web site provided comprehensive information content subscribers web site call citizens also provided access enhanced content broadband video clips email accounts personal web pages developed diversified revenue model provide citizens access web site hosting services broad range content provide affiliated businesses access large population internet users advertising promotional purposes 2000 focused efforts improving quality content available web site implementing web site hosting services reducing operating costs eliminating many services profitable year developed number new promotions designed generate new sources revenue third quarter 1999 began providing web site hosting internet connectivity services corporate customers services delivered stateoftheart internet data center located southern california using highperformance internet backbone network customers pay monthly fees professional services utilized onetime installation fees connectivity charges hosting revenues recognized period services provided loss reduction revenue customer may material impact total net revenues company also receives revenues premium account membership subscriptions membership programs offer premium services monthly fee providing additional services unlimited personal email accounts family friends unlimited nettaxi site builder web pages themed web page templates personal event calendar discussion groups options customize personal homepages pictures colors content may 1999 completed merger plus net inc california corporation allowed us provide users web based email program robust meta search engine plus net also ecommerce processing engine enables acceptance processing online credit card transactions believe merger also enhanced electronic commerce advertising opportunities result merger received revenues credit card processing fees first half 1999 minimal revenues earned third quarter 1999 contract fees derived terminated december 1999 anticipate revenues type minimal foreseeable future february 2000 completed private placement raised approximately 23 million exchange issuance companys common stock warrants purchase shares common fully exercised investors result additional 62 million equity funding nettaxicom acquisition new capital provide nettaxicom ability become aggressive competitor community portal arena company plans use funds raised increase ability develop new community content commerce relationships enhance nettaxicom citizens experience within communities funding also facilitate potential acquisitions mergers strategic partnerships fit companys overall longterm business strategy date entered business technology license arrangements order build web site community provide communityspecific content generate additional traffic provide subscribers additional products services including ecommerce tools fourth quarter ended september 30 2000 entered contract screaming media provide content users website expect new content increase brand awareness web site also entered contract annuncio software inc enhance marketing efforts direct marketing citizens may enhance time spent online products services purchase intend continue investigate potential acquisitions seek additional relationships content providers fall within scope business strategy serve increase subscriber base overall site traffic acquisitions carry numerous risks uncertainties cannot guarantee able successfully integrate businesses products technologies personnel might acquired future results operations comparison twelve months ended december 31 2000 1999 net revenues net revenues year ended december 31 2000 increased 87 approximately 94 million 50 million year ended december 31 1999 absolute dollar increase result increase revenues corporate web hosting increase advertising revenues advertising revenues included third party revenues traditional internet related advertisers also includes reciprocal arrangements year ended december 31 2000 four customers accounted greater 10 total net revenues total approximately 51 million 54 total revenues customers babenet spinrecordscom whitesand communications hearmecom accounted 20 13 11 10 respectively total revenues year ended december 31 1999 one customer whitesand communications accounted greater 10 total net revenues loss one customers could material adverse affect revenue advertising revenues advertising revenues year ended december 31 2000 1999 approximately 57 million approximately 27 million respectively represented 60 53 respectively total net revenues year increase absolute dollars resulted increase reciprocal advertising transactions increases number advertisers well increase average contract commitments advertisers result increased web traffic web sitereciprocal advertising arrangements exchanges similar services company advertisers arrangements accounted approximately 28 7 total revenues twelve months ended december 31 2000 1999 respectively reciprocal arrangements twelve months ended december 31 2000 result companys strategy developing strategic relationships advertisers service providers noncash media advertising transaction processing fees transaction processing fees year ended december 31 2000 transaction processing fees approximately 129 million year ended december 31 1999 represented 26 total net revenues transactions fees consisted revenue derived credit card evaluations processing online credit card transactions 1999 revenue attributable merger plus net inc may 1999 contract fees derived terminated december 1999 expect revenues type significant future periods hosting revenues hosting revenues approximately 37 million 945000 years ended december 31 2000 1999 respectively represented 40 19 total net revenues respectively year ended december 31 2000 recognized hosting revenues twelve months compared six months year ended december 31 1999 third quarter 1999 began providing internet hosting connectivity services corporate customers services delivered stateoftheart internet data center located southern california using highperformance internet backbone network customers pay monthly fees professional services utilized onetime installation fees monthly connectivity charges hosting revenues recognized period services provided company experienced strong revenue growth internet web hosting corporate customers expect growth continue current rate company sustain profitability business segment additionally company cannot assure increase number corporate customers maintain current customer base previously described two webhosting customers accounted 10 total net revenues twelve months ended december 31 2000 cost operations cost operations approximately 73 million 40 million years ended december 31 2000 1999 respectively cost operations increased 83 approximately 85 increase result additional expenses related costs colocation internet connection charges expenses third quarter 1999 began providing internet connectivity services corporate customers required purchases additional bandwidth service customers costs expected continue increase web traffic increases corporate customer require additional bandwidth citizens year ended december 31 2000 recognized hosting expenses twelve months compared six months year ended december 31 1999 approximately 11 increase related increased depreciation expense capital purchased 1999 approximately 6 increase related costs consultants improve website separately third quarter ended september 30 2000 also initiated cost effective measurement tools limit use unauthorized excessive bandwidth charging individual users use additional bandwidth cost measures resulted cost savings company third fourth quarter year 2000 cannot assured cost saving measures continue result substantial savings sales marketing expenses sales marketing expenses approximately 59 million 48 million twelve month periods ended december 31 2000 1999 respectively sales marketing expenses consisted primarily advertising including cobranding reciprocal salaries sales marketing personnel related costs marketing promotion costs approximately 19 million net increase result redirected marketing approach brand awareness implemented third quarter 2000 consisted using reciprocal online advertising arrangements increase brand awareness rather traditional print media marketing approach company recorded reciprocal advertising expenses relation reciprocal advertising revenues 22 million year ended december 31 2000 compared approximately 03 million year ended december 31 1999 company utilizes reciprocal advertising arrangements inexpensive advertising media increasing brand awareness assurance increased expenditures result increased visitors web site additional revenues future increase offset reduction approximately 08 million reduction spending traditional marketing media expenditures research development expenses research development expenses 16 million 22 million twelve months ended december 31 2000 1999 respectively 28 decrease primarily attributable lower utilization consultants company decrease average number technical personnel year 2000 approximately 06 million decrease related lower utilization consultants 02 million decrease related decrease recruiting fees paid hire new employees two costs offset approximately 03 million increase related increased depreciation expense capital equipment company experienced difficulty ability recruit retain technical personnel result current economic prosperity high cost living silicon valley expects condition continuous impact ability company retain hire additional technical personnel general administrative expenses general administrative expenses 50 million 35 million twelve months ended december 31 2000 1999 respectively general administrative costs consisted primarily salaries related costs executives administrative finance personnel well legal accounting professional service fees approximately 06 million increase general administrative expenses primarily attributable amortization deferred compensation expense related stock warrants options granted year various consultants services approximately 04 million increase result additional salaries personnel costs approximately 04 million increase related higher insurance costs associated public company also increase result legal fees related settlement agreement holder convertible debentures company also recorded approximately 500000 provision uncollectible accounts receivable company expects due highly volatile market conditions internet related advertising companies provision bad debt may higher future increase offset decrease expenditures related merger plus net interest expense net interest expense 40 million 04 million years ended december 31 2000 1999 respectively year 1999 period net interest expense primarily due convertible promissory note issued march 31 1999 amortization deferred interest related warrants issued conjunction convertible promissory note offset interest income year 2000 period net interest expense primarily result deemed interest expense related convertible debenture issued march 31 1999 recognized deemed interest expense approximately 39 million second quarter 2000 noncash interest expense resulted implied beneficial conversion feature value warrants issued connection settlement agreement reached holder convertible debenture income taxes december 31 2000 net operating loss carryforwards available reduce future taxable income aggregate approximately 251 million federal income tax purposes benefits begin expire 2017 company also california net operation loss carryforwards amount 134 million may applied future taxable income benefits begin expire 2002 ability utilize net operating loss carryforwards dependent upon ability generate taxable income future periods may limited due restrictions imposed federal state laws upon change ownership provision income taxes year ended december 31 2000 consisted minimum state taxes year ended december 31 1999 recorded tax provision related earnings made plusnet inc fiscal period merger results operations comparison twelve months ended december 31 1999 1998 net revenues net revenues year ended december 31 1999 increased 1851 approximately 503 million 258000 year ended december 31 1998 absolute dollar increase result increase number advertisers average contract duration value result higher web site traffic nettaxicom web pages increase revenues corporate web hosting transaction processing fee revenue lesser extent increases royalties customization fees associated distribution cd rom product barter revenues accounted approximately 7 total revenues twelve months ended december 31 1999 one customer whitesand communications inc accounted approximately 17 total revenues twelve months ended december 13 1999 customer accounted greater 10 total revenues year ended december 31 1998 four customers accounted greater 10 net revenues customers dventure unique media go4media pioneer technologies flycast communications accounted 28 21 13 12 net revenues respectively advertising revenues advertising revenues year ended december 31 1999 1998 approximately 267 million approximately 177000 respectively represented 53 69 respectively total net revenues year increase absolute dollars resulted increase number advertisers well increase average contract commitments advertisers result increased web traffic web site transaction processing fees transaction processing fees approximately 129 million year ended december 31 1999 represented 26 total net revenues transaction processing fees 1998 transactions fees consist revenue derived credit card evaluations processing online credit card transactions 1999 revenue attributable merger plus net inc may 1999 contract fees derived terminated december 1999 expect revenues type significant future periods hosting revenues hosting revenues approximately 945000 year ended december 31 1999 represented 19 total net revenues hosting revenues 1998 third quarter 1999 company began providing internet hosting connectivity services corporate customers services delivered stateoftheart internet data center located southern california using highperformance internet backbone network customers pay monthly fees professional services utilized onetime installation fees monthly connectivity charges hosting revenues recognized period services provided cost operations cost operations approximately 40 million 240000 years ended december 31 1999 1998 respectively approximately 93 increases twelve month period 1999 1998 result increased costs colocation expenses internet connection charges equipment costs depreciation equipment amortization intangible assets expenses third party content development accounted balance increase third quarter 1999 began providing internet connectivity services corporate customers required purchases additional bandwidth service customers costs expected continue increase web traffic increases corporate customer require additional bandwidth citizens sales marketing expenses sales marketing expenses consisted primarily salaries sales marketing personnel marketing promotion advertising related costs sales marketing expenses approximately 479 million 746000 twelve month periods ended december 31 1999 1998 respectively approximately 28 million increase related expansion online print advertising public relation promotional expenditures approximately 05 million increase related hiring 10 additional sales marketing personnel related expenses required implement marketing strategy third quarter 1999 company began implement aggressive marketing campaigns online traditional media promote nettaxicom brand attract increasing number visitors web site expect sales marketing expenses increase significantly future periods increases principally related hiring additional sales marketing personnel increased spending advertising variety media increase brand awareness attract additional visitors web site assurance increased expenditures result increased visitors web site additional revenues research development expenses research development expenses approximately 219 million 635000 twelve month periods ended december 31 1999 1998 respectively absolute dollar increases twelve month period 1999 1998 primarily attributable ongoing updating infrastructure technological development web site approximately 06 million increase includes increased salaries associated hiring costs result highly competitive nature hiring internet software marketplace hiring 7 additional personnel experienced substantial costs engineer consultants twelve month period ended december 31 1999 expects increased costs continue recruit retain personnel meet research development requirements costs accounted approximately 07 million net increase general administrative expenses general administrative expenses consisted primarily salaries related costs executive administrative finance personnel well legal accounting professional service fees general administrative expenses approximately 346 million 105 million respective twelve month periods ended december 31 1999 1998 respectively approximately 06 million increase related increases salaries general administrative personnel related costs result hiring key financial personnel second quarter 1999 approximately 06 million increase costs associated amortization deferred compensation expenses related issuance common stock options consultants approximately 07 million increase result higher legal accounting fees associated cost public company approximately 05 million increase result costs associated merger plus net inc 1999 expect general administrative expenses grow hire additional personnel incur additional expenses related growth business operation public company asset impairment year ended december 31 1998 operating expenses includes one time adjustment 667000 asset impairment asset impairment write adjust carrying amount portions purchased technology namely web database software application net realizable value period ended december 31 1999 asset impairment writedown recorded interest expense net interest expense approximately 351100 59000 respective twelve month period ended december 31 1999 1998 net interest expense twelve month periods ended december 31 1999 1998 related convertible promissory note issued march 31 1999 amortization deferred interest related warrants issued conjunction convertible promissory note income twelve months ended december 31 1998 realized gain 28500 disposal capital equipment gain realized 1999 income taxes december 31 1999 net operating loss carry forwards available reduce future taxable income aggregate approximately 11200000 federal income tax purposes benefits expire 2019 pursuant change ownership defined provisions tax reform act 1986 utilization net operating loss carry forwards may limited cumulative change ownership 50 occurs threeyear period twelve months ended december 31 1999 recorded tax provision relates earnings made plus net inc fiscal period merger results operations comparison period october 23 1997 date incorporation december 31 1997 twelve months ended december 31 net revenues net revenues twelve months ended december 31 1998 approximately 258000 period ended december 31 1997 approximately 144900 revenues 1997 period principally derived royalties distribution cdrom tutorial product revenues twelve months ended december 31 1998 reflect shift initial startup phase company current business model derives majority revenue sale banner advertisements advertising revenues advertising revenues twelve months ended december 31 1998 approximately 177000 approximately 69 total revenues advertising revenues period ended december 31 1997 company began sale banner advertising internet third quarter 1998 royalty revenues royalty revenues approximately 61700 twelve months ended december 31 1998 represented approximately 24 total revenues approximately 132300 period ended december 31 1997 represented approximately 51 total revenues company initially derived revenues distribution cdrom tutorial product cost operations cost operations approximately 239800 twelve months ended december 31 1998 87400 period ended december 31 1997 substantial absolute dollar result increased costs colocation expenses internet connection charges software equipment costs depreciation equipment result buildout web site sales marketing expenses sales marketing expenses consisted primarily salaries sales marketing personnel sales marketing expenses approximately 745600 3100 twelve month period ended december 31 1998 period ended december 31 1997 respectively absolute dollar increase represents shift early research development stages company current business model online community generating revenues sales advertising required shift resources focus sales marketing efforts promote brand awareness company increased traffic web site expect sales marketing expenses increase significantly future periods increases principally related hiring additional sales marketing personnel increased spending advertising variety media increase brand awareness attract additional visitors web site assurance increased expenditures result increased visitors web site additional revenues research development expenses research development expenses approximately 634700 36500 twelve month period ended december 31 1998 period ended december 31 1997 respectively absolute dollar increases research development expenses primarily attributable ongoing updating infrastructure technological development web site increased salaries result highly competitive nature hiring internet software marketplace expect increased costs continue recruit retain personnel meet research development requirements company general administrative expenses general administrative expenses consisted primarily salaries related costs executive administrative finance personnel well legal accounting professional service fees general administrative expenses approximately 105 million 160000 twelve month period ended december 31 1998 period ended december 31 1997 respectively increase absolute dollars general administrative expenses primarily due increases number general administrative personnel increase fees professional services expect general administrative expenses grow hire additional personnel incur additional expenses related growth business operation public company asset impairment twelve months ended december 31 1998 operating expenses includes one time adjustment 667000 asset impairment asset impairment write adjust carrying amount portions purchased technology namely web database software application net realizable value period ended december 31 1997 asset impairment writedown recorded interest incomeexpense net interest expense twelve months ended december 31 1998 approximately 59000 17000 period ended december 31 1997 net interest expense periods related convertible promissory note issued november 1 1997 converted shares common stock september 1998 income taxes provision income taxes year ended december 31 1998 period ended december 31 1997 consisted minimum state taxes december 31 1998 net operating loss carry forwards available reduce future taxable income aggregate approximately 1227000 federal income tax purposes liquidity capital resources december 31 2000 company cash equivalents approximately 13900000 compared approximately 988000 december 31 1999 net cash used operating activities equaled approximately 84 million 537 million twelvemonth periods ended december 31 2000 1999 respectively significant negative cash flows operating activities twelve month periods primarily net operating losses adjusted noncash items 1999 increase accounts receivable balances due time lag revenue recognition receipt payments advertisers 1999 factors offset significant increases accounts payable accrued expenses non cash adjustments included issuance common stock services 1019400 34200 years ended december 312000 1999 respectively compensation expense related options warrants granted 615700 211300 years ended december 31 2000 1999 respectively non cash adjustments year ended december 31 2000 included interest expense related settlement agreement issuance warrants related convertible note issued 1999 total expense 2000 approximately 46 million compared approximately 200000 1999 non cash adjustments also included bad debt writeoffs 350000 52400 years ended december 31 2000 1999 respectively net cash used investing activities approximately 744000 216 million twelve month periods ended december 31 2000 1999 respectively substantially cash used investing activities periods primarily related purchase capital equipment connection build web site infrastructure company outstanding orders capital equipment believes current capital equipment sustain needs forthcoming year company plan spend significant amount 2001 capital equipment net cash provided financing activities approximately 220 million 804 million twelve month periods ended december 31 2000 1999 respectively net cash provided financing activities 2000 consisted primarily net proceeds issuance common stock private placement offering net cash provided financing activities 1999 consisted net proceeds issuance common stock issuance convertible promissory note incurred net losses approximately 144 million 988 million year ended december 31 2000 1999 respectively december 31 2000 accumulated deficit approximately 277 million net losses accumulated deficit resulted significant operational infrastructure costs incurred development marketing services fact revenues failed keep pace costs result expansion plans expectation operating expenses especially areas sales marketing continue increase significantly expect incur additional losses operations foreseeable future extent increases operating expenses precede subsequently followed commensurate increases revenues unable adjust operating expense levels accordingly business results operations financial condition would materially adversely affected assurance ever achieve sustain profitability operating losses increase future february 2000 completed private placement common stock result raised approximately 23 million exchange approximately 154 million shares common stock issued investors also received warrants purchase equal number shares common stock exercisable exercise price 400 per share currently believe sufficient cash fund current operations december 2002 however given limited resources history losses operations need raise additional funds order fully execute business plan fund expansion business develop new enhanced services products respond competitive pressures acquire complementary products businesses technologies assurances given however able obtain additional resources unsuccessful generating anticipated resources one anticipated sources unable replace shortfall resources another source may able extend period available resources would adequate deferring creation satisfaction various commitments deferring introduction various services entry various markets otherwise scaling back operations unable generate required resources ability meet obligations continue operations would adversely affected recent accounting pronouncements december 1999 staff securities exchange commission issued staff accounting bulletin 101 revenue recognition staff accounting bulletin 101 provides sec staffs views applying generally accepted accounting principles selected revenue recognition issues staff accounting bulletin 101 effective fourth fiscal quarter fiscal years beginning december 15 1999 believe current revenue recognition policies comply provisions staff accounting bulletin 101 march 2000 financial accounting standards board issued interpretation 44 accounting certain transactions involving stock compensation interpretation abp opinion 25 became effective july 1 2000 interpretation 44 clarifies definition employee purposes applying opinion 25 b criteria determining whether stock compensation plan qualifies noncompensatory plan c accounting consequences various modifications terms previously fixed stock option award accounting exchange stock compensation awards business combination adoption provisions interpretation significant impact financial statements june 1998 financial accounting standards board issued statement financial accounting standards 133 accounting derivative instruments hedging activities statement financial accounting standards no133 amended statement financial accounting standards 138 establishes accounting reporting standards requiring every derivative instrument recorded balance sheet either asset liability measured fair value statement financial accounting standards 133 requires changes derivatives fair value recognized currently earnings unless specific hedge accounting criteria met june 1999 fasb issued sfas 137 accounting derivative instruments hedging activities deferral effective date fasb statement 133 amends sfas 133 effective fiscal quarters fiscal years beginning june 15 2000 historically entered derivatives contracts either hedge existing risks speculative purposes accordingly expect adoption new standard material impact results operations financial position cash flows item 7aitem 7 managements discussion analysis financial condition results operations report contains forwardlooking statements within meaning section 27a securities act 1933 section 21e securities exchange act 1934 including without limitation statements regarding companys expectations beliefs intentions future strategies signified words expects anticipates intends believes similar language forwardlooking statements involve risks uncertainties factors forwardlooking statements included document based information available company date hereof speak date hereof factors discussed risk factors elsewhere annual report form 10k among factors cases affected companys results could cause actual results differ materially projected forwardlooking statements following discussion read conjunction condensed consolidated financial statements notes thereto overview nettaxicom internet marketing portal provides content internet based services consumers businesses web site wwwnettaxicom serves gathering place people shared topics interest well entry point referred portal internet web site provide content addressing number targeted categories subscribers web site also provided access enhanced content broadband video clips email accounts 1999 developed diversified revenue model provided subscribers access web site hosting services broad range content provided affiliated businesses access large population internet users advertising promotional purposes 2001 nettaxi faced challenges overall downturn internet industry economy general december 31 2001 incurred losses approximately 362 million bankruptcy liquidation many internet based customers suppliers caused us reevaluate business model since internet infrastructure unstable customer base financially weak took corrective action significantly decrease cash burn determine best course action maintain enhance value company regard implemented acquisition strategy pursuant sought identify appropriate entity merge acquire restructure current business since announcement acquisition strategy may 2001 evaluated number potential merger candidates wide variety industries companies believe rae systems presents best fit shareholders believe merger rae systems fruit acquisition strategy merger provide us new direction avoids pitfalls crippled many internet businesses june 2001 reduced overhead burn rate reducing salaries employees reducing number personnel marketing expenses costs associated hosting activities current management team consisting finance administrative employees place maintain operations consummate proposed merger rae systems continue operate website however focused energies acquisition strategy therefore pursued revenue generating activities last six months 2001 prior june 2001 provided web site hosting internet connectivity services corporate customers services delivered stateoftheart internet data center located southern california using highperformance internet backbone network customers paid monthly fees professional services utilized onetime installation fees connectivity charges hosting revenues recognized period services provided hosting revenues variable based upon bandwidth usage services used resulted operating losses time june 2001 terminated significant cohosting customer contracts effective july 7 2001 connection also discontinued purchase bandwidth premium services third party provider reducing monthly expenditures terminations reduced operating expenses materially affected revenues beginning third quarter 2001 acquisitions carry numerous risks uncertainties cannot guarantee able successfully integrate businesses products technologies personnel might acquired future results operations comparison twelve months ended december 31 2001 2000 net revenues net revenues twelve months ended december 31 2001 21 million compared 94 million twelve months 2000 significant decrease primarily result substantial reduction operating activities expenditures connection adoption acquisition strategy current economic climate internet industry june 2001 terminated significant cohosting customer contracts effective july 7 2001 materially decreased revenues beginning third quarter 2001 substantial decrease also result significantly lower advertising revenues recognized twelve months ended december 31 2001 twelve months ended december 31 2001 three customers accounted greater 10 total net revenues total approximately 19 million 90 total revenues customers babenet whitesand communications whitehorn ventures limited accounted 47 19 25 respectively total revenues three customers cohosting customers twelve months ended december 31 2000 four customers babenet whitesand communications hearmecom spinrecordscom accounted greater 10 total net revenues total approximately 51 million 54 total revenues june 2001 terminated significant cohosting customer contracts effective july 7 2001 materially affected revenues beginning third quarter 2001 advertising revenues advertising revenues twelve months ended december 31 2001 2000 approximately 02 million approximately 57 million respectively represented 10 60 respectively total net revenues decline absolute dollars resulted substantial reduction operating activities expenditures connection adoption acquisition strategy current economic climate internet industry decline also attributable discontinued use reciprocal advertising transactions decreases number advertisers decrease average rate paid advertisers result increased bankruptcy liquidation trend marketplace tightened credit terms loss many customers also initiated several cost savings strategies first quarter 2001 resulted cancellation advertising arrangements customers decided new strategies meet criteria advertising promotions also first quarter 2001 terminated free hosting arrangements citizens resulted decreased page views therefore decreased number banner advertisements served believe revenues sale banner advertisements longer justify cost purchasing bandwidth reciprocal advertising arrangements accounted approximately 0 28 total revenues twelve months ended december 31 2001 2000 respectively reciprocal arrangements used strategy developing strategic relationships advertisers service providers noncash media advertising longer utilize agreements return investment agreements longer benefits us continue operate website sell advertising products revenues significantly lower prior periods expect revenues grow light changing market conditions recent actions taken us hosting revenues hosting revenues approximately 19 million 37 million twelve months ended december 31 2001 2000 represented 90 40 total net revenues respectively decline absolute dollars resulted substantial reduction operating activities expenditures connection adoption acquisition strategy current economic climate internet industry twelve months ended december 31 2001 hosting revenues higher percentage total net revenue advertising revenues significantly decreased twelve months ended december 31 2001 services delivered stateoftheart internet data center located southern california using highperformance internet backbone network customers pay monthly fees professional services utilized onetime installation fees monthly connectivity charges hosting revenues recognized period services provided receive onetime installation fees twelve months ended december 31 2001 2000 respectively june 2001 terminated significant cohosting customer contracts effective july 7 2001 materially affected revenues beginning third quarter 2001 cost operations cost operations approximately 43 million 73 million twelve months ended december 31 2001 2000 respectively cost operations decreased result substantial reduction operating activities expenditures connection adoption acquisition strategy decline also attributable termination cohosting customer contracts required purchasing bandwidth services third party provider also experienced substantial decrease traffic website resulted offset cost purchasing bandwidth beginning february 2001 changed web hosting provider alchemy communications carrier southern california new provider provides similar services substantial cost saving us entered traffic directive arrangements whereas selected web traffic page views diverted interest specific areas website advertisements arrangements require special tools costs third parties began new arrangements fourth quarter 2000 result acquisition strategy terminated arrangements july 2001 similar costs twelve months ended december 31 2001 sales marketing expenses sales marketing expenses approximately 09 million 59 million twelve months ended december 31 2001 2000 respectively decline sales marketing expenses attributable substantial reduction operating activities expenditures connection adoption acquisition strategy decline also attributable discontinued use reciprocal online advertising arrangements increase brand awareness traditional print media marketing advertising recorded reciprocal advertising expenses relation reciprocal advertising revenues approximately 22 million twelve months ended december 31 2000 similar expenses 2001 research development expenses research development expenses approximately 04 million 16 million twelve months ended december 31 2001 2000 respectively decline expense primarily attributable decrease salaries expense personnel result decreased personnel terminated research development personnel beginning second quarter 2001 currently hiring plan effect replacement individuals plan utilize consultants technical projects october 2001 engaged two technical consultants shortterm projects general administrative expenses general administrative expenses approximately 55 million 50 million twelve months ended december 31 2001 2000 respectively general administrative costs consisted primarily salaries related costs executives administrative finance personnel well legal accounting professional service fees addition recognized 2001 writedown approximately 823000 due impairment equipment purchased technology intangibles loss disposal certain equipment 327600 related move smaller facilities june 2001 due market conditions unable sell capital equipment costs storage moving equipment would exceeded gain realized sale june 2001 negotiated early termination facilities lease recognized onetime charge approximately 94000 included forfeited deposit fee necessary result market conditions san francisco bay area entered facilities lease smaller space campbell california believe space sufficient conduct current activities also recognized approximately 141000 onetime costs associated termination intended acquisition lookupguidecom additional expenses offset decreases personnel costs result termination personnel first second quarter 2001 interest income interest income approximately 447900 703800 twelve months ended december 31 2001 2000 respectively higher average cash balance twelve months ended december 31 2000 result issuance common stock private placement offering february 2000 cash proceeds became available march 2000 interest expense interest expense approximately 9400 47 million twelve months ended december 31 2001 2000 respectively year 2000 period interest expense primarily result noncash deemed interest expense related implied beneficial conversion feature value warrants issued connection settlement agreement reached holder convertible debentures issued march 31 1999 convertible note fully converted second quarter 2000 therefore interest expense recorded note 2001 income taxes provision income taxes years ended december 31 2001 2000 consisted minimum state taxes 2400 1600 respectively december 31 2001 net operating loss carryforwards available reduce future taxable income aggregate approximately 267 million federal income tax purposes benefits begin expire 2017 also california net operation loss carryforwards amount 142 million may applied future taxable income benefits begin expire 2002 ability utilize net operating loss carryforwards dependent upon ability generate taxable income future periods may limited due restrictions imposed federal state laws upon change ownership complete acquisition consistent acquisition strategy may unable apply net operating loss carryforwards results operations comparison twelve months ended december 31 2000 1999 net revenues net revenues year ended december 31 2000 increased 87 approximately 94 million 50 million year ended december 31 1999 absolute dollar increase result increase revenues corporate web hosting increase advertising revenues advertising revenues included third party revenues traditional internet related advertisers also includes reciprocal arrangements year ended december 31 2000 four customers accounted greater 10 total net revenues total approximately 51 million 54 total revenues customers babenet spinrecordscom whitesand communications hearmecom accounted 20 13 11 10 respectively total revenues year ended december 31 1999 one customer whitesand communications accounted greater 10 total net revenues loss one customers could material adverse affect revenue advertising revenues advertising revenues year ended december 31 2000 1999 approximately 57 million approximately 27 million respectively represented 60 53 respectively total net revenues year increase absolute dollars resulted increase reciprocal advertising transactions increases number advertisers well increase average contract commitments advertisers result increased web traffic web site reciprocal advertising arrangements exchanges similar services company advertisers arrangements accounted approximately 28 7 total revenues twelve months ended december 31 2000 1999 respectively reciprocal arrangements twelve months ended december 31 2000 result companys strategy developing strategic relationships advertisers service providers noncash media advertising transaction processing fees transaction processing fees year ended december 31 2000 transaction processing fees approximately 129 million year ended december 31 1999 represented 26 total net revenues transactions fees consisted revenue derived credit card evaluations processing online credit card transactions 1999 revenue attributable merger plus net inc may 1999 contract fees derived terminated december 1999 expect revenues type significant future periods hosting revenues hosting revenues approximately 37 million 945000 years ended december 31 2000 1999 respectively represented 40 19 total net revenues respectively year ended december 31 2000 recognized hosting revenues twelve months compared six months year ended december 31 1999 third quarter 1999 began providing internet hosting connectivity services corporate customers services delivered stateoftheart internet data center located southern california using highperformance internet backbone network customers pay monthly fees professional services utilized onetime installation fees monthly connectivity charges hosting revenues recognized period services provided company experienced strong revenue growth internet web hosting corporate customers expect growth continue current rate company sustain profitability business segment additionally company cannot assure increase number corporate customers maintain current customer base previously described two webhosting customers accounted 10 total net revenues twelve months ended december 31 2000 cost operations cost operations approximately 73 million 40 million years ended december 31 2000 1999 respectively cost operations increased 83 approximately 85 increase result additional expenses related costs colocation internet connection charges expenses third quarter 1999 began providing internet connectivity services corporate customers required purchases additional bandwidth service customers costs expected continue increase web traffic increases corporate customer require additional bandwidth citizens year ended december 31 2000 company recognized hosting expenses twelve months compared six months year ended december 31 1999 approximately 6 increase related increased depreciation expense capital purchased 1999 approximately 6 increase related costs consultants improve website separately third quarter ended september 30 2000 also initiated cost effective measurement tools limit use unauthorized excessive bandwidth charging individual users use additional bandwidth cost measures resulted cost savings company third fourth quarter year 2000 cannot assured cost saving measures continue result substantial savings sales marketing expenses sales marketing expenses approximately 59 million 48 million twelve month periods ended december 31 2000 1999 respectively sales marketing expenses consisted primarily advertising including cobranding reciprocal salaries sales marketing personnel related costs marketing promotion costs approximately 19 million net increase result redirected marketing approach brand awareness implemented third quarter 2000 consisted using reciprocal online advertising arrangements increase brand awareness rather traditional print media marketing approach company recorded reciprocal advertising expenses relation reciprocal advertising revenues 22 million year ended december 31 2000 compared approximately 03 million year ended december 31 1999 company utilizes reciprocal advertising arrangements inexpensive advertising media increasing brand awareness assurance increased expenditures result increased visitors web site additional revenues future increase offset reduction approximately 08 million reduction spending traditional marketing media expenditures research development expenses research development expenses 16 million 22 million twelve months ended december 31 2000 1999 respectively 28 decrease primarily attributable lower utilization consultants company decrease average number technical personnel year 2000 approximately 06 million decrease related lower utilization consultants 02 million decrease related decrease recruiting fees paid hire new employees two costs offset approximately 03 million increase related increased depreciation expense capital equipment company experienced difficulty ability recruit retain technical personnel result current economic prosperity high cost living silicon valley expects condition continuous impact ability company retain hire additional technical personnel general administrative expenses general administrative expenses 50 million 35 million twelve months ended december 31 2000 1999 respectively general administrative costs consisted primarily salaries related costs executives administrative finance personnel well legal accounting professional service fees approximately 06 million increase general administrative expenses primarily attributable amortization deferred compensation expense related stock warrants options granted year various consultants services approximately 04 million increase result additional salaries personnel costs approximately 04 million increase related higher insurance costs associated public company also increase result legal fees related settlement agreement holder convertible debentures company also recorded approximately 500000 provision uncollectible accounts receivable company expects due highly volatile market conditions internet related advertising companies provision bad debt may higher future increases offset decrease expenditures related merger plus net inc 1999 interest expense net interest expense 40 million 04 million years ended december 31 2000 1999 respectively year 1999 period net interest expense primarily due convertible promissory note issued march 31 1999 amortization deferred interest related warrants issued conjunction convertible promissory note offset interest income year 2000 period net interest expense primarily result deemed interest expense related convertible debenture issued march 31 1999 recognized deemed interest expense approximately 39 million second quarter 2000 noncash interest expense resulted implied beneficial conversion feature value warrants issued connection settlement agreement reached holder convertible debenture income taxes provision income taxes year ended december 31 2000 consisted minimum state taxes year ended december 31 1999 recorded tax provision related earnings made plusnet inc fiscal period merger december 31 2000 net operating loss carryforwards available reduce future taxable income aggregate approximately 251 million federal income tax purposes benefits begin expire 2017 company also california net operation loss carryforwards amount 134 million may applied future taxable income benefits begin expire 2002 ability utilize net operating loss carryforwards dependent upon ability generate taxable income future periods may limited due restrictions imposed federal state laws upon change ownership liquidity capital resources december 31 2001 company cash equivalents approximately 86 million compared approximately 139 million december 31 2000 net cash used operating activities equaled approximately 53 million 84 million twelve month periods ended december 31 2001 2000 respectively decline cash used related decrease approximately 58 million net loss twelve months ended december 31 2001 compared twelve months ended december 31 2000 however 2000 incurred approximately 46 million noncash interest expense relating settlement agreement issuance warrants net adjustment related customer receivables amounted approximately 17 million net cash used investing activities approximately 26400 744100 twelve months ended december 31 2001 2000 respectively substantially cash used investing activities periods primarily related purchase capital equipment net cash provided financing activities approximately 0 220 million twelve months period ended december 31 2001 2000 respectively net cash provided financing activities 2000 consisted primarily net proceeds issuance common stock incurred net losses approximately 86 million 114 million twelve months ended december 31 2001 2000 respectively december 31 2001 accumulated deficit approximately 362 million net losses accumulated deficit resulted significant operational infrastructure costs incurred development marketing services fact revenues failed keep pace costs beginning fourth quarter 2000 initiated cost reductions areas operations continuing review reduce nonessential expenditures pursue acquisition strategy longterm commitments currently require specified capital budget normal operations believe current cash equivalents would sufficient meet anticipated operating cash needs least next 12 months merger rae systems take place obligations rae systems close merger subject among things net cash least 7500000 may forced seek additional capital outside sources assurance financing available amounts terms acceptable us sale additional equity convertible debt securities could result additional dilution stockholders recent accounting pronouncements december 1999 staff securities exchange commission issued staff accounting bulletin 101 revenue recognition staff accounting bulletin 101 provides sec staffs views applying generally accepted accounting principles selected revenue recognition issues staff accounting bulletin 101 effective fourth fiscal quarter fiscal years beginning december 15 1999 believe current revenue recognition policies comply provisions staff accounting bulletin 101 march 2000 financial accounting standards board issued interpretation 44 accounting certain transactions involving stock compensation interpretation abp opinion 25 became effective july 1 2000 interpretation 44 clarifies definition employee purposes applying opinion 25 b criteria determining whether stock compensation plan qualifies noncompensatory plan c accounting consequences various modifications terms previously fixed stock option award accounting exchange stock compensation awards business combination adoption provisions interpretation significant impact financial statements june 1999 fasb issued sfas 137 accounting derivative instrument hedging activities deferral effective date fasb statement 133 amends sfas 133 effective fiscal years beginning june 15 2000 june 2000 sfas 133 amended sfas 138 accounting certain derivative instruments hedging activities amended modified certain issues discussed sfas 133 sfas 138 also effective fiscal years beginning june 15 2000 sfas 133 sfas 138 establish accounting reporting standards requiring every derivative instrument recorded balance sheet either asset liability measured fair value statements also require changes derivatives fair value recognized currently earnings unless specific hedge accounting criteria met company engage derivative instruments hedging activities accordingly impact companys financial statements adoption sfas 133 sfas 138 july 2001 fasb issued sfas 141 sfas 141 business combinations supersedes accounting principles board apb opinion 16 business combinations sfas 141 eliminates poolingofinterests method accounting business combinations modifies application purchase accounting method elimination poolingofinterests method effective transactions initiated june 30 2001 remaining provision sfas 141 effective transactions accounted using purchase method completed june 30 2001 july 2001 fasb also issued sfas 142 sfas 142 goodwill intangible assets supersedes apb opinion 17 intangible assets sfas 142 goodwill intangible assets indefinite lives amortized tested impairment annually using fair value approach except certain circumstances whether impairment indicator intangible assets continue valued amortized estimated lives inprocess research development continue written immediately acquired goodwill must assigned reporting units purposes impairment testing segment reporting existing goodwill longer subject amortization provisions sfas 142 required applied starting fiscal years beginning december 15 2001 august 2001 fasb issued sfas 143 sfas 143 accounting obligations associated retirement longlived assets sfas 143 addresses financial accounting reporting retirement obligation asset sfas 143 states companies recognize asset retirement cost fair value part cost asset classify accrued amount liability balance sheet asset retirement liability accreted ultimate payout interest expense initial measurement liability would subsequently updated revised estimates discounted cash outflows sfas 143 effective fiscal years beginning june 15 2002 company yet determined effect sfas 143 financial position results operations cash flows october 2001 fasb issued sfas 144 sfas 144 accounting impairment disposal longlived assets sfas 144 supersedes sfas 121 requiring one accounting model used longlived assets disposed sale whether previously held used newly acquired broadening presentation discontinued operation include disposal transactions sfas 144 effective fiscal years beginning december 15 2001 company yet determined effect sfas 144 financial position results operations cash flows item 7aitem 7 management’s discussion analysis financial condition results operation following management’s discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology “may” “will” “should” “could” “expects” “plans” “anticipates” “believes” “estimates” “predicts” “potential” “continue” statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein although management believes expectations reflected forwardlooking statements reasonable company cannot guarantee future results performance achievements information refer section entitled “factors may affect future results” form 10k following discussion read conjunction condensed consolidated financial statements notes thereto included elsewhere form 10k overview rae systems leading manufacturer technologically advanced single multiple sensor atmospheric monitors photoionization detectors gas detection tubes sampling pumps wirelesslyconnected gas detection security monitoring systems hazardous environment detection solutions used detect measure wide variety dangerous atmospheric contaminants conditions combustible gas vapor accumulations oxygen deficiencies toxic gases carbon monoxide hydrogen sulfide carbon dioxide many commonly encountered atmospheric hazards patented photoionization detector technology allows dependable linear partpermillion range readings many toxic gases vapors effectively undetectable means products particularly well suited measurement volatile organic compounds gasoline benzene paints degreasers jet fuel organic solvents products used detect weapons mass destruction wmd environmental safety hazardous materials hazmat toxic industrial chemical tic petrochemical semiconductor materials confined space entry monitoring programs world april 9 2002 merger nettaxicom “nettaxi” consummated nettaxi surviving corporation merger transaction registrant changed name rae systems inc stockholders received approximately 80 common stock newly merged entity effective time merger management team continued existing roles company accordingly merger nettaxi accounted reverse acquisition whereby accounting purposes deemed acquiror nettaxi deemed acquired entity nettaxi effectively ceased revenue generating activities nine months prior merger planned abandon business model effect consummation merger nettaxi deemed substance shell company accordingly merger nettaxi treated recapitalization goodwill reason pro forma information giving effect merger presented generate revenue sale gas monitoring devices smart sensing platform solutions well service repair equipment sell products network approximately 180 distributors account approximately 90 sales customer base varied spanning variety industries including government airlines oil industrial aerospace chemical shipping year ended december 31 2002 approximately 70 sales made customers north america 10 customers europe 16 customers asia continue strengthen presence portable gas monitoring business evidenced development two consumable products badgerae hydrogen sulfide monitor badgerae carbon monoxide monitor offer two years continuous protection commonly encountered toxic gases badgerae available volume sales comes equipped atex ul cul certification strategically redirecting company’s focus take advantage smart sensing platform solutions business information gas detector transmitted realtime basis base controller located two miles away launched several marketing campaigns geared towards sale technology currently building infrastructure support emerging opportunities area connection becoming public company reverse merger transaction certain options granted 1993 stock plan subject variable accounting accordance fasb interpretation 44 “accounting certain transactions involving stock compensation” fin 44 december 31 2002 2014941 options outstanding plan subject variable accounting year ended december 31 2002 financial statements herein reflect 374700 variable accounting charge based life options variable accounting treatment may result unpredictable stockbased compensation dependent fluctuations quoted prices common stock next nine years december 2001 issued 700000 nonplan stock purchase rights vested exercised immediately officer director consultant exercise price 0125 per share fair value underlying shares common stock date issuance approximately 700000 terms stock purchase agreement individuals shares placed escrow earned contingent upon consummation merger nettaxicom accordance terms merger agreement 700000 shares converted using exchange ratio 154869 1084083 shares based intrinsic fair value respective equity instruments april 9 2002 effective date merger recorded noncash compensation charge 23 million additionally connection closing merger recorded 21 million noncash compensation charge 960000 shares stock issued baytree capital 43 million noncash compensation charge warrants issued principals advisors nettaxi renex technology ltd renex completed 3 million private placement july 2002 based terms conditions contract rae asia’s equity voting interest renex decreased 47 approximately 36 prior july 2002 rae asia exercised managerial control daytoday operations renex held approximately 90 voting shares renex accordingly prior 2002 renex consolidated financial statements rae asia longer owns majority interest voting shares financial statements herein reflect change accounting renex consolidated method equity method change applied effect january 1 2002 accordingly change significantly impacted comparability 2002 amounts versus 2001 amounts regarding research development expenses loss unconsolidated entity minority interest loss consolidated subsidiary consolidated statements operations investments equity method consolidated balance sheet discussed elsewhere report form 10k currently involved various legal proceedings regardless eventual outcome litigation likely time consuming may result diversion internal resources two remaining lawsuits preliminary stage therefore eventual outcome difficult determine adverse result either lawsuits could materially affect results operations financial position critical accounting policies preparation financial statements conformity accounting principles generally accepted united states america requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenues expenses reporting period note 1 consolidated financial statements describes significant accounting policies methods used preparation consolidated financial statements estimates used limited allowance doubtful accounts inventory allowances warranty costs contingencies taxes actual results could differ materially estimates following critical accounting policies impacted significantly judgments assumptions estimates used preparation consolidated financial statements allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s credit worthiness actual defaults higher historical experience estimates recoverability amounts due us could overstated operating results could adversely affected inventories stated lower cost moving weighted average method market inventory purchases typically based estimated future demand event sudden significant decrease demand products higher occurrence inventory obsolescence due changing technology customer requirements could required increase inventory allowances gross margins could adversely affected generally provide one three year limited liability products establish estimated costs fulfilling warranty obligations time related revenue recorded historically warranty costs insignificant experience increase warranty claims compared historical experience costs servicing warranty claims greater expectations warranty reserve based operating results could adversely affected subject various loss contingencies arising ordinary course business consider likelihood loss impairment asset incurrence liability well ability reasonably estimate amount loss determining loss contingencies estimated loss contingency accrued management concludes probable asset impaired liability incurred amount loss reasonably estimated regularly evaluate current information available us determine whether accruals adjusted recognize deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent expected future tax return consequences differences expected either deductible taxable assets liabilities recovered settled future tax benefits pertaining unrealized foreign losses fully offset 100 valuation allowance management unable determine likely deferred tax asset realized recent accounting pronouncements april 2002 fasb issued statement financial accounting standards 145 rescission fasb statements 4 44 64 amendment fasb statement 13 technical corrections sfas 145 statement amends existing authoritative pronouncements make various technical corrections clarify meanings describe applicability changed conditions provisions sfas 145 adopted 2002 material impact financial position results operations june 2002 fasb issued statement financial accounting standards 146 accounting costs associated exit disposal activities addresses financial accounting reporting costs associated exit disposal activities sfas 146 statement requires liability costs associated exit disposal activity recognized liability incurred sfas 146 also establishes fair value objective initial measurement liability provisions statement effective exit disposal activities initiated december 31 2002 expect adoption statement material impact financial position results operations december 2002 fasb issued statement financial accounting standards 148 accounting stockbased compensation transition disclosure amendment fasb statement 123 sfas 148 statement provides alternative methods transition entity voluntarily changes fair value based method accounting stock based compensation also amends disclosure provisions sfas 123 require prominent disclosure effects reported net income entity’s accounting policy decisions respect stockbased employee compensation sfas 148 amends accounting principles board opinion 28 interim financial reporting require disclosure effects interim financial information sfas 148 effective financial statements beginning january 1 2003 currently evaluating effects adoption sfas 148 financial statements determined whether voluntarily change fair value based method accounting stockbased compensation november 2002 fasb issued fasb interpretation 45 guarantor’s accounting disclosure requirements guarantees including indirect guarantees indebtedness others fin 45 fin 45 requires guarantor recognize inception qualified guarantee liability fair value obligation undertaken issuing guarantee fin 45 effective prospective basis qualified guarantees issued modified december 31 2002 expect adoption interpretation material impact financial position results operations january 2003 fasb issued fasb interpretation 46 consolidation variable interest entities fin 46 fin 46 explains identify variable interest entities enterprise assesses interests variable interest entity decide whether consolidate entity interpretation requires existing unconsolidated variable interest entities consolidated primary beneficiaries entities effectively disperse risks among parties involved fin 46 effective immediately variable interest entities created january 31 2003 variable interest entities enterprise obtains interest date expect adoption interpretation material impact financial position results operations comparison 2002 2001 net sales net sales increased 19 million year ended december 31 2001 218 million year ended december 31 2002 increase 149 increase primarily result worldwide increase sales confined space gas monitors sales flexible multigas monitors patented photoionization detector also saw increase sales smart sensing solutions cost sales cost sales increased 7 million year ended december 31 2001 88 million year ended december 31 2002 increase 246 increase primarily due additional material required support higher volume production well additional personnel related expenses support expanding business opportunities bring manufacturing key components inhouse gross margins increased 12 million 63 revenue year ended december 31 2001 131 million 598 revenue year ended december 31 2002 due sales volume increases decrease margin percent revenue however attributable increases manufacturing cost support expanding business also attributable shift product mix decrease price selected products remain competitive marketplace sales marketing sales marketing expenses increased 45 million year ended december 31 2001 54 million year ended december 31 2002 increase 194 sales marketing costs increased result increase headcount support expanding business additionally advertising sales collateral increased support wireless systems business new line consumable products expanding international homeland security businesses increases partially offset decrease commissions resulting elimination outside sales representatives research development research development expenses decreased 33 million year ended december 31 2001 25 million year ended december 31 2002 decrease 231 decrease research development expenses 758200 primarily result change accounting renex consolidated method equity method partially offset increase research development activities specifically area wireless communications sensor development general administrative general administrative expenses increased 31 million year ended december 31 2001 44 million year ended december 31 2002 increase 456 result public entity incurred fees including public relations sec filings insurance 202400 would otherwise incurred also increased professional fees management consulting tax planning preparation quarterly review yearly audit 703300 also included 44 million noncash accounting charge 374700 relating options granted 1993 rae california stock option plan subject variable accounting legal fees settlement costs legal fees settlement costs decreased 12 million year ended december 31 2001 968700 year ended december 31 2002 decrease 217 legal costs high pending lawsuits three five lawsuits settled dismissed lawsuits described detail elsewhere form 10k merger costs merger costs 87 million year ended december 31 2002 recorded noncash compensation charge 23 million based 1084083 shares common stock issued principals advisors noncash charge 21 million based shares issued baytree capital 43 million noncash charge based warrants issued principals advisors nettaxi equity instruments issued connection closing merger nettaxi income expense net expenses year ended december 31 2001 167100 period 2002 expenses 348800 change 181700 change primarily due change accounting renex consolidated method equity method 283700 well decrease interest income resulting decline interest rates 82400 changes partially offset decrease interest expense resulting paid existing loans 175300 net loss income net income year ended december 31 2001 136800 period 2002 net loss 95 million decrease net income primarily result 93 million noncash accounting charge relating merger costs compensation increase cost goods support expanding business opportunities increase marketing expenses support new line consumable products smart sensing solutions business increase public company activities professional services increases partially offset deferred compensation charge 2001 decrease price material decrease commissions resulting elimination outside sales representatives comparison 2001 2000 net sales net sales increased 182 million year ended december 31 2000 190 million year ended december 31 2001 increase 45 sales year ended december 31 2000 included recognition 38 million single contract proceeds recognized entirely 2000 excluding revenue derived contract net sales increased 46 million 319 year ended december 31 2001 compared year ended december 31 2000 increase net sales due increase amount sales products including sales tube market cost sales cost sales increased 66 million year ended december 31 2000 70 million year ended december 31 2001 increase due primarily increase sales gross margins decreased 638 year ended december 31 2000 630 year ended december 31 2001 decrease gross margins primarily result decreases prices certain products order remain competitive market place decrease offset introduction new products higher gross margins sales marketing sales marketing expenses decreased 46 million year ended december 31 2000 45 million year ended december 31 2001 decrease due primarily decrease trade show expenses research development research development expenses increased 32 million year ended december 31 2000 33 million year ended december 31 2001 completion development various products resulted reduction approximately 500000 research development expenses 2001 personnel costs consulting fees raw materials costs associated development eliminated reclassification five employees research development manufacturing resulted decrease 176000 research development expenses 2001 consolidation renex 47 owned subsidiary resulted increase research development expenses 792000 year ended december 31 2001 general administrative general administrative expenses increased 22 million year ended december 31 2000 31 million year ended december 31 2001 increase primarily due additional personnel related expenses well increase bad debt miscellaneous reserves also connection various stock option grants employees consultants rae incurred noncash compensation charges 200100 year ended december 31 2001 compared 62100 year ended december 31 2000 legal fees settlement costs legal fees settlement costs increased 291100 year ended december 31 2000 12 million year ended december 31 2001 increase primarily due costs associated settlement litigation various lawsuits income expense increased 61800 year ended december 31 2000 167100 year ended december 31 2001 increase primarily attributable reduction interest income 2001 61500 increase interest expense 2001 21800 net income net income decreased 829200 year ended december 31 2000 136800 year ended december 31 2001 decrease net income primarily result increase legal fees settlement cost general administrative expenses increased research development activity renex partially offset minority interest’s share losses renex lower research development activity rae liquidity capital resources date financed operations primarily bank borrowings revenues operations proceeds issuances equity securities december 31 2002 72 million cash equivalents december 31 2002 83 million working capital excess current assets current liabilities current ratio 25 10 net loss year ended december 31 2002 comprised primarily noncash stockbased compensation 93 million substantially related stock warrant issuances 87 million noncash compensation charges relating common stock options 06 million net cash provided operating activities year ended december 31 2002 13 million compared net cash used operating activities 947500 year ended december 31 2001 year ended december 31 2002 changes operating assets liabilities provided increase 465700 operating cash flows whereas year ended december 31 2001 operating assets liabilities used 14 million operating cash flows favorable effects operating cash flows resulting change operating assets liabilities primarily reflected accrued expenses amount 458000 inventories amount 304100 net cash provided investing activities year ended december 31 2002 553600 compared net cash used investing activities 12 million year ended december 31 2001 cash provided investing activities year ended december 31 2002 consisted primarily release restriction 3 million cash resulting repayment outstanding lines credit partially offset deconsolidation renex 878300 investments renex 500000 acquisition property equipment 12 million investment property equipment implementation customer relations management system construction new warae manufacturing building jia ding shanghai net cash provided financing activities year ended december 31 2002 16 million compared 29 million year ended december 31 2001 cash provided financing activities year ended december 31 2002 primarily result proceeds merger transaction 7 million partially offset payment merger costs 762000 payments notes payable lines credit 44 million believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments future results operations april 2002 used proceeds received merger nettaxi pay cancel outstanding lines credit december 31 2002 lines credit available borrow future financing may require may unavailable favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership shareholders contractual cash obligations following table quantifies future contractual obligations december 31 2002 item 7aitem 7 managements discussion analysis financial condition results operation managements discussion analysis financial condition results operations following managements discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology may could expects plans anticipates believes estimates predicts potential continue statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein although management believes expectations reflected forwardlooking statements reasonable cannot guarantee future results performance achievements information refer section entitled risk factors form 10k following discussion read conjunction condensed consolidated financial statements notes thereto included elsewhere form 10k overview leading global developer manufacturer rapidlydeployable multisensor chemical detection monitors networks homeland security industrial applications addition offer full line portable singlesensor chemical radiation detection products founded 1991 develop technologies detection early warning hazardous materials market products evolved strictly focused environmental industrial monitoring encompassing public safety threat terrorism technologically advanced products based proprietary technology include portable wireless fixed atmospheric monitors photoionization detectors gamma neutron detectors products enable military first responders firefighters law enforcement emergency management personnel detect provide early warning weapons mass destruction hazardous materials industrial applications include detection toxic industrial chemicals volatile organic compounds petrochemicals generate revenue sale gas radiation monitoring devices smart sensing platform solutions service repair equipment sell products network approximately 180 distributors account approximately 90 sales customer base varied includes many worlds leading corporations airline automotive oil computer industries also significant number instruments currently service many us government agencies armed forces numerous city state federal agencies departments connection becoming public company reverse merger transaction nettaxicom april 9 2002 certain options 1993 stock plan became subject variable accounting accordance fasb interpretation 44 fin 44 december 31 2002 2014941 options outstanding 1993 stock plan subject variable accounting year ended december 31 2002 financial statements herein reflect 375000 variable accounting charge based life options variable accounting treatment would resulted unpredictable stockbased compensation dependent fluctuations quoted prices common stock next nine years eliminate variable effects accounting treatment adopted fair value recognition provisions sfas 123 stockbased employee compensation effective january 1 2003 modified prospective method provided sfas 148 accounting stockbased compensation transition disclosure amendment fasb statement 123 fair value recognition provisions generally result stockbased compensation charges options granted 1993 2002 stock option plans year ended december 31 2003 fair value charges options granted 1993 2002 stock option plans 789000 december 2001 issued 700000 nonplan stock purchase rights vested exercised immediately officer director consultant exercise price 0125 per share fair value underlying shares common stock date issuance approximately 700000 terms stock purchase agreement individuals shares placed escrow earned contingent upon consummation merger nettaxicom accordance terms merger agreement 700000 shares converted 1084083 shares using exchange ratio 1 154869 based intrinsic fair value respective equity instruments april 9 2002 effective date merger recorded noncash compensation charge 23 million additionally connection merger recorded 21 million noncash compensation charge 960000 shares stock issued baytree capital 43 million noncash compensation charge warrants issued michael gardner robert rositano dean rositano renex technology ltd renex completed 3 million private placement july 2002 result equity voting interest renex decreased 47 approximately 36 prior july 2002 exercised managerial control daytoday operations renex held approximately 90 voting shares renex accordingly prior 2002 renex consolidated financial statements longer majority interest voting shares financial statements herein reflect change accounting renex consolidated method equity method change applied effect january 1 2002 accordingly significantly impacted comparability 2002 amounts versus 2001 amounts regarding research development expenses equity loss unconsolidated affiliate minority interest loss consolidated subsidiary consolidated statements operations investments unconsolidated affiliate consolidated balance sheet january 28 2004 closed public offering 8050000 shares common stock 425 per share less applicable underwriting discount proceeds approximated 322 million used potential mergers acquisitions working capital general corporate purposes jefferies quarterdeck division jefferies company inc led underwriting team merriman curhan ford co comanager offering critical accounting policies preparation financial statements conformity accounting principles generally accepted united states america requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenues expenses reporting period estimates used limited allowance doubtful accounts inventory allowances warranty costs contingencies taxes actual results could differ materially estimates following critical accounting policies impacted significantly judgments assumptions estimates used preparation condensed consolidated financial statements allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond managements control deterioration major customers credit worthiness actual defaults higher experienced historically estimates recoverability amounts due could overstated operating results could adversely affected inventories stated lower cost moving weighted average method market inventory purchases typically based estimated future demand event sudden significant decrease demand products higher occurrence inventory obsolescence due changing technology customer requirements could required increase inventory allowances gross margins could adversely affected generally provide one three year limited liability products establish estimated costs fulfilling warranty obligations time related revenue recorded historically warranty costs insignificant experience increase warranty claims compared historical experience costs servicing warranty claims greater expectations warranty reserve based operating results could adversely affected subject various loss contingencies arising ordinary course business consider likelihood loss impairment asset incurrence liability well ability reasonably estimate amount loss determining loss contingencies estimated loss contingency accrued management concludes probable asset impaired liability incurred amount loss reasonably estimated regularly evaluate current information available determine whether accruals adjusted recognize deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent expected future tax return consequences differences expected either deductible taxable assets liabilities recovered settled valuation allowance provided deferred tax assets extent management unable conclude likely deferred tax assets realized results operations comparison years ended december 31 2002 2003 net sales net sales increased 218 million year ended december 31 2002 313 million year ended december 31 2003 increase 434 increase due significant increase government sales particularly homeland security applications recognized significant increase volume sales multirae minirae 2000 products increased 26 million integrated systems products increased 27 million additionally recognized growth confined space entry products consumable radiation products amount 11 million cost sales cost sales increased 88 million year ended december 31 2002 121 million year ended december 31 2003 increase 378 increase due material production increases 24 million support increased sales volume increase personnel costs 872000 support expanding service business gross margins increased 131 million 598 revenue year ended december 31 2002 192 million 614 revenue year ended december 31 2003 gross margin increased due production efficiencies resulting increase sales volume well growth sales higher margin products specifically integrated systems products multirae minirae 2000 sales marketing sales marketing expenses increased 54 million year ended december 31 2002 73 million year ended december 31 2003 increase 359 increase sales marketing cost due increase tradeshow advertising presence support homeland defense position mobile sensor network solution suite radiation detectors increase tradeshow advertising expenses amounted 813000 commissions sales representatives increased 495000 due increase integrated systems sales additionally expenses increased overseas approximately 700000 build infrastructure support anticipated growth europe asia research development research development expenses increased 25 million year ended december 31 2002 30 million year ended december 31 2003 increase 179 increase research development expenses 452000 primarily result increase headcount amount 261000 support development monitor combines radiological chemical sensors single unit development solution cargo container security inventory tracking development line consumable products general administrative general administrative expenses increased 44 million year ended december 31 2002 50 million year ended december 31 2003 increase 123 increase due accrued management incentives 494000 payment amex listing fee 65000 noncash warrant charges 331000 effective january 1 2003 adopted fair value recognition provisions sfas 123 stockbased employee compensation modified prospective method provided sfas 148 incurred noncash fair value accounting charge 789000 connection outstanding options 1993 2002 stock option plans year ended december 31 2003 compared noncash compensation charge 592000 period 2002 legal fees settlement costs legal fees settlement costs decreased 969000 year ended december 31 2002 164000 year ended december 31 2003 primarily due settlement certain lawsuits merger costs incurred noncash merger costs 87 million year ended december 31 2002 connection merger transaction nettaxicom costs factor year ended december 31 2003 income expense net expense net year ended december 31 2002 349000 period 2003 expenses net 315000 interest expense decreased due payment outstanding loans amount 87000 partially offset decrease interest income amount 23000 expenses net year ended december 31 2003 2002 consisted primarily equity loss unconsolidated affiliate amount 276000 284000 respectively income taxes year ended december 31 2002 2003 recognized tax expenses 136000 732000 respectively tax expenses relating year ended december 31 2003 consisted provision 12 relating pretax income reduced 574000 upon release prior year tax liability including 443000 relating settlement internal revenue service certain outstanding tax assessments originating prior years net income loss net loss year ended december 31 2002 95 million including 93 million noncash accounting charge relating merger costs compensation period 2003 net income 28 million increase primarily resulted increase sales 95 million specifically sales multirae minirae 2000 integrated systems products high margin products accounted 53 million total sales growth increase net income also result settlement certain lawsuits 805000 increase partially offset increase sales marketing expenses particularly advertising direct mail 813000 commissions outside sales representatives 495000 increase overseas sales costs support growth expansion 700000 general administrative expenses also increased due accrual management incentives 494000 increases noncash charges related issuance warrants options 11 million comparison years ended december 31 2001 2002 net sales net sales increased 190 million year ended december 31 2001 218 million year ended december 31 2002 increase 149 increase primarily result worldwide increase sales confined space gas monitors sales flexible multigas monitors patented photoionization detector amount 22 million also saw increase sales smart sensing solutions amount 487000 cost sales cost sales increased 70 million year ended december 31 2001 88 million year ended december 31 2002 increase 246 increase primarily due additional material required support higher volume production well additional personnel related expenses support expanding business opportunities bring manufacturing key components inhouse gross margins increased 120 million 630 revenue year ended december 31 2001 131 million 598 revenue year ended december 31 2002 due sales volume increases decrease margin percent revenue however attributable increases manufacturing cost support expanding business also attributable shift product mix decrease price selected products remain competitive marketplace sales marketing sales marketing expenses increased 45 million year ended december 31 2001 54 million year ended december 31 2002 increase 194 sales marketing costs increased amount 510000 build infrastructure support future growth advertising sales collateral increased amount 398000 support wireless systems business new line consumable products expanding international homeland security businesses increases partially offset decrease commissions resulting elimination outside sales representatives decrease commissions amounted 253000 research development research development expenses decreased 33 million year ended december 31 2001 25 million year ended december 31 2002 decrease 231 decrease research development expenses 758000 primarily result change accounting renex consolidated method equity method partially offset increase research development activities amount 106000 specifically area wireless communications sensor development general administrative general administrative expenses increased 31 million year ended december 31 2001 44 million year ended december 31 2002 increase 456 result public entity incurred fees including public relations sec filings insurance 202000 would otherwise incurred also increased professional fees management consulting tax planning preparation quarterly review yearly audit 689000 also included 44 million accounting charge 375000 relating options granted 1993 stock plan subject variable accounting legal fees settlement costs legal fees decreased 12 million year ended december 31 2001 969000 year ended december 31 2002 decrease 217 legal costs high result attorney fees settlement costs associated lawsuits three five lawsuits including lahey vs nettaxi envision media vs nettaxi rae systems vs ion science settled dismissed december 31 2002 merger costs merger costs 87 million year ended december 31 2002 specifically recorded noncash compensation charge 23 million based 1084083 shares common stock issued messrs ng flanzraich frost noncash charge 21 million based shares issued baytree capital 43 million noncash charge based warrants issued messrs gardner robert rositano dean rositano equity instruments issued connection closing merger nettaxi income expense net expenses net year ended december 31 2001 167000 period 2002 expenses net 349000 change 182000 change primarily due change accounting renex consolidated method equity method 284000 well decrease interest income resulting decline interest rates 82000 changes partially offset decrease interest expense resulting paid existing loans 175000 net income loss net income year ended december 31 2001 137000 period 2002 net loss 95 million decrease net income primarily result 93 million noncash accounting charge relating merger costs compensation increase sales marketing expenses support new line consumable products smart sensing solutions business amount 997000 variable accounting charges 375000 increase public company activities professional services amount 906000 increases partially offset decrease commissions resulting elimination outside sales representatives amount 253000 deconsolidation renex amount 758000 liquidity capital resources date financed operations primarily bank borrowings revenues operations proceeds issuances equity securities december 31 2003 75 million cash equivalents december 31 2003 125 million working capital current ratio 327 10 also 3 million line credit future growth expansion addition january 2004 completed public offering common shares raised 322 million cash net cash provided operating activities year ended december 31 2003 981000 compared net cash provided operating activities 13 million year ended december 31 2002 favorable effects operating cash flows year ended december 31 2003 due primarily net income 28 million depreciation amortization 753000 compensation expense fair value accounting 789000 accounts payable 669000 accrued expenses 469000 partially offset accounts receivable 29 million inventories 736000 income taxes payable 778000 net cash used investing activities year ended december 31 2003 719000 compared net cash provided investing activities 554000 year ended december 31 2002 net cash provided investing activities year ended december 31 2002 primarily result release restricted cash 3 million resulting paid lines credit cash used investing activities year ended december 31 2003 consisted acquisition property equipment amount 474000 increase deposits assets 245000 127000 represented costs capitalized connection public offering net cash provided financing activities year ended december 31 2003 50000 compared 16 million year ended december 31 2002 cash provided financing activities year ended december 31 2003 primarily result issuance common stock 195000 offset payments capital lease obligations 145000 cash provided financing activities year ended december 31 2002 consisted primarily net proceeds merger nettaxicom 70 million partially offset payments notes payable lines credit 44 million believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments future results operations future financing may require may unavailable favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership shareholders contractual obligations following table quantifies known contractual obligations december 31 2003 transactions affiliate certain companys sales made china market made tangrae china distribution company owned two individuals one current employee one former employee one companys whollyowned subsidiaries tangrae organized sales office solely facilitate sale companys product china market total sales made company tangrae amounted 479000 351000 0 2003 2002 2001 respectively recent accounting pronouncements may 2003 fasb issued sfas 150 accounting certain financial instruments characteristics liabilities equity statement establishes standards issuer classifies measures certain financial instruments characteristics liabilities equity statement effective financial instruments entered modified may 31 2003 otherwise effective beginning first interim period beginning june 15 2003 adoption statement material impact financial position results operations cash flows november 2002 fasb issued fasb interpretation 45 guarantors accounting disclosure requirements guarantees including indirect guarantees indebtedness others fin 45 fin 45 requires guarantor recognize inception qualified guarantee liability fair value obligation undertaken issuing guarantee fin 45 effective prospective basis qualified guarantees issued modified december 31 2002 adoption interpretation material impact financial position results operations january 2003 fasb issued fasb interpretation 46 consolidation variable interest entities fin 46 fin 46 explains identify variable interest entities enterprise assesses interests variable interest entity decide whether consolidate entity interpretation requires existing unconsolidated variable interest entities consolidated primary beneficiaries entities effectively disperse risks among parties involved fin 46 effective immediately variable interest entities created january 31 2003 variable interest entities enterprise obtains interest date adoption interpretation material impact financial position results operations item 7aitem 7 management’s discussion analysis financial condition results operation following management’s discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology “may” “will” “should” “could” “expects” “plans” “anticipates” “believes” “estimates” “predicts” “potential” “continue” statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein although management believes expectations reflected forwardlooking statements reasonable cannot guarantee future results performance achievements information refer section entitled “factors may affect future results” form 10k following discussion read conjunction condensed consolidated financial statements notes thereto included elsewhere annual report form 10k overview leading global developer manufacturer rapidlydeployable multisensor chemical detection monitors networks homeland security industrial applications addition offer full line portable singlesensor chemical radiation detection products founded 1991 develop technologies detection early warning hazardous materials market products evolved strictly focused environmental industrial monitoring encompassing public safety threat terrorism may 2004 invested 9 million cash 64 interest klh beijingbased manufacturer distributor security environmental personal safety monitors equipment result sales china market increased 8 2003 20 2004 sales rae systems business less sales klh “base business” united states europe asia continued grow primarily sales patented pid products well integrated wireless technology sales base business contributed 379 million 2004 compared 313 million 2003 increase 21 critical accounting policies preparation financial statements conformity accounting principles generally accepted united states america requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenues expenses reporting period estimates used limited allowance doubtful accounts inventory allowances warranty costs contingencies taxes actual results could differ materially estimates following critical accounting policies impacted significantly judgments assumptions estimates used preparation consolidated financial statements recognize revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provides sales returns standard product warranty provisions allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s credit worthiness actual defaults higher experienced historically estimates recoverability amounts due could overstated operating results could adversely affected inventories stated lower cost moving weighted average method market inventory purchases typically based estimated future demand event sudden significant decrease demand products higher occurrence inventory obsolescence due changing technology customer requirements could required increase inventory allowances generally provide one three year limited warranty majority products establish estimated costs fulfilling warranty obligations time related revenue recorded historically warranty costs insignificant experience increase warranty claims compared historical experience costs servicing warranty claims greater expectations warranty reserve based operating results could adversely affected recognize deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent expected future tax return consequences differences expected either deductible taxable assets liabilities recovered settled subject various loss contingencies arising ordinary course business consider likelihood loss impairment asset incurrence liability well ability reasonably estimate amount loss determining loss contingencies estimated loss contingency accrued management concludes probable asset impaired liability incurred amount loss reasonably estimated regularly evaluate current information available determine whether accruals adjusted adopted fair value recognition provisions sfas 123 stockbased employee compensation effective january 1 2003 modified prospective method provided sfas 148 consolidate investments controlling financial interest comply financial accounting standards board “fasb” interpretation 46r also consolidate investments primary beneficiary variable interest entity results operations comparison years ended december 31 2004 2003 total net sales net sales primarily increased due sales klh amount 79 million net sales also increased due increase approximately 34 million sales integrated systems products 13 million sales radiation products 12 million sales patented products homeland security 629000 service business cost sales gross margin cost sales total base business 140 million 2004 compared 121 million 2003 increase 19 million cost sales base business increased due 21 increase sales volume 2004 2003 additional costs build service infrastructure europe amount 276000 cost sales klh 46 million 2004 gross profit base business 239 million 192 million 2004 2003 respectively gross profit base business increased due sales higher margin integrated systems patented photoionization detection products gross profit klh 33 million main reason overall gross margin 2004 1 lower reported margins 2003 klh predominantly distribution business inherently lower margins sales marketing expense increase sales marketing expenses due primarily increases personnel europe united states build infrastructure future growth amount 15 million external commissions due increased sales integrated systems solutions amount 263000 outside services consulting fees amount 195000 travel related expenses amount 133000 also increase sales marketing expenses 15 million attributable new ownership klh research development expense increase research development expenses due primarily increased spending united states amount 540000 develop raewatch product enhance integrated systems products increased spending shanghai develop radiation consumable line products amount 344000 amortization intangible assets resulting acquisition klh amount 102000 well addition klh’s research development expenses 168000 period may 2004 december 2004 general administrative expense general administrative expenses base business increased primarily due increase noncash charges related issuances options warrants amount 682000 increase legal professional fees amount 529000 personnel costs build infrastructure united states shanghai amount 384000 consulting charges related comply section 404 sarbanesoxley act amount 366000 travel expenses amount 186000 rate increase directors officers insurance amount 78000 addition klh financial statements may 2004 added 429000 general administrative expenses income expense 2004 total income net 157000 compared total expense net 315000 2003 interest income increased amount 302000 interest received raised net 318 million january 2004 public offering net increased amount 232000 143000 attributable consulting income sales affiliate tangrae approximately 80000 attributable exchange gains partially offset increase loss unconsolidated affiliate renex amount 77000 income taxes years ended december 31 2004 2003 recognized tax expenses 1068000 732000 respectively tax expenses year ended december 31 2004 consisted current provision 18 million reduced 727000 primarily utilization research development credits 2004 income tax expense related valuation allowance certain deferred tax assets reduced 583000 reflect realization 2004 tax benefit certain capitalized expenditures foreign losses expected future benefit 2005 certain capitalized expenditures december 31 2004 based recent operating performance determined ability reasonably forecast shortterm operating performance oneyear look forward basis accordingly concluded morelikelythannot realize tax benefit attributable capitalized expenditures become available us 2005 determination represents change estimate 2004 effect reducing valuation allowance income tax expense increasing net income 2004 approximately 200000 tax expenses relating year ended december 31 2003 consisted current provision 11 million reduced 414000 primarily settlement internal revenue service certain outstanding tax assessments originating prior years overpayment prior year tax liability minority interest income consolidated subsidiaries year ended december 31 2004 recognized 364000 representing 36 minority interest’s share net income klh net 11000 representing 49 minority interest net loss rae france business interest acquired fiscal 2004 net income net income year ended december 31 2004 25 million period 2003 net income 28 million decrease primarily due decrease gross margin percentage approximately 1 well relative increase general administrative tax expenses 2003 2004 comparison years ended december 31 2003 2002 total net sales net sales increased due significant increase government sales particularly homeland security applications recognized 27 million increase sales integrated systems products 26 million increase sales multirae minirae 2000 products 11 million increase sales confined space entry products consumable radiation products cost sales gross margin cost sales increased due increases material production costs amount 24 million resulting increase sales volume cost sales also increased due increase personnel related expenses amount 872000 support expanding service business gross profit increased due production efficiencies resulting increase sales volume well growth sales higher margin products specifically integrated systems products multirae minirae 2000 sales marketing expense sales marketing expenses increased due increase tradeshow advertising presence support homeland defense position mobile sensor network solution suite radiation detectors amount 813000 additionally expenses increased overseas approximately 700000 build infrastructure support anticipated growth europe asia commissions sales representatives also increased 495000 due increase sales integrated systems solutions research development expense research development expenses increased due increase personnel related expenses amount 261000 support development monitor combines radiological chemical sensors single unit development solution cargo container security inventory tracking development line consumable products general administrative expense general administrative expenses increased primarily due legal fees amount 805000 accrued management incentives amount 494000 noncash warrant charges amount 331000 payment amex listing fee amount 65000 effective january 1 2003 adopted fair value recognition provisions sfas 123 stockbased employee compensation modified prospective method provided sfas 148 incurred noncash fair value accounting charge 789000 connection outstanding options 1993 2002 stock option plans year ended december 31 2003 compared noncash compensation charge 592000 period 2002 merger costs incurred noncash merger costs 87 million relating grant options warrants year ended december 31 2002 connection merger transaction nettaxicom income expense net expense net year ended december 31 2003 315000 period 2002 expenses net 349000 change 34000 expenses net year ended december 31 2003 2002 consisted primarily equity loss unconsolidated affiliate amount 276000 284000 respectively interest expense decreased amount 87000 due payment outstanding loans partially offset decrease interest income amount 23000 income taxes tax expense relating year ended december 31 2003 consisted provision 12 million relating pretax income reduced 574000 upon release prior year tax liability including 443000 relating settlement internal revenue service certain outstanding tax assessments originating prior years net income loss net income year ended december 31 2003 28 million period 2002 net loss 95 million including 93 million noncash accounting charge relating merger costs compensation increase primarily resulted increase sales amount 95 million settlement certain lawsuits amount 805000 increase partially offset increase noncash charges related issuance warrants options amount 11 million increase sales marketing expenses particularly advertising direct mail amount 813000 increase overseas sales marketing expenses amount 700000 build infrastructure support anticipated growth commissions outside sales representatives amount 495000 due increased sales integrated systems solutions accrual management incentives amount 494000 liquidity capital resources date financed operations primarily bank borrowings revenues operations proceeds issuances equity securities december 31 2004 328 million cash investments december 31 2004 384 million working capital current assets less current liabilities current ratio current assets divided current liabilities 447 10 two lines credit available future growth expansion aggregate total 10 million april 2004 secured 3000000 line credit based primelending rate expire may 2005 may 2004 secured additional 7000000 line credit fixed rate 325 expire may 2005 currently compliance debt covenants lines available us full present amounts outstanding agreements net cash provided operating activities year ended december 31 2004 27 million compared net cash provided operating activities 981000 year ended december 31 2003 favorable effects operating cash flows year ended december 31 2004 due primarily increases accrued liabilities 31 million net income 25 million noncash adjustments profit 14 million due fair value accounting stock options warrants adds operating cash flow additional cash flow contributions 10 million came tax benefit disqualification incentive stock options 10 million increases accounts payable depreciation amortization 994000 partially offset increases inventories 26 million accounts receivable 29 million prepaid expenses 840000 deferred income taxes 726000 net cash used investing activities year ended december 31 2004 210 million compared 719000 year ended december 31 2003 cash used investing activities consisted 112 million long short term investments 93 million due acquisition property equipment 50 million used purchase future site rae systems’ corporate headquarters san jose california remaining 43 million largely invested manufacturing capacity shanghai beijing net cash provided financing activities year ended december 31 2004 323 million compared 50000 year ended december 31 2003 cash provided financing activities year ended december 31 2004 primarily result raised net 318 million public offering 8050000 shares common stock 425 per share less applicable underwriting discount closed january 28 2004 proceeds continue used potential mergers acquisitions working capital general corporate purposes jefferies quarterdeck division jefferies company inc led underwriting team merriman curhan ford co comanager offering believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments future results operations future financing may require may unavailable favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership stockholders contractual obligations lease certain manufacturing warehousing facilities operating leases expiring various years 2009 leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property liabilities including employee agreement nonexecutive officer europe termination liability 260000 period one year 17 million payable next four years former klh owners part buyout provision following table quantifies known contractual obligations december 31 2004 transactions affiliate certain company’s sales made china market made tangrae china distribution company owned two individuals one kang lin liu sales representative one former employee one company’s whollyowned subsidiaries tangrae organized sales office solely facilitate sale company’s products china market total sales made company tangrae amounted 392000 479000 351000 2004 2003 2002 respectively 2004 consulting fees paid tangrae rae shanghai amount 143000 effective december 2004 tangrae officially closed operating entity september 2004 company entered agreement shanghai simax technology co ltd “simax” finance design benzenespecific gas detection module gcpid amount 100000 date payments simax rae systems right use technology future products company pay royalty fee 5 gcpid products sold date royalty payments technology dr peter c hsi company’s chief technology officer acting general manager simax dr hsi equity ownership simax june 2004 company entered agreement renex technologies ltd develop six prototype raelink modems price 95000 pay royalty fee 75 products sold renex technology’s intellectual property used date payment made renex amount 28000 develop modems 2004 company make royalty payments company 36 interest renex technologies ltd recent accounting pronouncements december 2004 fasb issued sfas 123r “sharebased payment” sfas 123r revises sfas 123 generally requires cost associated employee services received exchange award equity instruments measured based grantdate fair value award recognized financial statements period employees required provide services exchange award sfas 123r also provides guidance determine grantdate fair value awards equity instruments well alternative methods adopting requirements sfas 123r effective beginning first interim annual reporting period june 15 2005 quarter ended september 30 2005 company applies outstanding unvested sharebased payment awards company’s adoption date currently assessing impact statement consolidated financial statements december 2004 fasb issued sfas 153 “exchanges nonmonetary assets” sfas 153 amends guidance accounting principles board apb opinion 29 “accounting nonmonetary transactions” eliminate certain exceptions principle exchanges nonmonetary assets measured based fair value assets exchanged sfas 153 eliminates exception nonmonetary exchanges similar productive assets replaces general exception exchanges nonmonetary assets commercial substance statement effective nonmonetary asset exchanges fiscal years beginning june 15 2005 adoption sfas 153 expected impact consolidated results operations financial position cash flows november 2004 fasb issued sfas 151 “inventory costs” amendment accounting research bulletin arb 43 chapter 4 sfas 151 abnormal amounts idle facility expense freight handling costs wasted materials spoilage recognized currentperiod charges requiring allocation fixed production overheads inventory based normal capacity production facilities adoption pronouncement expected material impact company’s financial statements results operations cash flows october 2004 fasb issued fasb staff position fsp 1091 “application fasb statement 109 ‘accounting income taxes’ tax deduction qualified production activities provided american jobs creation act 2004” provides tax deduction nine percent fully phased lesser “qualified production activities income” taxable income deduction utilization net operating loss carryforwards adoption pronouncement expected material impact company’s financial statements results operations cash flows october 2004 fasb issued fsp 1092 “accounting disclosure guidance foreign earnings repatriation provision within american jobs creation act 2004” special onetime tax deduction 85 percent certain foreign earnings repatriated either enterprise’s last tax year began enactment date first tax year begins oneyear period beginning date enactment adoption pronouncement expected material impact company’s financial statements results operations cash flows december 2003 fasb revised interpretation fin 46 “consolidation variable interest entities interpretation arb 51” requires investor absorbs majority expected losses receives majority expected returns primary beneficiary variable interest entity vie consolidate assets liabilities results operations entity vie entity equity investors controlling interest equity investment risk sufficient finance entity’s activities without receiving additional subordinated financial support parties fin 46r replaces fin 46 issued january 2003 application public entities types entities required financial statements periods ending march 15 2004 adoption pronouncement material impact company’s financial statements results operations cash flows december 2003 staff sec issued staff accounting bulletin sab 104 “revenue recognition” supersedes sab 101 “revenue recognition financial statements” sab 104’s primary purpose rescind accounting guidance contained sab 101 related multipleelement revenue arrangements superseded result issuance emerging issues task force eitf 0021 “accounting revenue arrangements multiple deliverables” additionally sab 104 rescinds sec’s related “revenue recognition financial statements frequently asked questions answers” issued sab 101 codified sec topic 13 “revenue recognition” wording sab 104 changed reflect issuance eitf 0021 revenue recognition principles sab 101 remain largely unchanged issuance sab 104 effective upon issuance adoption pronouncement material impact company’s financial statements results operations cash flows item 7aitem 7 management’s discussion analysis financial condition results operation following management’s discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology “may” “will” “should” “could” “expects” “plans” “anticipates” “believes” “estimates” “predicts” “potential” “continue” statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein although management believes expectations reflected forwardlooking statements reasonable cannot guarantee future results performance achievements information refer section entitled “factors may affect future results” form 10k following discussion read conjunction condensed consolidated financial statements notes thereto included elsewhere annual report form 10k overview leading global developer manufacturer rapidlydeployable multisensor chemical detection monitors networks homeland security industrial applications addition offer full line portable singlesensor chemical radiation detection products founded 1991 develop technologies detection early warning hazardous materials market products evolved strictly focused environmental industrial monitoring encompassing public safety threat terrorism may 2004 invested 9 million cash 64 interest klh result sales china market increased 8 2003 20 2004 30 2005 sales rae systems business less sales klh “base business” united states europe asia continued grow primarily sales patented pid products well integrated wireless technology sales base business contributed 423 million 2005 compared 375 million 2004 increase 12 critical accounting policies discussion analysis financial condition results operations based upon consolidated financial statements prepared accordance accounting principles generally accepted united states preparation financial statements requires us make estimates judgments affect reported amounts assets liabilities revenues expenses related disclosure contingent assets liabilities ongoing basis evaluate estimates including related revenue recognition inventory valuation warranties valuation deferred tax assets allowance doubtful accounts base estimates historical experience various assumptions believed reasonable circumstances results form basis making judgments carrying values assets liabilities readily apparent sources actual results may differ estimates different assumptions conditions summary significant accounting policies see note 1 financial statements significant accounting policies believe following critical accounting policies affect significant judgments estimates used preparation consolidated financial statements senior management discussed development selection critical accounting policies estimates audit committee revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provides sales returns based historical product warranty returns revenues related services performed company’s extended warranty program represent less 5 net revenues 2005 2004 2003 recognized earned based upon contract terms generally ratable term service record project installation work china using percentageofcompletion method installation revenue represents less 4 net revenue 2005 2004 2003 net revenues include amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue “eitf” 0010 accounting shipping handling fees costs shipping fees represent less 1 net revenues 2005 2004 2003 shipping costs included cost goods sold accounts receivable trade notes receivable allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses company generally require collateral sales credit management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s creditworthiness actual defaults higher experienced historically additional allowances would required trade notes receivables presented company customers china payment outstanding trade receivables notes receivables bank guarantee promissory notes noninterest bearing generally mature within 6 months inventories stated lower cost using firstin firstout method market company exposed number economic industry factors could result portions inventory becoming either obsolete excess anticipated usage saleable amounts less carrying amounts factors include limited technological changes market competitive pressures products prices availability key components suppliers company established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded reserves intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required warranty repairs company sells majority products twelve month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized estimated future warranty obligations affected warranty periods sales volumes product failure rates material usage labor replacement costs incurred correcting product failure actual product failure rates material usage labor replacement costs differ company’s estimates revisions estimated warranty obligations would required warranty accrual represents best estimate amount necessary settle future existing claims products sold balance sheet date company periodically assesses adequacy reported warranty reserve adjusts amounts accordance changes factors purchase obligations company agreements suppliers parties purchase inventories goods services company estimated noncancelable obligations agreements 2006 2007 2008 2009 2010 approximately 3682000 282000 161000 43000 3000 respectively noncancelable obligations related inventories expected delivered within next 12 months company periodically reviews carrying value inventories noncancelable purchase commitments evaluating material usage requirements forecasts estimates inventory obsolescence excess quantities expected losses purchase commitments company may record charges write inventory due excess obsolete slow moving inventory lower cost market based analysis impact changes technology estimates future sales volumes market value estimates loss accrued related current purchase obligations however additional write downs inventories may negatively affect gross margins future periods income taxes part process preparing consolidated financial statements required estimate income taxes jurisdictions operate process involves estimating actual current tax exposure together assessing temporary differences resulting differing treatment items tax accounting purposes differences result deferred tax assets liabilities included within consolidated balance sheet must assess likelihood deferred tax assets recovered future taxable income extent believe recovery likely must establish valuation allowance extent establish valuation allowance increase allowance period must include expense within tax provision statement operations recorded valuation allowance 877000 december 31 2005 due uncertainties related ability utilize net deferred tax assets primarily consisting certain net operating losses carried forward foreign entities event actual results differ estimates adjust estimates future periods may need establish additional valuation allowance could materially impact financial position results operations results operations comparison years ended december 31 2005 2004 total net sales net sales increased 148 million year ended december 31 2005 year ended december 31 2004 increase primarily due higher sales reported klh 101 million included twelve months sales 2005 compared seven months sales 2004 partially offset decrease sales 14 million affiliates china transferred sales responsibility klh rae products china also sales increased 61 million americas europe sales patented pid wireless products overall nonamericas sales increased 106 million 2005 2004 44 total revenue compared 34 total revenue 2004 nonamericas sales growth also impacted favorably result klh included consolidated sales results twelve months year ended december 31 2005 compared seven months year ended december 31 2004 cost sales gross margin cost sales excluding klh 145 million year ended december 31 2005 compared 139 million year ended december 31 2004 increase 600000 cost sales excluding impact klh increased due 12 increase sales volume years 2005 2004 partially offset cost improvements volume increases manufacturing efficiencies cost sales klh increased 102 million year ended december 31 2005 46 million year ended december 31 2004 primarily result sales volume increases partially offset improved costs result increased volume gross profit excluding klh 278 million 237 million years ended december 31 2005 2004 respectively gross profit excluding klh increased due higher sales integrated systems patented photoionization detection products improved costs result higher volumes manufacturing efficiencies gross profit percentage sales year ended december 31 2005 59 yearended december 31 2004 increase lower margin distribution installation business klh offset favorable impact higher volumes manufacturing efficiencies overall product costs sales marketing expense sales marketing expenses increased 63 million year ended december 31 2005 compared year ended december 31 2004 approximately 39 million increase attributable increase klh sales marketing expenses included twelve months expenses 2005 compared seven months expenses 2004 well higher infrastructure costs support klh’s growth sales marketing expenses also increased approximately 24 million across sales marketing organizations 24 million primarily comprised 19 million support increased sales 325000 external commissions paid mainly support sale integrated systems products approximately 160000 severance expense research development expense research development expenses increased 10 million year ended december 31 2005 compared year ended december 31 2004 higher spending largely result increased spending klh 580000 twelve months expenses included 2005 results versus seven months expenses 2004 well increases rd personnel remaining 428000 increase mainly result increases rd personnel shanghai operation support new product development general administrative expense general administrative ga expenses increased 43 million year ended december 31 2005 compared year ended december 31 2004 increase primarily result 13 million additional expenses klh mainly due inclusion twelve months expenses 2005 versus seven months 2004 well increases ga personnel support klh’s growth also experienced increases across company audit sarbanesoxley certification costs 850000 legal fees 625000 amortization stock options warrants 470000 remaining amount 11 million additional infrastructure personnel support increased growth units loss abandonment lease loss abandonment lease cost approximately 20 million 2005 associated abandonment former us headquarters manufacturing leased site sunnyvale california completed move larger headquarters us manufacturing facility second quarter 2005 support increased growth income expense total income expense improved profits 133000 year ended december 31 2005 compared year ended december 31 2004 increase primarily result increased interest income 308000 largely increased interest rates earned cash investments equity loss unconsolidated affiliate also improved 157000 2004 mainly result lower operating losses renex affiliate year ended december 31 2005 partially offsetting items decline 169000 net received consulting payment 137000 2004 sales affiliate china longer operating increase interest expense 163000 primarily 126000 amortization discount interest expense related klh notes payable income taxes income tax expense decreased 15 million year ended december 31 2005 compared year ended december 31 2004 effective tax rate 37 benefit 2005 27 tax provision 2004 respectively tax benefit primarily operating losses largely result abandonment lease former sunnyvale headquarters research development tax credits minority interest income consolidated subsidiaries year ended december 31 2005 recognized 62000 net loss consolidated subsidiaries allocated minority interest related mainly 36 minority interest’s share klh losses partially offset 51 owners share income french subsidiary year ended december 31 2004 minority partners share profits 353000 representing 36 minority interest’s share profits klh 51 majority investors share rae france net income net loss year ended december 31 2005 759000 versus net income 23 million year ended december 31 2004 31 million decrease net income primarily result 20 million onetime charge related abandonment lease company’s former headquarters us manufacturing site well generally higher operating expenses comparison years ended december 31 2004 2003 total net sales net sales increased primarily due sales klh amount 79 million net sales also increased due increase approximately 34 million sales integrated systems products 13 million sales radiation products 900000 sales patented products homeland security 600000 service business cost sales gross margin cost sales year ended december 31 2004 increased 64 million period 2003 approximately 46 million due addition sales klh investment 18 million due increase sales volume base business base business gross profit 63 year ended december 31 2004 61 year ended december 31 2003 gross profit base business increased due sales higher margin integrated systems patented photoionization detection products addition klh predominantly distribution business inherently lower margins primary reason overall gross margin 2004 2 lower reported margins 2003 sales marketing expense increase sales marketing expenses year ended december 31 2004 compared year ended december 31 2003 due primarily expenses attributable new ownership klh 15 million increases personnel europe united states build infrastructure future growth amount 700000 sales marketing expenses also increased due external commissions increased sales integrated systems solutions amount 263000 outside services consulting fees amount 195000 travel related expenses amount 133000 research development expense increase research development expenses year ended december 31 2004 compared year ended december 31 2003 due primarily increased spending united states amount 540000 develop raewatch product enhance integrated systems products increased spending shanghai develop radiation consumable line products amount 344000 amortization intangible assets resulting acquisition klh amount 102000 well addition klh’s research development expenses 168000 period may 2004 december 2004 general administrative expense general administrative expenses company year ended december 31 2004 compared year ended december 31 2003 increased primarily due increases personnel europe shanghai united states build infrastructure future growth amount 12 million increase legal professional fees amount 529000 increase noncash charges related issuances options warrants amount 449000 consulting charges related compliance section 404 sarbanesoxley act amount 366000 travel expenses amount 186000 rate increase directors officers insurance amount 78000 addition klh financial statements may 2004 added 429000 general administrative expenses income expense 2004 total income 157000 compared total expense 315000 2003 interest income increased amount 302000 result interest received investing majority 318 million raised january 2004 public offering net increased amount 232000 137000 attributable consulting income earned sales affiliate tangrae approximately 95000 largely attributable foreign exchange gains equity loss unconsolidated affiliate increased 77000 result share larger loss renex 36owned unconsolidated affiliate income taxes years ended december 31 2004 2003 recognized tax expenses 983000 706000 respectively tax expenses year ended december 31 2004 consisted current provision 17 million reduced 717000 primarily utilization research development credits related valuation allowance reduction 2004 income tax expense related valuation allowance certain deferred tax assets reduced 583000 reflect realization 2004 tax benefit certain capitalized expenditures foreign losses expected future benefit 2005 certain capitalized expenditures december 31 2004 based recent operating performance determined ability reasonably forecast shortterm operating performance oneyear look forward basis accordingly concluded morelikelythannot realize tax benefit attributable capitalized expenditures become available us 2005 determination represents change estimate 2004 effect reducing valuation allowance income tax expense increasing net income 2004 approximately 200000 tax expenses relating year ended december 31 2003 consisted current provision 11 million reduced 414000 primarily settlement internal revenue service certain outstanding tax assessments originating prior years overpayment prior year tax liability minority interest income consolidated subsidiaries year ended december 31 2004 recognized 364000 representing 36 minority interest’s share net income klh net 11000 representing 51 majority interest’s share net loss rae france business interest acquired fiscal 2004 consolidate financial statements net income net income year ended december 31 2004 23 million period 2003 net income 27 million decrease primarily due decrease gross margins company approximately 2 due acquisition klh primarily distribution business lower margins well relative increase general administrative tax expenses 2003 2004 liquidity capital resources date financed operations primarily bank borrowings revenues operations proceeds issuances equity securities december 31 2005 295 million cash investments compared 328 million 2004 december 31 2005 414 million working capital current assets less current liabilities current ratio current assets divided current liabilities 39 10 compares 389 million working capital current ratio 45 10 december 31 2004 two lines credit available future growth expansion aggregate total 10 million october 2005 secured 5000000 line credit based primelending rate 5000000 line credit based fixed rate 53 lines expire october 2006 currently compliance debt covenants lines available us full present amounts outstanding agreements net cash provided operating activities year ended december 31 2005 14 million compared net cash provided operating activities 32 million year ended december 31 2004 18 million reduction operating cash flows yearended december 31 2005 versus prioryear ended december 31 2004 due primarily decreased profitability adjusting noncash items 22 million slower growth liabilities 09 million mainly result initial incorporation klh balance sheet 2004 partially offsetting unfavorable changes reduction growth assets 2005 13 million result initial incorporation klh balance sheet 2004 improvements asset management net cash used investing activities year ended december 31 2005 96 million compared 210 million year ended december 31 2003 cash used investing activities consisted reduction 47 million long short term investments moved investments cash accounts 2004 reduced investments 112 million also mainly moving investments cash accounts support investment klh 2005 used 49 million acquire property equipment refurbished new headquarters us manufacturing facility acquired new erp system worldwide deployment added equipment manufacturing operations productivity improvements new products 44 million reduction 2004 invested 93 million property equipment including 50 million new headquarters us manufacturing facility net cash provided financing activities year ended december 31 2005 01 million mainly exercise stock options compares net cash provided 318 million 2004 raised 322 million january 28 2004 public offering 8050000 shares common stock 425 per share less applicable underwriting discount proceeds offering continue used potential mergers acquisitions working capital general corporate purposes believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments future results operations future financing may require may unavailable favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership stockholders commitments contingencies operating leases company subsidiaries lease certain manufacturing warehousing facilities operating leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2005 2004 2003 624000 809000 666000 respectively future minimum lease payments next five years 2006 2010 excluding sunnyvale california abandoned lease described 310000 56000 38000 32000 0 respectively december 2004 company purchased property located 3775 north first street san jose california lease related previous headquarters sunnyvale california writtenoff second quarter 2005 total loss abandonment lease approximately 2 million future lease payments related sunnyvale building included accrued expenses 482000 long term liabilities 1466000 december 31 2005 future minimum lease payments sunnyvale california property next four years 2006 2009 495000 528000 627000 556000 respectively purchase obligations company agreements suppliers parties purchase inventories goods services company estimated noncancelable obligations agreements 2006 2007 2008 2009 2010 approximately 3682000 282000 161000 43000 3000 respectively noncancelable obligations related inventories expected delivered within next 12 months company periodically reviews carrying value inventories noncancelable purchase commitments evaluating material usage requirements forecasts estimates inventory obsolescence excess quantities expected losses purchase commitments company may record charges write inventory due excess obsolete slow moving inventory lower cost market based analysis impact changes technology estimates future sales volumes market value estimates additional write downs inventories may negatively impact gross margins future periods guarantee company permitted delaware law accordance bylaws indemnify officers directors certain events occurrences subject certain limits officer serving company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director officer insurance policy limits exposure enables recover portion future amounts paid result insurance policy coverage company believes fair value indemnification agreements minimal company’s sales agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits product warranties company generally provides one three year limited warranty majority products establishes provision estimated costs fulfilling warranty obligations time related revenue recorded december 31 2005 2004 warranty reserve recorded accrued expenses 377000 490000 respectively summary obligations following table quantifies known contractual obligations tabular form december 31 2005 1 conjunction klh investment note payable established previous klh shareholders part purchase price negotiation obligation described related party transactions section related party transactions september 2004 company entered agreement shanghai simax technology co ltd “simax” finance design benzenespecific gas detection module “gcpid” amount 100000 paid 2005 rae systems right use technology future products company pay royalty fee 5 gcpid products sold date royalty payments technology total purchase raw materials simax 2005 2004 2003 29000 0 respectively outstanding balance due simax december 31 2005 2004 dr peter c hsi company’s chief technology officer acting general manager simax resignation december 2004 dr hsi equity ownership simax conjunction klh investment note payable established previous klh shareholders part purchase price negotiation december 31 2005 2004 759000 423000 respectively included notes payablerelated party account 821000 1260000 respectively included long term notes payablerelated party account notes discounted per year interest rate 55 434000 due demand december 31 2005 addition future payment plan next four years 2006 2009 398000 249000 respectively company’s director information systems lien chen wife chief executive officer robert chen ms chen paid salary 96000 2005 2004 respectively ms chen also receives standard employee benefits offered fulltime us employees ms chen report robert chen compensation decisions performed manner us employees robert chen final approval signatory compensation recommendations recent accounting pronouncements may 2005 fasb issued sfas 154 accounting changes error corrections sfas 154 replaces apb opinion 20 accounting changes sfas 3 reporting accounting changes interim financial statements changes requirements accounting reporting change accounting principle sfas 154 requires voluntary change accounting principle applied retrospectively prior period financial statements presented using new accounting principle sfas 154 effective accounting changes corrections errors fiscal years beginning december 15 2005 company apply requirements sfas 154 changes principle made january 1 2006 december 2004 fasb issued sfas 123r sharebased payment sfas 123r revises sfas 123 accounting stockbased compensation generally requires cost associated employee services received exchange award equity instruments measured based grantdate fair value award recognized financial statements period employees required provide services exchange award sfas 123r also provides guidance determine grantdate fair value awards equity instruments well alternative methods adopting requirements april 14 2005 securities exchange commission amended compliance dates sfas 123r result sfas 123r effective company beginning january 1 2006 applies outstanding unvested sharebased payment awards company’s adoption date company currently assessing impact statement company’s consolidated financial statements november 2004 fasb issued sfas statement 151 inventory costs amendment accounting research bulletin arb 43 chapter 4 fasb statement 151 abnormal amounts idle facility expense freight handling costs wasted materials spoilage recognized currentperiod charges requiring allocation fixed production overheads inventory based normal capacity production facilities sfas 151 effective company beginning january 1 2006 adoption pronouncement expected material impact company’s consolidated results operations financial position cash flows company already follows procedures comparable described sfas 151 item 7aitem 7 management’s discussion analysis financial condition results operations following management’s discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology “may” “will” “should” “could” “expects” “plans” “anticipates” “believes” “estimates” “predicts” “potential” “continue” statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein factors might cause contribute differences include limited discussed item 1a “risk factors” well item 1 “business” item 7 “management’s discussion analysis financial condition results operations” annual report form 10k carefully review risks also review risks described documents file time securities exchange commission including quarterly reports form 10q file fiscal year 2007 cautioned place undue reliance forwardlooking statements expressly assume obligations update forwardlooking statements report occur date hereof overview leading global developer manufacturer rapidlydeployable multisensor chemical radiation detection monitors networks industrial applications homeland security addition offer full line portable singlesensor chemical radiation detection products founded 1991 develop technologies detection early warning hazardous materials market products evolved strictly focused environmental industrial monitoring encompassing public safety threat terrorism conjunction acquisition aegison corporation formation rae coal mine safety instruments fushun co ltd expect expand presence include mobile digital video security market united states broader energy exploration refining safety equipment market especially applies coal mine safety equipment market china 2006 leveraged expertise experience make two key investments china pursue opportunities one world’s largest fastest growing economies first july 2006 increased ownership rae beijing 96 percent benefit efforts drive higher revenue operating profit consolidated subsidiary rae beijing produces sells distributes safety security solutions chemical oil gas metals energy sectors china second december 2006 formed rae fushun joint venture capitalize china’s growing reliance coal based energy resources rae fushun manufactures sells coal mine safety equipment rae systems retains 70 percent ownership joint venture combines skill expertise fushun anyi former state owned company distribution partner number years rae fushun offers wide well balanced range safety products personal safety equipment like headlamps respiratory protection portable gas detection fixed mine based safety systems permanently mounted minewide gas detection systems methane pump systems “degasify” potentially explosive mines july 2006 also invested next generation mobile wireless digital video technology acquiring aegison corporation transaction added two patents intellectual property portfolio creates opportunity offer new solutions law enforcement mobile video customers number successful product deployments arearae adopted standard continuous monitoring worker safety petrochemical industry plant turnarounds believe arearae provides significant cost savings productivity advantage bringing facilities back online quickly national guard civil support teams deployed fiftyseven arearae platforms least one system state gammarae ii r portable radiation detectordosimeter selected evaluated state illinois part large multiyear radiation equipment procurement several chemical manufacturers throughout europe selected minirae 2000 ppbrae plus pid instruments industrial hygiene applications china received large order raeguard fixed sensor systems petrochina dushanzi project also received orders several state operated oil fields including dagang liaohe changqing early 2007 strengthened expanded sales distribution channels three geographic sales regions continue augment sales model introduction valueadded reseller program additional regional sales management inside sales resources also added direct sales component key national government accounts accelerate transactions channel partners deploying web portal value added resellers expanding training programs offer product service training american industrial hygiene certification classes expect launch number additional new products various global markets 2007 2006 oil gas customers experienced success deploying wireless gas detection solutions plant turnarounds one industrial targets 2007 extend success 260 chemical plants gulf coast region us india middle east added additional regional sales managers grow presence two emerging markets china focus growing environmental protection market industrial sector including oil gas petrochemicals certain telecom applications coal mining major priority introduce new products coal mine safety market rae fushun believe market provide us number exciting new business opportunities 2007 beyond china continues modernize coal mining industry markets continue explore develop strategic value added partnerships leverage product market expertise critical accounting policies preparation financial statements conformity united states generally accepted accounting principles requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period ongoing basis evaluate estimates including related allowance doubtful accounts valuation goodwill intangible assets investments valuation deferred tax assets restructuring costs contingencies inventory valuation warranty accrual stockbased compensation expense conjunction acquisitions allocate investment costs based fair value assets acquired liabilities assumed base estimates historical experience various assumptions believed reasonable circumstances results form basis making judgments carrying values assets liabilities readily apparent sources actual results may differ significantly estimates different assumptions conditions believe following critical accounting policies affect significant judgments estimates used preparation consolidated financial statements revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company generally recognizes revenue goods shipped distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provides sales returns standard product warranty provisions nonstandard contract terms title goods pass time delivery fob destination revenue recognized company established proof delivery revenues relating services performed company’s extended warranty program represent less 5 net revenues 2006 2005 2004 recognized earned based upon contract terms generally ratable term service record project installation work asia using percentageofcompletion method installation revenue represents less 5 net revenue 2006 2005 2004 net revenues include amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue “eitf” 0010 accounting shipping handling fees costs shipping fees represent less 1 net revenues 2006 2005 2004 shipping costs included cost goods sold accounts receivable trade notes receivable allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses company generally require collateral sales credit management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s creditworthiness actual defaults higher experienced historically additional allowances would required trade notes receivables presented company customers china payment outstanding trade receivables notes receivables bank guarantee promissory notes noninterest bearing generally mature within 6 months inventories stated lower cost using firstin firstout method market company exposed number economic industry factors could result portions inventory becoming either obsolete excess anticipated usage saleable amounts less carrying amounts factors include limited technological changes market competitive pressures products prices availability key components suppliers company established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded reserves intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required investments result 2006 investment commitments accordance financial accounting standard 115 “accounting certain investments debt equity” company changed classification investments “heldtomaturity” “availableforsale” resulting fairvalue calculation company’s investments led nominal net decrease carrying value investments 2006 stockbased compensation expense effective january 1 2003 company adopted fas 123 “accounting stockbased compensation” recognition stockbased compensation cost statement operations fair value option award estimated date grant using blackscholesmerton valuation method fair value amortized compensation expense straight line basis requisite service periods awards generally vesting period effective january 1 2006 company adopted fair value recognition provisions fas 123 revised 2004 “sharebased payment” fair value option adjusted reflect shares expected vest company’s implementation fas 123r uses modifiedprospectivetransition method compensation cost related unvested option january 1 2006 recalculated necessary adjustment reported first quarter adoption company made following estimates assumptions determining fair value valuation amortization method company estimates fair value stock options granted using blackscholesmerton optionpricing formula single option award approach fair value amortized straightline basis requisite service periods awards generally vesting period expected term company’s expected term represents period company’s stockbased awards expected outstanding determined using “simplified method” defined securities exchange commission’s staff accounting bulletin 107 expected volatility company’s expected volatilities based historical volatility company’s stock adjusted determined management unusual nonrepresentative stock price activity expected recur expected dividend blackscholesmerton valuation model calls single expected dividend yield input company currently pays dividends expect pay dividends foreseeable future riskfree interest rate company bases riskfree interest rate implied yield currently available united states treasury zerocoupon issues equivalent remaining term estimated forfeitures estimating forfeitures company uses average historical option forfeitures period four years business combinations accordance business combination accounting allocate purchase price acquired companies tangible intangible assets acquired liabilities assumed estimated fair values engage thirdparty appraisal firms assist management determining fair values certain assets acquired liabilities assumed valuation requires management make significant estimates assumptions especially respect intangible assets management makes estimates fair value based upon assumptions believed reasonable estimates based historical experience information obtained management acquired companies inherently uncertain critical estimates valuing certain intangible assets include limited future expected cash flows maintenance agreements customer contracts acquired developed technologies pending patents expected costs develop inprocess research development commercially viable products estimating cash flows projects completed acquired company’s brand awareness market position well assumptions period time acquired brand continue used combined company’s product portfolio discount rates unanticipated events circumstances may occur may affect accuracy validity assumptions estimates actual results income taxes subject income taxes united states numerous foreign jurisdictions significant judgment required evaluating tax positions determining provision income taxes effective tax rates differ statutory rate primarily due foreign earnings taxed lower rates foreign losses benefited nondeductible stock compensation deductions fas 123r change provisions uncertain tax positions future effective tax rates could adversely affected earnings lower anticipated countries lower statutory rates higher anticipated countries higher statutory rates changes valuation deferred tax assets liabilities changes tax laws regulations accounting principles interpretations thereof regularly assess likelihood adverse outcomes resulting tax examinations determine adequacy provision income taxes significant judgment also required determining valuation allowance recorded deferred tax assets assessing need valuation allowance consider available evidence including past operating results estimates future taxable income feasibility tax planning strategies event change determination amount deferred tax assets realized adjust valuation allowance corresponding impact provision income taxes period determination made results operations comparison years ended december 31 2006 2005 total net sales net sales 680 million year ended december 31 2006 increase 77 million 13 compared 603 million year ended december 31 2005 increase primarily result increases net sales asia 61 million europe 24 million partially offset decrease americas 08 million increase asia due higher sales third party products rae gas detector product sales increased installation revenue increase europe primarily driven integrated wireless systems sales decrease americas primarily result slower spending first half 2006 homeland security products compared 2005 well increased competitive product pricing pressure industrial sector 2006 cost sales gross profit cost sales 323 million year ended december 31 2006 increase 76 million 31 247 million year ended december 31 2005 gross profit year ended december 31 2006 357 million compared 356 million year ended december 31 2005 however ratio gross profit sales decreased 53 2006 compared 59 2005 lower gross profit ratio 2006 primarily due shift sales americas towards lowermargin portable products increase united states manufacturing overhead associated facility cost competitive product pricing pressure united states addition lower gross margin installation revenue third party product sales asia contributed yearoveryear decline gross margin sales marketing expense sales marketing expenses year ended december 31 2006 increased 24 million 15 168 million year ended december 31 2005 increase attributable increase sales marketing expenses related increased revenue payroll related expenses attributable increased headcount well higher infrastructure costs across company support sales growth research development expense research development expenses year ended december 31 2006 increased 08 million 15 compared year ended december 31 2005 increased expenses primarily result increased headcount project expenses development new portable wireless products engineering center shanghai china key product releases 2006 included gammarae systems ii r portable radiation detector dosimeter well neutron rae ii combined gamma neutron radiation detector also released chemrae portable device detection chemical warfare agents capable integration wireless communications products general administrative expense general administrative expenses year ended december 31 2006 increased 04 million 3 compared year ended december 31 2005 increased expenses primarily result increases sarbanesoxley compliance related charges company also experienced higher infrastructure costs increased communication consulting expenses following implementation oracle enterprise resource planning system loss abandonment lease loss abandonment lease cost approximately 20 million 2005 associated abandonment former headquarters manufacturing lease site sunnyvale california completed move larger headquarters united states manufacturing facility second quarter 2005 support sales growth income expense total income expense improved profits 03 million year ended december 31 2006 compared year ended december 31 2005 increase primarily result increased income 02 million 2006 primarily resulting foreign exchange gain 02 million eurodollar renminbi denominated balances litigation settlement gain 02 million increase partially offset loss fixed assets disposal 02 million also experienced increase interest income 01 million largely attributed higher interest rates investments 2006 compared 2005 income taxes income tax benefit increased 05 million year ended december 31 2006 compared year ended december 31 2005 effective tax rate 38 tax benefit 2006 37 tax benefit 2005 tax rate fiscal years 2006 2005 differed united states statutory rate due foreign earnings taxed lower rates foreign losses benefited nondeductible stock compensation deductions fas 123 fas 123r adjustments reserves uncertain tax positions 2006 internal revenue service completed examination federal income tax returns years ended december 31 2003 2004 based results examination company paid 391000 irs april 2006 accrued december 31 2005 based favorable outcome audit company released 337000 additional reserves applicable 2003 2004 year additionally company reported 190000 release tax reserves related interest upon expiration statute limitations federal tax liabilities applicable uncertain tax positions year ended december 31 2002 2006 tax authority denmark skat completed audit company’s subsidiary denmark year ended december 31 2004 without adjustment minority interest income consolidated subsidiaries minority interest loss consolidated entities year ended december 31 2006 decreased approximately 13000 21 compared year ended december 31 2005 minority interest loss consolidated subsidiaries represented net loss allocated minority shareholders’ interest rae beijing majority shareholders’ interest rae france reduction minority interest loss consolidated entities due improved profitability rae beijing rae france partially offsetting reduction decrease minority ownership resulted company’s increase ownership rae beijing 64 96 july 2006 comparison years ended december 31 2005 2004 certain 2005 2004 numbers reclassified order comply 2006 presentation reclassification adjustments impact net income loss year total net sales net sales increased 148 million year ended december 31 2005 year ended december 31 2004 increase primarily due higher sales reported rae beijing 101 million included twelve months sales 2005 compared seven months sales 2004 partially offset decrease sales 14 million affiliates china transferred sales responsibility rae beijing rae products china also sales increased 61 million americas europe sales patented photoionization detection wireless products overall nonamericas sales increased 106 million 2005 2004 44 total revenue compared 34 total revenue 2004 nonamericas sales growth also impacted favorably result rae beijing included consolidated sales results twelve months year ended december 31 2005 compared seven months year ended december 31 2004 cost sales gross profit cost sales excluding rae beijing 145 million year ended december 31 2005 compared 139 million year ended december 31 2004 increase 06 million cost sales excluding impact rae beijing increased due 12 increase sales volume years 2005 2004 partially offset cost improvements volume increases manufacturing efficiencies cost sales rae beijing increased 102 million year ended december 31 2005 46 million year ended december 31 2004 primarily result sales volume increases partially offset improved costs result increased volume gross profit excluding rae beijing 278 million 237 million years ended december 31 2005 2004 respectively gross profit excluding rae beijing increased due higher sales integrated systems patented photoionization detection products improved costs result higher volumes manufacturing efficiencies gross profit percentage sales year ended december 31 2005 59 yearended december 31 2004 increase lower margin distribution installation business rae beijing offset favorable impact higher volumes manufacturing efficiencies overall product costs sales marketing expense sales marketing expenses increased 63 million year ended december 31 2005 compared year ended december 31 2004 approximately 39 million increase attributable increase rae beijing sales marketing expenses included twelve months expenses 2005 compared seven months expenses 2004 well higher infrastructure costs support rae beijing’s growth sales marketing expenses also increased 19 million support increased sales americas europe 03 million external commissions paid primarily support sale integrated systems products approximately 02 million severance expense research development expense research development expenses increased 10 million year ended december 31 2005 compared year ended december 31 2004 higher spending largely result increased spending rae beijing 06 million twelve months expenses included 2005 results compared seven months expenses 2004 well increases rd personnel related expenses rae beijing remaining 04 million increase mainly result increases rd personnel shanghai support new product development general administrative expense general administrative ga expenses increased 44 million year ended december 31 2005 compared year ended december 31 2004 increase primarily result 13 million additional expenses rae beijing primarily due inclusion twelve months expenses 2005 compared seven months 2004 well increases ga personnel related expenses support rae beijing’s growth also experienced increases across company audit sarbanesoxley certification costs 09 million legal fees 06 million amortization stock options warrants 05 million remaining amount 11 million additional infrastructure personnel support increased sales growth units loss abandonment lease loss abandonment lease cost approximately 20 million 2005 associated abandonment former united states headquarters manufacturing lease site sunnyvale california completed move larger headquarters united states manufacturing facility second quarter 2005 support sales growth income expense total income expense improved profits 133000 year ended december 31 2005 compared year ended december 31 2004 increase result increased interest income 308000 largely increased interest rates earned cash investments equity loss unconsolidated affiliate also improved 157000 compared 2004 mainly result lower operating losses renex affiliate year ended december 31 2005 partially offsetting items decline 169000 income received consulting payment 137000 2004 sales affiliate china longer operating increase interest expense 163000 primarily 126000 amortization discount interest expense related rae beijing notes payable income taxes income tax expense decreased 15 million year ended december 31 2005 compared year ended december 31 2004 effective tax rate 37 benefit 2005 27 tax provision 2004 respectively tax benefit primarily operating losses largely result abandonment lease former sunnyvale headquarters research development tax credits minority interest income consolidated subsidiaries year ended december 31 2005 recognized 62000 net loss consolidated subsidiaries allocated minority interest related mainly 36 minority interest’s share rae beijing losses partially offset 51 owners share income french subsidiary year ended december 31 2004 minority partners share profits 353000 representing 36 minority interest’s share profits rae beijing 51 majority investors share rae france liquidity capital resources date financed operations primarily bank borrowings revenues operations proceeds issuance equity securities december 31 2006 21367000 cash investments compared 29488000 december 31 2005 8121000 million yearoveryear reduction company’s cash investments primarily due business acquisitions 7439000 investments property equipment 2235000 partially offset net cash provided operating activities 1051000 cash provided financing activities 230000 december 31 2006 36641000 working capital current assets less current liabilities current ratio current assets current liabilities 26 10 compared working capital 41366000 current ratio 39 10 december 31 2005 march 14 2007 company signed one year 15 million revolving credit agreement available help fund future growth expansion agreement provides borrowings 7 million based blanket security interest company’s assets additional 8 million borrowing available based percentage qualifying assets company required comply certain bank specific reporting requirements whenever borrowings line credit exceed 3 million addition ongoing requirement submit quarterly financial statements company full compliance borrowing requirements including certain financial covenants full line available present outstanding amounts line credit agreement believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments future results operations future financing may require may unavailable favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership stockholders summary consolidated statements cash flows years 2006 2005 2004 follows operating activities year ended december 31 2006 net cash provided operating activities 1051000 exceeded net loss 1529000 primarily two reasons 1 noncash charges net income approximately 4672000 noncash adjustments net income resulted primarily depreciation amortization longlived assets 3189000 compensation expense fair value accounting stock options 1620000 reserve noncash adjustments company’s net income approximately 1043000 partially offset adjustment company’s deferred income taxes 1180000 2 positive effect noncash adjustments described item 1 year 2006 offset increased investment working capital 2092000 increase working capital primarily result increased sales asia longer average collection period accounts receivable sales united states partially offset higher payables related increased volume december 2006 year ended december 31 2005 net cash provided operating activities 1368000 exceeded net loss 759000 primarily two reasons 1 noncash charges net income approximately 5397000 noncash adjustments net income resulted primarily depreciation amortization longlived assets 2143000 reserve amounts cover anticipated payment landlord sunnyvale california headquarters building 2027000 abandoned company purchased headquarters building san jose california compensation expense fair value accounting stock options 1970000 reserve noncash adjustments company’s net income approximately 1182000 partially offset adjustment company’s deferred income taxes 1925000 2 positive effect noncash adjustments described item 1 year 2005 partially offset increased investment working capital 3270000 comprised primarily increases accounts receivable inventory related increased sales levels continued growth business asia year ended december 31 2004 net cash provided operating activities 3207000 exceeded net income 2335000 two reasons 1 noncash charges net income 4414000 2445000 comprised stock option expense stock option income tax benefits depreciation amortization 991000 noncash adjustments 1788000 partially offset deferred income taxes 810000 2 increase working capital 3542000 primarily result inclusion rae beijing balance sheet 2004 investing activities net cash provided used investing activities years ended december 31 2006 2005 2004 amounted 3025000 9562000 21009000 respectively 2006 proceeds investing activities contributed 3025000 cash increase consisted primarily 12699000 net proceeds sale investments maturity investments net proceeds partially offset investments 7439000 used business acquisitions approximately 4850000 invested increase stake rae beijing 64 96 2100000 acquire assets aegison corporation 467000 acquire certain assets tianjin securay technology co ltd addition 2235000 used acquisition property equipment 2005 increase investing activities reduced cash available business operations 9562000 cash reduction resulting increased investing activities 2005 primarily result 4855000 used acquisition property equipment related existing businesses net increase investments surplus cash held company approximately 4707000 2004 increase investing activities reduced cash available business operations 21009000 cash reduction resulting increased investing activities 2004 primarily due 9273000 invested property including 5000000 new headquarters manufacturing facilities united states addition company net increase investments 11245000 cash used investing activities 491000 financing activities net cash provided financing activities years ended december 31 2006 2005 2004 amounted 230000 108000 31816000 respectively net cash provided financing activities 2006 2005 mainly proceeds exercise stock options warrants net cash 318 million provided 2004 primarily result public offering 8050000 shares common stock 425 per share less applicable discount commitments contingencies operating leases company subsidiaries lease certain manufacturing warehousing facilities operating leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2006 2005 2004 654000 624000 809000 respectively future minimum lease payments next five years 2007 2011 thereafter excluding sunnyvale california abandoned building lease described 947000 621000 426000 378000 349000 801000 respectively december 2004 company purchased property located 3775 north first street san jose california lease related previous headquarters sunnyvale california writtenoff second quarter 2005 total loss abandonment lease approximately 2 million future discounted lease payments related sunnyvale building included accrued expenses totaling 478000 long term liabilities totaling 1000000 december 31 2006 future minimum lease payments next three years 2007 2009 528000 627000 556000 respectively discount rate used 485 liability reduced anticipated future sublease income based upon broker estimates current real estate market conditions factors considered likely potential sublease income would offset brokerage refurbishment costs make facility ready sublease purchase obligations company agreements suppliers parties purchase inventories goods services company estimated noncancelable obligations agreements next three years 2007 2009 approximately 3844000 244000 230000 respectively noncancelable obligations 2009 noncancelable obligations related inventories expected delivered within next 12 months company periodically reviews carrying value inventories noncancelable purchase commitments evaluating material usage requirements forecasts estimates inventory obsolescence excess quantities expected losses purchase commitments company may record charges writedown inventory due excess obsolete slowmoving inventory lowerofcost market based analysis impact changes technology estimates future sales volumes market value estimates loss accrued related current purchase obligations however additional future writedowns inventories loss accrued inventory purchase commitments due market conditions may negatively affect gross margins future periods december 2006 rae fushun entered agreement fushun economic development zone administration purchase land use right approximately 446000 land use right used construct rae fushun’s new manufacturing administrative facility construction expected begin prior june 2007 guarantees company permitted delaware law accordance bylaws indemnify officers directors certain events occurrences subject certain limits officer serving company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director officer insurance policy limits exposure enables recover portion future amounts paid date company incurred losses agreements company’s sales agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits product warranties company sells majority products 12 24 month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized december 31 2006 2005 warranty reserve recorded accrued expenses 553000 377000 respectively summary obligations following table quantifies known contractual obligations tabular form december 31 2006 related party transactions conjunction original subsequent additional investment rae beijing unsecured note payables established previous rae beijing shareholders part purchase price agreement may 2004 july 2006 december 31 2006 december 31 2005 822000 759000 respectively included notes payable related parties 3222000 821000 respectively included long term notes payable related parties notes issued conjunction original rae beijing purchase may 2004 noninterest bearing recorded net present value using discount rate 55 conjunction additional investment rae beijing july 2006 110 million shares preferred stock issued four shareholders rae beijing accordance financial accounting standards board statements 150 accounting certain financial instruments characteristics liabilities equity “fas 150” preferred shares classified liabilities recorded longterm notes payable related parties although preferred shares bear dividend yield rate 3 per annum notes payable discounted using market interest rate 648 included current portion notes payable sum 448000 due demand december 31 2006 addition future payment plan years 2007 2011 411000 257000 1756000 967000 940000 respectively company’s director information systems lien chen wife chief executive officer robert chen ms chen paid salary bonus 103000 96000 2006 2005 respectively ms chen also receives standard employee benefits offered fulltime us employees ms chen report robert chen compensation decisions regarding ms chen performed manner us employees robert chen final approval signatory compensation recommendations january 14 2006 lien chen sandy hsi wife chief technology officer peter c hsi signed promissory note lend 200000 aegison corporation interest rate 10 per year july 11 2006 company purchased assets including two pending patents aegison corporation total purchase price 2 million cash time promissory note held lien chen sandy hsi repaid aegison corporation recent accounting pronouncements july 2006 fasb issued financial interpretation 48 “accounting uncertainty income taxesan interpretation fasb statement 109” fin 48 change accounting income taxes fin 48 specifies tax benefits uncertain tax positions recognized measured derecognized financial statements requires certain disclosures uncertain tax matters specifies reserves uncertain tax positions classified balance sheet provides transition interimperiod guidance among provisions fin 48 effective fiscal years beginning december 15 2006 result effective us january 1 2007 currently evaluating impact fin 48 consolidated financial statements september 2006 fasb issued statement 157 “fair value measurements” sfas 157 sfas 157 defines fair value establishes framework gives guidance regarding methods used measuring fair value expands disclosures fair value measurements sfas 157 applicable whenever another accounting pronouncement requires permits assets liabilities measured fair value sfas 157 expand require new fair value measures however application statement may change current practice sfas 157 effective fiscal years beginning november 15 2007 result effective fiscal year beginning january 1 2008 currently evaluating impact adopting sfas 157 consolidated financial statements item 7aitem 7 management’s discussion analysis financial condition results operations following management’s discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology “may” “will” “should” “could” “expects” “plans” “anticipates” “believes” “estimates” “predicts” “potential” “continue” statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein factors might cause contribute differences include limited discussed item 1a “risk factors” well item 1 “business” item 7 “management’s discussion analysis financial condition results operations” annual report form 10k carefully review risks also review risks described documents file time securities exchange commission including quarterly reports form 10q file fiscal year 2009 cautioned place undue reliance forwardlooking statements expressly assume obligations update forwardlooking statements report occur date hereof overview leader delivering innovative sensor solutions serve industrial energy environmental government safety markets worldwide addition offer full line portable single multisensor chemical radiation detection products market products evolved strictly focused environmental industrial monitoring encompassing public safety energy markets expanded presence include broader global energy exploration refining safety equipment market formation rae fushun serving coal mine safety equipment market china 2006 made two investments china first july 2006 increased ownership rae beijing 96 percent rae beijing produces sells distributes safety security solutions chemical oil gas metals energy sectors china second december 2006 formed rae fushun anyi former state owned company serving coal mine safety market joint venture formed capitalize china’s growing reliance coal based energy rae fushun manufactures sells coal mine safety equipment rae systems owns 70 percent joint venture india middle east regional sales managers grow presence two emerging markets china focus growing environmental protection market industrial sector including oil gas petrochemicals steel certain telecom applications coal mining major priority introduce new products coal mine safety market rae fushun believe market provide us number exciting new business opportunities china continues modernize coal mining industry 2008 introduced eight new products offer complete line products serve needs global energy market products range breathing zone single sensor products specific toxic chemicals toxirae 3 belt worn multigas monitors qrae 2 handheld instruments minirae 3000 ppbrae 3000 ultrarae measure total specific volatile organic compounds wireless monitors industrial public safety applications arearae steel meshguard markets continue explore develop strategic value added partnerships leverage product market expertise critical accounting policies preparation financial statements conformity united states generally accepted accounting principles requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period ongoing basis evaluate estimates including related allowance doubtful accounts valuation goodwill intangible assets investments valuation deferred tax assets restructuring costs contingencies inventory valuation warranty accrual stockbased compensation expense conjunction acquisitions allocate investment costs based fair value assets acquired liabilities assumed base estimates historical experience various assumptions believed reasonable circumstances results form basis making judgments carrying values assets liabilities readily apparent sources actual results may differ significantly estimates different assumptions conditions believe following critical accounting policies affect significant judgments estimates used preparation consolidated financial statements revenue recognition recognize revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectability reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically experienced insignificant amount sales returns generally recognize revenue goods shipped distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provides sales returns standard product warranty provisions nonstandard contract terms title goods passes time delivery fob destination revenue recognized established proof delivery revenues relating services performed extended warranty program represent less 5 net revenues 2008 2007 2006 recognized earned based upon contract terms generally ratable term service record project installation work asia using percentageofcompletion method installation revenue represents less 5 net revenue 2008 2007 2006 net revenues include amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue “eitf” 0010 “accounting shipping handling fees costs” shipping fees represent less 1 net revenues 2008 2007 2006 shipping costs included cost goods sold accounts receivable trade notes receivable allowance doubtful accounts grant credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses generally require collateral sales credit management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s creditworthiness actual defaults higher experienced historically additional allowances would required able predict changes financial stability customers material change financial status one group customers could material adverse effect results operations financial condition trade notes receivables presented us customers china payment outstanding trade receivables notes receivables bank guarantee promissory notes noninterest bearing generally mature within 6 months inventories stated lower cost using firstin firstout method market exposed number economic industry factors could result portions inventory becoming either obsolete excess anticipated usage saleable amounts less carrying amounts factors include limited technological changes market competitive pressures products prices availability key components suppliers established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded reserves intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required goodwill test goodwill possible impairment annual basis time events occur circumstances indicate carrying amount goodwill may recoverable impairment review process compares fair value goodwill carrying value according statement financial accounting standards “sfas” 142 “goodwill intangible assets” “sfas 142” one reporting unit tested goodwill impairment basis single reporting unit determination whether write goodwill necessary involves significant judgment based shortterm longterm projections future performance assumptions supporting estimated future performances includes factors related estimating market value based market capitalization measurement dates longlived assets test longlived asset groups recoverability events changes circumstances indicate carrying amounts may recoverable recoverability assessed based carrying amounts asset fair value generally determined based sum undiscounted cash flows expected result use eventual disposal asset well specific appraisals certain instances impairment loss recognized carrying amount recoverable exceeds fair value stockbased compensation expense effective january 1 2006 adopted fair value recognition provisions sfas 123 revised 2004 “sharebased payment” “sfas 123r” fair value option adjusted reflect shares expected vest made following estimates assumptions determining fair value valuation amortization method estimate fair value stock options granted using blackscholesmerton optionpricing formula single option award approach fair value amortized straightline basis requisite service periods awards generally vesting period expected term expected term represents weightedaverage period stockbased awards expected outstanding prior 2007 applied “simplified method” defined securities exchange commission’s staff accounting bulletin 107 first quarter 2007 used historical exercise patterns previously granted options relation company’s stock price estimate expected exercise patterns expected volatility company’s expected volatilities based historical volatility company’s stock adjusted determined management unusual nonrepresentative stock price activity expected recur expected dividend blackscholesmerton valuation model calls single expected dividend yield input company currently pays dividends expect pay dividends foreseeable future riskfree interest rate company bases riskfree interest rate implied yield currently available united states treasury zerocoupon issues equivalent remaining term estimated forfeitures estimate forfeitures apply historical rate option forfeitures estimated forfeiture rates truedup actual forfeiture results stockbased awards vest business combinations accordance sfas 141 “business combinations” “sfas 141” allocate purchase price acquired companies tangible intangible assets acquired liabilities assumed based estimated fair values engage thirdparty appraisal firms assist management determining fair values certain assets acquired liabilities assumed valuation requires management make significant estimates assumptions especially respect intangible assets management makes estimates fair value based upon assumptions believed reasonable estimates based historical experience information obtained management acquired companies inherently uncertain critical estimates valuing certain intangible assets include limited future expected cash flows customer contracts acquired developed technologies pending patents expected costs develop inprocess research development commercially viable products estimating cash flows projects completed acquired company’s brand awareness market position well assumptions period time acquired brand continue used combined company’s product portfolio discount rates unanticipated events circumstances may occur may affect accuracy validity assumptions estimates actual results income taxes subject income taxes united states numerous foreign jurisdictions significant judgment required evaluating tax positions determining provision income taxes effective tax rates differ statutory rate primarily due foreign earnings taxed lower rates foreign losses benefited stock compensation expenses sfas 123r deductible tax purposes valuation allowance future effective tax rates could adversely affected earnings lower anticipated countries lower statutory rates higher anticipated countries higher statutory rates changes valuation deferred tax assets liabilities changes tax laws regulations accounting principles interpretations thereof regularly assess likelihood adverse outcomes resulting tax examinations determine adequacy provision income taxes significant judgment also required determining valuation allowance recorded deferred tax assets assessing need valuation allowance consider available evidence including past operating results estimates future taxable income feasibility tax planning strategies event change determination amount deferred tax assets realized adjust valuation allowance corresponding impact provision income taxes period determination made results operations net sales net sales 2008 increased 45 million 5 908 million 2007 increase primarily result increase net sales 14 million 38 million americas europe respectively offset decrease net sales asia 07 million approximately 42 million total increase due appreciation renminbi “rmb” euro us dollar 2007 2008 remainder increase mainly due 35 million contract united states national guard arearae wireless rapid deployment kits equip civil support teams throughout united states territories increases sales new products qrae ii toxirae iii 3 g pid arearae mainly europe offset volume decline china mine safety equipment sales general sales slow following beijing olympics second half 2008 net sales 2007 increased 231 million 34 677 million 2006 increase primarily result increase net sales 118 million acquisition rae fushun december 2006 increase net sales 42 million americas 28 million europe 43 million rest asia excluding fushun increase revenue primarily due overall greater market penetration sales team led higher government orders united states larger sales oil steel industries china cost sales gross profit cost sales consists direct material labor overhead stockbased compensation expenses sfas 123r included direct labor costs cost sales 2008 increased 27 million 6 444 million 2007 increase cost sales primarily result increase net sales 908 million 2007 954 million 2008 gross margin 2008 remained consistent 2007 51 cost sales 2007 increased 122 million 38 322 million 2006 increase cost sales primarily result increase net sales 677 million 2006 908 million 2007 gross profit 2007 increased 109 million 31 355 million 2006 gross margin decreased slightly 2007 51 52 2006 due primarily acquisition rae fushun december 2006 lower gross margin due older technology products new operation sales marketing expense sales marketing expenses 2008 decreased 40 million 16 254 million 2007 decrease primarily due companywide costcontrol initiatives ten percent reduction force primarily americas put place end first quarter 2008 additional savings realized decreases office expenses advertising trade show expenses travel entertainment expenses consultant expenses project expenses sales marketing expenses 2007 increased 64 million 34 190 million 2006 increase primarily due 19 million increase payroll benefit related expenses result 13 headcount increases regions 85 headcount increases acquisition rae fushun december 2006 well 19 million increased travel entertainment expenses 15 million increased office facility expenses addition commission expenses increased 09 million reflecting increase revenue amortization intangible increased 03 million primarily result acquisition customer list connection acquisition rae fushun research development expense research development expenses 2008 decreased 13 million 16 80 million 2007 decrease primarily due 07 million decrease amortization expense certain intangible assets fully amortized 07 million decrease project expenses due completion certain rd projects 2008 research development expenses 2007 increased 19 million 31 61 million 2006 increase primarily due 07 million increase payroll benefit related expenses result headcount increases china acquisition rae fushun december 2006 well 01 million increase office travel expenses project expenses increased 05 million mainly due increases product certifications testing expenses additional projects formation rae fushun well new projects related future products regions also impaired certain patents approximately 06 million china related products reached end life discontinued general administrative expense general administrative expenses 2008 increased 51 million 29 178 2007 increase primarily due net increase 25 million professional service expenses charge comprised 40 million increase related previously disclosed fcpa investigation related remediation plans conducted supervision audit committee board directors offset decrease legal costs associated conclusion polimaster arbitration 2007 bad debt expenses increased 14 million due increase accounts receivable reserves rae fushun rae beijing general administrative expenses 2007 increased 44 million 33 133 million 2006 increase primarily due 20 million increase payroll benefit related expenses result headcount increases regions formation rae fushun december 2006 well 08 million increase office facility expenses 02 million increase travel expenses increase 17 million professional fees primarily comprised 13 million increase legal costs associated polimaster arbitration 08 million increase accounting tax services related international nature business offset 04 million decrease consulting fees permanent positions replaced consultants increase general administrative expenses offset 04 million gain recognized result sale leaseback san jose headquarters building december 2007 impairment goodwill review goodwill impairment annually fourth quarter frequently events circumstances indicate impairment loss may occurred recoverability goodwill measured reporting unit level comparing reporting unit’s carrying amount including goodwill fair value reporting unit measured based upon among factors market capitalization well forecasted operating results one reporting unit recorded value assets including goodwill liabilities “net book value” reporting unit exceeds fair value impairment loss may exist extent net book value whole greater market capitalization significant portion goodwill may considered impaired experienced significant decline market capitalization fourth quarter 2008 decline market capitalization driven largely deteriorating macroeconomic conditions contributed decline forecasted operating results business uncertainties associated current fcpa investigation result recognized noncash impairment charge approximately 33 million threemonth period year ended december 31 2008 writeoff entire carrying value goodwill gainloss abandonment lease income abandonment lease 2007 06 million march 2007 revised estimated loss abandonment lease related former headquarters sunnyvale california reduced operating expenses 06 million change estimate primarily reflected management’s expectation premises would subleased current market conditions office rentals second quarter 2007 sublease executed rents commencing june income expense 2008 total expenses increased 03 million 65 05 million 2007 increase primarily due increases foreign exchange losses balances payments euro rmb offset decreases interest expenses repaid outstanding loan balance using funds sale san jose building 2007 total income decreased 13 million 163 08 million 2006 decrease primarily result lower interest income made substantial investments rae fushun securay aegison corporation second half 2006 2007 addition interest expenses increased 05 million due short term bank borrowings us china support operations income decreased 02 million mainly due realized foreign exchange loss payments fushun shareholders 2007 income tax benefit expense income tax expense decreased 53 million 91 income tax expense 59 million 2007 effective tax rate 9 2008 53 2007 tax rate years 2008 2007 differed united states statutory rate due change realization deferred tax assets dtas foreign earnings taxed lower rates foreign losses benefited nondeductible stock compensation deductions sfas 123 sfas 123r currently significant deferred tax assets resulting anticipated net operating losses deductible temporary differences reduce taxable income future periods continue maintain full valuation allowance deferred assets except 05 million related foreign entities based current projections believe “more likely not” able benefit deferred tax assets exception 05 million foreign deferred tax assets sfas 109 “accounting income taxes” “sfas 109” requires valuation allowance established “more likely not” portion deferred tax assets realized difficult conclude valuation allowance needed negative evidence cumulative losses recent years therefore cumulative losses weighed heavily overall assessment believe sufficient uncertainty exists regard realizability tax assets valuation allowance necessary factors considered providing valuation allowance include lack significant history consistent profits current believed continued weakness overall market thereby potentially impacting ability sustain grow revenues earnings length carryback carryforward periods considered expectations risks associated estimates future taxable income ongoing prudent feasible tax planning strategies based absence sufficient positive objective verifiable evidence december 31 2008 placed valuation deferred tax assets except 05 million foreign deferred tax assets expect record valuation allowance future tax benefits sustain appropriate level profitability time would expect recognize significant tax benefits future results operations effective tax rate 53 tax expense 2007 38 tax benefit 2006 tax rate 2007 2006 differed united states statutory rate due foreign earnings taxed lower rates foreign losses benefited nondeductible stock compensation deductions sfas 123 sfas 123r adjustments reserves uncertain tax positions minority interest loss consolidated subsidiaries minority interest loss consolidated subsidiaries 2008 increased 02 million income 6000 2007 increase minority interest loss consolidated entities mainly due increased loss generated rae fushun offset increased profitability rae france 2008 minority interest income consolidated entities 2007 increased 55000 112 loss 49000 2006 increase minority interest income consolidated entities mainly due improved profitability rae beijing well increase ownership 64 96 second half fiscal 2006 increase partially offset loss generated rae fushun formed december 2006 less profit rae france 2007 loss discontinued operations august 24 2007 board directors approved discontinuation mobile dvr business order reduce expenses concentrate resources gas radiation detection business mobile dvr business acquired purchases aegison securay see “note 2 mergers acquisitions” notes consolidated financial statements details august 28 2007 notified dvr customers terminated personnel reassigned continuing operations suspended related production sales activities dvr business operates substantial loss management intends liquidate tangible assets mainly inventories component parts accordingly value assets adjusted reflect anticipated disposals result discontinuing dvr business management impaired remaining value intangible assets goodwill acquired purchases aegison july 2006 securay january 2007 impairment expense recognized fiscal 2007 totaled 42 million accordance sfas 144 “accounting impairment disposal longlived assets” “sfas 144” financial results dvr business reported discontinued operations periods presented financial results included discontinued operations follows liquidity capital resources date financed operations primarily operating revenues proceeds issuance equity securities shortterm bank borrowings 2007 also sold leased back corporate headquarters san jose california december 31 2008 148 million cash equivalents compared 159 million december 31 2007 11 million yearoveryear reduction company cash primarily due investments plant scheduled payment notes payable related parties december 31 2008 371 million working capital current assets less current liabilities current ratio current assets current liabilities 25 10 compared working capital 409 million current ratio 28 10 december 31 2007 united states 150 million revolving credit agreement december 31 2008 december 31 2007 credit facility renewed annually currently expires march 13 2009 currently renegotiating terms line credit bank march 11 2009 received extension existing line may 12 2009 also changed certain terms conditions amended credit agreement provides borrowings 100 million based percentage specific qualifying assets blanket security interest assets united states required comply certain reporting requirements addition ongoing requirement submit quarterly financial statements assurance successful securing renewed agreement line credit time period may 12 2009 december 31 2008 december 31 2007 18 million zero respectively outstanding loan agreements united states one financial covenants requirement achieve earnings interest taxes depreciation amortization “ebitda” least 35 million period july 1 2008 december 31 2008 primarily due effect net sales sharp global economic downturn fourth quarter compliance covenant however bank provided waiver noncompliance notwithstanding loss continuing operations 2008 generated cash operating activities 32 million china two unsecured revolving lines credit december 31 2008 december 31 2007 amount rmb 20 million approximately 29 million year end 2007 also maintained unsecured line credit amount rmb 10 million approximately 14 million borrowings lines credit available provide working capital generally current market rate fixed rate loans amount duration requested one year continuing credit facilities renewed annually may october respectively december 31 2008 december 31 2007 rmb 5 million approximately 07 million rmb 19 million approximately 26 million respectively outstanding loan agreements china believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital debt service capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments ultimate resolution issues arising internal investigation regarding potential fcpa violations future results operations future financing may require may unavailable favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership stockholders consolidated statements cash flows 2008 2007 2006 may summarized follows operating activities year ended december 31 2008 net cash provided operating activities 32 million due following • noncash charges included net loss 72 million totaled 82 million principal noncash expenses follows 33 million reduction goodwill 33 million depreciation amortization 16 million stockbased compensation 13 million provision doubtful accounts noncash expenses partially offset 06 million gains disposal property equipment 06 million deferred income tax benefits net gains 01 million • net reduction working capital 22 million attributable changes operating assets liabilities decrease working capital resulted primarily 12 million decline accounts receivable 11 million decline trade notes receivable operating accounts offset change receivables 01 million net year ended december 31 2007 net cash used operating activities 100 million due following • cash used mainly support increase 95 million working capital primarily consisting increase 57 million accounts receivable 18 million inventories primarily related increased sales remaining 20 million primarily comprised changes deferred revenue deposits current operating accounts • positive effect noncash adjustments due depreciation amortization long lived assets 37 million deferred taxes 41 million stock based compensation expense 19 million provision doubtful accounts 19 million year ended december 31 2006 net cash provided operating activities 11 million due following • noncash charges net income approximately 41 million noncash adjustments net income resulted primarily depreciation amortization longlived assets 32 million compensation expense fair value accounting stock options 16 million reserve noncash adjustments net income approximately 05 million partially offset adjustment deferred income taxes 12 million • positive effect noncash adjustments described year 2006 partially offset increased investment working capital 15 million increase working capital primarily result increased sales asia longer average collection period accounts receivable sales united states partially offset higher payables related increased volume december 2006 investing activities 2008 cash used investing activities primarily used complete occupy manufacturing facility fushun china total project fushun also includes administrative offices research development facility living quarters estimated cost complete project approximately 23 million however committed timeline remaining construction 2007 increase cash due investing activities 100 million primarily due net proceeds sale leaseback san jose headquarters building approximately 124 million sale investments securities 32 million partially offset approximately 40 million used acquisition property equipment 16 million used business acquisitions 2007 began construct rae fushun’s new manufacturing administrative facility china 2006 proceeds investing activities contributed 30 million cash increase consisted primarily 127 million net proceeds sale investments maturity investments net proceeds partially offset investments 74 million used business acquisitions approximately 48 million invested increase stake rae beijing 64 96 21 million acquire assets aegison corporation 05 million acquire certain assets tianjin securay technology co ltd addition 22 million used acquisition property equipment financing activities cash used financing activities 14 million 2008 primarily applied payments related party notes totaling 12 million payments bank lines credit 02 million net amounts borrowed bank lines credit provide working capital operations united states china cash provided financing activities 27 million 2007 primarily bank borrowings net repayment 26 million used repay related party note 50 million repurchase restricted stock awards 03 million net cash provided financing activities 2006 2005 mainly proceeds exercise stock options warrants commitments contingencies summary obligations following table quantifies known contractual obligations tabular form december 31 2008 obligations impact short longterm liquidity capital resource needs certain contractual obligations reflected consolidated balance sheets others disclosed future obligations 1 discussion surrounding notes payablerelated parties refer “note 11 related party transactions” consolidated financial statements 2 discussion surrounding purchase lease obligations refer “note 8 commitments contingencies” consolidated financial statements 3 represents estimated cancelable open purchase orders purchase inventory goods services normal course business meet operational requirements guarantees permitted delaware law required certificate incorporation bylaws indemnify officers directors certain events occurrences subject certain limits director officer serving request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however director officer insurance policy reduces exposure enables us recover portion future amounts paid date incurred losses agreements sales agreements typically agree indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date paid amounts settle claims defend lawsuits product warranties sell majority products 12 24 month repair replacement warranty date shipment provide accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized uncertain tax positions effective january 1 2007 adopted provisions fin 48 december 31 2008 liability uncertain tax positions including associated interest penalties approximately 14 million pursuant fin 48 liability represents estimate tax positions company taken tax returns may ultimately sustained upon examination tax authorities since ultimate amount timing future cash settlements cannot predicted reasonable certainty estimated liability excluded contractual obligations table recent accounting pronouncements december 2007 financial accounting standards board “fasb” issued sfas 141r “business combinations” “sfas 141r” statement changes accounting acquisition transaction costs requiring expensed period incurred also changes accounting contingent consideration acquired contingencies restructuring costs related acquisition sfas 141r effective fiscal years beginning december 15 2008 adoption sfas 141r expected change accounting treatment business combinations prospective basis beginning period adopted december 2007 fasb issued sfas 160 “noncontrolling interests consolidated financial statementsan amendment arb 51” “sfas 160” statement change accounting reporting minority interests recharacterized noncontrolling interests classified component equity sfas 160 effective fiscal years beginning december 15 2008 believe adoption sfas 160 material impact consolidated financial position results operations cash flows march 2008 fasb issued sfas 161 “disclosures derivative instruments hedging activities amendment fasb statement 133” statement establishes enhanced entity uses derivative instruments derivative instruments related hedged items accounted sfas 133 “accounting derivative instruments hedging activities” related interpretations derivative instruments related hedged items affect entity’s financial position financial performance cash flows effective financial statements issued fiscal years interim periods beginning november 15 2008 early adoption encouraged statement encourages require comparative disclosures earlier periods initial adoption statement expected material effect consolidated financial statements april 2008 fasb issued fasb staff position fas 1423 fsp 1423 “determination useful life intangible assets” fsp 1423 amends factors considered developing renewal extension assumptions used determine useful life recognized intangible asset sfas 142 “goodwill intangible assets” fsp 1423 also requires expanded disclosure regarding determination intangible asset useful lives fsp 1423 effective fiscal years beginning december 15 2008 earlier adoption permitted currently evaluating potential impact adoption fsp 1423 consolidated financial position results operations cash flows may 2008 fasb issued sfas 162 “the hierarchy generally accepted accounting principles” sfas 162 intended improve financial reporting identifying consistent framework hierarchy selecting accounting principles used preparing financial statements presented conformity us generally accepted accounting principles nongovernmental entities effective financial statements issued fiscal years interim periods beginning november 15 2008 expect adoption sfas 162 material impact consolidated financial statements item 7aitem 7 management’s discussion analysis financial condition results operations following management’s discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology “may” “will” “should” “could” “expects” “plans” “anticipates” “believes” “estimates” “predicts” “potential” “continue” statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein factors might cause contribute differences include limited discussed item 1a “risk factors” well item 1 “business” item 7 “management’s discussion analysis financial condition results operations” annual report form 10k carefully review risks also review risks described documents file time securities exchange commission including quarterly reports form 10q file fiscal year 2010 cautioned place undue reliance forwardlooking statements expressly assume obligations update forwardlooking statements report occur date hereof overview leader delivering innovative sensor solutions serve industrial energy environmental government safety markets worldwide addition offer full line portable single multisensor chemical radiation detection products market products evolved strictly focused environmental industrial monitoring encompassing public safety energy markets expanded presence include broader global energy exploration refining safety equipment market formation rae fushun serving coal mine safety equipment market china 2006 made two significant business investments china first july 2006 increased ownership rae beijing 96 rae beijing produces sells distributes safety security solutions chemical oil gas metals energy sectors china second december 2006 formed rae fushun joint venture fushun anyi former state owned company serving coal mine safety market joint venture formed capitalize china’s growing reliance coal based energy rae fushun manufactures sells coal mine safety equipment rae systems owns 70 joint venture china focus growing environmental protection market industrial sector including oil gas petrochemicals steel telecommunications coal mining major priority introduce new products coal mine safety market rae fushun believe market provide us number new business opportunities china continues modernize coal mining industry offer complete line products meet requirements various markets serve products range breathing zone single sensor products specific toxic chemicals toxirae 3 belt worn multigas monitors qrae 2 handheld instruments minirae 3000 ppbrae 3000 ultrarae measure total specific volatile organic compounds wireless monitors industrial public safety applications arearae steel expanded wireless product offering introduction meshguard singlegas mesh radiobased monitor designed replace singlegas fixed monitors industrial environments include steel mills oil gas exploration chemical processing continue improve product offerings advances sensors wireless networking technologies including raelink 3 wireless modem integrated gps bluetooth radio technology provides data bridge products complementary products chemical warfare agents particle counters updated several fixed gas monitors meet needs china market received additional sensor patent new gamma radiation detectordosimeter deployed gammarae ii r product markets continue explore develop strategic value added partnerships leverage product market expertise critical accounting policies preparation financial statements conformity united states generally accepted accounting principles requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period ongoing basis evaluate estimates including related allowance doubtful accounts valuation longlived assets goodwill intangible assets valuation deferred tax assets contingencies inventory valuation warranty accrual stockbased compensation expense conjunction acquisitions allocate investment costs based fair value assets acquired liabilities assumed base estimates historical experience various assumptions believed reasonable circumstances results form basis making judgments carrying values assets liabilities readily apparent sources actual results may differ significantly estimates different assumptions conditions believe following critical accounting policies affect significant judgments estimates used preparation consolidated financial statements revenue recognition recognize revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectability reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically experienced insignificant amount sales returns generally recognize revenue goods shipped distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provide sales returns standard product warranty provisions nonstandard contract terms title goods passes time delivery fob destination revenue recognized established proof delivery revenues relating services performed extended warranty program represent less 5 net revenues 2009 2008 2007 recognized earned based upon contract terms generally ratable term service record project installation work asia using percentageofcompletion method installation revenue represents less 7 net revenue 2009 2008 2007 net revenues include amounts billed customers sales transactions shipping handling shipping fees represent less 1 net revenues 2009 2008 2007 shipping costs included cost goods sold accounts receivable trade notes receivable allowance doubtful accounts grant credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses generally require collateral sales credit management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s creditworthiness actual defaults higher experienced historically additional allowances would required able predict changes financial stability customers material change financial status one group customers could material adverse effect results operations financial condition trade notes receivables presented us customers china payment outstanding trade receivables notes receivables bank guarantee promissory notes noninterest bearing generally mature within 6 months inventories stated lower cost using firstin firstout method market exposed number economic industry factors could result portions inventory becoming either obsolete excess anticipated usage saleable amounts less carrying amounts factors include limited technological changes market competitive pressures products prices availability key components suppliers established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded reserves intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required goodwill intangible assets test goodwill intangible assets possible impairment annual basis time events occur circumstances indicate carrying amount may recoverable recoverability measured reporting unit level comparing reporting unit’s carrying amount including goodwill fair value reporting unit measured based upon among factors market capitalization well forecasted operating results one reporting unit recorded value assets including goodwill intangible assets liabilities “net book value” reporting unit exceeds fair value impairment loss may exist extent consolidated net book value greater market capitalization significant portion goodwill may impaired experienced significant decline market capitalization fourth quarter 2008 decline market capitalization driven largely deteriorating macroeconomic conditions contributed decline forecasted operating results business result recognized noncash impairment charge approximately 33 million threemonth period year ended december 31 2008 writeoff entire carrying value goodwill longlived assets test longlived asset groups recoverability events occur circumstances indicate carrying amounts may recoverable recoverability assessed based carrying amounts asset fair value generally determined based sum undiscounted cash flows expected result use eventual disposal asset well specific appraisals certain instances impairment loss recognized carrying amount recoverable exceeds fair value stockbased compensation expense estimate fair value option award date grant using blackscholesmerton “bsm” valuation model single option award approach accordingly stockbased compensation cost measured grant date based fair value award recognized expense requisite service period generally vesting period make following estimates assumptions determining fair value expected term expected term represents weightedaverage period stockbased awards expected outstanding used historical exercise patterns previously granted options relation company’s stock price estimate expected exercise patterns expected volatility company’s expected volatilities based historical volatility company’s stock adjusted determined management unusual nonrepresentative stock price activity expected recur management determined historical stock price volatility period april 11 2002 commencement public trading common stock december 31 2002 likely representative future excluded period management also applies mean reversion techniques historical stock prices results emphasis recent activity distant past determining expected volatility rate included blackscholesmerton valuation model expected dividend blackscholesmerton valuation model calls single expected dividend yield input company currently pays dividends expect pay dividends foreseeable future riskfree interest rate company bases riskfree interest rate implied yield currently available united states treasury zerocoupon issues equivalent remaining term estimated forfeitures estimate forfeitures apply historical rate option forfeitures estimated forfeiture rates truedup actual forfeiture results stockbased awards vest business combinations accordance authoritative accounting guidance allocate purchase price acquired companies tangible intangible assets acquired liabilities assumed based estimated fair values engage thirdparty appraisal firms assist management determining fair values certain assets acquired liabilities assumed valuation requires management make significant estimates assumptions especially respect intangible assets management makes estimates fair value based upon assumptions believed reasonable estimates based historical experience information obtained management acquired companies inherently uncertain critical estimates valuing certain intangible assets include limited future expected cash flows customer contracts acquired developed technologies pending patents expected costs develop inprocess research development commercially viable products estimating cash flows projects completed acquired company’s brand awareness market position well assumptions period time acquired brand continue used combined company’s product portfolio discount rates unanticipated events circumstances may occur may affect accuracy validity assumptions estimates actual results income taxes subject income taxes united states numerous foreign jurisdictions significant judgment required evaluating tax positions determining provision income taxes effective tax rates differ statutory rate primarily due foreign earnings taxed lower rates foreign losses benefited stock compensation expenses asc 718 “stock compensation” deductible tax purposes changes valuation allowances future effective tax rates could adversely affected earnings lower anticipated countries lower statutory rates higher anticipated countries higher statutory rates changes valuation deferred tax assets liabilities changes tax laws regulations accounting principles interpretations thereof regularly assess likelihood adverse outcomes resulting tax examinations determine adequacy provision income taxes significant judgment also required determining valuation allowance recorded deferred tax assets assessing need valuation allowance consider available evidence including past operating results estimates future taxable income feasibility tax planning strategies event change determination amount deferred tax assets realized adjust valuation allowance corresponding impact provision income taxes period determination made results operations net sales net sales 2009 decreased 122 million 13 954 million 2008 decease primarily result decrease net sales 35 million 9 americas 77 million 19 asia 10 million 6 europe decrease primarily attributable negative impact worldwide economic downturn first half 2009 disruption sales activity china due management changes fushun beijing operations believe two factors negatively impacted sales approximately 62 million first nine months 2009 additionally decrease 2009 resulted impact two significant nonrecurring orders 2008 totaling approximately 56 million one united states national guard another beijing international airport approximately 05 million decrease due unfavorable exchange rate fluctuations net sales 2008 increased 45 million 5 908 million 2007 increase primarily result increase net sales 14 million 38 million americas europe respectively offset decrease net sales asia 07 million increase 2007 2008 consisted primarily two large nonrecurring orders 2008 totaling approximately 56 million one united states national guard another beijing international airport additional increases net sales approximately 42 million due appreciation renminbi “rmb” euro us dollar 2007 2008 increase partially offset economic slow china following beijing olympics second half 2008 cost sales gross profit cost sales consists direct material labor overhead cost sales 2009 decreased 50 million 11 472 million 2008 decrease cost sales primarily result decrease net sales 954 million 2008 832 million 2009 gross margin change 49 2009 51 2008 primarily result yearoveryear decline revenue particularly americas europe regions generally sell higher margin products cost sales 2008 increased 27 million 6 444 million 2007 increase cost sales primarily result increase net sales 908 million 2007 954 million 2008 gross margin 2008 remained consistent 2007 51 sales marketing expense sales marketing expenses 2009 decreased 26 million 12 214 million 2008 decrease primarily due reduced headcount travel employees participation trade shows sales marketing expenses 2008 decreased 40 million 16 254 million 2007 decrease primarily due companywide costcontrol initiatives ten percent workforce reduction americas end first quarter 2008 additional savings realized decreases office expenses advertising trade show expenses travel entertainment expenses consultant expenses project expenses research development expense research development expenses 2009 decreased 03 million 5 67 million 2008 decrease primarily result business tax exemption prc granted rae shanghai engineering services provided rae shanghai rae asia lower project related expenses partially offset increase payroll expenses due increase headcount research development expenses 2008 decreased 13 million 16 80 million 2007 decrease primarily due 07 million decrease amortization expense certain intangible assets fully amortized 07 million decrease project expenses due completion certain rd projects 2008 general administrative expense general administrative expenses 2009 increased 03 million 229 million 2008 general administrative expenses relatively constant 2009 2008 management accrued 35 million estimate settle outstanding joint investigation company’s alleged violations fcpa increased bad debt expense associated doubtful accounts receivable 08 million offset lower professional fees 45 million consisting primarily legal fees general administrative expenses 2008 increased 51 million 29 178 2007 increase primarily due net increase 25 million professional service expenses charge comprised 40 million increase related previously disclosed fcpa investigation related remediation plans conducted supervision audit committee board directors offset decrease legal costs associated conclusion polimaster arbitration 2007 bad debt expenses increased 14 million due increase accounts receivable reserves rae fushun rae beijing impairment goodwill experienced significant decline market capitalization fourth quarter 2008 decline market capitalization driven largely deteriorating macroeconomic conditions contributed decline forecasted operating results business result recognized noncash impairment charge approximately 33 million threemonth period year ended december 31 2008 writeoff entire carrying value goodwill gainloss abandonment lease income expense 2009 total expenses decreased 05 million 64 08 million 2008 decrease interest income primarily due lower interest rates decreased cash interest earning accounts change 08 million income net 2009 primarily foreign exchange gains asia europe expense increase 02 million equity loss unconsolidated affiliates represents company’s share unconsolidated losses investments various businesses 2008 total expenses increased 03 million 57 05 million 2007 increase primarily due increases foreign exchange losses balances payments euro rmb offset decreases interest expenses repaid outstanding loan balance using funds sale san jose building income tax benefit expense income tax expense decreased 14 million income tax expense 05 million 2008 effective tax rate 12 2009 8 2008 tax rate years 2009 2008 differed united states statutory rate due realization certain deferred tax assets dtas foreign earnings taxed lower rates foreign losses benefited nondeductible stock compensation deductions november 2009 worker homeownership business assistance act 2009 enacted law companies may elect increase carryback period net operating loss tax year ending december 31 2007 beginning january 1 2010 3 4 5 years accordingly elected carry 2008 net operating loss back 2003 result refund approximately 659000 currently significant deferred tax assets resulting anticipated net operating losses deductible temporary differences reduce taxable income future periods continue maintain full valuation allowance deferred assets except 09 million related certain foreign entities based current projections believe “more likely not” able realize deferred tax assets exception 09 million foreign deferred tax assets asc 740 “income taxes” requires valuation allowance established “more likely not” portion deferred tax assets realized difficult conclude valuation allowance needed negative evidence cumulative losses recent years therefore cumulative losses weighed heavily overall assessment believe sufficient uncertainty exists regard realizability tax assets valuation allowance necessary factors considered providing valuation allowance include lack significant history consistent profits current believed continued weakness overall market thereby potentially impacting ability sustain grow revenues earnings length carryback carryforward periods considered expectations risks associated estimates future taxable income ongoing prudent feasible tax planning strategies based absence sufficient positive objective verifiable evidence december 31 2009 placed valuation deferred tax assets except 09 million foreign deferred tax assets expect record valuation allowance future tax benefits sustain appropriate level profitability time would expect recognize significant tax benefits future results operations effective tax rate 8 tax expense 2008 126 tax 2007 tax rate 2008 2007 differed united states statutory rate due change realization deferred tax assets foreign earnings taxed lower rates foreign losses benefited nondeductible stock compensation deductions net loss attributable noncontrolling interest noncontrolling interest losses consolidated subsidiaries 2009 increased 735000 loss 220000 2008 increase loss attributable noncontrolling interest mainly due increased loss generated rae fushun rae beijing net loss attributable noncontrolling interest 2008 increased 226000 income 6000 2007 increase loss attributable noncontrolling interest mainly due increased loss generated rae fushun offset increased profitability rae france 2008 gain loss discontinued operations august 24 2007 board directors approved discontinuation mobile dvr business order reduce expenses concentrate resources gas radiation detection business mobile dvr business acquired purchases aegison securay see “note 2 business combinations dispositions” notes consolidated financial statements details august 28 2007 notified dvr customers terminated personnel reassigned continuing operations suspended related production sales activities dvr business operates substantial loss management intended liquidate tangible assets mainly inventories component parts accordingly value assets adjusted reflect anticipated disposals result discontinuing dvr business management impaired remaining value intangible assets goodwill acquired purchases aegison july 2006 securay january 2007 impairment expense recognized fiscal 2007 totaled 42 million accordance authoritative accounting guidance financial results dvr business reported discontinued operations periods presented financial results included discontinued operations follows liquidity capital resources date financed operations primarily operating revenues proceeds issuance equity securities shortterm bank borrowings 2007 also sold leased back corporate headquarters san jose california december 31 2009 185 million cash equivalents compared 148 million december 31 2008 37 million yearoveryear increase company cash due part global initiatives reduce worldwide inventory levels december 31 2009 317 million working capital current assets less current liabilities current ratio current assets current liabilities 22 10 compared working capital 371 million current ratio 25 10 december 31 2008 54 million reduction working capital 35 million attributable proposed fcpa settlement discussed note 7 consolidated financial statements united states 100 million revolving credit agreement december 31 2009 150 million revolving credit agreement december 31 2008 credit facility renewed annually currently expires may 15 2010 available credit based percentage specific qualifying assets total facility collateralized blanket security interest company’s assets united states required comply certain reporting financial requirements addition ongoing requirement submit monthly financial information must also maintain compensating balance lending bank least 20 million times included restricted cash consolidated balance sheets intend pursue renewal assurance successful securing renewed agreement line credit time period may 15 2010 december 31 2009 december 31 2008 18 million outstanding revolving credit agreements united states fourth quarter 2009 company obtained amendment financial covenants revolving credit agreement result noncompliance amended financial covenants revolving credit agreement 1 require us maintain specified trailing twoquarter minimum earnings interest depreciation amortization noncash stock compensation expenses 2 limits size potential monetary penalties fcpa 35 million compliance covenants december 31 2009 china two unsecured revolving lines credit december 31 2009 december 31 2008 amount rmb 20 million approximately 29 million borrowings lines credit available provide working capital generally current market rate fixed rate loans amount duration requested one year continuing credit facilities renewed annually december 31 2009 december 31 2008 rmb 15 million approximately 22 million rmb 5 million approximately 07 million respectively outstanding loan agreements china november 2009 borrowed rmb 100 million approximately 15 million term 18 months provide working capital 70 owned subsidiary fushun china “rae fushun” loan repayment guaranteed unrelated third party rae fushun granted lien wholly owned plant associated land rights condition loan lending bank required deposit approximately 01 million guarantor deposit funded rae fushun loan proceeds included restricted cash consolidated balance sheets believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital debt service capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments ultimate resolution potential fcpa violations future results operations future financing may require may unavailable favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership shareholders consolidated statements cash flows 2009 2008 2007 may summarized follows operating activities year ended december 31 2009 net cash provided operating activities 76 million due following • noncash charges included net loss 67 million totaled 56 million principal noncash expenses follows 32 million depreciation amortization 19 million provision doubtful accounts 13 million stockbased compensation noncash expenses partially offset 06 million gains disposal property equipment 04 million deferred income tax benefits net losses 02 million • net change operating assets liabilities generated cash flow 87 million cash primarily provided managed reduction 56 million inventories additional cash flow contributed increases accounts payable accrued liabilities reduction prepaid expenses 11 million 22 million 14 million respectively cash applied reduce accounts payable affiliate 03 million net change operating assets liabilities used cash totaling 13 million year ended december 31 2008 net cash provided operating activities 32 million due following • noncash charges included net loss 74 million totaled 78 million principal noncash expenses follows 33 million reduction goodwill 33 million depreciation amortization 16 million stockbased compensation 13 million provision doubtful accounts noncash expenses partially offset 06 million gains disposal property equipment 12 million deferred income tax benefits net gains 01 million • net reduction working capital 28 million attributable changes operating assets liabilities decrease working capital resulted primarily 12 million decline accounts receivable 11 million decline trade notes receivable operating accounts provided net cash 05 million year ended december 31 2007 net cash used operating activities 100 million due following • cash used mainly support increase 95 million working capital primarily consisting increase 57 million accounts receivable 18 million inventories primarily related increased sales remaining 20 million primarily comprised changes deferred revenue deposits current operating accounts • positive effect noncash adjustments due depreciation amortization long lived assets 37 million deferred taxes 40 million stock based compensation expense 19 million provision doubtful accounts 19 million investing activities disclosed discussion banking relationships 2009 agreed maintain restricted cash arrangements 21 million 2009 investing activities primarily consisted ongoing construction outfitting activities new facility fushun china payment land use rights preconstruction site improvements shanghai december 2008 purchased land use rights 50 years 5 acres land shanghai plan use site construct new manufacturing research development facility replace current shanghai facility construction began first quarter 2010 upon completion intend vacate existing leased facility based discussions shanghai government officials landlord believe able terminate lease without penalty negotiations project longterm financing arrangements ongoing however assurance given able arrange financing terms acceptable us subject lease termination penalties 2008 cash used investing activities primarily used complete occupy manufacturing facility fushun china total project fushun also includes administrative offices research development facility living quarters estimated cost complete project approximately 23 million however committed timeline remaining construction 2007 increase cash due investing activities 100 million primarily due net proceeds sale leaseback san jose headquarters building approximately 124 million sale investments securities 32 million partially offset approximately 40 million used acquisition property equipment 16 million used business acquisitions 2007 began construct rae fushun’s new manufacturing administrative facility china financing activities cash provided financing activities 10 million 2009 primarily bank borrowings net payments made 29 million disclosed discussion banking relationships 15 million borrowed rae fushun working capital addition borrowed 14 million fund purchase land use rights shanghai construction new manufacturing facility discussed investing activities also made principal payments totaling 19 million reduce notes payable related parties acquisition rae beijing payments made general working capital next scheduled principal payment july 2010 cash used financing activities 14 million 2008 primarily applied payments related party notes totaling 12 million payments bank lines credit 02 million net amounts borrowed bank lines credit provide working capital operations united states china cash provided financing activities 27 million 2007 primarily bank borrowings net repayment 26 million used repay related party note 50 million repurchase restricted stock awards 03 million commitments contingencies summary obligations following table quantifies known contractual obligations tabular form december 31 2009 obligations impact short longterm liquidity capital resource needs certain contractual obligations reflected consolidated balance sheets others disclosed future obligations 1 discussion surrounding longterm debt refer “note 6 bank debt” consolidated financial statements 2 discussion surrounding notes payablerelated parties refer “note 10 related party transactions” consolidated financial statements 3 discussion surrounding deferred gain sale real estate refer “note 3 balance sheet details” consolidated financial statements 4 discussion surrounding purchase lease obligations refer “note 7 commitments contingencies” consolidated financial statements 5 represents estimated cancelable open purchase orders purchase inventory goods services normal course business meet operational requirements guarantees permitted delaware law required certificate incorporation bylaws indemnify officers directors certain events occurrences subject certain limits director officer serving request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however director officer insurance policy reduces exposure enables us recover portion future amounts paid date incurred losses agreements sales agreements typically agree indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date paid amounts settle claims defend lawsuits product warranties sell majority products 12 24 month repair replacement warranty date shipment provide accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized uncertain tax positions december 31 2009 liability uncertain tax positions including associated interest penalties approximately 15 million liability represents estimate tax positions company taken tax returns may ultimately sustained upon examination tax authorities since ultimate amount timing future cash settlements cannot predicted reasonable certainty estimated liability excluded contractual obligations table recent accounting pronouncements december 2007 fasb issued authoritative guidance applies business combinations new guidance changes accounting acquisition transaction costs requiring expensed period incurred also changes accounting contingent consideration acquired contingencies restructuring costs related acquisition new guidance effective company beginning january 1 2009 change company’s accounting treatment business combinations prospective basis june 2009 fasb issued authoritative guidance determining whether entity variable interest entity “vie” requires enterprise perform analysis determine whether enterprise’s variable interest interests give controlling financial interest vie guidance enterprise controlling financial interest power direct activities vie significantly impact entity’s economic performance b obligation absorb losses entity right receive benefits entity could potentially significant vie guidance also requires enterprise assess whether implicit financial responsibility ensure vie operates designed determining whether power direct activities vie significantly impact entity’s economic performance guidance effective company january 1 2010 requires ongoing assessments whether enterprise primary beneficiary vie well certain enhanced disclosures company currently evaluating potential impact adoption guidance consolidated financial statements october 2009 fasb issued authoritative guidance revenue recognition become effective company beginning january 1 2011 earlier adoption permitted new guidance arrangements include software elements tangible products software components essential functionality tangible product longer within scope software revenue recognition guidance softwareenabled products subject relevant revenue recognition guidance additionally fasb issued authoritative guidance revenue arrangements multiple deliverables outside scope software revenue recognition guidance new guidance vendor specific objective third party evidence deliverables arrangement cannot determined best estimate selling price required separate deliverables allocate arrangement consideration using relative selling price method new guidance includes new disclosure requirements application relative selling price method affects timing amount revenue recognition company currently assessing potential effect financial statements item 7aitem 7 management’s discussion analysis financial condition results operations following management’s discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology “may” “will” “should” “could” “expects” “plans” “anticipates” “believes” “estimates” “predicts” “potential” “continue” statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein factors might cause contribute differences include limited discussed item 1a “risk factors” well item 1 “business” item 7 “management’s discussion analysis financial condition results operations” annual report form 10k carefully review risks also review risks described documents file time securities exchange commission including quarterly reports form 10q file fiscal year 2010 cautioned place undue reliance forwardlooking statements expressly assume obligations update forwardlooking statements report occur date hereof overview leader delivering innovative sensor solutions serve industrial energy environmental government safety markets worldwide addition offer full line portable single multisensor chemical radiation detection products market products evolved strictly focused environmental industrial monitoring encompassing public safety energy markets 2006 made two significant business investments china first july 2006 increased ownership rae beijing 96 rae beijing produces sells distributes safety security solutions chemical oil gas metals energy sectors china december 2006 formed rae fushun serve coal mine safety market china joint venture 30 owned fushun anyi 70 owned rae systems january 12 2011 entered definitive agreement sell 70 percent ownership rae fushun shenyang research institute china coal research institute agreement expected close within 180 days signing definitive agreement subject customary closing conditions china focus growing environmental protection market industrial sector including oil gas petrochemicals steel telecommunications offer complete line products meet requirements various markets serve products range breathing zone single sensor products specific toxic chemicals toxirae 3 multigas monitors qrae 2 handheld instruments minirae 3000 ppbrae 3000 ultrarae measure total specific volatile organic compounds wireless monitors industrial public safety applications arearae steel expanded wireless product offering introduction meshguard singlegas mesh radiobased monitor designed replace singlegas fixed monitors industrial environments include steel mills oil gas exploration chemical processing continue improve product offerings advances sensors wireless networking technologies including raelink 3 wireless modem integrated gps bluetooth radio technology provides data bridge products complementary products chemical warfare agents particle counters developed prorae guardian represents advanced generation realtime wireless threat detection solutions new software program serves mobile command center safety managers incident commanders connecting relaying data rae systems arearae family select third party wireless products remote locations anywhere world markets continue explore develop strategic value added partnerships leverage product market expertise critical accounting policies preparation financial statements conformity united states generally accepted accounting principles requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period ongoing basis evaluate estimates including related allowance doubtful accounts valuation longlived assets goodwill intangible assets valuation deferred tax assets inventory valuation stockbased compensation expense base estimates historical experience various assumptions believed reasonable circumstances results form basis making judgments carrying values assets liabilities readily apparent sources actual results may differ significantly estimates different assumptions conditions believe following critical accounting policies affect significant judgments estimates used preparation consolidated financial statements revenue recognition recognize revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectability reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically experienced insignificant amount sales returns generally recognize revenue goods shipped distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provide sales returns standard product warranty provisions nonstandard contract terms title goods passes time delivery fob destination revenue recognized established proof delivery revenues relating services performed extended warranty program represent less 5 net revenues 2010 2009 2008 recognized earned based upon contract terms generally ratable term service project revenue asia use percentageofcompletion method project revenue represents less 8 net revenue 2010 2009 2008 net revenues include amounts billed customers sales transactions shipping handling shipping fees represent less 1 net revenues 2010 2009 2008 shipping costs included cost goods sold accounts receivable trade notes receivable allowance doubtful accounts grant credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses generally require collateral sales credit management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s creditworthiness actual defaults higher experienced historically additional allowances would required able predict changes financial stability customers material change financial status one group customers could material adverse effect results operations financial condition trade notes receivables presented us customers china payment outstanding trade receivables notes receivables bank guarantee promissory notes noninterest bearing generally mature within 6 months inventories stated lower cost using firstin firstout method market exposed number economic industry factors could result portions inventory becoming either obsolete excess anticipated usage saleable amounts less carrying amounts factors include limited technological changes market competitive pressures products prices availability key components suppliers established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded reserves intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required goodwill test goodwill possible impairment annual basis time events occur circumstances indicate carrying amount goodwill may recoverable recoverability goodwill measured reporting unit level comparing reporting unit’s carrying amount including goodwill fair value reporting unit measured based upon among factors market capitalization well forecasted operating results one reporting unit recorded value assets including goodwill liabilities “net book value” reporting unit exceeds fair value impairment loss may exist extent consolidated net book value greater market capitalization significant portion goodwill may impaired experienced significant decline market capitalization fourth quarter 2008 decline market capitalization driven largely deteriorating macroeconomic conditions contributed decline forecasted operating results business result recognized noncash impairment charge approximately 33 million threemonth period year ended december 31 2008 writeoff entire carrying value goodwill longlived assets test recoverability longlived assets finite lives periodically whenever events occur changes circumstances indicate carrying amount asset may recoverable carrying amount longlived asset recoverable exceeds sum undiscounted cash flows expected result use eventual disposition asset carrying amount longlived asset deemed recoverable impairment loss recognized difference carrying amount asset fair value generally present value estimated future cash flows asset’s appraised value third quarter 2010 company evaluated carrying values customer list longlived assets rae fushun revenues declined significantly quarter year date company expect nearterm recovery coal mine safety equipment business company determined carrying value customer list estimated undiscounted cash flows generated use eventual disposition assets accordingly company estimated fair value customer list using discounted cash flow analysis recorded impairment charge 15 million remaining carrying amount asset impairment included reported loss discontinued operations company’s consolidated statements operations january 12 2011 company signed definitive agreement sell 70 interest rae fushun shenyang research institute china coal research institute “shenyang institute” stateowned enterprise zero proceeds asc topic 360 “property plant equipment” provides disposal group classified held sale measured lower carrying amount fair value less cost sell based rae fushun’s sales price carrying amount net assets exceeded fair value december 31 2010 accordingly company recorded impairment expense fourth quarter 2010 totaling 46 million includes 02 million estimated direct transaction costs impairment included reported loss discontinued operations company’s consolidated statements operations stockbased compensation expense estimate fair value option award date grant using blackscholesmerton “bsm” valuation model single option award approach accordingly stockbased compensation cost measured grant date based fair value award recognized expense requisite service period generally vesting period make following estimates assumptions determining stockbased compensation expected term expected term represents weightedaverage period stockbased awards expected outstanding used historical exercise patterns previously granted options relation company’s stock price estimate expected exercise patterns expected volatility company’s expected volatilities based historical volatility company’s stock adjusted determined management unusual nonrepresentative stock price activity expected recur management determined historical stock price volatility period april 11 2002 commencement public trading common stock december 31 2002 likely representative future excluded period management also applies mean reversion techniques historical stock prices results emphasis recent activity distant past determining expected volatility rate included blacksholesmerton valuation model expected dividend blackscholesmerton valuation model calls single expected dividend yield input company currently pays dividends expect pay dividends foreseeable future riskfree interest rate company bases riskfree interest rate implied yield currently available united states treasury zerocoupon issues equivalent remaining term estimated forfeitures estimate forfeitures apply historical rate option forfeitures estimated forfeiture rates truedup actual forfeiture results stockbased awards vest income taxes subject income taxes united states numerous foreign jurisdictions significant judgment required evaluating tax positions determining provision income taxes effective tax rates differ statutory rate primarily due foreign earnings taxed lower rates foreign losses benefited stock compensation expenses asc 718 “stock compensation” deductible tax purposes changes valuation allowances future effective tax rates could adversely affected earnings lower anticipated countries lower statutory rates higher anticipated countries higher statutory rates changes valuation deferred tax assets liabilities changes tax laws regulations accounting principles interpretations thereof regularly assess likelihood adverse outcomes resulting tax examinations determine adequacy provision income taxes significant judgment also required determining need valuation allowance recorded deferred tax assets assessing need valuation allowance consider available evidence including past operating results estimates future taxable income feasibility tax planning strategies event change determination amount deferred tax assets realized adjust valuation allowance corresponding impact provision income taxes period determination made results operations financial data set forth excludes discontinued operations net sales net sales 2010 increased 121 million 16 75 million 2009 increase primarily result increase net sales 124 million 36 americas 09 million 6 europe middle east partially offset decrease 13 million 5 asia increase americas primarily result orders related gulf mexico oil spill 33 million increase sales us government 29 million generally improved sales emergency response market compared 2009 increase europe middle east primarily due sales oil gas market middle east partially offset foreign exchange losses attributable euro pound sterling 08 million decrease asia primarily result decreased sales fire security integrated project installation revenue beijing china operations approximately 35 million partially offset increased sales fixed system products beijing china operations increased asia sales outside china increased sales australia new zealand favorable foreign exchange gain 02 million net sales 2009 decreased 81 million 10 83 million 2008 decease primarily result decrease net sales 35 million 9 americas 35 million 12 asia 10 million 6 europe middle east decrease primarily attributable negative impact worldwide economic downturn first half 2009 disruption sales activity china due management changes beijing operations believe two factors negatively impacted sales approximately 20 2009 additionally decrease 2009 resulted impact two significant nonrecurring orders 2008 totaling approximately 56 million one united states national guard another beijing international airport approximately 05 million decrease due unfavorable exchange rate fluctuations cost sales gross profit cost sales 2010 decreased 07 million 2 354 million 2009 decrease cost sales primarily due decrease approximately 35 million associated spreading fixed overhead costs higher production volume efficiencies resulting moving production fixed system products sold china global manufacturing center shanghai partially offset approximately 28 million higher material labor cost due higher sales volume gross margin increase 60 2010 53 2009 also result yearoveryear increase sales higher margin products americas europe cost sales 2009 decreased 35 million 9 389 million 2008 decrease cost sales primarily result decrease net sales 83 million 2008 75 million 2009 gross margin remained constant 53 2009 2008 sales marketing expense sales marketing expenses increased 31 million 19 2010 increase expense due increase sales commissions approximately 12 million headcount increases americas approximately 06 million additional management bonuses approximately 06 million marketing activities improve sales management information web service capabilities brand awareness company products approximately 04 million sales marketing expenses 2008 decreased 16 million 9 179 million 2008 decrease primarily due companywide costcontrol initiatives ten percent workforce reduction americas end first quarter 2008 additional savings realized decreases office expenses advertising trade show expenses travel entertainment expenses consultant expenses project expenses research development expense research development expenses 2010 increased 11 million 19 60 million 2009 increase primarily due increased headcount increased salaries rae engineering center shanghai china project expenses support new product development research development expenses 2009 increased approximately 7000 5949000 2008 general administrative expense general administrative expenses 2010 197 million decreased 15 million 7 211 million 2009 decrease primarily due 35 million accrual 2009 management’s estimate settle outstanding joint investigation company’s alleged violations fcpa subsequent joint settlement 30 million december 2010 resulted net reduction 2010 expenses 05 million collection accounts receivable previously written bad debt approximately 03 million lower depreciation assets fully depreciated approximately 03 million partially offset fees approximately 31 million paid legal financial advisors special committee company’s board directors related proposed transaction take company private general administrative expenses 2009 decreased approximately 11000 21160000 2008 general administrative expenses relatively constant 2009 2008 management accrued 35 million estimate settle outstanding joint investigation company’s alleged violations fcpa increased bad debt expense associated doubtful accounts receivable 08 million offset lower professional fees 45 million consisting primarily legal fees impairment goodwill review goodwill impairment annually fourth quarter frequently events circumstances indicate impairment loss may occurred recoverability goodwill measured reporting unit level comparing reporting unit’s carrying amount including goodwill fair value reporting unit measured based upon among factors market capitalization well forecasted operating results one reporting unit recorded value assets including goodwill liabilities “net book value” reporting unit exceeds fair value impairment loss may exist extent net book value whole greater market capitalization significant portion goodwill may considered impaired experienced significant decline market capitalization fourth quarter 2008 decline market capitalization driven largely deteriorating macroeconomic conditions contributed decline forecasted operating results business uncertainties associated current fcpa investigation result recognized noncash impairment charge approximately 33 million threemonth period year ended december 31 2008 writeoff entire carrying value goodwill income expense 2010 total expense 05 million increased 03 million 166 02 million 2009 decrease interest expense primarily due capitalizing interest constructioninprogress company’s new facility shanghai china offset increase net comprised primarily net foreign exchange losses asia europe 2009 total expenses decreased 08 million 81 09 million 2008 decrease interest income primarily due lower interest rates decreased cash interest earning accounts change 10 million income net 2009 primarily foreign exchange gains asia europe expense increase 02 million equity loss unconsolidated affiliates represents company’s share unconsolidated losses investments various businesses income tax expense benefit income tax expense increased 11 million income tax benefit 08 million 2009 effective tax rate 5 2010 20 2009 tax rate years 2010 2009 differed united states statutory rate due foreign earnings taxed lower rates foreign losses benefited nondeductible transaction costs stock compensation expenses asc 718 “stock compensation” deductible tax purposes changes valuation allowances company recorded tax benefit approximately 06 million fourth quarter 2010 related expiration hightech status shanghai beijing entities expiration resulted increase tax rate used establish deferred tax assets 15 25 applied renewal hightech status respective jurisdictions obtain 15 tax rate however certainty renewal granted hightech status granted calculate deferred tax assets lower rate 15 would result tax expense period new status granted currently significant deferred tax assets resulting anticipated net operating losses deductible temporary differences reduce taxable income future periods continue maintain full valuation allowance deferred assets except 15 million related certain foreign entities based current projections believe “more likely not” able realize deferred tax assets exception 15 million foreign deferred tax assets asc 740 “income taxes” requires valuation allowance established “not likely not” portion deferred tax assets realized negative evidence form cumulative losses weighed heavily overall assessment believe sufficient uncertainty exists regard realizability tax assets valuation allowance necessary factors considered providing valuation allowance include lack significant history consistent profits current believed continued weakness overall market thereby potentially impacting ability sustain grow revenues earnings length carryback carryforward periods considered expectations risks associated estimates future taxable income ongoing prudent feasible tax planning strategies based absence sufficient positive objective verifiable evidence december 31 2009 placed valuation deferred tax assets except 09 million foreign deferred tax assets expect record valuation allowance future tax benefits sustain appropriate level profitability time would expect recognize significant tax benefits future results operations effective tax rate 20 tax expense 2009 10 tax benefit 2008 tax rate 2009 2008 differed united states statutory rate due change realization deferred tax assets foreign earnings taxed lower rates foreign earnings tax lower rates foreign losses benefited nondeductible stock compensation deductions net income loss attributable noncontrolling interest noncontrolling interest net income consolidated subsidiaries 2010 increased 45000 loss 3000 2009 increase net income attributable noncontrolling interest primarily due income generated rae france partially offset losses rae beijing noncontrolling interest losses consolidated subsidiaries 2009 increased 151000 income 148000 2008 increase loss attributable noncontrolling interest mainly due increased loss generated rae beijing loss discontinued operations december 22 2010 board directors approved management’s plan pursue sale company’s 70 interest rae coal mine safety instruments fushun co ltd “rae fushun” sinoforeign joint venture china rae fushun met company’s revenue earnings expectations joint venture well positioned capitalize company’s future strategies january 12 2011 company signed definitive agreement sell 70 interest shenyang research institute china coal research institute “shenyang institute” stateowned enterprise zero proceeds however terms agreement shenyang institute assumes documented joint venture liabilities pay approximately rmb 1225 million approximately 185 million intercompany balances owed rae shanghai rae beijing products services previously provided joint venture march 15 2011 shenyang institute made scheduled payments rae systems totaling rmb 6 million approximately 09 million company expects receive rmb 2 million approximately 03 million monthly paid full purchase agreement rae systems shenyang institute subject customary closing conditions china includes obtaining certain government approvals company shenyang institute anticipate receiving necessary approvals final transfer shares within six months signing definitive agreement therefore rae systems provided shenyang institute complete operating control rae fushun january 12 2011 rae systems involved daytoday management operating activities rae fushun company still retains 70 ownership entity time regulatory approvals obtained however company anticipate providing financial support management support entity time asc topic 360 “property plant equipment” provides disposal group classified held sale measured lower carrying amount fair value less cost sell based rae fushun’s sales price carrying amount net assets exceeded fair value december 31 2010 accordingly company recorded impairment expense fourth quarter 2010 totaling 46 million includes 02 million estimated direct transaction costs impairment included reported loss discontinued operations company’s consolidated statements operations liquidity capital resources date financed operations primarily operating revenues proceeds issuance equity securities shortterm bank borrowings december 31 2010 163 million cash equivalents compared 172 million december 31 2009 december 31 2010 311 million working capital current assets less current liabilities current ratio current assets current liabilities 22 10 compared working capital 317 million current ratio 22 10 december 31 2009 united states 100 million revolving credit agreement december 31 2010 credit facility renewed annually december 31 2010 line scheduled mature may 14 2011 available credit based percentage specific qualifying assets total facility collateralized blanket security interest company’s assets united states required comply certain reporting requirements addition ongoing requirement submit quarterly financial statements interest accrues floating prime bank lending rate plus 100 basis points subject minimum total rate 5 addition company pays 30 basis points annually average unused portion facility december 31 2010 2009 required maintain compensating balance least 20 million times compensating balance included restricted cash consolidated balance sheets compensating balance requirement released january 2011 december 31 2010 2009 18 million outstanding revolving credit agreement interest accruing 5 per annum financial covenants revolving credit agreement 1 require us maintain specified trailing twoquarter minimum earnings interest depreciation amortization noncash stock compensation expenses 2 limits size potential monetary penalties fcpa 35 million result impairment expense incurred discontinue operations fushun china default trailing twoquarter minimum earnings requirement period ended december 31 2010 however lender issued waiver non compliance fourth quarter 2010 settled fcpa violation doj sec 30 million 13 million paid december 2010 17 million paid january 2011 march 2011 amended credit facility extend maturity date earlier june 15 2011 consummation merger vector capital exclude assets liabilities held sale rae fushun financial covenants refer “note 13 subsequent events” details merger agreement amendment also allows borrowings 2 million nonformula basis increases interest rate borrowings floating prime bank lending rate plus 400 basis points china renew credit facility repaid rmb 15 million approximately 22 million bank loan maturity october 2010 time cash balances china sufficient fund operations however may seek new financing facility future november 2009 rae fushun borrowed rmb 100 million approximately 15 million term 18 months provide working capital loan repayment guaranteed unrelated third party rae fushun granted lien wholly owned plant associated land rights condition loan lending bank required deposit approximately 01 million guarantor deposit funded rae fushun loan proceeds january 2011 signed definitive agreement sell 70 interest rae fushun shenyang research institute china coal research institute took immediate complete operating control rae fushun included financial statements discontinued operation rae systems involved daytoday management operating activities rae fushun company still retains 70 ownership entity time regulatory approvals obtained however company anticipate providing financial support management support entity time refer “note 2 discontinued operation” details transaction believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital debt service capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments future results operations future financing may require may available favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership shareholders consolidated statements cash flows 2010 2009 2008 may summarized follows operating activities year ended december 31 2010 net cash provided operating activities 38 million 48 million continuing operations 10 million discontinued operations due following • noncash charges included income continuing operations 53 million totaled 25 million principal noncash expenses follows 17 million depreciation amortization 08 million provision doubtful accounts 11 million stockbased compensation noncash expenses partially offset 06 million gains disposal property equipment 07 million deferred income tax benefits net losses 02 million • net change operating assets liabilities continuing operations consumed cash flow 30 million cash applied increase inventories 20 million reduce accounts payable accrued expense prepaid expense 04 million 08 million 03 million respectively cash contributed collection 05 million income taxes receivable 04 million increase income taxes payable net change operating assets liabilities used cash totaling 03 million year ended december 31 2009 net cash provided operating activities 77 million 76 million continuing operations 01 million discontinued operations due following • noncash charges included loss continuing operations 33 million totaled 38 million principal noncash expenses follows 22 million depreciation amortization 11 million provision doubtful accounts 13 million stockbased compensation expenses 02 million noncash expenses partially offset 06 million gains disposal property equipment 04 million deferred income tax benefits • net change operating assets liabilities continuing operations generated cash flow 70 million cash primarily provided managed reduction 5 million inventories additional cash flow contributed increases accounts payable accrued liabilities 14 million 17 million respectively cash applied reduce accounts payable affiliate 03 million net change operating assets liabilities used cash totaling 08 million year ended december 31 2008 net cash provided operating activities 32 million 24 million continuing operations 08 million discontinued operations due following • noncash charges included loss continuing operations 57 million totaled 61 million principal noncash expenses follows 33 million reduction goodwill 24 million depreciation amortization 16 million stockbased compensation 06 million provision doubtful accounts noncash expenses partially offset 06 million gains disposal property equipment 12 million deferred income tax benefits • net change operating assets liabilities continuing operations generated cash flow 20 million cash primarily provided decline accounts receivable trade notes receivable 13 million 12 million respectively operating accounts used net cash 05 million investing activities 2010 cash 31 million invested construction outfitting new manufacturing facility shanghai china 2009 investing activities primarily consisted ongoing construction outfitting activities new facility fushun china payment land use rights preconstruction site improvements shanghai december 2008 purchased land use rights 50 years 5 acres land shanghai plan use site construct new manufacturing research development facility replace current shanghai facility construction began first quarter 2010 upon completion intend vacate existing leased facility based discussions shanghai government officials landlord believe able terminate lease without penalty negotiations project longterm financing arrangements ongoing however assurance given able arrange financing terms acceptable us subject lease termination penalties 2008 cash used investing activities primarily used complete occupy manufacturing facility fushun china total project fushun also includes administrative offices research development facility living quarters estimated cost complete project approximately 23 million however committed timeline remaining construction financing activities 2010 repaid 23 million bank loan shanghai china maturity also made principal payments totaling 04 million notes payable related parties acquisition rae beijing payments made general working capital next scheduled principal payment notes payable related parties july 2011 order redeploy cash balances declared dividend rae beijing result dividend 01 million paid noncontrolling interest cash provided financing activities 10 million 2009 primarily bank borrowings net payments made 29 million disclosed discussion banking relationships 15 million borrowed rae fushun discontinued operation working capital addition borrowed 14 million fund purchase land use rights shanghai construction new manufacturing facility discussed investing activities also made principal payments totaling 19 million reduce notes payable related parties acquisition rae beijing payments made general working capital next scheduled principal payment july 2010 cash used financing activities 14 million 2008 primarily applied payments related party notes totaling 12 million payments bank lines credit 02 million net amounts borrowed bank lines credit provide working capital operations united states china commitments contingencies summary obligations following table quantifies known contractual obligations tabular form december 31 2010 obligations impact short longterm liquidity capital resource needs certain contractual obligations reflected consolidated balance sheets others disclosed future obligations 1 discussion surrounding notes payablerelated parties refer “note 10 related party transactions” consolidated financial statements 2 discussion surrounding deferred gain sale real estate refer “note 3 balance sheet details” consolidated financial statements 3 discussion surrounding purchase lease obligations refer “note 7 commitments contingencies” consolidated financial statements 4 represents estimated cancelable open purchase orders purchase inventory goods services normal course business meet operational requirements guarantees permitted delaware law required certificate incorporation bylaws indemnify officers directors certain events occurrences subject certain limits director officer serving request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however director officer insurance policy reduces exposure enables us recover portion future amounts paid date incurred losses agreements sales agreements typically agree indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date paid amounts settle claims defend lawsuits product warranties sell majority products 12 24 month repair replacement warranty date shipment provide accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized uncertain tax positions december 31 2010 liability uncertain tax positions including associated interest penalties approximately 10 million liability represents estimate tax positions company taken tax returns may ultimately sustained upon examination tax authorities since ultimate amount timing future cash settlements cannot predicted reasonable certainty estimated liability excluded contractual obligations table recent accounting pronouncements october 2009 financial accounting standards board “fasb” issued accounting standards update “asu” 200913 multipledeliverable revenue arrangements amendments fasb accounting standards codification “asc” topic 605 revenue recognition “asu 200913” asu 200914 certain arrangements include software elements amendments fasb asc topic 985 software “asu 200914” asu 200913 requires entities allocate revenue arrangement using estimated selling prices delivered goods services based selling price hierarchy amendments eliminate residual method revenue allocation require revenue allocated using relative selling price method asu 200914 removes tangible products scope software revenue guidance provides guidance determining whether software deliverables arrangement includes tangible product covered scope software revenue guidance asu 200913 asu 200914 applied prospective basis revenue arrangements entered materially modified fiscal years beginning june 15 2010 early adoption permitted adoption guidance expected material impact company’s consolidated financial statements january 2010 fasb issued guidance amend disclosure requirements related recurring nonrecurring fair value measurements guidance requires new disclosures transfers assets liabilities level 1 quoted prices active market identical assets liabilities level 2 significant observable inputs fair value measurement hierarchy including reasons timing transfers additionally guidance requires roll forward activities purchases sales issuance settlements assets liabilities measured using significant unobservable inputs level 3 fair value measurements guidance became effective entities reporting period beginning january 1 2010 except disclosure roll forward activities level 3 fair value measurements become effective reporting period beginning january 1 2011 adoption changes material impact company’s consolidated financial statements december 2010 fasb issued asu 201029 disclosure supplementary pro forma information business combinations amendments fasb asc topic 805 business combinations guidance asu 201029 provides amendments clarify acquisition date used reporting pro forma financial information disclosures topic 805 comparative financial statements presented amendments also improve usefulness pro forma revenue earnings disclosures requiring description nature amount material nonrecurring pro forma adjustments directly attributable business combinations amendments update effective prospectively business combinations acquisition date beginning first annual reporting period beginning december 15 2010 early adoption permitted adoption guidance expected material impact company’s consolidated financial statements december 2010 fasb issued asu 201028 perform step 2 goodwill impairment test reporting units zero negative carrying amounts amendments fasb asc topic 350 intangibles goodwill objective asu address diversity practice application goodwill impairment testing entities reporting units zero negative carrying amounts eliminating entity’s ability assert reporting unit required perform step 2 carrying amount reporting unit zero negative despite existence qualitative factors indicate goodwill likely impaired asu effective interim periods january 1 2011 adoption asu expected material impact company’s consolidated financial statements item 7aitem 7 management’s discussion analysis financial condition results operations following management’s discussion analysis financial condition results operations contains forwardlooking statements cases readers identify forwardlooking statements terminology “may” “will” “should” “could” “expects” “plans” “anticipates” “believes” “estimates” “predicts” “potential” “continue” statements involve known unknown risks uncertainties factors may cause actual results performance achievements materially different stated herein factors might cause contribute differences include limited discussed item 1a “risk factors” well item 1 “business” item 7 “management’s discussion analysis financial condition results operations” annual report form 10k carefully review risks also review risks described documents file time securities exchange commission including quarterly reports form 10q file fiscal year 2008 cautioned place undue reliance forwardlooking statements expressly assume obligations update forwardlooking statements report occur date hereof overview leader delivering innovative sensor solutions serve industrial energy environmental government safety markets worldwide addition offer full line portable singlesensor chemical radiation detection products market products evolved strictly focused environmental industrial monitoring encompassing public safety expanded presence include broader global energy exploration refining safety equipment market formation rae fushun serving coal mine safety equipment market china oil production safety world wide 2006 leveraged expertise experience make two investments china pursue opportunities one world’s largest fastest growing economies first july 2006 increased ownership rae beijing 96 percent benefit efforts drive higher revenue operating profit rae beijing produces sells distributes safety security solutions chemical oil gas metals energy sectors china second december 2006 formed rae fushun joint venture capitalize china’s growing reliance coal based energy resources rae fushun manufactures sells coal mine safety equipment rae systems owns 70 percent joint venture combines skills expertise fushun anyi former state owned company serving coal mine safety market arearae deployed continuous monitoring worker safety petrochemical industry plant turnarounds believe arearae provides significant cost savings productivity advantage bringing facilities back online quickly national guard civil support teams deployed fiftyseven arearae wireless network systems least one system state several chemical manufacturers throughout europe selected minirae 2000 ppbrae plus pid instruments industrial hygiene applications china petrochina dushanzi selected raeguard fixed sensor systems received orders several state operated oil fields including dagang liaohe changqing early 2007 strengthened expanded sales distribution channels three geographic sales regions continued augment sales model introduction valueadded distributor program additional regional sales management inside sales resources offer channel partners web portal facilitate sale orders expanding training programs offer product service training american industrial hygiene certification classes india middle east added additional regional sales managers grow presence two emerging markets china focus growing environmental protection market industrial sector including oil gas petrochemicals certain telecom applications coal mining major priority introduce new products coal mine safety market rae fushun believe market provide us number exciting new business opportunities 2008 beyond china continues modernize coal mining industry markets continue explore develop strategic value added partnerships leverage product market expertise critical accounting policies preparation financial statements conformity united states generally accepted accounting principles requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period ongoing basis evaluate estimates including related allowance doubtful accounts valuation goodwill intangible assets investments valuation deferred tax assets restructuring costs contingencies inventory valuation warranty accrual stockbased compensation expense conjunction acquisitions allocate investment costs based fair value assets acquired liabilities assumed base estimates historical experience various assumptions believed reasonable circumstances results form basis making judgments carrying values assets liabilities readily apparent sources actual results may differ significantly estimates different assumptions conditions believe following critical accounting policies affect significant judgments estimates used preparation consolidated financial statements revenue recognition recognize revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectability reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically experienced insignificant amount sales returns generally recognizes revenue goods shipped distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provides sales returns standard product warranty provisions nonstandard contract terms title goods pass time delivery fob destination revenue recognized established proof delivery revenues relating services performed extended warranty program represent less 5 net revenues 2007 2006 2005 recognized earned based upon contract terms generally ratable term service record project installation work asia using percentageofcompletion method installation revenue represents less 5 net revenue 2007 2006 2005 net revenues include amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue “eitf” 0010 “accounting shipping handling fees costs” shipping fees represent less 1 net revenues 2007 2006 2005 shipping costs included cost goods sold accounts receivable trade notes receivable allowance doubtful accounts grant credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses generally require collateral sales credit management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s creditworthiness actual defaults higher experienced historically additional allowances would required able predict changes financial stability customers material change financial status one group customers could material adverse effect results operations financial condition trade notes receivables presented us customers china payment outstanding trade receivables notes receivables bank guarantee promissory notes noninterest bearing generally mature within 6 months inventories stated lower cost using firstin firstout method market exposed number economic industry factors could result portions inventory becoming either obsolete excess anticipated usage saleable amounts less carrying amounts factors include limited technological changes market competitive pressures products prices availability key components suppliers established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded reserves intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required goodwill test goodwill possible impairment annual basis time events occur circumstances indicate carrying amount goodwill may recoverable impairment review process compares fair value goodwill carry value according sfas 142 “goodwill intangible assets” “sfas 142” since operate single business segment sfas 131 “segment reporting” “sfas 131” treated single reporting unit sfas 142 purpose testing goodwill impairment determination whether write goodwill necessary involves significant judgment based shortterm longterm projections future performance company assumptions supporting estimated future cash flows company including discount rate used estimated terminal value reflect best estimates longlived assets test longlived asset groups recoverability events changes circumstances indicate carrying amounts may recoverable recoverability assessed based carrying amounts asset fair value generally determined based sum undiscounted cash flows expected result use eventual disposal asset well specific appraisals certain instances impairment loss recognized carrying amount recoverable exceeds fair value stockbased compensation expense effective january 1 2003 adopted sfas 123 “accounting stockbased compensation” recognition stockbased compensation cost statement operations fair value option award estimated date grant using blackscholesmerton valuation method fair value amortized compensation expense straight line basis requisite service periods awards generally vesting period effective january 1 2006 adopted fair value recognition provisions sfas 123 revised 2004 “sharebased payment” “sfas 123r” fair value option adjusted reflect shares expected vest implementation sfas 123r used modifiedprospectivetransition method compensation cost related unvested option january 1 2006 recalculated necessary adjustment reported first quarter adoption made following estimates assumptions determining fair value valuation amortization method estimates fair value stock options granted using blackscholesmerton optionpricing formula single option award approach fair value amortized straightline basis requisite service periods awards generally vesting period expected term expected term represents weightedaverage period stockbased awards expected outstanding prior 2007 applied “simplified method” defined securities exchange commission’s staff accounting bulletin 107 first quarter 2007 used historical exercise patterns previously granted options relation company’s stock price estimate expected exercise patterns expected “simplified method” would disallowed december 31 2007 expected volatility company’s expected volatilities based historical volatility company’s stock adjusted determined management unusual nonrepresentative stock price activity expected recur expected dividend blackscholesmerton valuation model calls single expected dividend yield input company currently pays dividends expect pay dividends foreseeable future riskfree interest rate company bases riskfree interest rate implied yield currently available united states treasury zerocoupon issues equivalent remaining term estimated forfeitures estimate forfeitures apply historical rate option forfeitures estimated forfeiture rates truedup actual forfeiture results stockbased awards vest business combinations accordance sfas 141 “business combinations” “sfas 141” allocate purchase price acquired companies tangible intangible assets acquired liabilities assumed based estimated fair values engage thirdparty appraisal firms assist management determining fair values certain assets acquired liabilities assumed valuation requires management make significant estimates assumptions especially respect intangible assets management makes estimates fair value based upon assumptions believed reasonable estimates based historical experience information obtained management acquired companies inherently uncertain critical estimates valuing certain intangible assets include limited future expected cash flows customer contracts acquired developed technologies pending patents expected costs develop inprocess research development commercially viable products estimating cash flows projects completed acquired company’s brand awareness market position well assumptions period time acquired brand continue used combined company’s product portfolio discount rates unanticipated events circumstances may occur may affect accuracy validity assumptions estimates actual results income taxes subject income taxes united states numerous foreign jurisdictions significant judgment required evaluating tax positions determining provision income taxes effective tax rates differ statutory rate primarily due foreign earnings taxed lower rates foreign losses benefited stock compensation expenses sfas 123r deductible tax purposes valuation allowance future effective tax rates could adversely affected earnings lower anticipated countries lower statutory rates higher anticipated countries higher statutory rates changes valuation deferred tax assets liabilities changes tax laws regulations accounting principles interpretations thereof regularly assess likelihood adverse outcomes resulting tax examinations determine adequacy provision income taxes significant judgment also required determining valuation allowance recorded deferred tax assets assessing need valuation allowance consider available evidence including past operating results estimates future taxable income feasibility tax planning strategies event change determination amount deferred tax assets realized adjust valuation allowance corresponding impact provision income taxes period determination made effective january 1 2007 company adopted financial accounting standards board interpretation 48 accounting uncertainty income taxes “fin 48” requires morelikelythannot threshold financial statement recognition measurement tax positions taken expected taken tax return company records liability difference benefit recognized measured pursuant fin 48 tax position taken expected taken tax return extent company’s assessment tax positions changes change estimate recorded period determination made adoption fin 48 company also began reporting taxrelated interest penalties component income tax expense results operations net sales net sales 2007 increased 231 million 34 677 million 2006 increase primarily result increase net sales 118 million acquisition rae fushun december 2006 increase net sales 42 million americas 28 million europe 43 million rest asia excluding fushun increase revenue primarily due overall greater market penetration sales team led higher government orders united states larger sales oil steel industries china net sales 2006 increased 74 million 12 603 million 2005 increase primarily result increases net sales asia 61 million europe 24 million partially offset decrease americas 11 million increase asia due higher sales third party products rae gas detector product sales increased installation revenue increase europe primarily driven integrated wireless systems sales decrease americas primarily result slower spending first half 2006 homeland security products compared 2005 well increased competitive product pricing pressure industrial sector 2006 cost sales gross profit cost sales 2007 increased 122 million 38 322 million 2006 increase cost sales primarily result increase net sales 677 million 2006 908 million 2007 gross profit 2007 increased 109 million 31 355 million 2006 gross margin decreased slightly 2007 51 52 2006 due primarily acquisition rae fushun december 2006 lower gross margin due older technology products new operation cost sales 2006 increased 75 million 30 247 million 2005 gross profit 2006 decreased less 01 million 356 million 2005 however gross margin decreased 52 2006 compared 59 2005 lower gross margin 2006 primarily due shift sales americas towards lowermargin portable products increase united states manufacturing overhead associated facility cost competitive product pricing pressure united states addition lower gross margin installation revenue third party product sales asia contributed yearoveryear decline gross margin sales marketing expense sales marketing expenses 2007 increased 64 million 34 190 million 2006 increase primarily due 19 million increase payroll benefit related expenses result 13 headcount increases regions 85 headcount increases acquisition rae fushun december 2006 well 19 million increased travel entertainment expenses 15 million increased office facility expenses addition commission expenses increased 09 million reflecting increase revenue amortization intangible increased 03 million primarily result acquisition customer list connection acquisition rae fushun sales marketing expenses 2006 increased 22 million 13 168 million 2005 increase attributable increase sales marketing expenses related increased revenue payroll related expenses attributable increased headcount well higher infrastructure costs across company support sales growth research development expense research development expenses 2007 increased 19 million 31 61 million 2006 increase primarily due 07 million increase payroll benefit related expenses result headcount increases china acquisition rae fushun december 2006 well 01 million increase office travel expenses project expenses increased 05 million mainly due increases product certifications testing expenses additional projects formation rae fushun well new projects related future products regions also impaired certain patents approximately 06 million china related products reached end life discontinued research development expenses 2006 increased 07 million 12 54 million 2005 increased expenses primarily result increased headcount project expenses development new portable wireless products engineering center shanghai china key product releases 2006 included gammarae systems ii r portable radiation detector dosimeter well neutron rae ii combined gamma neutron radiation detector also released chemrae portable device detection chemical warfare agents capable integration wireless communications products general administrative expense general administrative expenses 2007 increased 44 million 33 133 million 2006 increase primarily due 20 million increase payroll benefit related expenses result headcount increases regions formation rae fushun december 2006 well 08 million increase office facility expenses 02 million increase travel expenses increase 17 million professional fees primarily comprised 13 million increase legal costs associated polimaster arbitration 08 million increase accounting tax services related international nature business offset 04 million decrease consulting fees permanent positions replaced consultants increase general administrative expenses offset 04 million gain recognized result sale leaseback san jose headquarters building december 2007 general administrative expenses 2006 increased 04 million 3 129 million 2005 increased expenses primarily result increases sarbanesoxley compliance related charges also experienced higher infrastructure costs increased communication consulting expenses following implementation oracle enterprise resource planning system gainloss abandonment lease income abandonment lease 2007 06 million march 2007 revised estimated loss abandonment lease related former headquarters sunnyvale california reduced operating expenses 06 million change estimate primarily reflected management’s expectation premises would subleased current market conditions office rentals second quarter 2007 sublease executed rents commencing june loss abandonment lease approximately 20 million 2005 associated abandonment former headquarters manufacturing lease site sunnyvale california completed move larger headquarters united states manufacturing facility second quarter 2005 support sales growth income expense 2007 total income decreased 13 million 163 08 million 2006 decrease primarily result lower interest income made substantial investments rae fushun securay aegison corporation second half 2006 2007 addition interest expenses increased 05 million due short term bank borrowings us china support operations income decreased 02 million mainly due realized foreign exchange loss payments fushun shareholders 2007 2006 total income increased 03 million 97 03 million 2005 increase primarily result increased income 02 million 2006 primarily resulting foreign exchange gain 02 million eurodollar renminbi denominated balances litigation settlement gain 02 million increase partially offset loss fixed assets disposal 02 million also experienced increase interest income 01 million largely attributed higher interest rates investments 2006 compared 2005 income tax benefit expense income tax expense increased 68 million 767 income tax benefit 09 million 2006 effective tax rate 53 2007 38 tax benefit 2006 tax rate years 2007 2006 differed united states statutory rate due change realization deferred tax assets dtas foreign earnings taxed lower rates foreign losses benefited nondeductible stock compensation deductions sfas 123 sfas 123r currently significant deferred tax assets resulting anticipated net operating losses deductible temporary differences reduce taxable income future periods established full valuation allowance remaining deferred tax assets recognized 73 million charge fourth quarter 2007 previously provided valuation allowances future tax benefits resulting certain foreign net operating losses believed likely remaining net deferred tax assets would realized principally based upon anticipated continued revenue growth profitable results 2008 expectation based number factors including introduction several new products 2007 2008 growing revenue geographic markets serve continued management focus controlling operating expenses believed combination factors would result future profitable operations realization deferred tax assets would fully utilized statement financial accounting standards 109 “accounting income taxes” “sfas 109” requires valuation allowance established “more likely not” portion deferred tax assets realized difficult conclude valuation allowance needed negative evidence cumulative losses recent years therefore cumulative losses weighed heavily overall assessment believe sufficient uncertainty exists regard realizability tax assets valuation allowance necessary factors considered providing valuation allowance include lack significant history consistent profits current believed continued weakness overall market thereby potentially impacting ability sustain grow revenues earnings length carryback carryforward periods considered expectations risks associated estimates future taxable income ongoing prudent feasible tax planning strategies based absence sufficient positive objective verifiable evidence december 31 2007 increased total valuation allowance deferred tax assets approximately 84 million resulting 73 million charge expect record full valuation allowance future tax benefits sustain appropriate level profitability time would expect recognize significant tax benefits future results operations income tax benefit increased 04 million 85 05 million 2005 effective tax rate 38 tax benefit 2006 37 tax benefit 2005 tax rate 2006 2005 differed united states statutory rate due foreign earnings taxed lower rates foreign losses benefited nondeductible stock compensation deductions sfas 123 sfas 123r adjustments reserves uncertain tax positions 2006 internal revenue service completed examination federal income tax returns years ended december 31 2003 2004 based results examination paid 391000 irs april 2006 accrued december 31 2005 based favorable outcome audit released 337000 additional reserves applicable 2003 2004 year additionally reported 190000 release tax reserves related interest upon expiration statute limitations federal tax liabilities applicable uncertain tax positions year ended december 31 2002 2006 tax authority denmark skat completed audit subsidiary denmark year ended december 31 2004 without adjustment minority interest loss consolidated subsidiaries minority interest income consolidated entities 2007 increased 55000 112 loss 49000 2006 increase minority interest income consolidated entities mainly due improved profitability rae beijing well increase ownership 64 96 second half fiscal 2006 increase partially offset loss generated rae fushun formed december 2006 less profit rae france 2007 minority interest loss consolidated entities 2006 decreased 13000 21 62000 2005 minority interest loss consolidated subsidiaries represented net loss allocated minority shareholders’ interest rae beijing majority shareholders’ interest rae france reduction minority interest loss consolidated entities due improved profitability rae beijing rae france partially offsetting reduction decrease minority ownership resulted increase ownership rae beijing 64 96 july 2006 loss discontinued operations august 24 2007 board directors approved discontinuation mobile dvr business order reduce expenses concentrate resources gas radiation detection business mobile dvr business acquired purchases aegison securay see “note 2 mergers acquisitions” notes consolidated financial statements details august 28 2007 notified dvr customers terminated personnel reassigned continuing operations suspended related production sales activities dvr business operates substantial loss management intends liquidate tangible assets mainly inventories component parts accordingly value assets adjusted reflect anticipated disposals result discontinuing dvr business management impaired remaining value intangible assets goodwill acquired purchases aegison july 2006 securay january 2007 impairment expense recognized fiscal 2007 totaled 42 million accordance sfas 144 “accounting impairment disposal longlived assets” “sfas 144” financial results dvr business reported discontinued operations periods presented financial results included discontinued operations follows liquidity capital resources date financed operations primarily revenues operations proceeds issuance equity securities bank borrowings december 31 2007 159 million cash investments compared 214 million december 31 2006 55 million yearoveryear reduction company cash primarily due operating losses combined increase working capital due increase business activities china partially offset sale long term assets december 31 2007 409 million working capital current assets less current liabilities current ratio current assets current liabilities 28 10 compared working capital 366 million current ratio 26 10 december 31 2006 march 14 2007 signed 150 million revolving credit agreement available help fund future growth expansion agreement provided borrowings 70 million based blanket security interest assets additional 80 million borrowing available based percentage qualifying assets addition ongoing requirement submit quarterly financial statements required comply certain reporting requirements whenever borrowings line credit exceeds 30 million amendment revolving credit agreement december 2007 subsequent sale leaseback san jose office building 150 million revolving credit agreement continued divided two components first 70 million borrowing previously based blanket security interest changed 50 million 80 million previously based qualifying assets changed 100 million key terms conditions remained essentially unchanged full compliance borrowing requirements including certain financial covenants full line available present outstanding amounts line credit agreement expires june 2008 also two unsecure lines credit renminbi 20 million approximately 27 million renminbi 10 million approximately 14 million provide working capital china december 31 2007 believe existing balances cash equivalents together cash generated product sales sufficient meet cash needs working capital expenditures least next twelve months future capital requirements depend many factors difficult predict including size timing structure future acquisitions future capital investments future results operations future financing may require may unavailable favorable terms difficulty obtaining additional financial resources could force us curtail operations could prevent us pursuing growth strategy future funding may dilute ownership stockholders summary consolidated statements cash flows years 2007 2006 2005 follows operating activities year ended december 31 2007 net cash used operating activities 100 million due following • cash used mainly support increase 95 million working capital primarily consisting increase 57 million accounts receivable 18 million inventories primarily related increased sales remaining 20 million primarily comprised changes deferred revenue deposits current operating accounts • positive effect noncash adjustments due depreciation amortization long lived assets 37 million deferred taxes 41 million stock based compensation expense 19 million provision doubtful accounts 19 million year ended december 31 2006 net cash provided operating activities 11 million due following • noncash charges net income approximately 41 million noncash adjustments net income resulted primarily depreciation amortization longlived assets 32 million compensation expense fair value accounting stock options 16 million reserve noncash adjustments net income approximately 05 million partially offset adjustment deferred income taxes 12 million • positive effect noncash adjustments described year 2006 partially offset increased investment working capital 15 million increase working capital primarily result increased sales asia longer average collection period accounts receivable sales united states partially offset higher payables related increased volume december 2006 year ended december 31 2005 net cash provided operating activities 14 million due following • noncash charges net income approximately 50 million noncash adjustments net income resulted primarily depreciation amortization longlived assets 21 million reserve amounts cover anticipated payment landlord sunnyvale california headquarters building 20 million abandoned purchased headquarters building san jose california compensation expense fair value accounting stock options 22 million reserve noncash adjustments net income approximately 06 million partially offset adjustment deferred income taxes 19 million • positive effect noncash adjustments described year 2005 partially offset increased investment working capital 28 million comprised primarily increases accounts receivable inventory related increased sales levels continued growth business asia investing activities net cash provided investing activities years ended december 31 2007 2006 amounted 100 million 30 million respectively net cash used investing activities year ended december 31 2005 amounted 96 million 2007 increase cash due investing activities 100 million primarily due net proceeds sale leaseback san jose headquarters building approximately 124 million sale investments securities 32 million partially offset approximately 40 million used acquisition property equipment 16 million used business acquisitions 2007 began construct rae fushun’s new manufacturing administrative facility china estimated cost complete project 2008 28 million 2006 proceeds investing activities contributed 30 million cash increase consisted primarily 127 million net proceeds sale investments maturity investments net proceeds partially offset investments 74 million used business acquisitions approximately 48 million invested increase stake rae beijing 64 96 21 million acquire assets aegison corporation 05 million acquire certain assets tianjin securay technology co ltd addition 22 million used acquisition property equipment 2005 increase investing activities reduced cash available business operations 96 million cash reduction resulting increased investing activities 2005 primarily result 49 million used acquisition property equipment related existing businesses net increase investments surplus cash held company approximately 47 million financing activities net cash provided financing activities years ended december 31 2007 2006 2005 amounted 27 million 02 million 01 million respectively cash provided financing activities 27 million 2007 primarily bank borrowings net repayment 26 million used repay related party note 50 million repurchase restricted stock awards 03 million net cash provided financing activities 2006 2005 mainly proceeds exercise stock options warrants commitments contingencies summary obligations following table quantifies known contractual obligations tabular form december 31 2007 obligations impact short longterm liquidity capital resource needs certain contractual obligations reflected consolidated balance sheets others disclosed future obligations 1 discussion surrounding notes payablerelated parties refer “note 12 related party transactions” consolidated financial statements 2 discussion surrounding purchase lease obligations refer “note 9 commitments contingencies” consolidated financial statements 3 represents estimated cancelable open purchase orders purchase inventory goods services normal course business meet operational requirements guarantees permitted delaware law accordance bylaws indemnify officers directors certain events occurrences subject certain limits officer serving request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however director officer insurance policy limits exposure enables recover portion future amounts paid date incurred losses agreements sales agreements typically agree indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date paid amounts settle claims defend lawsuits product warranties sell majority products 12 24 month repair replacement warranty date shipment provide accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized uncertain tax positions effective january 1 2007 adopted provisions fin 48 december 31 2007 liability uncertain tax positions including associated interest penalties approximately 14 million pursuant fin 48 liability represents estimate tax positions company taken tax returns may ultimately sustained upon examination tax authorities since ultimate amount timing future cash settlements cannot predicted reasonable certainty estimated liability excluded contractual obligations table recent accounting pronouncements september 2006 fasb issued statement 157 “fair value measurements” “sfas 157” sfas 157 defines fair value establishes framework gives guidance regarding methods used measuring fair value expands disclosures fair value measurements sfas 157 applicable whenever another accounting pronouncement requires permits assets liabilities measured fair value sfas 157 expand require new fair value measures however application statement may change current practice sfas 157 effective fiscal years beginning november 15 2007 result effective fiscal year beginning january 1 2008 currently evaluating impact adopting sfas 157 related fasb staff positions consolidated financial statements february 2007 fasb issued sfas 159 “the fair value option financial assets financial liabilitiesincluding amendment fasb statement 115” statement permits entities choose measure many financial instruments certain items fair value fair value option may elected instrumentbyinstrument basis exceptions sfas 159 also establishes presentation disclosure requirement facilitate comparisons companies choose different measurement attributes similar assets liabilities sfas 159 effective fiscal years beginning november 15 2007 currently evaluating impact adopting sfas 159 expect material effect financial condition results operations december 2007 fasb issued sfas 141r “business combinations” “sfas 141r” statement changes accounting acquisition transaction costs requiring expensed period incurred also changes accounting contingent consideration acquired contingencies restructuring costs related acquisition sfas 141r effective fiscal years beginning december 15 2008 currently evaluation impact adopting sfas 141r expect material impact financial condition results operations december 2007 fasb issued sfas 160 “noncontrolling interests consolidated financial statementsan amendment arb 51” “sfas 160” statement change accounting reporting minority interests recharacterized noncontrolling interests classified component equity sfas 160 effective fiscal years beginning december 15 2008 currently evaluating impact adopting sfas 160 expect material effect financial condition results operations item 7a item 7a quantitative qualitative disclosures market risk market risk could exposed market risk related debt obligations financing working capital equipment requirements future historically financed requirements issuance preferred common stock addition augmented equity financing activities via issuance convertible debt continue consider financing alternatives may include incurrence long term indebtedness actual capital requirements may vary based upon timing success expansion operations believe based terms maturities future debt obligations market risk would minimal currently material market rate risks effects inflation due relatively low levels inflation 1997 1998 1999 inflation significant effect results operations item 8item 7a quantitative qualitative disclosures market risk market risk december 31 2000 long term debt obligations therefore immediate 10 increase market interest rates would material adverse effect financial position currently material market rate risks could exposed market risk related debt obligations financing working capital equipment requirements future historically financed requirements issuance preferred common stock continue consider financing alternatives may include incurrence long term indebtedness actual capital requirements may vary based upon timing success expansion operations believe based terms maturities future debt obligations market risk would minimal effects inflation due relatively low levels inflation 1997 1998 1999 2000 inflation significant effect results operations item 8item 7a quantitative qualitative disclosures market risk market risk december 31 2001 long term debt obligations therefore immediate 10 increase market interest rates would material adverse effect financial position currently material market rate risks could exposed market risk related debt obligations financing working capital equipment requirements future historically financed requirements issuance preferred common stock continue consider financing alternatives may include incurrence long term indebtedness actual capital requirements may vary based upon timing success expansion operations believe based terms maturities future debt obligations market risk would minimal effects inflation due relatively low levels inflation 1997 1998 1999 2000 2001 inflation significant effect results operations item 8item 7a quantitative qualitative disclosures market risk following discussion analyzes disclosure market risk related concentration credit risk changes interest rates foreign currency exchange rates concentration credit risk currently cash equivalents deposited three large united states financial institutions one large hong kong financial institution one large danish financial institution deposits may exceed amount insurance available cover deposits date experienced losses deposit cash equivalents management regularly reviews deposit amounts credit worthiness financial institution holds deposits interest rate risk december 31 2002 cash equivalents 72 million consisting cash highly liquid shortterm investments impact interest rate fluctuations immaterial declines interest rates time however reduce interest income shortterm investments foreign currency exchange rate risk date substantially recognized revenue denominated united states dollars generated primarily customers united states exposure foreign currency exchange rates immaterial expect however future products service revenue may also derived international markets may denominated currency applicable market result operating results may become subject significant fluctuations based upon changes exchange rates specific currencies relation united states dollar furthermore extent engage international sales denominated united states dollars fluctuation value united states dollar relative foreign currencies could affect competitive position international markets although would continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot assure exchange rate fluctuations adversely affect financial results future factors may affect future results carefully consider risks described making decision regarding investment common stock following risks actually occur business could harmed trading price common stock could decline may lose part investment also refer information contained report including financial statements related notes future revenues unpredictable operating results likely fluctuate quarter fail meet expectations securities analysts investors stock price could decline significantly quarterly annual operating results fluctuated past likely fluctuate significantly future due variety factors outside control accordingly believe periodtoperiod comparisons results operations meaningful relied upon indications future performance factors could cause quarterly annual operating results fluctuate include market acceptance products ongoing product development production competitive pressures customer retention likely future quarters operating results may fall expectations investors event trading price common stock would significantly decline expense levels based large part estimates future revenues unexpected shortfall revenue would significantly harm results operations expense levels based largely investment plans estimates future revenue may unable adjust spending compensate unexpected shortfall revenue accordingly significant shortfall revenue relative planned expenditures particular quarter would harm results operations could cause stock price fall sharply particularly following quarters operating results fail meet expectations securities analysts investors ownership interest renex cause us incur losses would otherwise incur approximately 36 percent renex wireless systems development company required incorporate share losses consolidated statements operation renex still research development stage date renex generated revenues renex begin generate revenues level anticipate otherwise incurs greater losses could incur greater losses anticipate results operations suffer variable accounting related past option grants 1993 stock option plan may impact earnings next nine years connection becoming public company reverse merger transaction certain options 1993 stock plan subject variable accounting accordance fasb interpretation 44 fin 44 december 31 2002 2014941 options outstanding plan subject variable accounting year ended december 31 2002 financial statements herein reflect 374700 variable accounting charge based life options variable accounting treatment may result unpredictable stockbased compensation charges dependent fluctuations quoted prices common stock next nine years could adversely affect results operations may unable meet future capital requirements attempts raise additional capital future may cause substantial dilution stockholders may need seek additional funding future uncertain whether able obtain additional financing favorable terms issue equity securities connection additional financing stockholders may experience dilution andor new equity securities may rights preferences privileges senior existing holders common stock cannot raise funds acceptable terms needed may able develop enhance products services take advantage future opportunities respond competitive pressures unanticipated requirements could seriously harm business benefits inventory procurement strategy asia materialize anticipate results operations may suffer part overall strategy increase gross margins improve operating results executing strategy procure number component parts closer production source asia past strategy involved purchase parts delivery parts vendors united states parts kitted shipped shanghai subassemblies made current strategy involves procurement component parts asia effective price much lower parts shipped directly shanghai thereby reducing transit time shipping cost inventory execution current strategy may adverse consequences vendors qualified ensure parts acceptable quality meet requisite specifications called engineering drawings significant amount time funding may required complete analysis fail execute currently procurement strategy effective manner results operations may suffer depend distributors derive approximately 90 revenues via sales distribution channels therefore dependent distributors principal distributors significant group distributors experience financial difficulties become unwilling promote sell products reason business results operations could materially harmed depend third party suppliers dependent third party suppliers component parts including various sensors microprocessors material components interruption supply component parts business could adversely affected expansion gas detection instrument manufacturer wireless systems company unsuccessful business results operations suffer process expanding current business providing gas detection instruments include wireless systems local remote security monitoring pricing wireless products services may subject rapid frequent change may forced competitive technical reasons reduce prices wireless products would reduce revenue could harm business wireless systems market still evolving little basis assess demand wireless products services evaluate whether wireless products services accepted market wireless products services gain broad market acceptance business results operations harmed economic downturn united states abroad could material adverse impact business results operations business date minimally impacted current economic downturn united states abroad could eventually succumb conditions many customers already experienced severe declines revenues could impact size frequency purchases products services although routinely perform credit checks customer base assess creditworthiness assurance able collect payments customers become due decrease size frequency purchases customers failure us collect payments become due could material adverse impact business results operations compliance safety regulations could delay new product delivery adversely affect results operations compliance safety regulations specifically need obtain ul cul atex eex approvals could delay introduction new products us result may experience delays realizing revenues new products could adverse effect results operations deterioration trade relations china could material adverse effect business results operations significant portion products components manufactured whollyowned facility shanghai china trade relations united states china deteriorate ability transfer products china regions world including united states asia europe could significantly impacted result business results operations would suffer involved pending legal proceedings october 23 2001 estate virgil johnson filed products liability wrongful death lawsuit us district court harris county texas plaintiffs allege product defective unsafe intended purposes time left premises product defective failed conform product design specifications gas monitors additionally plaintiffs allege product defectively designed marketed render unreasonably dangerous plaintiff event adequate insurance coverage expenses related lawsuit may incur substantial legal fees expenses connection litigation may also result diversion internal resources defense litigation regardless eventual outcome likely costly time consuming litigation preliminary stage unable predict final outcome however adverse outcome could materially affect results operations financial position march 26 2002 straughan technical distribution llc filed lawsuit us superior court state california county santa clara similar lawsuit pending district court harris county texas served us march 27 2002 nearly identical lawsuits straughan distributor gastec gas detection devices claims experienced diminished sales customers loss profits damages result stated allegations include claims interference present prospective business relations false advertising trade dress infringement slander antitrust violations april 17 2002 removed california action united states district court northern district california april 18 2002 removed texas action united states district court southern district texas october 8 2002 principals straughan rae systems met discussed potential settlement opportunities february 2003 agreed straughan settle claims asserted currently finalizing terms settlement agreement addition litigation described time may subject various legal proceedings claims arise ordinary course business market gas detection monitoring devices highly competitive cannot compete effectively business may harmed market gas detection monitoring devices highly competitive expect emerging wireless gas monitoring system market equally competitive competitors gas monitoring industry differentiate basis technology quality product service offerings cost time market gas detection monitoring devices primary competitors include industrial scientific corporation mine safety appliances company bw technologies ion science perkinelmer inc drager safety inc gastec corporation bacoudalloz competitors longer operating histories larger customer bases greater brand recognition significantly greater financial marketing resources us addition competitors may able • devote greater resources marketing promotional campaigns • adopt aggressive pricing policies • devote resources technology systems development light factors may unable compete successfully may successful developing brand could prevent us remaining competitive believe future success depend ability maintain strengthen rae systems brand depend turn largely success marketing efforts ability provide customers highquality products fail successfully promote maintain brand incur excessive expenses attempting promote maintain brand business harmed may able recruit retain qualified personnel future success depends ability attract retain motivate highly skilled employees despite recent economic slowdown competition qualified employees silicon valley particularly management technical sales marketing personnel intense although provide compensation packages include stock options cash incentives employee benefits may unable retain key employees attract assimilate retain highly qualified employees future could harm business could suffer lose services executive officers future success depends significant extent continued service executive officers including robert chen joseph ng peter hsi loss services executive officers could harm business might successful development introduction new products services timely effective manner revenue growth dependent timely introduction new products market may unsuccessful identifying new product service opportunities developing marketing new products services timely costeffective manner addition product innovations may achieve market penetration price stability necessary profitability officers directors principal stockholders beneficially approximately 64 common stock accordingly may exert substantial influence company executive officers directors principal stockholders aggregate beneficially approximately 64 common stock stockholders acting together ability control matters requiring approval stockholders matters include election removal directors amendment certificate incorporation merger consolidation sale substantially assets addition may dictate management business affairs furthermore concentration ownership could effect delaying deferring preventing change control impeding merger consolidation takeover business combination may substantially reduce marketability common stock future sales common stock existing stockholders could adversely affect stock price sales substantial amounts common stock public market connection offering could reduce prevailing market prices common stock registered resale approximately 42671491 shares common stock including shares underlying outstanding warrants purchase common stock registration statement form s1 shares approximately 12680080 subject six month lockup agreements expired october 9 2002 23261326 subject one year lockup agreements set expire april 9 2003 future sales holders shares could adversely affect trading price common stock facilities operations vulnerable natural disasters unexpected losses success depends efficient uninterrupted operation business facilities sunnyvale california area susceptible earthquakes backup facility provide redundant capacity event natural disaster unexpected damage fire floods power loss telecommunications failures breakin similar events seek replicate operations locations face number technical well financial challenges may able address successfully although carry property business interruption insurance coverage may adequate compensate us losses may occur business subject risks associated conducting business internationally business subject risks normally associated conducting business outside united states foreign government regulations nationspecific regionspecific certifications political unrest disruptions delays shipments fluctuations foreign currency exchange rates changes economic conditions countries raw materials suppliers service providers customers located business may also adversely affected imposition additional trade restrictions related imported products including quotas duties taxes charges restrictions foregoing factors render conduct business particular country undesirable impractical current foreign manufacturing sources cease business us reason business results operations could adversely affected example recently informed certain intercompany shipments united states china compliant chinese customs requirements although believe changes implementing standard procedures avoid issues future assurance issues future china jurisdictions problems result fines restrictions operations could adversely affect business may unable adequately protect intellectual property rights regard intellectual property critical success rely patent trademark copyright trade secret laws protect proprietary rights notwithstanding laws may unsuccessful protecting intellectual property rights obtaining patents registered trademarks apply ability compete affected ability protect company’s intellectual property rights rely combination patents trade secrets nondisclosure agreements confidentiality procedures although processes place protect intellectual property rights cannot guarantee procedures adequate prevent misappropriation current technology competitors develop technology similar specifically cannot ensure future patent applications approved current patents challenged third parties furthermore cannot ensure challenged patents found valid enforceable litigation relating intellectual property rights could regardless outcome materially adverse impact business results operations might face intellectual property infringement claims might costly resolve may time subject claims infringement parties’ proprietary rights claims trademarks patents intellectual property rights invalid claims type regardless merit could timeconsuming defend result costly litigation divert management’s attention resources require us enter royalty license agreements terms license agreements may available reasonable terms assertion prosecution infringement claims could significantly harm business future acquisitions undertake could difficult integrate disrupt business dilute stockholder value harm results operations may acquire make investments complementary businesses technologies services products appropriate opportunities arise process integrating acquired business technology service product business operations may result unforeseen operating difficulties expenditures integration acquired company also may consume much management’s time attention would otherwise available ongoing development business moreover anticipated benefits acquisition may realized future acquisitions could result dilutive issuances equity securities incurrence debt contingent liabilities expenses related goodwill recognition intangible assets could harm business provisions charter documents delaware law could prevent delay change control company could reduce market price common stock discourage potential acquirers offering premium prevailing trading price common stock provisions certificate incorporation bylaws could effect delaying preventing change control company changes management addition provisions delaware law may discourage delay prevent third party acquiring merging us provisions could limit price investors might willing pay future shares common stock provisions may also effect discouraging preventing potential acquirer offering stockholders premium prevailing trading price common stock item 8item 7a quantitative qualitative disclosures market risk following discussion analyzes disclosure market risk related concentration credit risk changes interest rates foreign currency exchange rates concentration credit risk currently cash equivalents deposited two large united states financial institutions one large hong kong financial institution two large shanghai financial institutions one large danish financial institution deposits may exceed amount insurance available cover deposits date experienced losses deposits cash equivalents management regularly reviews deposit amounts credit worthiness financial institution holds deposits interest rate risk december 31 2003 cash equivalents 75 million consisting cash highly liquid shortterm investments impact interest rate fluctuations immaterial declines interest rates time however reduce interest income shortterm investments foreign currency exchange rate risk date substantial portion recognized revenue denominated united states dollars generated primarily customers united states exposure foreign currency exchange rates immaterial sales international customers increase operating results may become subject significant fluctuations based upon changes exchange rates specific currencies relation united states dollar furthermore extent engage international sales denominated united states dollars fluctuation value united states dollar relative foreign currencies could affect competitive position international markets although would continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot assure exchange rate fluctuations adversely affect financial results future item 8item 7a quantitative qualitative disclosures market risk following discussion analyzes disclosure market risk related concentration credit risk changes interest rates foreign currency exchange rates concentration credit risk currently cash equivalents deposited two large united states financial institutions one large hong kong financial institution two large shanghai financial institutions two local beijing financial institutions one large danish financial institution deposits may exceed amount insurance available cover deposits date experienced losses deposits cash equivalents management regularly reviews deposit amounts credit worthiness financial institution hold deposits interest rate risk december 31 2004 cash equivalents 328 million consisting cash highly liquid shortterm investments impact interest rate fluctuations immaterial changes interest rates time may however reduce increase interest income shortterm investments example hypothetical 150 bps change interest rates united states approximate impact cash shortterm investments would 100000 foreign currency exchange rate risk date substantial portion recognized revenue denominated united states dollars generated primarily customers united states 62 revenue generated european operations 10 primarily euros revenue generated china operations 21 renminbi revenue generated hong kongbased operations 4 hong kong dollars united states dollars manufacture majority component parts manufacturing facility shanghai china operations china largely unaffected currency fluctuations china’s currency rate fixed relative united states dollar strategy continue increase overseas manufacturing research development activities capitalize low cost intellectual property efficiency supply chain management 2004 made strategic investment china acquisition klh beijingbased manufacturer distributor environmental safety security equipment recent speculation financial press china’s currency renminbi subject market adjustment relative united states dollar currencies example hypothetical 10 change renminbi relative united states dollar approximate impact profits would 500000 furthermore extent engage international sales denominated united states dollars countries china fluctuation value us dollar relative foreign currencies could affect competitive position international markets although would continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot certain exchange rate fluctuations adversely affect financial results future item 8item 7a quantitative qualitative disclosures market risk following discussion analyzes disclosure market risk related concentration credit risk changes interest rates foreign currency exchange rates concentration credit risk currently cash equivalents deposited one large united states financial institution one large hong kong financial institution two large shanghai financial institutions two local beijing financial institutions one large danish financial institution deposits may exceed amount insurance available cover deposits date experienced losses deposits cash equivalents management regularly reviews deposit amounts credit worthiness financial institution hold deposits interest rate risk december 31 2005 cash equivalents short term investments 279 million consisting cash highly liquid shortterm investments impact interest rate fluctuations immaterial changes interest rates time may however reduce increase interest income shortterm investments example hypothetical 150 basis points 15 bps change interest rates united states approximate impact cash shortterm investments would 132000 foreign currency exchange rate risk date substantial portion recognized revenue denominated united states dollars generated primarily customers americas 56 revenue generated european operations 11 primarily euros revenue generated china operations 30 local currency renminbi “rmb” revenue generated hong kongbased operations 3 hong kong dollars united states dollars manufacture majority component parts manufacturing facility shanghai china operations china largely unaffected currency fluctuations july 2005 approximately 21 appreciation rmb relative united states dollar strategy continue increase overseas manufacturing research development activities capitalize low cost intellectual property efficiency supply chain management 2004 made strategic investment china acquisition klh beijingbased manufacturer distributor environmental safety security equipment continued speculation financial press china’s currency rmb subject market adjustment relative united states dollar currencies example hypothetical 10 change rmb relative united states dollar approximate impact profits would 430000 currencies countries europe asia operations change unison rmb hypothetical 10 us dollar approximate impact profits would 260000 reduction total impact rmb appreciation impact rmb change would offset changes reported sales net expenses units result changes countries functional currencies furthermore extent engage international sales denominated united states dollars countries china fluctuation value us dollar relative foreign currencies could affect competitive position international markets although would continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot certain exchange rate fluctuations adversely affect financial results future item 8item 7a quantitative qualitative disclosures market risk following discussion analyzes disclosure market risk related concentration credit risk changes interest rates foreign currency exchange rates concentration credit risk currently cash equivalents deposited one large united states financial institution one large hong kong financial institution three large shanghai financial institutions one local beijing financial institutions two large beijing financial institutions one large danish financial institution deposits may exceed amount insurance available cover deposits date experienced losses deposits cash equivalents management regularly reviews deposit amounts credit worthiness financial institution hold deposits interest rate risk december 31 2006 cash equivalents short term investments 214 million consisting cash highly liquid shortterm investments result 2006 investment commitments accordance financial accounting standard 115 “accounting certain investments debt equity” company changed classification investments “heldtomaturity” “availableforsale” resulting fairvalue calculation company’s investments led nominal net decrease carrying value investments 2006 addition changes interest rates time may reduce increase interest income shortterm investments example hypothetical 150 basis points 15 bps change interest rates united states approximate impact cash shortterm investments would 97000 foreign currency exchange rate risk year ended december 31 2006 substantial portion recognized revenue denominated us dollars generated primarily customers americas 49 revenue generated european operations 13was primarily euros revenue generated asia operations 38was primarily renminbi “rmb” manufacture majority component parts manufacturing facility shanghai china since january 2006 operations china affected currency fluctuations due approximate 31 appreciation rmb relative us dollar strategy continue increase overseas manufacturing research development activities capitalize lowcost intellectual property efficiency supplychain management 2004 2006 made strategic investment china acquisition 96 interest rae bejing beijingbased manufacturer distributor environmental safety security equipment also formed rae coal mine safety instruments fushun co ltd late 2006 capitalize increase demand safety equipment energy sector china continued speculation financial press china’s currency rmb subject market adjustment relative us dollar currencies example 2006 hypothetical 10 change rmb relative us dollar approximate impact profits would approximately 536000 2006 fiscal year currencies countries europe asia operations change unison rmb hypothetical 10 us dollar approximate impact profits would approximately 151000 2006 fiscal year reduction impact rmb due offset changes reported net sales units resulting changes countries local currencies furthermore extent engage international sales denominated us dollars countries china fluctuation value us dollar relative foreign currencies could affect competitive position international markets although would continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot certain exchange rate fluctuations adversely affect financial results future item 8item 7a quantitative qualitative disclosures market risk concentration credit risk currently cash equivalents deposited major financial institutions countries conduct business deposits may exceed amount insurance available cover deposits date experienced losses deposits cash equivalents management regularly reviews deposit amounts credit worthiness financial institution hold deposits interest rate risk december 31 2008 cash equivalents 148 million changes interest rates time may reduce increase interest income shortterm investments impact cash equivalents expected insignificant foreign currency exchange rate risk year ended december 31 2008 substantial portion recognized revenue denominated us dollars generated primarily customers americas 40 revenue generated european operations 16 primarily euros revenue generated asia operations 44 primarily rmb manufacture majority component parts manufacturing facility shanghai china since january 2008 operations china affected currency fluctuations due approximate 67 appreciation rmb relative us dollar strategy continue increase overseas manufacturing research development activities capitalize lower cost capacity efficiencies supplychain management 2004 2006 made strategic investment china acquisition 96 interest rae beijing beijingbased manufacturer distributor environmental safety security equipment formation rae fushun late 2006 capitalize increase demand safety equipment mining energy sectors china continued speculation financial press china’s currency rmb subject market adjustment relative us dollar currencies example hypothetical 10 change rmb relative us dollar effect profits would approximately 12 million fiscal 2008 currencies countries europe asia operations change unison rmb hypothetical 10 us dollar approximate effect profits would approximately 06 million fiscal 2008 reduction impact rmb due offset changes reported net sales units resulting changes countries local currencies furthermore extent engage international sales denominated us dollars countries china fluctuation value us dollar relative foreign currencies could affect competitive position international markets although would continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot certain exchange rate fluctuations adversely affect financial results future item 8item 7a quantitative qualitative disclosures market risk concentration credit risk currently cash equivalents deposited major financial institutions countries conduct business deposits may exceed amount insurance available cover deposits date experienced losses deposits cash equivalents management regularly reviews deposit balances credit worthiness financial institutions hold deposits interest rate risk december 31 2009 cash equivalents 185 million restricted cash 21 million company significant interest bearing assets time changes interest rates may reduce increase interest income impact net income loss fair value interest bearing assets expected significant borrowings china fixed interest rates fixed 12 months outstanding balance line credit united states bears interest floating prime bank lending rate plus 100 basis points subject minimum total rate 5 prime rate december 31 2009 325 cost funds united states increase prime rate rises 75 basis points outstanding balance 18 million loan balance united states december 31 2009 annual interest expense would increase 1800 basis point thereafter foreign currency exchange rate risk year ended december 31 2009 substantial portion recognized revenue denominated us dollars generated primarily customers americas 42 revenue generated european operations 17 primarily euros revenue generated asia operations 41 primarily rmb manufacture majority component parts manufacturing facility shanghai china since january 2009 operations china affected currency fluctuations due approximate 03 appreciation rmb relative us dollar strategy continue increase overseas manufacturing research development activities capitalize lower cost capacity efficiencies supplychain management 2004 2006 made strategic investment acquisition 96 interest rae beijing beijingbased manufacturer distributor environmental safety security equipment formation rae fushun late 2006 capitalize increases demand safety equipment mining energy sectors china continued speculation financial press china’s currency rmb subject market adjustment relative us dollar currencies example hypothetical 10 change rmb relative us dollar effect loss would approximately 11 million fiscal 2009 currencies countries europe asia operations change unison rmb hypothetical 10 relative us dollar effect loss would approximately 07 million fiscal 2009 difference 04 million attributable impact foreign currencies outside china extent international sales denominated us dollars fluctuation value us dollar relative foreign currencies could affect competitive position international markets although continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot certain exchange rate fluctuations adversely affect financial results future item 8item 7a quantitative qualitative disclosures market risk concentration credit risk currently cash equivalents deposited major financial institutions countries conduct business deposits may exceed amount insurance available cover deposits date experienced losses deposits cash equivalents management regularly reviews deposit balances credit worthiness financial institutions hold deposits interest rate risk december 31 2010 cash equivalents 163 million restricted cash 20 million company significant interest bearing assets time changes interest rates may reduce increase interest income impact net income loss fair value interest bearing assets expected significant borrowings china generally fixed interest rates fixed 12 months adjustable rate debt outstanding december 31 2010 outstanding balance line credit united states bears interest floating prime bank lending rate plus 100 basis points subject minimum total rate 5 prime rate december 31 2010 325 cost funds united states increase prime rate rises 75 basis points outstanding balance 18 million loan balance united states december 31 2010 annual interest expense would increase 1800 basis point thereafter foreign currency exchange rate risk year ended december 31 2010 substantial portion recognized revenue denominated us dollars generated primarily customers americas 54 revenue generated european operations 18 primarily euros revenue generated asia operations 28 primarily rmb manufacture majority component parts manufacturing facility shanghai china since january 2010 operations china affected currency fluctuations due approximate 34 appreciation rmb relative us dollar strategy continue increase overseas manufacturing research development activities capitalize lower cost capacity efficiencies supplychain management 2004 2006 made strategic investment acquisition 96 interest rae beijing beijingbased manufacturer distributor environmental safety security equipment continued speculation financial press china’s currency rmb subject market adjustment relative us dollar currencies example hypothetical 10 change rmb relative us dollar effect income continuing operations would approximately 07 million fiscal 2010 currencies countries europe asia operations change unison rmb hypothetical 10 relative us dollar effect loss would approximately 03 million fiscal 2010 difference 04 million attributable impact foreign currencies outside china extent international sales denominated us dollars fluctuation value us dollar relative foreign currencies could affect competitive position international markets although continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot certain exchange rate fluctuations adversely affect financial results future item 8item 7a quantitative qualitative disclosures market risk concentration credit risk currently cash equivalents deposited major financial institutions countries conduct business deposits may exceed amount insurance available cover deposits date experienced losses deposits cash equivalents management regularly reviews deposit amounts credit worthiness financial institution hold deposits interest rate risk december 31 2007 cash equivalents 159 million changes interest rates time may reduce increase interest income shortterm investments impact cash equivalents expected insignificant foreign currency exchange rate risk year ended december 31 2007 substantial portion recognized revenue denominated us dollars generated primarily customers americas 41 revenue generated european operations 13 primarily euros revenue generated asia operations 46 primarily renminbi “rmb” manufacture majority component parts manufacturing facility shanghai china since january 2007 operations china affected currency fluctuations due approximate 68 appreciation rmb relative us dollar strategy continue increase overseas manufacturing research development activities capitalize lower cost capacity efficiencies supplychain management 2004 2006 made strategic investment china acquisition 96 interest rae bejing beijingbased manufacturer distributor environmental safety security equipment formation rae fushun late 2006 capitalize increase demand safety equipment mining energy sectors china continued speculation financial press china’s currency rmb subject market adjustment relative us dollar currencies example hypothetical 10 change rmb relative us dollar effect profits would approximately 06 million fiscal 2007 currencies countries europe asia operations change unison rmb hypothetical 10 us dollar approximate effect profits would approximately 03 million fiscal 2007 reduction impact rmb due offset changes reported net sales units resulting changes countries local currencies furthermore extent engage international sales denominated us dollars countries china fluctuation value us dollar relative foreign currencies could affect competitive position international markets although would continue monitor exposure currency fluctuations appropriate may use financial hedging techniques future minimize effect fluctuations cannot certain exchange rate fluctuations adversely affect financial results future item 8 item 8 financial statements supplementary data financial statements schedules supplementary data listed item 14 appear separate section report beginning page item 9item 8 financial statements supplementary data financial statements schedules supplementary data listed item 14 appear separate section report beginning page item 9item 8 financial statements supplementary data financial statements schedules supplementary data listed item 14 appear separate section report beginning page item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9item 8 financial statements supplementary data consolidated financial statements included report beginning page incorporated herein reference item 9 nannannanitem 15 exhibits financial statement schedule reports form 8k 1 financial statements see contents containing index consolidated financial statements page fi form 10k 2 financial statement schedules provided absence conditions required information given financial statements notes thereto 3 exhibits exhibit number description document 21 merger agreement plan reorganization rae systems inc raes acquisition corporation nettaxicom dated january 9 2002 1 31 certificate incorporation registrant 2 32 bylaws registrant 2 41 specimen certificate representing common stock registrant 2 42 registration rights agreement rgc international investors ldc nettaxicom dated april 28 2000 3 101 form indemnity agreement registrant’s directors officers 2 102 rae systems inc 2002 stock option plan 2 103 rae systems inc 1993 stock plan 2 104 nettaxicom 1999 stock option plan 4 105 nettaxicom 1998 stock option plan 5 106 restricted stock purchase agreement registrant joseph ng dated december 6 2001 2 107 restricted stock purchase agreement registrant neil flanzraich dr phillip frost dated december 5 2001 2 108 lease agreement aetna life insurance company registrant dated june 1 1999 2 109 first amendment lease moffett office park investors llc registrant dated effective november 1 2002 amending lease agreement aetna life insurance company registrant dated june 1 1999 1010 manufacturing building lease agreement shanghai china academic science high tech industrial park development co ltd rae systems asia ltd incorporated hong kong dated september 15 2001 2 1011 lease agreement shanghai institute metallurgy research chinese academy sciences warae instrument shanghai incorporated jiading shanghai dated january 8 1999 2 1012 separation agreement nettaxicom nettaxi online communities inc mr dean rositano dated april 9 2002 6 1013 separation agreement nettaxicom nettaxi online communities inc mr robert rositano dated april 9 2002 6 1014 warrant agreement nettaxicom mr michael gardner dated april 9 2002 7 211 subsidiaries registrant 231 consent bdo seidman llp 241 power attorney included signature page 991 certification pursuant 18 usc section 1350 adopted pursuant section 906 sarbanesoxley act 992 certification pursuant 18 usc section 1350 adopted pursuant section 906 sarbanesoxley act 1 previously filed january 10 2002 exhibit nettaxicom’s current report form 8k incorporated herein reference 2 previously filed exhibit registrant’s quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 3 previously filed june 2 2000 exhibit nettaxicom’s registration statement form s1 incorporated herein reference 4 previously filed march 17 2000 exhibit nettaxicom’s registration statement form s8 incorporated herein reference 5 previously filed may 10 1999 exhibit nettaxicom’s registration statement form s1 incorporated herein reference 6 previously filed may 31 2002 exhibit registrant’s registration statement form s1 incorporated herein reference 7 previously filed april 8 2002 exhibit nettaxicom’s registration statement form s8 incorporated herein reference b reports form 8k none signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized february 27 2003 rae systems inc robert chen robert chen chief executive officer know persons presents person whose signature appears constitutes appoints robert chen joseph ng person’s true lawful attorneysinfact agents full power substitution resubstitution person’s name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated signature title date robert chen robert chen president chief executive officer chairman board principal executive officer february 27 2002 joseph ng joseph ng vice president business development chief financial officer principal financial accounting officer february 27 2002 peter h hsi peter h hsi vice president chief technology officer director february 27 2002 lyle feisel lyle feisel director february 27 2002 neil w flanzraich neil w flanzraich director february 27 2002 edward c ross edward c ross director february 27 2002 bo andersson bo andersson director february 27 2002 certifications robert chen certify 1 reviewed annual report form 10k rae systems inc 2 based knowledge annual report contain untrue statement material fact omit state material fact necessary make statements made light circumstances statements made misleading respect period covered annual report 3 based knowledge financial statements financial information included annual report fairly present material respects financial condition results operations cash flows registrant periods presented annual report 4 registrant’s certifying officers responsible establishing maintaining disclosure controls procedures defined exchange act rules 13a14 15d14 registrant designed disclosure controls procedures ensure material information relating registrant including consolidated subsidiaries made known us others within entities particularly period annual report prepared b evaluated effectiveness registrant’s disclosure controls procedures date within 90 days prior filing date annual report “evaluation date” c presented annual report conclusions effectiveness disclosure controls procedures based evaluation date 5 registrant’s certifying officers disclosed based recent evaluation registrant’s auditors audit committee registrant’s board directors persons performing equivalent functions significant deficiencies design operation internal controls could adversely affect registrant’s ability record process summarize report financial data identified registrant’s auditors material weaknesses internal controls b fraud whether material involves management employees significant role registrant’s internal controls 6 registrant’s certifying officers indicated annual report whether significant changes internal controls factors could significantly affect internal controls subsequent date recent evaluation including corrective actions regard significant deficiencies material weaknesses robert chen name robert chen title president chief executive officer chairman board february 27 2003 joseph ng certify 1 reviewed annual report form 10k rae systems inc 2 based knowledge annual report contain untrue statement material fact omit state material fact necessary make statements made light circumstances statements made misleading respect period covered annual report 3 based knowledge financial statements financial information included annual report fairly present material respects financial condition results operations cash flows registrant periods presented annual report 4 registrant’s certifying officers responsible establishing maintaining disclosure controls procedures defined exchange act rules 13a14 15d14 registrant designed disclosure controls procedures ensure material information relating registrant including consolidated subsidiaries made known us others within entities particularly period annual report prepared b evaluated effectiveness registrant’s disclosure controls procedures date within 90 days prior filing date annual report “evaluation date” c presented annual report conclusions effectiveness disclosure controls procedures based evaluation date 5 registrant’s certifying officers disclosed based recent evaluation registrant’s auditors audit committee registrant’s board directors persons performing equivalent functions significant deficiencies design operation internal controls could adversely affect registrant’s ability record process summarize report financial data identified registrant’s auditors material weaknesses internal controls b fraud whether material involves management employees significant role registrant’s internal controls 6 registrant’s certifying officers indicated annual report whether significant changes internal controls factors could significantly affect internal controls subsequent date recent evaluation including corrective actions regard significant deficiencies material weaknesses joseph ng name joseph ng title chief financial officer vicepresident business development february 27 2003 board directors shareholders rae systems inc subsidiaries audited accompanying consolidated balance sheets rae systems inc subsidiaries company december 31 2002 2001 related consolidated statements operations shareholders’ equity cash flows three years period ended december 31 2002 financial statements responsibility company’s management responsibility express opinion financial statements based audits conducted audits accordance auditing standards generally accepted united states america standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements referred present fairly material respects financial position rae systems inc subsidiaries december 31 2002 2001 results operations cash flows three years period ended december 31 2002 conformity accounting principles generally accepted united states america bdo seidman llp san jose california january 28 2003 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders’ equity note 10 see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements 1 summary significant accounting policies company rae systems inc “rae” “the company” smart sensing network platform solution provider leading manufacturer single multiple sensor atmospheric monitors photoionization detectors gas detection tubes sampling pumps wirelessly connected gas detection security monitoring devices rae’s products designed enable customers monitor gas volatile organic compounds confined spaces establish perimeter security around hazardous material sites weapons mass destruction rae’s customers operate industries safety security oil gas pharmaceuticals utilities food chemical airlines military hazardous material storage disposal monitors used civilian government atmospheric monitoring programs 50 countries rae’s headquarters located sunnyvale california rae manufacturing sites jiading shanghai manufactures approximately 50 components products sales office hong kong china sales service center skanderborg denmark business combination april 9 2002 merger rae systems inc california corporation “raecalifornia” nettaxicom delaware corporation “nettaxi” consummated nettaxi surviving entity merger registrant changed name rae systems inc stockholders raecalifornia received approximately 80 common stock rae systems inc effective time merger raecalifornia management team continued existing roles rae systems inc accordingly merger transaction accounted reverse merger whereby accounting purposes rae deemed acquirer nettaxi deemed acquired entity nettaxi effectively ceased revenue generating activities nine months prior merger planned abandon business model effect consummation merger nettaxi deemed substance shell company accordingly merger treated recapitalization rae goodwill reason pro forma information giving effect merger presented refer note 10 rae systems inc notes consolidated financial statements principles consolidation accompanying consolidated financial statements include accounts rae systems inc subsidiaries described rae owns 100 rae systems europe aps “rae europe” rae systems asia limited “rae asia” rae europe denmark corporation distributes provides services rae’s products europe australia new zealand throughout middle east rae asia hong kong corporation distributes provides services rae’s products asia pacific rim rae asia owns 100 warae science instruments ltd “warae” ii 36 renex technology ltd “renex” warae incorporated jiading shanghai designs manufactures rae’s products final assembly united states renex hong kong based research development corporation designs develops wireless platform detection monitoring july 2002 renex completed 3 million private placement capital stock based terms conditions contract rae asia’s equity interest renex decreased 47 36 prior july 2002 rae exercised managerial control daytoday operations renex controlled approximately 90 voting shares renex accordingly prior 2002 renex consolidated company’s financial statements rae longer holds majority interest voting shares financial statements herein reflect change accounting renex consolidated method equity method change made effect january 1 2002 intercompany accounts transactions eliminated consolidated financial statements certain amounts reported previous years reclassified conform current year presentation use estimates preparation financial statements conformity accounting principles generally accepted united states requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue rae systems inc notes consolidated financial statements expenses reporting period actual results could differ materially estimates revenue recognition company recognizes sales upon shipment product provided significant obligations remain collectibility probable provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns service revenues relating maintenance services performed company represent less 5 net revenues 2002 2001 2000 recognized earned based upon contract terms generally ratably term service net revenues includes amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue 0010 accounting shipping handling fees costs shipping fees represent approximately 1 net revenues 2002 2001 2000 december 1999 staff securities exchange commission sec issued staff accounting bulletin sab 101 revenue recognition sab 101 provides staff’s views applying generally accepted accounting principles selected revenue recognition issues company believes current revenue recognition policies comply provisions sab 101 cash equivalents company considers highly liquid investments original maturities 90 days less cash equivalents accounts receivable allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses management uses rae systems inc notes consolidated financial statements best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control inventories stated lower cost moving weighted average method market property equipment property equipment stated cost net accumulated depreciation provided using straightline method related estimated useful lives follows equipment 5 7 years furniture fixtures 5 7 years computers equipment 5 years automobiles 5 years building improvements lesser 5 years remaining lease term warranty repairs company generally provides one three year limited warranty products establishes provision estimated costs fulfilling warranty obligations time related revenue recorded historically warranty costs insignificant research development research development costs incurred company expensed incurred advertising costs company expenses costs advertising incurred years ended december 31 2002 2001 2000 advertising expense 321700 235000 271600 respectively rae systems inc notes consolidated financial statements income taxes company reports income taxes accordance sfas 109 accounting income taxes requires asset liability approach results recognition deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent future tax return consequences differences either deductible taxable assets liabilities recovered settled future tax benefits pertaining unrealized foreign losses fully offset 100 valuation allowance management unable determine likely deferred tax asset realized longlived assets company periodically reviews longlived assets impairment events changes circumstances indicate carrying amount asset may recoverable company writes asset estimated fair value fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments • cash equivalents accounts receivable accounts payable carrying amount reported balance sheet items approximates fair value short maturity instruments • line credits company’s borrowings lines credit made floating rates based primelending rate carrying value borrowings approximates fair value april 2002 company used proceeds received merger nettaxi pay cancel outstanding lines credit december 31 2002 company available lines credit rae systems inc notes consolidated financial statements december 31 2002 2001 fair values company’s financial instruments approximate historical carrying amounts translation foreign currencies balance sheets income statements company’s foreign subsidiaries translated current exchange rates effect end fiscal period translation gains losses immaterial consolidated financial statements foreign currency transaction gains losses included consolidated net income stockbased incentive programs statement financial accounting standards sfas 123 accounting stockbased compensation encourages entities recognize compensation costs stockbased employee compensation plans using fair value based method accounting defined sfas 123 allows continued use intrinsic value based method accounting prescribed accounting principles board apb opinion 25 accounting stock issued employees company continues use accounting prescribed apb opinion 25 required disclose pro forma net income earnings per share fair value based method accounting applied march 2000 financial accounting standards board fasb issued interpretation 44 accounting certain transactions involving stock compensation interpretation apb opinion 25 became effective july 1 2000 interpretation 44 clarifies definition employee purposes applying opinion 25 b criteria determining whether stock compensation plan qualifies noncompensatory plan c accounting consequences various modifications terms previously fixed stock option award accounting exchange stock compensation awards business combination adoption provisions interpretation significant impact company’s consolidated financial statements connection becoming public company reverse merger transaction certain options granted company’s 1993 stock option plan subject variable accounting accordance rae systems inc notes consolidated financial statements interpretation 44 december 31 2002 2014941 options outstanding 1993 stock option plan company could subject variable accounting next nine years life options earnings per share company applies provisions sfas 128 earnings per share sfas 128 provides calculation basic diluted earnings per share basic earnings per share includes dilution computed dividing income available common shareholders weighted average number common shares outstanding period diluted earnings per share reflect potential dilution securities could share earnings entity antidilution provisions sfas 128 require consistency diluted percommonshare amounts basic percommon share amounts loss periods company recognized net income fiscal 2002 incremental shares attributable assumed exercise 3453441 outstanding options would increased diluted shares outstanding 543660 shares warrants purchase 2102734 shares common stock prices 119 per share 134 per share nonplan options purchase 400000 shares common stock 098 per share included computation diluted eps exercise prices greater average market price common stock recent accounting pronouncements april 2002 fasb issued statement financial accounting standards 145 rescission fasb statements 4 44 64 amendment fasb statement 13 technical corrections sfas 145 statement amends existing authoritative pronouncements make various technical corrections clarify meanings describe applicability changed conditions provisions sfas 145 company adopted 2002 material impact company’s financial position results operations june 2002 fasb issued statement financial accounting standards 146 accounting costs associated exit disposal activities addresses financial accounting reporting costs associated exit disposal activities sfas 146 statement rae systems inc notes consolidated financial statements requires liability costs associated exit disposal activity recognized liability incurred sfas 146 also establishes fair value objective initial measurement liability provisions statement effective exit disposal activities initiated december 31 2002 management expect adoption statement material impact company’s financial position results operations december 2002 fasb issued statement financial accounting standards 148 accounting stockbased compensation transition disclosure amendment fasb statement 123 sfas 148 statement provides alternative methods transition entity voluntarily changes fair value based method accounting stock based compensation also amends disclosure provisions sfas 123 require prominent disclosure effects reported net income entity’s accounting policy decisions respect stockbased employee compensation sfas 148 amends accounting principles board opinion 28 interim financial reporting require disclosure effects interim financial information sfas 148 effective financial statements beginning january 1 2003 company currently evaluating effects adoption sfas 148 company’s financial statements company determined whether voluntarily change fair value based method accounting stockbased compensation november 2002 fasb issued fasb interpretation 45 guarantor’s accounting disclosure requirements guarantees including indirect guarantees indebtedness others fin 45 fin 45 requires guarantor recognize inception qualified guarantee liability fair value obligation undertaken issuing guarantee fin 45 effective prospective basis qualified guarantees issued modified december 31 2002 management expect adoption interpretation material impact company’s financial position results operations january 2003 fasb issued fasb interpretation 46 consolidation variable interest entities fin 46 fin 46 explains identify variable interest entities enterprise assesses interests variable interest entity decide whether consolidate rae systems inc notes consolidated financial statements entity interpretation requires existing unconsolidated variable interest entities consolidated primary beneficiaries entities effectively disperse risks among parties involved fin 46 effective immediately variable interest entities created january 31 2003 variable interest entities enterprise obtains interest date management expect adoption interpretation material impact company’s financial position results operations 2 inventories consist following 3 property equipment summary property equipment follows december 31 2002 2001 cost company’s equipment capital leases consist principally computer equipment totaled 622800 281900 accumulated amortization 300100 121000 december 31 2002 2001 respectively rae systems inc notes consolidated financial statements 4 accrued expenses accrued expenses december 31 2002 2001 summarized follows 5 note payable lines credit december 31 2002 company notes payable outstanding amounts owed lines credit notes payable amounts due lines credit summarized follows december 31 2001 company line credit arrangement hsbc bank usa borrow 3000000 interest rate 05 prime rate 425 december 31 2001 expired october 2002 rae asia placed 3000000 restricted cash account collateralized letter credit december 31 2001 2000000 outstanding line credit order satisfy restricted cash requirement rae asia entered oneyear loan agreement due july 2002 ascendant incorporated borrow 1000000 interest rate 95 rae systems inc notes consolidated financial statements december 31 2001 company also line credit arrangement general bank borrow 2000000 interest rate prime rate plus 025 5 december 31 2001 line credit expired april 2002 collateralized substantially business assets december 31 2001 1425800 outstanding line credit april 2002 proceeds received merger nettaxi company paid cancelled outstanding line credit facilities whereby restriction cash released accordingly december 31 2002 company available lines credits 6 income taxes income loss income taxes minority interest comprises income tax expense benefit comprises rae systems inc notes consolidated financial statements following summarizes differences income tax expense amount computed applying federal income tax rate 2002 2001 2000 income taxes deferred tax assets liabilities december 31 2002 2001 comprised following us income taxes provided deferred taxes undistributed earnings nonus subsidiaries expected permanently rae systems inc notes consolidated financial statements reinvested companies provision us income taxes remaining undistributed earnings approximately 660000 december 31 2002 company intends reinvest earnings indefinitely operations outside united states earnings distributed additional us taxes approximately 224000 would accrue utilization us tax credits foreign withholding taxes incurred result remittance previously undistributed earnings would creditable us tax liabilities december 31 2002 company research credit carryforwards approximately 153000 255000 federal california income tax purposes respectively california credits subject expiration current california tax law 7 operating capital leases company subsidiaries lease certain manufacturing warehousing facilities operating leases expiring various years 2009 leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2002 2001 2000 656900 660700 631700 respectively company also leases certain computer equipment capital leases expiring various years 2004 december 31 2002 future minimum rental payments required operating capital leases follows rae systems inc notes consolidated financial statements 8 employee benefit plans company defined contribution 401k plan domestic employees plan available employees reached age twentyone completed three months service company plan eligible employees may defer portion salaries contributions plan company’s contributions determined based 25 first 6 covered employee’s salary subject statutory maximum levels contributions plan totaled 60100 47700 31400 years ended december 31 2002 2001 2000 respectively 9 concentrations financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade receivables company places domestic foreign cash equivalents high quality financial institutions domestic cash balances insured federal deposit insurance company 100000 per bank december 31 2002 2001 company deposits several domestic financial institutions excess insured limits 5189000 978100 respectively also company deposits several foreign financial institutions insured aggregated 1715000 5177500 december 31 2002 2001 respectively rae systems inc notes consolidated financial statements significant portion company’s revenues accounts receivable derived sales made unrelated distributors located primarily throughout north america well europe asia following table presents certain data geographic area year ended december 31 2000 company sales one customer comprised 21 consolidated sales individual customer comprised 10 consolidated net sales 2002 2001 company believes risk accounting loss significantly reduced due diversity customers geographic sales areas company extending credit based established limits terms company performs credit evaluations customers’ financial condition whenever necessary generally require cash collateral 10 shareholders’ equity common stock april 9 2002 merger raecalifornia nettaxi consummated see note 1 nettaxi surviving entity merger registrant changed name rae systems inc pursuant merger outstanding share raecalifornia common stock exchanged 154869 shares rae systems inc common stock outstanding option warrant purchase shares raecalifornia common stock exchanged 154869 options warrants purchase shares rae systems inc common stock share per share data prior merger restated reflect stock split rae systems inc notes consolidated financial statements connection merger company received 6965500 cash nettaxi exchange issuance 7896764 shares company’s common stock proceeds reduced 762000 reflect cash expenses incurred directly attributable merger discussed fully company also incurred total 8735700 merger costs attributable fair value certain equity instruments issued connection merger 8735700 included operating expenses accompanying consolidated statements operations year ended december 31 2002 shares company’s preferred stock outstanding time merger automatically converted common stock rate four shares common stock share preferred stock connection closing merger company recorded 2121600 noncash compensation charge 960000 shares common stock issued financial adviser services rendered common stock purchase rights december 2001 company issued 1084083 nonplan stock purchase rights vested exercisable immediately officer director consultant exercise price approximately 008 per share terms stock purchase agreement individuals shares placed escrow earned upon consummation merger nettaxicom april 9 2002 effective date merger fair value company’s stock 221 based fair value respective equity instruments april 9 2002 company recorded noncash compensation charge 2308300 relating stock purchase rights warrants april 2002 connection closing merger company issued warrants vested immediately follows warrants purchase 1750000 shares common stock 119 per share exercisable three years company option redeem warrants redemption price 005 per share company’s common stock trades price equal greater 600 per share 20 consecutive days rae systems inc notes consolidated financial statements warrants purchase 352734 shares common stock 134 per share exercisable ten years company recognized total 4305800 noncash compensation warrants issued b based estimated fair value warrants date grant company estimates fair value warrants grant date using blackscholes valuation model following weightedaverage assumptions used grants 2002 dividend yield 0 expected volatility 174 riskfree interest rate 562 contractual lives warrant nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares nonplan restricted stock weightedaverage exercise price 0985 options vest 25 one year remainder vesting monthly following three years exercisable ten years december 31 2002 none nonplan options outstanding exercisable stock option plan august 1993 company’s board directors adopted 1993 stock option plan may 2002 board directors adopted 2002 stock option plan collectively “the plans” subject ratification shareholders plans authorizes grant options purchase shares common stock employees directors consultants company affiliates options combination incentive nonstatutory options incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting monthly following three years exercisable ten years rae systems inc notes consolidated financial statements company reserved 2014941 shares common stock issuance 1993 stock option plan 5000000 shares common stock issuance 2002 stock option plan december 31 2002 company 3561500 shares common stock available future grant 2002 stock option plan summary status company’s stock option plan december 31 2002 2001 2000 changes years ended presented following table rae systems inc notes consolidated financial statements following table summarizes information stock options outstanding december 31 2002 company accounts stockbased awards using intrinsic value method accordance apb 25 accordingly compensation cost recognized stock options accompanying financial statements date grant current market value underlying common stock exceeded exercise price stock options date grant connection merger nettaxi completed april 2002 certain options granted company’s 1993 stock option plan subject variable accounting year ended december 31 2002 company recognized noncash compensation amount 374700 relating option subject variable accounting years ended december 31 2002 2001 2000 deferred compensation approximately 0 765700 160900 respectively recorded options granted exercise price estimated fair market value underlying common stock approximately 217600 200100 62100 amortized compensation expense 2002 2001 2000 respectively remaining deferred compensation amortized balance fouryear vesting period stock options sfas 123 accounting stockbased compensation requires company provide pro forma information regarding net income earnings per share compensation cost company’s stock option plan determined accordance fair value based method prescribed sfas 123 company estimates fair value stock options grant date using blackscholes option rae systems inc notes consolidated financial statements valuation model following weighted average assumptions used grants 2002 2001 2000 dividend yield 0 expected volatility 63 01 riskfree interest rates 501 502 57 expected lives five years plan options accounting provisions sfas 123 company’s net loss income basic diluted net loss income per common share would adjusted pro forma amounts 11 commitments contingencies royalty 1998 dragerwerk aktiengesellschaft “dragerwerk” german corporation filed patent infringement lawsuit company november 2000 part settlement dispute company entered nonexclusive nonsublicensable right license agreement dragerwerk use us patent 5654498 issued august 5 1997 entitled “device selective detection component gas mixture” part settlement agreement company required pay 73200 back royalties relating net sales certain company’s products period january 1 1998 december 31 2000 additionally commencing january 1 2001 continuing december 31 2009 company required pay rae systems inc notes consolidated financial statements dragerwerk royalty equal 75 net sales certain licensed products manufactured imported sale company united states years ended december 31 2002 2001 2000 company incurred royalty expense 50800 47900 73200 respectively litigation october 2001 estate virgil johnson filed products liability wrongful death lawsuit company district court harris county texas plaintiffs allege company’s product defective unsafe intended purposes time left company’s premises product defective failed conform product design specifications gas monitors additionally plaintiffs allege product defectively designed marketed render unreasonably dangerous plaintiff event company adequate insurance coverage expenses related lawsuit company may incur substantial legal fees expenses connection litigation may also result diversion company’s internal resources company’s defense litigation regardless eventual outcome likely costly time consuming litigation preliminary stage management unable predict final outcome however adverse outcome could materially affect company’s results operations financial position march 2002 straughan technical distribution llc filed lawsuit company superior court state california county santa clara similar lawsuit also served company pending district court harris county texas nearly identical lawsuits straughan distributor gastec gas detection devices claims experienced diminished sales customers loss profits damages result stated allegations include claims interference present prospective business relations false advertising trade dress infringement slander antitrust violations april 2002 company removed california action united states district court northern district california removed texas action united states district court southern district texas october 2002 principals straughan rae systems met discussed potential settlement rae systems inc notes consolidated financial statements opportunities adverse outcome could materially affect company’s results operations financial position company engaged various ongoing legal proceedings incidental normal business activities company unable however predict outcome matters reasonably estimate range possible losses given current status litigation employment agreements company entered employment agreements two key executives employment agreements provide minimum combined aggregate annual base compensation 330000 options purchase 100000 shares company stock vesting four years employment agreements “at will” terminated without cause without notice time either employee company 12 related party transactions 2001 company recognized 11400 sales revenue company whollyowned officer shareholder company included accounts receivable december 31 2001 3000 due related customer rae systems inc notes consolidated financial statements summarized financial data renex company’s 36 owned subsidiary accounted equity method effect january 1 2002 year ended december 31 2002 follows rae systems inc notes consolidated financial statements 13 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presented rae systems inc notes consolidated financial statements 14 supplemental disclosures following supplemental disclosure valuation qualifying accountsitem 15 exhibits financial statement schedule reports form 8k a1 financial statements see index consolidated financial statements page fi form 10k 2financial statement schedules provided absence conditions required information given financial statements notes thereto 3exhibits see index exhibits pages 32 33 hereof breports form 8k company filed current report form 8k october 27 2003 reported financial results third fiscal quarter ended september 30 2003 signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized march 23 2004 know persons presents person whose signature appears constitutes appoints robert chen joseph ng persons true lawful attorneysinfact agents full power substitution resubstitution person persons name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated signature title date robert chen robert chen president chief executive officer chairman board principal executive officer march 23 2004 joseph ng joseph ng vice president business development chief financial officer principal financial accounting officer march 23 2004 peter h hsi peter h hsi vice president chief technology officer director march 23 2004 lyle feisel lyle feisel director march 23 2004 neil w flanzraich neil w flanzraich director march 23 2004 edward c ross edward c ross director march 23 2004 sigrun hjelmquist sigrun hjelmquist director march 23 2004 index exhibits exhibit number description document 21 merger agreement plan reorganization rae systems inc raes acquisition corporation nettaxicom dated january 9 20021 31 certificate incorporation registrant2 32 bylaws registrant2 41 specimen certificate representing common stock registrant2 42 registration rights agreement rgc international investors ldc nettaxicom dated april 28 20003 101 form indemnity agreement registrant registrants directors officers2 102 rae systems inc 2002 stock option plan2 103 rae systems inc 1993 stock plan2 104 restricted stock purchase agreement registrant joseph ng dated december 6 20012 105 restricted stock purchase agreement registrant neil flanzraich dr phillip frost dated december 5 20012 106 lease agreement aetna life insurance company registrant dated june 1 19992 107 first amendment lease moffett office park investors llc registrant dated effective november 1 2002 amending lease agreement aetna life insurance company registrant dated june 1 19996 108 manufacturing building lease agreement shanghai china academic science high tech industrial park development co ltd rae systems asia ltd incorporated hong kong dated september 15 20012 109 lease agreement shanghai institute metallurgy research chinese academy sciences warae instrument shanghai incorporated jiading shanghai dated january 8 19992 1010 separation agreement nettaxicom nettaxi online communities inc mr dean rositano dated april 9 20024 1011 separation agreement nettaxicom nettaxi online communities inc mr robert rositano dated april 9 20024 1012 warrant agreement nettaxicom mr michael gardner dated april 9 20025 211 subsidiaries registrant6 231 consent bdo seidman llp 241 power attorney included signature page 311 certifications 312 certifications 321 certification pursuant 18 usc section 1350 adopted pursuant section 906 sarbanesoxley act 2002 322 certification pursuant 18 usc section 1350 adopted pursuant section 906 sarbanesoxley act 2002 1previously filed january 10 2002 exhibit nettaxicoms current report form 8k incorporated herein reference 2previously filed exhibit registrants quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 3previously filed june 2 2000 exhibit nettaxicoms registration statement form s1 incorporated herein reference 4previously filed may 31 2002 exhibit registrants registration statement form s1 incorporated herein reference 5previously filed april 8 2002 exhibit nettaxicoms registration statement form s8 incorporated herein reference 6previously filed february 28 2003 exhibit registrants annual report form 10k year ended december 31 2002 incorporated herein reference contents report independent certified public accountants board directors shareholders rae systems inc subsidiaries audited accompanying consolidated balance sheets rae systems inc subsidiaries company december 31 2003 2002 related consolidated statements operations shareholders equity cash flows three years period ended december 31 2003 financial statements responsibility companys management responsibility express opinion financial statements based audits conducted audits accordance auditing standards generally accepted united states america standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements referred present fairly material respects financial position rae systems inc subsidiaries december 31 2003 2002 results operations cash flows three years period ended december 31 2003 conformity accounting principles generally accepted united states america discussed note 1q consolidated financial statements effective january 1 2003 company adopted fair value method accounting stockbased compensation bdo seidman llp san jose california january 23 2004 except note 15 date january 28 2004 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders equity notes 10 15 see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements 1 summary significant accounting policies company rae systems inc leading global developer manufacturer rapidly deployable multisensor chemical detection monitors networks homeland security industrial applications addition rae line portable singlesensor chemical radiation detection products raes technologically advanced products based proprietary technology including portable wireless fixed atmospheric monitors photoionization detectors gamma neutron detectors raes products enable military first responders firefighters law enforcement emergency management personnel detect provide early warning weapons mass destruction hazardous materials industrial applications include detection toxic industrial chemicals volatile organic compounds petrochemicals rae founded 1991 develop technologies detection early warning hazardous materials company broad patent portfolio consisting 18 issued pending patents basis many products example raes patented photoionization detector technology allows products rapidly reliably identify many toxic chemicals vapors partperbillion range readings 1994 rae expanded operations shanghai china giving company access high quality cost efficient manufacturing world class research capabilities raes products used many us government agencies including department homeland security department justice department state well branches us military numerous city state agencies raes end users also include many worlds leading corporations airline automotive computer oil industries companys products used civilian government atmospheric monitoring programs 50 countries certain federal agencies departments standardized programs raes products hazardous materials incident response b merger transaction april 9 2002 merger rae systems inc california corporation raecalifornia nettaxicom delaware corporation nettaxi consummated nettaxi surviving entity merger registrant changed name rae systems inc stockholders raecalifornia received approximately 80 common stock rae systems inc effective time merger raecalifornia management team continued existing roles rae systems inc accordingly merger transaction accounted reverse merger whereby accounting purposes rae deemed acquirer nettaxi deemed acquired entity nettaxi effectively ceased revenue generating activities nine months prior merger planned abandon business model effect consummation merger nettaxi deemed substance shell company accordingly merger treated recapitalization rae goodwill reason pro forma information giving effect merger presented refer note 10 c principles consolidation accompanying consolidated financial statements include accounts rae systems inc subsidiaries described rae owns 100 rae systems europe aps rae europe rae systems asia limited rae asia rae europe denmark corporation distributes provides services raes products europe australia new zealand throughout middle east rae asia hong kong holding company rae asia owns 100 rae systems shanghai incorporated rae shanghai formerly known warae science instruments ltd ii 100 rae systems hong kong limited rae hong kong iii 36 renex technology ltd renex rae shanghai incorporated jiading shanghai designs manufactures raes products final assembly united states rae hong kong distributes provides services raes products asia pacific rim renex hong kong based research development corporation designs develops wireless platform detection monitoring july 2002 renex completed 3 million private placement capital stock based terms conditions contract rae asias equity interest renex decreased 47 36 prior july 2002 rae exercised managerial control daytoday operations renex controlled approximately 90 voting shares renex accordingly prior 2002 renex consolidated companys financial statements rae longer holds majority interest voting shares financial statements herein reflect change accounting renex consolidated method equity method change made effect january 1 2002 intercompany accounts transactions eliminated consolidated financial statements certain amounts reported previous years reclassified conform current year presentation use estimates preparation financial statements conformity accounting principles generally accepted united states requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period actual results could differ materially estimates e revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns service revenues relating maintenance services performed company represent less 5 net revenues 2003 2002 2001 recognized earned based upon contract terms generally ratably term service net revenues includes amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue 0010 accounting shipping handling fees costs shipping fees represent approximately 1 net revenues 2003 2002 2001 december 1999 staff securities exchange commission sec issued staff accounting bulletin sab 101 revenue recognition sab 101 provides staffs views applying generally accepted accounting principles selected revenue recognition issues company believes current revenue recognition policies comply provisions sab 101 f cash equivalents company considers highly liquid investments original maturities 90 days less cash equivalents g accounts receivable allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond managements control h inventories stated lower cost moving weighted average method market property equipment property equipment stated cost net accumulated depreciation provided using straightline method related estimated useful lives follows j warranty repairs company generally provides one three year limited warranty products establishes provision estimated costs fulfilling warranty obligations time related revenue recorded historically warranty costs insignificant see note 14 k research development research development costs incurred company expensed incurred l advertising costs company expenses costs advertising incurred years ended december 31 2003 2002 2001 advertising expense 1062000 322000 235000 respectively income taxes company reports income taxes accordance sfas 109 accounting income taxes requires asset liability approach results recognition deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent future tax return consequences differences either deductible taxable assets liabilities recovered settled valuation allowance provided deferred tax assets extent management unable conclude likely deferred tax assets realized n longlived assets company periodically reviews longlived assets impairment events changes circumstances indicate carrying amount asset may recoverable company writes asset estimated fair value fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments •cash equivalents accounts receivable accounts payable carrying amount reported balance sheet items approximates fair value short maturity instruments •line credits companys borrowings lines credit made floating rates based primelending rate carrying value borrowings approximates fair value april 2002 company used proceeds received merger nettaxi pay cancel outstanding lines credit may 2003 company secured 3000000 line credit floating rates based primelending rate company made borrowings december 31 2003 2002 fair values companys financial instruments approximate historical carrying amounts p translation foreign currencies balance sheets income statements companys foreign subsidiaries translated current exchange rates effect end fiscal period translation gains losses immaterial consolidated financial statements foreign currency transaction gains losses included consolidated net income q stockbased incentive programs statement financial accounting standards sfas 123 accounting stockbased compensation encourages entities recognize compensation costs stockbased employee compensation plans using fair value based method accounting defined sfas 123 allows continued use intrinsic value based method accounting prescribed accounting principles board apb opinion 25 accounting stock issued employees prior january 1 2003 company used accounting prescribed apb opinion 25 provided footnote disclosure pro forma net income earnings per share fair value based method accounting applied march 2000 financial accounting standards board fasb issued interpretation 44 accounting certain transactions involving stock compensation interpretation apb opinion 25 became effective july 1 2000 interpretation 44 clarifies definition employee purposes applying opinion 25 b criteria determining whether stock compensation plan qualifies noncompensatory plan c accounting consequences various modifications terms previously fixed stock option award accounting exchange stock compensation awards business combination adoption provisions interpretation significant impact companys consolidated financial statements connection becoming public company reverse merger transaction certain options granted companys 1993 stock option plan became subject variable accounting accordance interpretation 44 december 31 2002 2014941 options outstanding 1993 stock option plan december 2002 fasb issued statements financial accounting standards 148 accounting stockbased compensation transition disclosure amendment fasb statement 123 sfas 148 statement provides alternative methods transition entity voluntary changes fair value based method accounting stock based compensation also amends disclosure provisions sfas 123 require prominent disclosure effects reported net income entitys accounting policy decisions respect stockbased employee compensation sfas 148 amends accounting principles board opinion 28 interim financial reporting require disclosure effects interim financial information effective january 1 2003 company elected adopt fair value recognition provisions sfas 123 stockbased employee compensation modified prospective method provided sfas 148 effects adoption sfas 123 accordance sfas 148 companys financial statements year ended december 31 2003 consist reversal 517000 deferred compensation offsetting adjustment additional paidincapital consolidated statements shareholders equity sfas 123 accounting stockbased compensation requires company provide pro forma information regarding net income earnings per share compensation cost companys stock option plan determined accordance fair value based method prescribed sfas no123 company estimates fair value stock options grant date using blackscholes option valuation model following weighted average assumptions used grants 2003 2002 2001 dividend yield 0 expected volatility 91 63 01 riskfree interest rates 320 501 502 expected lives five years plan options accounting provisions sfas 123 companys net income loss basic diluted net income loss per common share would adjusted pro forma amounts r earnings per share company applies provisions sfas 128 earnings per share sfas 128 provides calculation basic diluted earnings per share basic earnings per share includes dilution computed dividing income available common shareholders weighted average number common shares outstanding period diluted earnings per share reflect potential dilution securities could share earnings entity antidilution provisions sfas no128 require consistency diluted percommonshare amounts basic percommon share amounts loss periods incremental shares attributable assumed exercise 5613490 outstanding options warrants would increased diluted shares outstanding 3277950 shares year ended december 31 2003 warrants options purchase 4083050 shares common stock prices 198 per share 2483 per share included computation diluted earnings per share exercise prices greater average market price common stock recent accounting pronouncements may 2003 fasb issued sfas 150 accounting certain financial instruments characteristics liabilities equity statement establishes standards issuer classifies measures certain financial instruments characteristics liabilities equity statement effective financial instruments entered modified may 31 2003 otherwise effective beginning first interim period beginning june 15 2003 adoption statement material impact companys financial position results operations cash flows november 2002 fasb issued fasb interpretation 45 guarantors accounting disclosure requirements guarantees including indirect guarantees indebtedness others fin 45 fin 45 requires guarantor recognize inception qualified guarantee liability fair value obligation undertaken issuing guarantee fin 45 effective prospective basis qualified guarantees issued modified december 31 2002 adoption interpretation material impact companys financial position results operations january 2003 fasb issued fasb interpretation 46 consolidation variable interest entities fin 46 fin 46 explains identify variable interest entities enterprise assesses interests variable interest entity decide whether consolidate entity interpretation requires existing unconsolidated variable interest entities consolidated primary beneficiaries entities effectively disperse risks among parties involved fin 46 effective immediately variable interest entities created january 31 2003 variable interest entities enterprise obtains interest date adoption interpretation material impact companys financial position results operations 2 inventories consist following 3 property equipment summary property equipment follows december 31 2003 2002 cost companys equipment capital leases consist principally computer equipment totaled 623000 accumulated amortization 480000 300000 december 31 2003 2002 respectively 4 accrued expenses accrued expenses december 31 2003 2002 summarized follows 5 line credit may 2003 company secured line credit arrangement first bank borrow 3000000 prime lending rate line credit expires may 2004 december 31 2003 company borrowed line 6 income taxes income loss income taxes minority interest comprises income tax expense benefit comprises following summarizes differences income tax expense amount computed applying federal income tax rate 2003 2002 2001 income taxes deferred tax assets liabilities december 31 2003 2002 comprised following assessing recoverability deferred tax assets management considers whether likely portion deferred tax assets realized ultimate realization deferred tax assets dependent generation future taxable income periods temporary differences become deductible management considers scheduled reversal deferred tax liabilities historical projected future taxable income tax planning strategies making assessment based foregoing management believes likely company realize benefits certain deductible differences existing december 31 2003 2002 december 31 2003 valuation allowance amount 2202000 established deferred tax assets management unable concluded time likely company realize tax benefit deferred tax assets 2003 valuation allowance reduced 222000 reflect companys realization 2003 certain tax benefits attributable deferred tax assets management continue evaluate appropriateness valuation allowance light current anticipated future taxable income 2003 company reduced income tax expense 574000 upon release prior year tax liability including 443000 upon settlement internal revenue service certain outstanding tax assessments originating prior years us income taxes provided deferred taxes undistributed earnings nonus subsidiaries expected permanently reinvested companies provision us income taxes remaining undistributed earnings approximately 1511000 december 31 2003 company intends reinvest earnings indefinitely operations outside united states earnings distributed additional us taxes approximately 514000 would accrue utilization us tax credits foreign withholding taxes incurred result remittance previously undistributed earnings would creditable us tax liabilities december 31 2003 company research credit carryforwards approximately 0 297000 federal california income tax purposes respectively california credits subject expiration current california tax law 7 operating capital leases company subsidiaries lease certain manufacturing warehousing facilities operating leases expiring various years 2009 leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2003 2002 2001 666000 657000 661000 respectively company also leases certain computer equipment capital leases expiring various years 2005 december 31 2003 future minimum rental payments required operating capital leases follows 8 employee benefit plans company defined contribution 401k plan domestic employees plan available employees reached age twentyone completed three months service company plan eligible employees may defer portion salaries contributions plan companys contributions determined based 25 first 6 covered employees salary subject statutory maximum levels contributions plan totaled 74000 60000 48000 years ended december 31 2003 2002 2001 respectively 9 concentrations financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade receivables company places domestic foreign cash equivalents high quality financial institutions domestic cash balances insured federal deposit insurance company 100000 per bank december 31 2003 2002 company deposits several domestic financial institutions excess insured limits 3856000 5189000 respectively also company deposits several foreign financial institutions insured aggregated 3356000 1715000 december 31 2003 2002 respectively significant portion companys revenues accounts receivable derived sales made distributors located primarily throughout north america well europe asia following table presents certain data geographic area individual customer comprised 10 consolidated net sales 2003 2002 2001 company believes risk accounting loss significantly reduced due diversity customers geographic sales areas company extending credit based established limits terms company performs credit evaluations customers financial condition whenever necessary generally require cash collateral 10 shareholders equity common stock april 9 2002 merger raecalifornia nettaxi consummated see note 1 nettaxi surviving entity merger registrant changed name rae systems inc pursuant merger outstanding share raecalifornia common stock exchanged 154869 shares rae systems inc common stock outstanding option warrant purchase shares raecalifornia common stock exchanged 154869 options warrants purchase shares rae systems inc common stock share per share data prior merger restated reflect stock split connection merger company received 6967000 cash nettaxi exchange issuance 7896764 shares companys common stock proceeds reduced 762000 reflect cash expenses incurred directly attributable merger discussed fully company also incurred total 8735000 merger costs attributable fair value certain equity instruments issued connection merger 8735000 included operating expenses accompanying consolidated statements operations year ended december 31 2002 shares companys preferred stock outstanding time merger automatically converted common stock rate four shares common stock share preferred stock connection closing merger company recorded 2121000 noncash compensation charge 960000 shares common stock issued financial adviser services rendered common stock purchase rights december 2001 company issued 1084083 nonplan stock purchase rights vested exercisable immediately officer director consultant exercise price approximately 008 per share terms stock purchase agreement individuals shares placed escrow earned upon consummation merger nettaxicom april 9 2002 effective date merger fair value companys stock 221 based fair value respective equity instruments april 9 2002 company recorded noncash compensation charge 2308000 relating stock purchase rights warrants summary companys warrants december 31 2003 2002 changes 2003 presented following table april 2002 connection closing merger company issued warrants vested immediately follows awarrants purchase 1750000 shares common stock 119 per share exercisable three years company option redeem warrants redemption price 005 per share companys common stock trades price equal greater 600 per share 20 consecutive days 2003 455000 warrants exchanged 221130 shares common stock based cashless exercise bwarrants purchase 352734 shares common stock 113 per share exercisable ten years 2003 352734 warrants exchanged 251468 shares common stock based cashless exercise company recognized total 4306000 noncash compensation warrants issued b based estimated fair value warrants date grant company estimates fair value warrants grant date using blackscholes valuation model following weightedaverage assumptions used grants 2002 dividend yield 0 expected volatility 174 riskfree interest rate 562 contractual lives warrant 2003 company issued 63214 shares common stock exchange 79366 warrants based cashless exercises issued 97002 shares common stock cash proceeds 66000 due exercise warrants april 2003 company issued warrants purchase 24000 shares companys common stock exercise price 054 warrants vest ratably 12 month period exercisable four year period june 2003 company issued warrants purchase 450000 shares companys common stock exercise price 107 per share third party financial advisory services warrants vested immediately nonforfeitable exercisable four year period nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares nonplan restricted stock weightedaverage exercise price 0985 options vest 25 one year remainder vesting monthly following three years exercisable ten years stock option plan august 1993 companys board directors adopted 1993 stock option plan may 2002 board directors adopted 2002 stock option plan collectively plans subject ratification shareholders plans authorizes grant options purchase shares common stock employees directors consultants company affiliates options combination incentive nonstatutory options incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting monthly following three years exercisable ten years december 31 2003 company reserved 1338210 shares common stock issuance 1993 stock option plan 4910229 shares common stock issuance 2002 stock option plan december 31 2003 company 2201756 shares common stock available future grant 2002 stock option plan summary status companys stock option plan december 31 2003 2002 2001 changes years ended presented following table following table summarizes information stock options outstanding december 31 2003 company historically accounted stockbased awards using intrinsic value method accordance apb 25 prior january 1 2003 compensation cost recognized stock options accompanying financial statements date grant current market value underlying common stock exceeded exercise price stock options date grant connection merger nettaxi completed april 2002 certain options granted companys 1993 stock option plan subject variable accounting year ended december 31 2002 company recognized noncash compensation amount 375000 relating option subject variable accounting effective january 1 2003 company adopted fair value recognition provision sfas 123 stockbased employee compensation years ended december 31 2002 2001 deferred compensation approximately 0 766000 respectively recorded options granted exercise price estimated fair market value underlying common stock approximately 217000 200000 amortized compensation expense 2002 2001 respectively connection adopted sfas 123 effective january 1 2003 unamortized deferred compensation balance 517000 eliminated additional paidincapital accordance sfas 148 comprehensive income components comprehensive income year ended december 31 2003 accumulated comprehensive income december 31 2003 consist foreign currency translation amount 7000 components comprehensive income periods prior 2003 11 commitments contingencies royalty commencing january 1 2001 continuing december 31 2009 company required pay dragerwerk royalty equal 75 net sales certain licensed products relating us patent 5654498 issued august 5 1997 entitled device selective detection component gas mixture manufactured imported sale company united states years ended december 31 2003 2002 2001 company incurred royalty expense 60000 51000 48000 respectively litigation time company engaged various legal proceedings incidental normal business activities although results litigation claims cannot predicted certainty company believes final outcome matters material adverse effect financial position results operations cash flows 12 related party transactions arenex technologies ltd summarized financial data renex companys 36 owned subsidiary accounted equity method effect january 1 2002 year ended december 31 2003 2002 follows btangrae certain companys sales made china market made tangrae china distribution company owned two individuals one current employee one former employee one companys whollyowned subsidiaries tangrae organized sales office solely facilitate sale companys product china market total sales made company tangrae amounted 739000 351000 0 2003 2002 2001 respectively 13 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presented 14 supplemental disclosures following supplemental disclosure valuation qualifying accounts 15 subsequent events january 28 2004 company closed public offering 8050000 shares common stock 425 per share less applicable underwriting discount proceeds approximated 322 million used potential mergers acquisitions working capital general corporate purposes part 1 item 1 business industry background strengths strategy factors may affect future results item 2 properties item 3 legal proceedings item 4 submission matters vote security holders part ii item 5 market registrants common equity related stockholder matters item 6 selected financial data item 7 managements discussion analysis financial condition results operation item 7a quantitative qualitative disclosures market risk item 8 financial statements supplementary data item 9 changes disagreements accountants accounting financial disclosure item 9a controls procedures part iii item 10 directors executive officers registrant item 11 executive compensation item 12 security ownership certain beneficial owners management related stockholder matters item 13 certain relationships related transactions item 14 principal accounting fees services part iv item 15 exhibits financial statement schedule reports form 8k signatures index exhibits contents report independent certified public accountants rae systems inc consolidated balance sheets rae systems inc consolidated statements operations rae systems inc consolidated statements shareholders equity notes 10 15 rae systems inc consolidated statements cash flows rae systems inc notes consolidated financial statementsitem 15 exhibits financial statement schedule 1 financial statements see index consolidated financial statements form 10k 2 financial statement schedules provided absence conditions required information given financial statements notes thereto 3 exhibits see index exhibits index exhibits 1 previously filed january 10 2002 exhibit nettaxicom’s current report form 8k incorporated herein reference 2 previously filed exhibit registrant’s quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 3 previously filed june 2 2000 exhibit nettaxicom’s registration statement form s1 incorporated herein reference 4 previously filed march 17 2000 exhibit nettaxicom’s registration statement form s8 incorporated herein reference 5 previously filed may 10 1999 exhibit nettaxicom’s registration statement form s1 incorporated herein reference 6 previously filed may 31 2002 exhibit registrant’s registration statement form s1 incorporated herein reference 7 previously filed april 8 2002 exhibit nettaxicom’s registration statement form s8 incorporated herein reference 8 previously filed february 28 2003 exhibit registrant’s annual report form 10k year ended december 31 2002 incorporated herein reference 9 previously filed november 2 2004 exhibit registrant’s current report form 8k incorporated herein reference signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized march 16 2005 know persons presents person whose signature appears constitutes appoints robert chen donald w morgan person’s true lawful attorneysinfact agents full power substitution resubstitution person’s name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated rae systems inc consolidated financial statements december 31 2004 2003 report independent registered public accounting firm consolidated financial statements consolidated balance sheets consolidated statements operations consolidated statements shareholders’ equity consolidated statements cash flows notes consolidated financial statements report independent registered public accounting firm board directors shareholders rae systems inc subsidiaries audited accompanying consolidated balance sheets rae systems inc subsidiaries company december 31 2004 2003 related consolidated statements operations shareholders’ equity cash flows three years period ended december 31 2004 financial statements responsibility company’s management responsibility express opinion financial statements based audits conducted audits accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements referred present fairly material respects financial position rae systems inc subsidiaries december 31 2004 2003 results operations cash flows three years period ended december 31 2004 conformity accounting principles generally accepted united states america discussed note 1p consolidated financial statements effective january 1 2003 company adopted fair value method accounting stockbased compensation bdo seidman llp san jose california march 16 2005 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders’ equity see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements 1 summary significant accounting policies company rae systems inc “the company” develops manufactures chemical radiation detection monitors networks homeland security industrial applications rae systems’ products based proprietary technology include portable wireless fixed chemical detection monitors gamma neutron detectors b principles consolidation consolidated financial statements include accounts rae systems inc subsidiaries described rae systems inc owns 100 rae systems europe aps “rae europe” rae systems asia limited “rae asia” rae europe denmark corporation distributes provides services rae systems’ products europe australia new zealand throughout middle east rae europe owns 100 rae united kingdom limited “rae uk” ii 49 rae france rae uk rae france distribution companies rae asia hong kong holding company rae asia owns 100 rae systems shanghai incorporated “rae shanghai” formerly known warae science instruments ltd ii 100 rae systems hong kong limited “rae hong kong” iii 64 rae klh beijing co ltd formerly known beijing ke li heng security equipment co ltd “klh” iv 36 renex technology ltd “renex” rae shanghai incorporated jiading shanghai designs manufactures rae’s products final assembly testing united states rae hong kong distributes provides services rae systems’ products asia pacific rim klh beijingbased manufacturer distributor security environmental personal safety monitors equipment renex hong kong based research development corporation designs develops wireless platform detection monitoring significant intercompany accounts transactions eliminated c use estimates preparation financial statements conformity accounting principles generally accepted united states requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period actual results could differ materially estimates revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provides sales returns standard product warranty provisions service revenues relating maintenance services performed company represent less 5 net revenues 2004 2003 2002 recognized earned based upon contract terms generally ratably term service net revenues include amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue “eitf” 0010 accounting shipping handling fees costs shipping fees represent less 1 net revenues 2004 2003 2002 shipping costs included cost goods sold rae systems inc notes consolidated financial statementscontinued e cash equivalents company considers highly liquid investments original maturities 90 days less cash equivalents f accounts receivable allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s credit worthiness actual defaults higher experienced historically company’s estimates recoverability amounts due could overstated company’s operating results could adversely affected g inventories stated lower cost moving weighted average method market inventory purchases typically based estimated future demand event sudden significant decrease demand company’s products higher occurrence inventory obsolescence due changing technology customer requirements rae systems’ gross margins could adversely affected h property equipment property equipment stated cost net accumulated depreciation provided using straightline method related estimated useful lives follows warranty repairs company generally provides one three year limited warranty majority products establishes provision estimated costs fulfilling warranty obligations time related revenue recorded historically warranty costs insignificant j research development research development costs incurred company expensed incurred rae systems inc notes consolidated financial statementscontinued k advertising costs company expenses costs advertising incurred years ended december 31 2004 2003 2002 advertising expense 1026000 1062000 322000 respectively l income taxes company reports income taxes accordance sfas 109 accounting income taxes requires asset liability approach results recognition deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent future tax return consequences differences either deductible taxable assets liabilities recovered settled valuation allowance provided deferred tax assets extent management unable conclude likely deferred tax assets realized longlived assets company periodically reviews longlived assets impairment events changes circumstances indicate carrying amount asset may recoverable company writes asset estimated fair value n fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments • cash equivalents accounts receivable accounts payable accrued liabilities carrying amount reported balance sheet items approximates fair value short maturity instruments • investments company’s investments consist debt securities management classifies accounts heldtomaturity fair value investments determined using quoted market prices securities similar financial instruments december 31 2004 fair value investments amounted 11160000 carrying value 11245000 • lines credits company two lines credit available future growth aggregate total 10 million april 2004 company secured 3000000 line credit based primelending rate may 2004 company secured additional 7000000 line credit fixed rate 325 rae systems currently compliance debt covenants lines available full december 31 2004 2003 fair values company’s financial instruments approximate historical carrying amounts translation foreign currencies assets liabilities nonus subsidiaries translated us dollars exchange rates effect balance sheet date resulting translation adjustments directly recorded accumulated rae systems inc notes consolidated financial statementscontinued comprehensive income shareholders’ equity income expense accounts translated average exchange rates period translation gains losses recorded income loss net functional currency local currency nonus subsidiaries p stockbased incentive programs sfas 123 accounting stockbased compensation encourages entities recognize compensation costs stockbased employee compensation plans using fair value based method accounting defined sfas 123 allows continued use intrinsic value based method accounting prescribed accounting principles board apb opinion 25 accounting stock issued employees prior january 1 2003 company used accounting prescribed apb opinion 25 provided footnote disclosure pro forma net income earnings per share fair value based method accounting applied march 2000 financial accounting standards board fasb issued interpretation 44 accounting certain transactions involving stock compensation interpretation apb opinion 25 became effective july 1 2000 interpretation 44 clarifies definition employee purposes applying opinion 25 b criteria determining whether stock compensation plan qualifies noncompensatory plan c accounting consequences various modifications terms previously fixed stock option award accounting exchange stock compensation awards business combination adoption provisions interpretation significant impact company’s consolidated financial statements connection becoming public company reverse merger transaction certain options granted company’s 1993 stock option plan became subject variable accounting accordance interpretation 44 december 31 2002 2014941 options outstanding 1993 stock option plan became subject variable accounting december 2002 fasb issued statements sfas 148 accounting stockbased compensation transition disclosure amendment fasb statement 123 statement provides alternative methods transition entity voluntary changes fair value based method accounting stock based compensation also amends disclosure provisions sfas 123 require prominent disclosure effects reported net income entity’s accounting policy decisions respect stockbased employee compensation sfas 148 amends apb 28 interim financial reporting require disclosure effects interim financial information effective january 1 2003 company elected adopt fair value recognition provisions sfas 123 stockbased employee compensation modified prospective method provided sfas 148 effects adoption sfas 123 accordance sfas 148 company’s financial statements year ended december 31 2003 consist reversal 517000 deferred compensation offsetting adjustment additional paidincapital consolidated statements shareholders’ equity sfas 123 requires company provide pro forma information regarding net income earnings per share compensation cost company’s stock option plan determined accordance fair value based method prescribed sfas no123 company estimates fair value stock options grant date using blackscholes option valuation model following weighted average assumptions used grants 2004 2003 2002 dividend yield 0 expected volatility 124 91 63 respectively riskfree interest rates 320 501 respectively expected lives five years plan options rae systems inc notes consolidated financial statementscontinued accounting provisions sfas 123 company’s net income loss basic diluted net income loss per common share would adjusted pro forma amounts q earnings per share company applies provisions sfas 128 earnings per share sfas 128 provides calculation basic diluted earnings per share basic earnings per share includes dilution computed dividing income available common shareholders weighted average number common shares outstanding period diluted earnings per share reflect potential dilution securities could share earnings entity antidilution provisions sfas 128 require consistency diluted percommonshare amounts basic percommon share amounts loss periods following table describes outstanding options warrants fiscal 2004 warrants options purchase shares common stock prices 646 per share 2268 per share included computation diluted earnings per share exercise prices greater average market price common stock similarly fiscal 2003 2002 warrants options purchase shares common stock prices 198 per share 2483 per share 098 per share 7017 per share respectively included computation diluted earnings per share rae systems inc notes consolidated financial statementscontinued r recent accounting pronouncements december 2004 fasb issued sfas 123r “sharebased payment” sfas 123r revises sfas 123 “accounting stockbased compensation” generally requires cost associated employee services received exchange award equity instruments measured based grantdate fair value award recognized financial statements period employees required provide services exchange award sfas 123r also provides guidance determine grantdate fair value awards equity instruments well alternative methods adopting requirements sfas 123r effective beginning first interim annual reporting period june 15 2005 quarter ended september 30 2005 company applies outstanding unvested sharebased payment awards company’s adoption date company currently assessing impact statement company’s consolidated financial statements december 2004 fasb issued sfas 153 “exchanges nonmonetary assets” “sfas 153” sfas 153 amends guidance apb opinion 29 “accounting nonmonetary transactions” eliminate certain exceptions principle exchanges nonmonetary assets measured based fair value assets exchanged sfas 153 eliminates exception nonmonetary exchanges similar productive assets replaces general exception exchanges nonmonetary assets commercial substance statement effective nonmonetary asset exchanges fiscal years beginning june 15 2005 adoption sfas 153 expected impact company’s consolidated results operations financial position cash flows november 2004 financial accounting statements board fasb issued sfas statement 151 “inventory costs” amendment accounting research bulletin arb 43 chapter 4 fasb statement 151 abnormal amounts idle facility expense freight handling costs wasted materials spoilage recognized currentperiod charges requiring allocation fixed production overheads inventory based normal capacity production facilities adoption pronouncement expected material impact company’s financial statements results operations cash flows october 2004 fasb issued fasb staff position fsp 1091 application fasb statement 109 “accounting income taxes” tax deduction qualified production activities provided american job creation act 2004 provides tax deduction nine percent fully phased lesser “qualified production activities income” taxable income deduction utilization net operating loss carryforwards adoption pronouncement expected material impact company’s financial statements results operations cash flows october 2004 fasb issued fsp 1092 accounting disclosure guidance foreign earnings repatriation provision within american job creations act 2004 special onetime tax deduction 85 percent certain foreign earnings repatriated either enterprise’s last tax year began enactment date first tax year begins oneyear period beginning date enactment adoption pronouncement expected material impact company’s financial statements results operations cash flows december 2003 fasb revised interpretation fin 46 consolidation variable interest entities interpretation arb 51 requires investor absorbs majority expected losses receives majority expected returns primary beneficiary variable interest entity “vie” consolidate assets liabilities results operations entity vie entity equity investors controlling interest equity investment risk sufficient finance rae systems inc notes consolidated financial statementscontinued entity’s activities without receiving additional subordinated financial support parties fin 46r replaces fin 46 issued january 2003 application public entities types entities required financial statements periods ending march 15 2004 adoption pronouncement material impact company’s financial statements results operations cash flows december 2003 staff securities exchange commission “sec” issued staff accounting bulletin sab 104 revenue recognition supersedes sab 101 revenue recognition financial statements sab 104’s primary purpose rescind accounting guidance contained sab 101 related multipleelement revenue arrangements superseded result issuance emerging issues task force eitf 0021 accounting revenue arrangements multiple deliverables “eitf 0021” additionally sab 104 rescinds sec’s related revenue recognition financial statements frequently asked questions answers issued sab 101 codified sec topic 13 revenue recognition wording sab 104 changed reflect issuance eitf 0021 revenue recognition principles sab 101 remain largely unchanged issuance sab 104 effective upon issuance adoption pronouncement material impact company’s financial statements results operations cash flows 2 mergers acquisitions april 9 2002 merger rae systems inc california corporation “raecalifornia” nettaxicom delaware corporation “nettaxi” consummated nettaxi surviving entity merger registrant changed name rae systems inc stockholders raecalifornia received approximately 80 common stock rae systems inc effective time merger raecalifornia management team continued existing roles rae systems inc accordingly merger transaction accounted reverse merger whereby accounting purposes rae systems deemed acquirer nettaxi deemed acquired entity nettaxi effectively ceased revenue generating activities nine months prior merger planned abandon business model effect consummation merger nettaxi deemed substance shell company accordingly merger treated recapitalization rae systems goodwill reason pro forma information giving effect merger presented may 27 2004 company invested 9 million cash 64 interest beijing ke li heng security equipment co ltd “klh” klh beijingbased manufacturer distributor security environmental personal safety monitors equipment results klh’s operations included consolidated financial statements company since may 27 2004 rae systems inc notes consolidated financial statementscontinued klh investment costs allocated fair value assets acquired including management’s estimate developed technologies liabilities assumed following table summarizes estimated fair value assets acquired liabilities assumed date acquisition pro forma information necessarily indicative would occurred acquisition made periods indicative future results operations pro forma amounts give effect appropriate adjustments fair value assets acquired amortization intangibles income taxes 3 investments management accounts investments debt securities heldtomaturity include united states treasury bills united states corporate bonds notes united states government agencies united states treasury notes ranging maturity dates march 2005 september 2006 rae systems inc notes consolidated financial statementscontinued 4 inventories consist following klh contributed 319000 raw materials 20 million finished goods yearend 2004 balances 5 property equipment summary property equipment follows 6 intangible assets company intangible assets result investments klh may 2004 rae uk limited october 2004 amount 2424000 intangible assets consist technology customer base trade name amortized estimated useful life 5 years december 31 2004 company net intangible assets amount 2150000 future annual amortization expense intangible assets based upon current useful lives estimated following december 31 2004 rae systems inc notes consolidated financial statementscontinued 7 accrued liabilities accrued liabilities december 31 2004 2003 summarized follows 8 income taxes income loss income taxes minority interest comprises income tax expense benefit comprises rae systems inc notes consolidated financial statementscontinued following summarizes differences income tax expense amount computed applying federal income tax rate 2004 2003 2002 income taxes deferred tax assets liabilities december 31 2004 2003 comprised following assessing recoverability deferred tax assets management considers whether likely portion deferred tax assets realized ultimate realization deferred tax assets dependent generation future taxable income periods temporary differences become deductible management considers scheduled reversal deferred tax liabilities historical projected future taxable income tax planning strategies making assessment december 31 2004 valuation allowance amount 1253000 established deferred tax assets management unable conclude time likely company realize tax benefit deferred tax assets 2004 valuation allowance reduced 949000 reflect company’s realization 2004 tax benefit certain capitalized expenditures foreign losses expected future benefit 2005 certain capitalized expenditures effects trueup adjustments certain deferred tax assets impact income tax provision rae systems inc notes consolidated financial statementscontinued december 31 2004 based company’s recent operating performance management determined ability reasonably forecast shortterm operating performance oneyear look forward basis accordingly management concluded morelikelythannot company realize tax benefit attributable capitalized expenditures become available company 2005 determination represents change estimate 2004 effect reducing valuation allowance reducing income tax expense increasing net income 2004 approximately 200000 management continue evaluate appropriateness valuation allowance light current anticipated future taxable income us income taxes provided deferred taxes undistributed earnings nonus subsidiaries expected permanently reinvested companies provision us income taxes remaining undistributed earnings approximately 3586000 december 31 2004 company intends reinvest earnings indefinitely operations outside united states accordance sfas 5 company maintains reserves estimated income tax exposures various tax jurisdictions exposure item becomes probable estimable exposures settled primarily settlement audits within individual tax jurisdiction closing statute limitation exposures also affected changes applicable tax law factors may cause management believe revision past estimates appropriate management believes appropriate liability established income tax exposure however actual amounts may differ materially estimates december 31 2004 company recorded tax contingency reserves approximately 10 million included within income taxes payable consolidated balance sheet december 31 2004 company research credit carryforwards approximately 0 federal income tax purposes 135000 california income tax purposes california credits subject expiration current california tax law 9 lease commitments company subsidiaries lease certain manufacturing warehousing facilities operating leases expiring various years 2009 leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2004 2003 2002 809000 666000 657000 respectively december 31 2004 company outstanding capital leases future minimum lease commitments required december 31 2004 follows december 2004 company purchased property located 3775 north first street san jose california purchase price 50 million cash company financed transaction available cash building currently renovated expected ready occupancy spring 2005 time company expects abandon current headquarters sunnyvale california write lease obligation estimated 23 million rae systems inc notes consolidated financial statementscontinued 10 employee benefit plans company defined contribution 401k plan domestic employees plan available employees reached age twentyone completed three months service company plan eligible employees may contribute portion salaries plan company’s contributions determined based matching 25 first 6 covered employee’s salary subject statutory maximum levels contributions plan totaled 92000 74000 60000 years ended december 31 2004 2003 2002 respectively 11 concentrations financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade receivables company places domestic foreign cash equivalents large financial institutions domestic cash balances insured federal deposit insurance company 100000 per bank december 31 2004 2003 company deposits several domestic financial institutions excess insured limits 11566000 3856000 respectively company also deposits several foreign financial institutions insured aggregated 9900000 3356000 december 31 2004 2003 respectively significant portion company’s revenues accounts receivable derived sales made distributors located primarily throughout north america well asia europe following table presents certain data geographic area fiscal 2004 2003 2002 20 8 7 revenues derived sales china country generated 10 revenue individual customer comprised 10 consolidated net sales 2004 2003 2002 company believes risk loss significantly reduced due diversity customers geographic sales areas company’s credit policy establishing payment terms credit limits based risk analysis company performs credit evaluations customers’ financial condition whenever necessary generally require cash collateral rae systems inc notes consolidated financial statementscontinued 2004 approximately 51 property equipment located united states 36 located china 12 shareholders’ equity common stock april 9 2002 merger raecalifornia nettaxi consummated see note 2 nettaxi surviving entity merger registrant changed name rae systems inc pursuant merger outstanding share raecalifornia common stock exchanged 154869 shares rae systems inc common stock outstanding option warrant purchase shares raecalifornia common stock exchanged 154869 options warrants purchase shares rae systems inc common stock share per share data prior merger restated reflect stock split connection merger company received 6967000 cash nettaxi exchange issuance 7896764 shares company’s common stock proceeds reduced 762000 reflect cash expenses incurred directly attributable merger discussed fully company also incurred total 8735000 merger costs attributable fair value certain equity instruments issued connection merger 8735000 included operating expenses accompanying consolidated statements operations year ended december 31 2002 shares company’s preferred stock outstanding time merger automatically converted common stock rate four shares common stock share preferred stock connection closing merger company recorded 2121000 noncash compensation charge 960000 shares common stock issued financial adviser services rendered january 28 2004 company closed public offering 8050000 shares common stock 425 per share less applicable underwriting discount net proceeds approximated 318 million continue used potential mergers acquisitions working capital general corporate purposes common stock purchase rights december 2001 company issued 1084083 nonplan stock purchase rights vested exercisable immediately officer director consultant exercise price approximately 008 per share terms stock purchase agreement individuals shares placed escrow earned upon consummation merger nettaxicom april 9 2002 effective date merger fair value company’s stock 221 based fair value respective equity instruments april 9 2002 company recorded noncash compensation charge 2308000 relating stock purchase rights nonplan stock purchase rights exercised december 2001 rae systems inc notes consolidated financial statementscontinued warrants summary company’s warrants december 31 2004 2003 2002 changes 2004 2003 presented following tables april 2002 connection closing merger company issued warrants purchase 1750000 shares common stock 119 per share exercisable three years company option redeem warrants redemption price 005 per share company’s common stock trades price equal greater 600 per share 20 consecutive days 2003 455000 warrants exchanged 221130 shares common stock based cashless exercise 2004 1285000 warrants exchanged 1015078 shares common stock based cashless exercise april 2002 company also issued warrants purchase 352734 shares common stock 113 per share exercisable ten years 2003 352734 warrants exchanged 251468 shares common stock based cashless exercise company recognized total 4306000 noncash compensation warrants issued based estimated fair value warrants date grant company estimated fair value warrants grant date using blackscholes valuation model following weightedaverage assumptions used grants 2002 dividend yield 0 expected volatility 174 riskfree interest rate 562 contractual lives warrant rae systems inc notes consolidated financial statementscontinued 2003 company issued 63214 shares common stock exchange 79366 warrants based cashless exercises issued 97002 shares common stock cash proceeds 66000 due exercise warrants april 2003 company issued warrants purchase 24000 shares company’s common stock exercise price 054 warrants vest ratably 12 month period exercisable four year period 2004 warrants exercised company issued 24000 shares common stock cash proceeds 13000 june 2003 company issued warrants purchase 450000 shares company’s common stock exercise price 107 per share third party financial advisory services warrants vested immediately nonforfeitable exercisable four year period warrants remain outstanding nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares nonplan restricted stock weightedaverage exercise price 0985 options vest 25 one year remainder vesting monthly following three years exercisable ten years 2004 company issued 63000 shares nonplan restricted stock due exercise options december 31 2004 company 337000 nonplan options outstanding weighted average exercise price 102 stock option plan august 1993 company’s board directors adopted 1993 stock option plan may 2002 board directors adopted 2002 stock option plan collectively “the plans” plans authorize grant options purchase shares common stock employees directors consultants company affiliates options combination incentive nonstatutory options incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting monthly following three years exercisable ten years december 31 2004 company reserved 544509 shares common stock issuance 1993 stock option plan 4358745 shares common stock issuance 2002 stock option plan december 31 2004 company 1797760 shares common stock available future grant 2002 stock option plan rae systems inc notes consolidated financial statementscontinued summary status company’s stock option plan december 31 2004 2003 2002 changes years ended presented following table following table summarizes information stock options outstanding december 31 2004 company historically accounted stockbased awards using intrinsic value method accordance apb 25 prior january 1 2003 compensation cost recognized stock options accompanying financial statements date grant current market value underlying common stock exceeded exercise price stock options date grant connection merger nettaxi completed april 2002 certain options granted company’s 1993 stock option plan subject variable accounting year ended december 31 2002 company recognized noncash compensation amount 375000 relating options subject variable accounting effective january 1 2003 company adopted fair value recognition provision sfas rae systems inc notes consolidated financial statementscontinued 123 stockbased employee compensation connection adoption sfas 123 effective january 1 2003 unamortized deferred compensation balance 517000 eliminated additional paidincapital accordance sfas 148 13 commitments contingencies royalty commencing january 1 2001 continuing december 31 2009 company required pay dragerwerk germanbased competitor royalty equal 75 net sales certain licensed products manufactured imported sale company united states royalty relates us patent 5654498 issued august 5 1997 entitled “device selective detection component gas mixture” years ended december 31 2004 2003 2002 company incurred royalty expense 46000 60000 51000 respectively litigation time company engaged various legal proceedings incidental normal business activities although results litigation claims cannot predicted certainty company believes final outcome matters material adverse effect financial position results operations cash flows 14 guarantees company contractual obligations operating leases amount 34 million company recorded liabilities future payments yet incurred company permitted delaware law accordance bylaws indemnify officers directors certain events occurrences subject certain limits officer serving company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director officer insurance policy limits exposure enables recover portion future amounts paid result insurance policy coverage company believes fair value indemnification agreements minimal company’s sales agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits rae systems inc notes consolidated financial statementscontinued 15 related party transactions renex technologies ltd june 2004 company entered agreement renex technologies ltd develop six prototype raelink modems price 95000 pay royalty fee 75 products sold renex technology’s intellectual property used date company made payment renex amount 28000 develop modems 2004 company make royalty payments company 36 interest renex technologies ltd accounts equity method effect january 1 2002 summarized financial data renex year ended december 31 2004 2003 follows b tangrae certain company’s sales made china market made tangrae china distribution company owned two individuals one kang lin liu sales representative one former employee one company’s whollyowned subsidiaries tangrae organized sales office solely facilitate sale company’s products china market total sales made company tangrae amounted 392000 479000 351000 2004 2003 2002 respectively 2004 consulting fees paid tangrae rae shanghai amount 143000 effective december 2004 tangrae officially closed operating entity rae systems inc notes consolidated financial statementscontinued c shanghai simax technology co ltd “simax” september 2004 company entered agreement shanghai simax technology co ltd “simax” finance design benzenespecific gas detection module gcpid amount 100000 date payments simax rae systems right use technology future products company pay royalty fee 5 gcpid products sold date royalty payments technology dr peter c hsi company’s chief technology officer acting general manager simax dr hsi equity ownership simax 16 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presented rae systems inc notes consolidated financial statementscontinued 17 supplemental disclosures following supplemental disclosure valuation qualifying accountsitem 15 exhibits financial statement schedule 1 financial statements see index consolidated financial statements form 10k 2 financial statement schedules provided absence conditions required information given financial statements notes thereto 3 exhibits see index exhibits page 45 herein signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized march 31 2006 know persons presents person whose signature appears constitutes appoints robert chen donald w morgan person’s true lawful attorneysinfact agents full power substitution resubstitution person’s name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated index exhibits 1 previously filed exhibit registrant’s quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 2 previously filed exhibit registrant’s current report form 8k november 2 2004 incorporated herein reference 3 previously filed february 28 2003 exhibit registrant’s annual report form 10k year ended december 31 2002 incorporated herein reference rae systems inc consolidated financial statements december 31 2005 2004 report independent registered public accounting firm consolidated financial statements consolidated balance sheets consolidated statements operations consolidated statements shareholders’ equity consolidated statements cash flows notes consolidated financial statements report independent registered public accounting firm board directors shareholders rae systems inc audited accompanying consolidated balance sheets rae systems inc company december 31 2005 2004 related consolidated statements operations shareholders’ equity cash flows three years period ended december 31 2005 financial statements responsibility company’s management responsibility express opinion financial statements based audits conducted audits accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements referred present fairly material respects financial position rae systems inc december 31 2005 2004 results operations cash flows three years period ended december 31 2005 conformity accounting principles generally accepted united states america also audited accordance standards public company accounting oversight board united states effectiveness rae systems inc’s internal control financial reporting december 31 2005 based criteria established internal controlintegrated framework issued committee sponsoring organizations treadway commission coso report dated march 24 2006 expressed unqualified opinion management’s assessment effectiveness internal control financial reporting adverse opinion effectiveness internal control financial reporting due existence material weaknesses bdo seidman llp san jose california march 24 2006 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders’ equity see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements 1 summary significant accounting policies company rae systems inc “company” delaware company develops manufactures chemical radiation detection monitors networks homeland security industrial applications company’s products based proprietary technology include portable wireless fixed chemical detection monitors gamma neutron detectors b principles consolidation consolidated financial statements include accounts rae subsidiaries described rae owns 100 rae systems europe aps “rae europe” rae systems asia limited “rae asia” rae europe denmark corporation distributes provides services rae’s products europe australia new zealand throughout middle east rae europe owns 100 rae united kingdom limited “rae uk” ii 49 rae france “rae france” rae uk rae france distribution companies rae asia hong kong holding company rae asia owns 100 rae systems shanghai incorporated “rae shanghai” ii 100 rae systems hong kong limited “rae hong kong” iii 64 rae klh beijing co ltd formerly known beijing ke li heng security equipment co ltd “klh” rae shanghai incorporated jiading shanghai designs manufactures rae’s products final assembly testing united states rae hong kong distributes provides services rae systems’ products asia pacific rim klh beijingbased manufacturer distributor security environmental personal safety monitors equipment also serves distributor rae products significant intercompany accounts transactions eliminated c use estimates preparation financial statements conformity accounting principles generally accepted united states requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period ongoing basis evaluate estimates including related allowance doubtful accounts valuation goodwill intangible assets valuation deferred tax assets restructuring costs contingencies inventory valuation warranty accrual stock compensation expense base estimates historical experience various assumptions believed reasonable circumstances results form basis making judgments carrying values assets liabilities readily apparent sources actual results may differ significantly estimates different assumptions conditions revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory revenues related services performed company’s extended warranty program represent less 5 net revenues 2005 2004 2003 recognized earned based upon contract terms generally ratable term service record project installation work performed china using percentageofcompletion method installation rae systems inc notes consolidated financial statementscontinued revenue represents less 4 net revenue 2005 2004 2003 net sales include amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue “eitf” 0010 accounting shipping handling fees costs shipping fees represent less 1 net revenues 2005 2004 2003 shipping costs included cost goods sold e cash equivalents company considers highly liquid investments original maturities 90 days less cash equivalents f accounts receivable trade notes receivable allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses company generally require collateral sales credit management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s creditworthiness actual defaults higher experienced historically additional allowances would required trade notes receivables presented company customers china payment outstanding trade receivables notes receivables bank guarantee promissory notes noninterest bearing generally mature within six months g inventories stated lower cost using firstin firstout method market company exposed number economic industry factors could result portions inventory becoming either obsolete excess anticipated usage saleable amounts less carrying amounts factors include limited technological changes market competitive pressures products prices availability key components suppliers company established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded reserves intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required h property equipment property equipment stated cost net accumulated depreciation provided using straightline method related estimated useful lives follows rae systems inc notes consolidated financial statementscontinued warranty repairs company sells majority products twelve month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized estimated future warranty obligations affected warranty periods sales volumes product failure rates material usage labor replacement costs incurred correcting product failure actual product failure rates material usage labor replacement costs differ company’s estimates revisions estimated warranty obligations would required warranty accrual represents best estimate amount necessary settle future existing claims products sold balance sheet date company periodically assesses adequacy reported warranty reserve adjusts amounts accordance changes factors j research development research development costs incurred company expensed incurred k advertising costs company expenses costs advertising incurred years ended december 31 2005 2004 2003 advertising expense 1086000 1026000 1062000 respectively l income taxes company reports income taxes accordance statement financial accounting standards “sfas” 109 accounting income taxes requires asset liability approach results recognition deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent future tax return consequences differences either deductible taxable assets liabilities recovered settled valuation allowance provided deferred tax assets extent management unable conclude likely deferred tax assets realized longlived assets company periodically reviews longlived assets impairment events changes circumstances indicate carrying amount asset may recoverable company writes asset estimated fair value n fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments • cash equivalents accounts receivable trade notes receivables accounts receivables affiliate accounts payable accrued expenses inventory purchase obligations carrying amount reported balance sheet items approximates fair value short maturity instruments addition inventory purchase obligations carrying value approximates fair value based market rates comparable products rae systems inc notes consolidated financial statementscontinued • investments fair value investments determined using quoted market prices securities similar financial instruments management accounts debt investments heldtomaturity • lines credits company two lines credit available future growth aggregate total 10 million currently compliance debt financial covenants debt worth ratio working capital requirements nonfinancial covenants lines available us full present amounts outstanding agreements • notes payablerelated parties carrying value notes payablerelated parties approximates fair value company discounted non interest bearing notes payables interest rate commensurate commercial borrowing rate available company china december 31 2005 2004 fair values company’s financial instruments approximate historical carrying amounts translation foreign currencies assets liabilities nonus subsidiaries translated us dollars exchange rates effect balance sheet date resulting translation adjustments directly recorded accumulated comprehensive income shareholders’ equity income expense accounts translated average exchange rates period foreign currency transaction gains losses recorded income loss net functional currency local currency nonus subsidiaries p stockbased incentive programs company applies provisions sfas 123 accounting stockbased compensation stock option plans years ended december 31 2005 2004 2003 company estimates fair value stock options grant date using blackscholes option valuation model following assumptions used total stockbased compensation year ended december 31 2005 2004 2003 1970000 1404000 789000 respectively q earnings per share basic earnings per share includes dilution computed dividing income available common shareholders weighted average number common shares outstanding period diluted earnings per share reflects potential dilution common stock equivalents options warrants extent impact dilutive antidilutive shares excluded diluted earnings per share calculation 2005 2004 2003 5948755 3898448 3759257 respectively rae systems inc notes consolidated financial statementscontinued r retained earnings included retained earnings 1469000 restricted retained earnings company complies chinese statutory rules regarding profit appropriation restricted funds used specific purposes defined ministry finance department china funds available company use operations recent accounting pronouncements may 2005 fasb issued sfas 154 accounting changes error corrections sfas 154 replaces apb opinion 20 accounting changes sfas 3 reporting accounting changes interim financial statements changes requirements accounting reporting change accounting principle sfas 154 requires voluntary change accounting principle applied retrospectively prior period financial statements presented using new accounting principle sfas 154 effective accounting changes corrections errors fiscal years beginning december 15 2005 company apply requirements sfas 154 changes principle made january 1 2006 december 2004 fasb issued sfas 123r sharebased payment sfas 123r revises sfas 123 accounting stockbased compensation generally requires cost associated employee services received exchange award equity instruments measured based grantdate fair value award recognized financial statements period employees required provide services exchange award sfas 123r also provides guidance determine grantdate fair value awards equity instruments well alternative methods adopting requirements april 14 2005 securities exchange commission amended compliance dates sfas 123r result sfas 123r effective company beginning january 1 2006 applies outstanding unvested sharebased payment awards company’s adoption date company currently assessing impact statement company’s consolidated financial statements november 2004 fasb issued sfas statement 151 inventory costs amendment accounting research bulletin arb 43 chapter 4 fasb statement 151 abnormal amounts idle facility expense freight handling costs wasted materials spoilage recognized currentperiod charges requiring allocation fixed production overheads inventory based normal capacity production facilities sfas 151 effective company beginning january 1 2006 adoption pronouncement expected material impact company’s consolidated results operations financial position cash flows company already follows procedures comparable described sfas 151 segment reporting operating divisions consist geographically based entities americas china rest asia europe operating divisions similar economic characteristics defined sfas 131 disclosures segments enterprise related information accordingly operate one reportable segment years ended december 31 2005 2004 2003 u reclassifications certain prior year amounts reclassified conform current year presentation rae systems inc notes consolidated financial statementscontinued 2 mergers acquisitions may 27 2004 company invested 9 million cash 64 interest beijing ke li heng security equipment co ltd “klh” klh beijingbased manufacturer distributor security environmental personal safety monitors equipment results klh’s operations included consolidated financial statements company since may 27 2004 following table summarizes fair value assets acquired liabilities assumed date acquisition purchase price allocation finalized 2005 completion study independent appraisal firm company recorded additional 107000 intangible assets 136000 goodwill 243000 longterm liabilities included longterm liabilities fourth quarter 2005 goodwill expected deductible income tax purposes see note 15 additional disclosure 3 investments management accounts investments heldtomaturity break follows rae systems inc notes consolidated financial statementscontinued following table summarizes maturities company’s fixed income securities december 31 2005 fair value heldtomaturity debt securities december 31 2005 2004 approximates cost 4 inventories consist following 5 property equipment summary property equipment follows depreciation expense years ended december 31 2005 2004 2003 1559000 720000 753000 respectively construction progress primarily represents cost implement oracle erp system estimated additional cost complete project 700000 incurred 2006 6 goodwill intangible assets goodwill represents excess purchase price related costs value assigned net tangible identifiable intangible assets company recorded goodwill result investment klh amount 136000 goodwill impaired december 31 2005 result required annual impairment review rae systems inc notes consolidated financial statementscontinued total intangible assets accumulated amortization balances december 31 2004 2424000 274000 respectively majority intangible assets related klh investment components purchased intangible assets follows company’s purchased intangible assets goodwill subject amortization weighted average life 532 years amortization expense calculated using straight line method years ended december 31 2005 2004 2003 474000 274000 0 respectively estimated future amortization expense shown following table 7 accrued liabilities accrued liabilities december 31 2005 2004 summarized follows rae systems inc notes consolidated financial statementscontinued 8 income taxes loss income taxes minority interest comprises income tax benefit expense comprises following summarizes differences income tax expense amount computed applying federal income tax rate 2005 2004 2003 income taxes rae systems inc notes consolidated financial statementscontinued deferred tax assets liabilities december 31 2005 2004 comprised following assessing recoverability deferred tax assets management considers whether likely portion deferred tax assets realized ultimate realization deferred tax assets dependent generation future taxable income periods temporary differences become deductible management considers scheduled reversal deferred tax liabilities historical projected future taxable income tax planning strategies making assessment recorded valuation allowance 877000 december 31 2005 due uncertainties related ability utilize net deferred tax assets primarily consisting certain net operating losses carried forward foreign entities event actual results differ estimates adjust estimates future periods may need establish additional valuation allowance could materially impact financial position results operations internal revenue service irs currently auditing company’s federal income tax returns fiscal year 2003 final proposed adjustments received management believes ultimate outcome irs audit material adverse impact company’s financial position results operations us income taxes provided deferred taxes undistributed earnings nonus subsidiaries expected permanently reinvested companies provision us income taxes remaining undistributed earnings approximately 2583000 december 31 2005 company intends reinvest earnings indefinitely operations outside united states october 22 2004 american job creation act 2004 “act” signed law act includes deduction 85 certain foreign earnings repatriated defined act respect repatriation provision continue evaluate potential benefits compared cost december 31 2005 company research credit carryforwards 411000 california income tax purposes california credits subject expiration current california tax law rae systems inc notes consolidated financial statementscontinued 9 commitments contingencies legal proceedings time company engaged various legal proceedings incidental normal business activities although results litigation claims cannot predicted certainty company believes final outcome matters material adverse effect financial position results operations cash flows motion filed june 17 2005 polimaster ltd na se trading co limited injunction would prevent rae systems shipping gamma rae ii product prohibiting rae making additional sales products possession licensed polimaster ltd na se trading co limited pending resolution arbitration parties motion denied september 6 2005 claim may subject arbitration accordance original contract parties expect material effect upon business results operations b operating leases company subsidiaries lease certain manufacturing warehousing facilities operating leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2005 2004 2003 624000 809000 666000 respectively future minimum lease payments next five years 2006 2010 excluding sunnyvale california abandoned building lease described 310000 56000 38000 32000 0 respectively december 2004 company purchased property located 3775 north first street san jose california lease related previous headquarters sunnyvale california writtenoff second quarter 2005 total loss abandonment lease approximately 2 million future discounted lease payments related sunnyvale building included accrued expenses totaling 482000 long term liabilities totaling 1466000 december 31 2005 future minimum lease payments next four years 2006 2009 495000 528000 627000 556000 respectively discount rate used 485 liability reduced anticipated future sublease income based upon broker estimates current real estate market conditions factors considered likely potential sublease income would offset brokerage refurbishment costs make facility ready sublease c purchase obligations company agreements suppliers parties purchase inventories goods services company estimated noncancelable obligations agreements 2006 2007 2008 2009 2010 approximately 3682000 282000 161000 43000 3000 respectively noncancelable obligations related inventories expected delivered within next 12 months company periodically reviews carrying value inventories noncancelable purchase commitments evaluating material usage requirements forecasts estimates inventory obsolescence excess quantities expected losses purchase commitments company may record charges write inventory due excess obsolete slow moving inventory lower cost market based analysis impact changes technology estimates future sales volumes market value estimates loss accrued related current purchase obligations however additional write downs inventories may negatively affect gross margins future periods guarantees company permitted delaware law accordance bylaws indemnify officers directors certain events occurrences subject certain limits officer serving rae systems inc notes consolidated financial statementscontinued company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director officer insurance policy limits exposure enables recover portion future amounts paid result insurance policy coverage company believes fair value indemnification agreements minimal company’s sales agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits e product warranties company sells majority products twelve month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized december 31 2005 2004 warranty reserve recorded accrued expenses 377000 490000 respectively summary obligations following table quantifies known contractual obligations tabular form december 31 2005 1 conjunction klh investment note payable established previous klh shareholders part purchase price negotiation obligation described related party transactions section payments listed include principal interest 10 employee benefit plans company defined contribution 401k plan “plan” domestic employees plan available employees reached age 21 completed three months service company plan eligible employees may contribute portion salaries plan company’s contributions determined based matching 25 first 6 covered employee’s salary subject statutory maximum levels contributions plan totaled 108000 92000 74000 years ended december 31 2005 2004 2003 respectively 11 concentrations financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade receivables company places domestic foreign cash rae systems inc notes consolidated financial statementscontinued cash equivalents large financial institutions domestic cash balances insured federal deposit insurance company 100000 per financial institution december 31 2005 2004 company deposits excess insured limits 5906000 11566000 respectively company also deposits several foreign financial institutions insured aggregated 7518000 9900000 december 31 2005 2004 respectively significant portion company’s revenues accounts receivable derived sales made distributors located primarily throughout north america well asia europe following table presents certain data geographic area 1 americas revenue included sales customers united states canada latin american countries sales canada latin american countries represent less 3 total americas sales fiscal 2005 2004 2003 30 20 8 respectively revenues derived sales china individual customer comprised 10 consolidated net sales 2005 2004 2003 company believes risk loss significantly reduced due diversity customers geographic sales areas company’s credit policy establishing payment terms credit limits based risk analysis company performs credit evaluations customers’ financial condition whenever necessary generally require cash collateral 2005 2004 approximately 52 51 respectively property equipment located americas 47 48 respectively located china 12 shareholders’ equity common stock january 28 2004 company closed public offering 8050000 shares common stock 425 per share less applicable underwriting discount net proceeds approximated 318 million continue used potential mergers acquisitions working capital general corporate purposes rae systems inc notes consolidated financial statementscontinued warrants since 2002 company warrants outstanding purchase company’s common stock summary company’s warrants december 31 2005 2004 2003 changes 2005 2004 presented following tables nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares nonplan restricted stock weightedaverage exercise price 0985 options vest 25 one year remainder vesting monthly following three years exercisable ten years 2004 company issued 63000 shares nonplan restricted stock due exercise options december 31 2005 company 337000 nonplan options outstanding weighted average exercise price 102 313558 options exercisable december 31 2005 remaining contractual life six years stock option plan august 1993 company’s board directors adopted 1993 stock option plan may 2002 board directors adopted 2002 stock option plan collectively “plans” plans authorize grant options purchase shares common stock employees directors consultants company affiliates plans feature incentive nonstatutory options incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share date grant determined board directors committee thereof except options granted person owning greater 10 rae systems inc notes consolidated financial statementscontinued outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting monthly following three years exercisable ten years december 31 2005 company reserved 299298 shares common stock issuance 1993 stock option plan 2402256 shares common stock issuance 2002 stock option plan december 31 2005 company 1684034 shares common stock available future grant 2002 stock option plan summary status company’s stock option plan december 31 2005 2004 2003 changes years ended presented following table following table summarizes information stock options outstanding december 31 2005 rae systems inc notes consolidated financial statementscontinued information stock options outstanding december 31 2005 exercise price less closing price december 31 2005 351 per share follows 13 investments entities company accounts 36 ownership renex technologies ltd“renex” hong kong company using equity method starting january 1 2002 company’s total investment renex december 31 2005 2004 449000 156000 respectively years ended december 31 2005 2004 2003 company recorded losses renex 196000 353000 276000 respectively renex technologies ltd’s financial information derived unaudited financial statements follows june 2004 company entered agreement renex develop six prototype raelink modems price 95000 pay royalty fee 75 products sold renex’s intellectual property used sum 29000 paid 2004 66000 paid 2005 2004 company made royalty payments amounting 70000 0 respectively 2005 2004 2003 company purchased 28000 7000 2000 respectively inventory items renex sold 48000 108000 286000 inventory items renex company also paid 139000 renex research project accounts receivable due renex december 31 2005 2004 84000 119000 respectively company recorded 489000 investment additional paid capital fourth quarter 2005 adjust prior year investment balance properly reflect carrying value investment prorata share net equity renex rae systems inc notes consolidated financial statementscontinued 14 related party transactions september 2004 company entered agreement shanghai simax technology co ltd “simax” finance design benzenespecific gas detection module gcpid amount 100000 paid 2005 rae systems right use technology future products company pay royalty fee 5 gcpid products sold date royalty payments technology total purchase raw materials simax 2005 2004 2003 29000 0 respectively outstanding balance due simax december 31 2005 2004 dr peter c hsi company’s chief technology officer acting general manager simax resignation december 2004 dr hsi equity ownership simax conjunction klh investment unsecured note payable established previous klh shareholders part purchase price agreement december 31 2005 2004 759000 423000 respectively included notes payablerelated party account 821000 1260000 respectively included long term notes payablerelated party account notes non interest bearing recorded net present value using discounted interest rate 55 sum 434000 due demand december 31 2005 addition future payment plan next four years 2006 2009 398000 249000 respectively company’s director information systems lien chen wife chief executive officer robert chen ms chen paid salary 96000 2005 2004 respectively ms chen also receives standard employee benefits offered fulltime us employees ms chen report robert chen compensation decisions regarding ms chen performed manner us employees robert chen final approval signatory compensation recommendations rae systems inc notes consolidated financial statementscontinued 15 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presented 1 second quarter 2005 company abandoned leased facility sunnyvale california moved new headquarters us manufacturing facility result company took beforetax charge approximately 20 million abandonment lease second quarter 2005 2 company made following adjustments fourth quarter 2005 • company recorded 488000 investment additional paid capital adjust prior year investment balance properly reflect carrying value investment prorata share net equity renex conjunction adjustment company recorded additional 39000 equity loss unconsolidated subsidiaries • company recorded 84000 additional stockbased compensation expense additional paid capital correct errors stockbased compensation calculation • company recorded discount notes payable due related parties 288000 correct purchase price allocation klh investment related amortization discount notes payable 126000 tax effect adjustments resulted reduction tax 56000 net impact adjustments increased operating loss 193000 increased assets 161000 decreased liabilities 162000 increased equity 323000 rae systems inc notes consolidated financial statementscontinued 16 supplemental disclosures following supplemental disclosure valuation qualifying accountsitem 15 exhibits financial statement schedules 1 financial statements see index consolidated financial statements form 10k 2 financial statement schedules provided absence conditions required information given financial statements notes thereto 3 exhibits see index exhibits page 49 herein signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized march 16 2007 rae systems inc robert chen robert chen president chief executive officer know persons presents person whose signature appears constitutes appoints robert chen randall gausman person’s true lawful attorneysinfact agents full power substitution resubstitution person’s name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated index exhibits 1 previously filed exhibit registrant’s quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 2 previously filed exhibit registrant’s current report form 8k november 2 2004 incorporated herein reference 3 previously filed february 28 2003 exhibit registrant’s annual report form 10k year ended december 31 2002 incorporated herein reference 4 previously filed march 31 2006 exhibit registrant’s annual report form 10k year ended december 31 2005 incorporated herein reference 5 previously filed august 8 2006 exhibit registrant’s quarterly report form 10q quarter ended june 30 2006 incorporated herein reference 6 previously filed exhibit registrant’s current report form 8k august 8 2006 incorporated herein reference 7 previously filed exhibit registrant’s current report form 8k august 16 2006 incorporated herein reference 8 previously filed exhibit registrant’s current report form 8k october 18 2006 incorporated herein reference 9 filed herewith rae systems inc consolidated financial statements december 31 2006 2005 report independent registered public accounting firm board directors shareholders rae systems inc audited accompanying consolidated balance sheets rae systems inc company december 31 2006 2005 related consolidated statements operations shareholders’ equity cash flows three years period ended december 31 2006 financial statements responsibility company’s management responsibility express opinion financial statements based audits conducted audits accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements referred present fairly material respects financial position rae systems inc december 31 2006 2005 results operations cash flows three years period ended december 31 2006 conformity accounting principles generally accepted united states america discussed note 1 effective january 1 2006 company adopted statement financial accounting standards 123r “sharebased payment” also audited accordance standards public company accounting oversight board united states effectiveness rae systems inc’s internal control financial reporting december 31 2006 based criteria established internal control integrated framework issued committee sponsoring organizations treadway commission coso report dated march 16 2007 expressed unqualified opinion management’s assessment effectiveness internal control financial reporting adverse opinion effectiveness internal control financial reporting due existence material weakness bdo seidman llp san jose california march 16 2007 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders’ equity see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements note 1 summary significant accounting policies company rae systems inc “company” “rae” delaware company develops manufactures chemical radiation detection monitors networks industrial applications homeland security company’s products based proprietary technology include portable wireless fixed chemical detection monitors radiation detectors b principles consolidation consolidated financial statements include accounts rae systems inc subsidiaries ownership interest holders consolidated subsidiaries reflected minority interest significant intercompany balances transactions eliminated consolidation c use estimates preparation financial statements conformity generally accepted accounting principles united states requires management make estimates assumptions affect reported amounts assets liabilities disclosure contingent assets liabilities date financial statements reported amounts revenue expenses reporting period ongoing basis evaluate estimates including related allowance doubtful accounts valuation goodwill intangible assets valuation deferred tax assets restructuring costs contingencies inventory valuation warranty accrual stock compensation expense base estimates historical experience various assumptions believed reasonable circumstances results form basis making judgments carrying values assets liabilities readily apparent sources actual results may differ significantly estimates different assumptions conditions revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company generally recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier fob factory provides sales returns standard product warranty provisions nonstandard contract terms title goods pass time delivery fob destination revenue recognized company established proof delivery revenues related services performed company’s extended warranty program represent less 5 net revenues 2006 2005 2004 recognized earned based upon contract terms generally ratable term service record project installation work asia using percentageofcompletion method installation revenue represents less 5 net revenue 2006 2005 2004 net revenues include amounts billed customers sales transactions shipping handling prescribed emerging issues task force issue “eitf” 0010 accounting shipping handling fees costs shipping fees represent less 1 net revenues 2006 2005 2004 shipping costs included cost goods sold e cash equivalents company considers highly liquid investments original maturities 90 days less cash equivalents rae systems inc notes consolidated financial statements continued f accounts receivable trade notes receivable allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts provided estimated credit losses level deemed appropriate adequately provide known inherent risks related amounts allowance based reviews loss adjustments history current economic conditions factors deserve recognition estimating potential losses company generally require collateral sales credit management uses best information available making determination ultimate recovery recorded accounts receivable also dependent upon future economic conditions may beyond management’s control deterioration major customer’s creditworthiness actual defaults higher experienced historically additional allowances would required trade notes receivable presented company customers china payment outstanding trade receivables notes receivable bank guarantee promissory notes noninterest bearing generally mature within six months g inventories stated lowerofcost using firstin firstout method market company exposed number economic industry factors could result portions inventory becoming either obsolete excess anticipated usage saleable amounts less carrying amounts factors include limited technological changes market competitive pressures products prices availability key components suppliers company established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded reserves intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required h property equipment property equipment stated cost net accumulated depreciation provided using straight line method related estimated useful lives follows warranty repairs company sells majority products 12 24 month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized estimated future warranty obligations affected warranty periods sales volumes product failure rates material usage labor replacement costs incurred correcting product failure actual product failure rates material usage labor replacement costs differ company’s estimates revisions estimated warranty obligations would required warranty accrual represents best estimate amount necessary settle future existing claims rae systems inc notes consolidated financial statements continued products sold balance sheet date company periodically assesses adequacy reported warranty reserve adjusts amounts accordance changes factors j research development research development costs incurred company expensed incurred k advertising costs company expenses costs advertising incurred years ended december 31 2006 2005 2004 advertising expense 1029000 1086000 1026000 respectively l income taxes company reports income taxes accordance statement financial accounting standards “sfas” 109 accounting income taxes requires asset liability approach results recognition deferred tax assets future tax benefits liabilities expected future tax consequences temporary differences book carrying amounts tax basis assets liabilities deferred tax assets liabilities represent future tax return consequences differences either deductible taxable assets liabilities recovered settled valuation allowance provided deferred tax assets extent management unable conclude likely deferred tax assets realized subject income taxes united states numerous foreign jurisdictions significant judgment required evaluating tax positions determining provision income taxes effective tax rates differ statutory rates primarily due foreign earnings taxed lower rates foreign losses benefited nondeductible stockbased compensation deductions “sharebased payment” “fas 123r” additional provisions uncertain tax positions future effective tax rates could adversely affected earnings lower anticipated countries lower statutory rates higher anticipated countries higher statutory rates changes valuation deferred tax assets liabilities changes tax laws regulations accounting principles interpretations thereof regularly assess likelihood adverse outcomes resulting tax examinations determine adequacy provision income taxes significant judgment also required determining valuation allowance recorded deferred tax assets assessing need valuation allowance consider available evidence including past operating results estimates future taxable income feasibility tax planning strategies event change determination amount deferred tax assets realized adjust valuation allowance corresponding impact provision income taxes period determination made goodwill intangible assets accordance statement financial accounting standards “sfas” 141 “business combinations” sfas 142 “goodwill intangible assets” “sfas 142” goodwill intangible assets deemed indefinite lives longer amortized instead subject annual impairment tests company periodically evaluates purchased intangibles including goodwill impairment assessment goodwill subjective nature significant management judgment required forecast future operating results projected cash flows current period market capitalization levels estimates related assumptions change future changes conditions could require material writedowns net intangible assets including impairment charges goodwill valuation intangible assets based management’s estimates intangible assets finite useful lives amortized estimated life asset rae systems inc notes consolidated financial statements continued n long lived assets company evaluates recoverability longlived assets finite lives accordance sfas 144 “accounting impairment longlived assets” “sfas 144” sfas 144 requires recognition impairment longlived assets whenever events changes circumstances indicate carrying amount asset may recoverable company periodically reviews long lived assets impairment events changes circumstances indicate carrying amount asset may recoverable based estimated undiscounted cash flows company writes asset estimated fair value fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments • cash equivalents accounts receivable trade notes receivables accounts receivable affiliate accounts payable accrued expenses inventory purchase obligations carrying amount reported balance sheet items approximates fair value short maturity instruments addition inventory purchase obligations carrying value approximates fair value based market rates comparable products • investments fair value investments determined using quoted market prices securities similar financial instruments management accounts debt investments availableforsale • lines credits company two lines credit available future growth aggregate total 10 million december 31 2006 currently compliance debt financial covenants minimum quick ratio tangible net worth nonfinancial covenants lines available us full present amounts outstanding agreements march 14 2007 company replaced lines credit please refer note 15 subsequent events present outstanding amounts line credit agreement • notes payable related parties carrying value notes payable related parties approximates fair value company discounted non interest bearing notes payables interest rate commensurate commercial borrowing rates available company china december 31 2006 2005 fair values company’s financial instruments approximate historical carrying amounts p translation foreign currencies assets liabilities nonus subsidiaries translated us dollars exchange rates effect balance sheet date resulting translation adjustments directly recorded accumulated comprehensive income shareholders’ equity income expense accounts translated average exchange rates period foreign currency transaction gains losses recorded income loss net functional currency local currency nonus subsidiaries rae systems inc notes consolidated financial statements continued q stockbased compensation expense january 1 2003 company adopted financial accounting standards board statement 123 “accounting stockbased compensation” “fas 123” recognition stockbased compensation cost statement operations fair value option award estimated date grant using blackscholesmerton valuation method fair value amortized compensation expense straight line basis requisite service periods awards generally vesting period effective january 1 2006 company adopted fair value recognition provisions fas 123 revised 2004 “sharebased payment” “fas 123r” fair value option adjusted reflect shares expected vest company’s implementation fas 123r uses modifiedprospectivetransition method compensation cost related unvested option january 1 2006 recalculated necessary adjustment reported first quarter adoption november 10 2005 financial accounting standards board “fasb” issued fasb staff position fas 123r3 “transition election related accounting tax effects stockbased payment awards” allows simplified method establish beginning balance additional paidin capital pool “apic pool” related tax effects employee stockbased compensation determine subsequent impact apic pool consolidated statements cash flows tax effects employee stockbased compensation awards outstanding upon adoption sfas 123r january 1 2006 company adopted simplified method computation beginning balance apic pool determining fair value valuation amortization method company estimates fair value stock options granted using blackscholesmerton optionpricing formula single option award approach fair value amortized straightline basis requisite service periods awards generally vesting period expected term company’s expected term represents period company’s stockbased awards expected outstanding determined using “simplified method” defined securities exchange commission’s staff accounting bulletin 107 expected volatility company’s expected volatilities based historical volatility company’s stock adjusted determined management unusual nonrepresentative stock price activity expected recur expected dividend blackscholesmerton valuation model calls single expected dividend yield input company currently pays dividends expect pay dividends foreseeable future riskfree interest rate company bases riskfree interest rate implied yield currently available us treasury zerocoupon issues equivalent remaining term estimated forfeitures estimating forfeitures company uses average historical option forfeitures period four years fair value fair value company’s stock options granted employees years ended december 31 2006 2005 2004 estimated using following weighted average assumptions rae systems inc notes consolidated financial statements continued total stockbased compensation year ended december 31 2006 2005 2004 16 million 20 million 14 million respectively r earnings per share basic earnings per share includes dilution computed dividing income available common shareholders weighted average number common shares outstanding period diluted earnings per share reflects potential dilution common stock equivalents options warrants extent impact dilutive antidilutive shares excluded diluted earnings per share calculation 2006 2005 2004 2953204 6765118 3898448 respectively retained earnings included retained earnings december 31 2006 2005 17 million 15 million respectively restricted retained earnings company complies chinese statutory rules regarding profit appropriation restricted funds used specific purposes defined ministry finance department china funds available company use operations distribution recent accounting pronouncements july 2006 fasb issued financial interpretation 48 “accounting uncertainty income taxesan interpretation fasb statement 109” “fin 48” change accounting income taxes fin 48 specifies tax benefits uncertain tax positions recognized measured derecognized financial statements requires certain disclosures uncertain tax matters specifies reserves uncertain tax positions classified balance sheet provides transition interimperiod guidance among provisions fin 48 effective fiscal years beginning december 15 2006 result effective us january 1 2007 currently evaluating impact fin 48 consolidated financial statements september 2006 fasb issued statement 157 “fair value measurements” “sfas 157” sfas 157 defines fair value establishes framework gives guidance regarding methods used measuring fair value expands disclosures fair value measurements sfas 157 applicable whenever another accounting pronouncement requires permits assets liabilities measured fair value sfas 157 expand require new fair value measures however application statement may change current practice sfas 157 effective fiscal years beginning november 15 2007 result effective fiscal year beginning january 1 2008 currently evaluating impact adopting sfas 157 consolidated financial statements u segment reporting operating divisions consist geographically based entities americas asia europe operating divisions similar economic characteristics defined sfas 131 disclosures segments enterprise related information accordingly operated one reportable segment years ended december 31 2006 2005 2004 v reclassifications certain prior year amounts reclassified conform current year presentation reclassifications effect previously reported results operations rae systems inc notes consolidated financial statements continued note 2 mergers acquisitions rae coal mine safety instruments fushun co ltd december 10 2006 wholly owned subsidiary company rae systems asia ltd “rae asia” entered agreement form joint venture liaoning coal industry group co ltd “liaoning group” company liaoning group formed rae coal mine safety instruments fushun co ltd limited liability company “rae fushun” laws people’s republic china duration 50 years forming joint venture liaoning group company obtained control fushun anyi ltd wholly owned subsidiary liaoning group manufacturer distributor coalmining safety equipment fushun anyi ltd separate whollyowned subsidiary formerly division liaoning group coal mining safety business 50 years primary reason acquisition penetrate china’s coal mine safety equipment industry capitalize growth increases demand safety equipment coal mining industry joint venture agreement provided rae asia 70 interest rae fushun would contribute 108 million cash 22 million due immediately upon formation rae fushun remainder payable installments december 2007 30 interest rae fushun note payable 39 million liaoning group contributed operating assets fushun anyi ltd book value 85 million total purchase price rae asia’s 70 interest rae fushun follows rae asia’s purchase 70 joint venture allocated fair value assets acquired liabilities assumed company process completing valuation certain intangible assets thus allocation purchase price subject refinement following table summarizes purchase price allocation rae asia’s 70 interest rae fushun balance eliminated consolidation rae systems inc notes consolidated financial statements continued following intangible assets acquired part acquisition customer list amortized using accelerated method represents estimated pattern use intangible assets amortized straight line basis estimated useful lives unaudited financial information table summarizes combined results operations company rae fushun pro forma basis though companies combined beginning fiscal years presented pro forma financial information presented information purpose indicative would occurred acquisition made periods indicative future results operations pro forma amounts give effect appropriate adjustments fair value assets acquired amortization intangibles income taxes rae beijing acquisition july 12 2006 rae asia entered four separate agreements purchase aggregate thirtytwo percent 32 outstanding common stock rae klh beijing co ltd “rae beijing” four minority interest holders 32 combined 64 rae beijing acquired may 2004 raises company’s ownership 96 management believes increase company’s rae beijing ownership strengthen company’s ability benefit fastgrowing industrial market china purchase shares accomplished via initial cash payment minority shareholders 48 million 19 total 32 purchased remaining common shares effect purchase company converted common shares nonvoting redeemable convertible preferred stock preferred stock redeemable accordance following schedule preferred shares contingently convertible option holders event initial public offering china rae beijing subsidiary management believes likelihood initial public offering china remote result believe conversion provision substantive therefore accordance guidance statement financial accounting standards 150 “accounting certain financial instruments characteristics liabilities equity” company classified preferred stock liability preferred stock also accrues dividends rate 3 per year due classification liability rae systems inc notes consolidated financial statements continued company discounted preferred stock dividends market rate 648 resulting discount 08 million total purchase price 32 minority interest summarized follows since may 2004 company consolidated results rae beijing within publicly reported financial statements rae beijing purchase price additional 32 ownership interest allocated fair value assets acquired liabilities assumed follows represents 32 total fair value following table represents details intangible assets acquired part rae beijing acquisition 28 million goodwill recorded conjunction rae beijing acquisition deductible income tax purposes customer list amortized using accelerated method represents estimated pattern use intangible assets amortized straight line basis estimated useful lives acquisitions july 11 2006 company purchased assets including two pending patents santa clara california based aegison corporation “aegison” supplier fixed mobile digital video surveillance systems approximately 2 million cash expect expand presence include mobile digital video security market united states rae systems inc notes consolidated financial statements continued acquisition constitutes business combination accordance criteria defined emerging issues task force 983 “determining whether nonmonetary transaction involves receipt productive assets business” following table allocates purchase price fair value assets acquired liabilities assumed following table presents details purchased intangible assets goodwill 816000 recorded conjunction aegison purchase deductible income tax purposes purchase aegison deemed management immaterial business combination therefore pro forma information included acquisition progress december 31 2006 company process acquiring tianjin securay technology ltd co “securay” company owns 20 securay acquisition aegison july 2006 december 31 2006 company recorded 820000 acquisition progress 467000 represented purchase inventories property equipment remaining 353000 representing 20 ownership interest company previously acquired conjunction aegison acquisition discussed additional information regarding securay acquisition please refer note 15 subsequent events note 3 investments accordance financial accounting standard 115 “accounting certain investments debt equity” company changed classification investments “heldtomaturity” “availableforsale” second quarter 2006 resulting fairvalue adjustment company’s investments led net 23000 reduction carrying value investments date change rae systems inc notes consolidated financial statements continued break company’s availableforsale investments december 31 2006 follows company’s investments classified availableforsale securities december 31 2006 heldtomaturity securities december 31 2005 broken follows company’s unrealized losses investments temporary nature due company’s intent ability hold investments maturity par value realized based review securities including assessment duration severity related unrealized losses company recorded otherthantemporary impairments securities following table summarizes maturities company’s fixed income securities december 31 2006 2005 note 4 inventories consist following rae systems inc notes consolidated financial statements continued note 5 property equipment summary property equipment follows significant construction progress 2005 primarily represented cost implement oracle erp system erp system placed service 2006 therefore costs transferred computer equipment account depreciation expense years ended december 31 2006 2005 2004 26 million 16 million 07 million respectively note 6 goodwill intangible assets goodwill represents excess purchase price related costs value assigned net tangible identifiable intangible assets company recorded goodwill result investments rae beijing aegison amount 30 million 08 million respectively goodwill impaired december 31 2006 result required annual impairment review majority intangible assets related rae beijing investment components purchased intangible assets follows company’s purchased intangible assets goodwill subject amortization weighted average life 562 years amortization expense years ended december 31 2006 2005 2004 rae systems inc notes consolidated financial statements continued 07 million 05 million 03 million respectively estimated future amortization expense shown following table note 7 accrued liabilities accrued liabilities december 31 2006 2005 summarized follows note 8 income taxes loss income taxes minority interest comprises rae systems inc notes consolidated financial statements continued income tax benefit expense comprises following summarizes differences income tax benefit expense amount computed applying federal income tax rate 2006 2005 2004 income taxes rae systems inc notes consolidated financial statements continued deferred tax assets liabilities december 31 2006 2005 comprised following assessing recoverability deferred tax assets management considers whether likely portion deferred tax assets realized ultimate realization deferred tax assets dependent generation future taxable income periods temporary differences become deductible management considers scheduled reversal deferred tax liabilities historical projected future taxable income tax planning strategies making assessment december 31 2006 valuation allowance amount approximately 11 million established deferred tax assets management unable conclude time likely company realize tax benefit deferred tax assets 2006 valuation allowance reduced approximately 02 million reflect company’s realization 2006 certain tax benefits attributable deferred tax assets management continue evaluate appropriateness valuation allowance light current anticipated future taxable income us income taxes provided deferred taxes undistributed earnings nonus subsidiaries expected permanently reinvested companies provision us income taxes remaining undistributed earnings approximately 25 million december 31 2006 company intends reinvest earnings indefinitely operations outside united states accordance statement financial accounting standards 5 “sfas 5” “accounting contingencies” company maintains reserves estimated income tax exposures various tax jurisdictions exposure item becomes probable estimable exposures settled primarily settlement audits within individual tax jurisdiction closing statute limitation exposures also affected changes applicable tax law factors may cause management believe revision past estimates appropriate management believes appropriate liability established income tax exposure however actual amounts may differ materially estimates december 31 2006 rae systems inc notes consolidated financial statements continued company recorded tax contingency reserves approximately 06 million included within income taxes payable consolidated balance sheet 2006 internal revenue service completed examination federal income tax returns years ended december 31 2003 2004 based results examination company paid 391000 irs april 2006 accrued december 31 2005 based favorable outcome audit company released 337000 additional reserves applicable 2003 2004 year additionally company reported 190000 release tax reserves related interest upon expiration statute limitations federal tax liabilities applicable uncertain tax positions year ended december 31 2002 2006 tax authority denmark skat completed audit company’s subsidiary denmark year ended december 31 2004 without adjustment december 31 2006 company research development credit carryforwards approximately 03 million california income tax purposes california credits subject expiration current california tax law note 9 commitments contingencies legal proceedings polimaster ltd v rae systems inc united states district court northern district california case 05cv01887jf polimaster ltd filed complaint rae systems inc may 9 2005 united states district court northern district california case styled polimaster ltd v rae systems inc case 05cv01887jf complaint alleges among things rae systems inc breached contract polimaster infringed upon polimaster’s intellectual property rights polimaster moved preliminary injunction june 17 2005 court denied polimaster’s request september 6 2005 dispute subject contractual arbitration agreement although federal court retained jurisdiction matter pending arbitration parties arbitration formally commenced june 12 2006 polimaster ltd matter arbitration conducted auspices judicial arbitration mediation services inc jams california tenday arbitration preceding scheduled march 516 2007 polimaster’s demand arbitration asserts damages totaling 132 million seeks injunction sales company’s gamma rae ii neutron rae ii radiation detection products company asserted counterclaims polimaster breach contract tortious interference contract among things seeks monetary damages time due preliminary speculative nature proceedings believe amount loss reasonably estimated matter also believe claim polimaster without merit expect vigorously defend position notwithstanding polimaster proceeding described time company engaged various legal proceedings incidental normal business activities although results litigation claims cannot predicted certainty company believes final outcome matters material adverse effect financial position results operations cash flows b operating leases company subsidiaries lease certain manufacturing warehousing facilities operating leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2006 2005 2004 654000 624000 809000 respectively future minimum lease payments next five rae systems inc notes consolidated financial statements continued years 2007 2011 thereafter excluding sunnyvale california abandoned building lease described 947000 621000 426000 378000 349000 801000 respectively december 2004 company purchased property located 3775 north first street san jose california lease related previous headquarters sunnyvale california writtenoff second quarter 2005 total loss abandonment lease approximately 2 million future discounted lease payments related sunnyvale building included accrued expenses totaling 478000 long term liabilities totaling 1000000 december 31 2006 future minimum lease payments next three years 2007 2009 528000 627000 556000 respectively discount rate used 485 liability reduced anticipated future sublease income based upon broker estimates current real estate market conditions factors considered likely potential sublease income would offset brokerage refurbishment costs make facility ready sublease c purchase obligations company agreements suppliers parties purchase inventories goods services company estimated noncancelable obligations agreements next three years 2007 2009 approximately 3844000 244000 230000 respectively noncancelable obligations 2009 noncancelable obligations related inventories expected delivered within next 12 months company periodically reviews carrying value inventories noncancelable purchase commitments evaluating material usage requirements forecasts estimates inventory obsolescence excess quantities expected losses purchase commitments company may record charges writedown inventory due excess obsolete slowmoving inventory lowerofcost market based analysis impact changes technology estimates future sales volumes market value estimates loss accrued related current purchase obligations however additional future writedowns inventories loss accrued inventory purchase commitments due market conditions may negatively affect gross margins future periods december 2006 rae fushun entered agreement fushun economic development zone administration purchase land use right approximately 446000 land use right used construct rae fushun’s new manufacturing administrative facility construction expected begin prior june 2007 guarantees company permitted delaware law accordance bylaws indemnify officers directors certain events occurrences subject certain limits officer serving company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director officer insurance policy limits exposure enables recover portion future amounts paid date company incurred losses agreements company’s sales agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits rae systems inc notes consolidated financial statements continued e product warranties company sells majority products 12 24 month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized december 31 2006 2005 warranty reserve recorded accrued expenses 553000 377000 respectively summary obligations following table quantifies known contractual obligations tabular form december 31 2006 note 10 employee benefit plans company defined contribution 401k plan “plan” domestic employees plan available employees reached age 21 completed three months service company plan eligible employees may contribute portion salaries plan company’s contributions determined based matching 25 first 6 covered employee’s salary subject statutory maximum levels contributions plan totaled 113000 108000 92000 years ended december 31 2006 2005 2004 respectively note 11 concentrations financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade receivables company places domestic foreign cash equivalents large financial institutions domestic cash balances insured federal deposit insurance company 100000 per financial institution december 31 2006 2005 company deposits excess insured limits 7859000 5906000 respectively company also deposits several foreign financial institutions insured aggregated 10159000 7518000 december 31 2006 2005 respectively significant portion company’s revenues accounts receivable derived sales made distributors located primarily throughout americas well asia europe following table presents certain data geographic area rae systems inc notes consolidated financial statements continued 1 americas revenue included sales customers united states canada latin american countries sales canada latin american countries represent less 8 total americas sales fiscal 2006 2005 2004 38 33 24 respectively revenues derived sales asia individual customer comprised 10 consolidated net sales 2006 2005 2004 company believes risk loss significantly reduced due diversity customers geographic sales areas company’s credit policy establishing payment terms credit limits based risk analysis company performs credit evaluations customers’ financial condition whenever necessary generally require cash collateral 2006 2005 approximately 46 52 respectively property equipment located americas 54 48 respectively located asia note 12 shareholders’ equity warrants since 2002 company warrants outstanding purchase company’s common stock summary company’s warrants december 31 2006 2005 2004 changes 2006 2005 presented following tables rae systems inc notes consolidated financial statements continued nonplan restricted stock august 2006 company granted 536000 shares restricted stock four individuals inducement enter employment company restricted stock granted individuals vest rate 25 july 2007 remainder vest quarterly subsequent threeyear period weightedaverage fair value awards granted period 281 nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares nonplan restricted stock weightedaverage exercise price 099 options vest 25 one year remainder vesting monthly following three years exercisable ten years summary status directors nonplan options december 31 2006 2005 2004 changes years ended presented following table rae systems inc notes consolidated financial statements continued following table summarizes information stock options included directors nonplan options outstanding december 31 2006 stock option plan august 1993 company’s board directors adopted 1993 stock option plan may 2002 board directors adopted 2002 stock option plan collectively “plans” plans authorize grant options purchase shares common stock employees directors consultants company affiliates plans feature incentive nonstatutory options incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting monthly following three years exercisable ten years december 31 2006 company reserved 235870 shares common stock issuance 1993 stock option plan 2902945 shares common stock issuance 2002 stock option plan december 31 2006 company 899276 shares common stock available future grant 2002 stock option plan rae systems inc notes consolidated financial statements continued summary status company’s stock option plan december 31 2006 2005 2004 changes years ended presented following table following table summarizes information stock options included 1993 2002 plans outstanding december 31 2006 december 31 2006 stock options outstanding 1993 2002 plans included 2921796 options either vested expected vest weightedaverage exercise price 318 aggregate intrinsic value 20 million remaining contractual term 755 years rae systems inc notes consolidated financial statements continued information stock options included 1993 2002 plans outstanding december 31 2006 exercise price less closing price december 31 2006 320 per share follows stockbased compensation expense company recorded 16 million 20 million 14 million stockbased compensation years ended december 31 2006 2005 2004 respectively required fas 123r management made estimate expected forfeitures recognizing compensation costs equity awards expected vest december 31 2006 total unearned compensation cost related unvested options granted employees company’s stock option plans yet recognized approximately 33 million net estimated forfeitures approximately 11 million fair value grant amortized straightline basis weightedaverage period approximately 3 years adjusted subsequent changes estimated forfeitures december 31 2006 total unearned compensation cost related unvested restricted stock awards granted employees approximately 11 million net estimated forfeitures approximately 03 million fair value award amortized straightline basis weightedaverage period approximately 35 years adjusted subsequent changes estimated forfeitures note 13 investments entities company accounts 40 ownership renex technologies ltd“renex” hong kong company using equity method starting january 1 2002 company’s total investment renex december 31 2006 2005 402000 449000 respectively years ended december 31 2006 2005 2004 company recorded losses renex 194000 196000 353000 respectively renex technologies ltd’s financial information derived unaudited financial statements follows rae systems inc notes consolidated financial statements continued company paid 75 royalty renex using certain modems developed renex 2006 2005 company made royalty payments amounting 91000 70000 respectively 2006 2005 2004 company purchased 573000 408000 98000 respectively inventory items renex sold 91000 48000 108000 respectively inventory items renex company also paid 254000 139000 renex research project 2006 2005 respectively accounts receivable due renex december 31 2006 2005 154000 84000 respectively accounts payable due renex december 31 2006 2005 360000 0 respectively company recorded 146000 489000 investment additional paid capital 2006 2005 respectively adjust prior year investment balance properly reflect carrying value investment prorated share net equity renex note 14 related party transactions conjunction original subsequent additional investment rae beijing unsecured note payables established previous rae beijing shareholders part purchase price agreement may 2004 july 2006 december 31 2006 december 31 2005 822000 759000 respectively included notes payable related parties 3222000 821000 respectively included long term notes payable related parties notes issued conjunction original rae beijing purchase may 2004 noninterest bearing recorded net present value using discount rate 55 conjunction additional investment rae beijing july 2006 110 million shares preferred stock issued four shareholders rae beijing accordance fas 150 preferred shares classified liabilities recorded longterm notes payable related parties although preferred shares bear dividend yield rate 3 per annum notes payable discounted using market interest rate 648 included current portion notes payable sum 448000 due demand december 31 2006 addition future payment plan years 2007 2011 411000 257000 1756000 967000 940000 respectively company’s director information systems lien chen wife chief executive officer robert chen ms chen paid salary bonus 103000 96000 2006 2005 respectively ms chen also receives standard employee benefits offered fulltime us employees ms chen report robert chen compensation decisions regarding ms chen performed manner us employees robert chen final approval signatory compensation recommendations january 14 2006 lien chen sandy hsi wife chief technology officer peter c hsi signed promissory note lend 200000 aegison corporation interest rate 10 per year july 11 2006 company purchased assets including two pending patents aegison corporation total purchase price 2 million cash time promissory note held lien chen sandy hsi repaid aegison corporation note 15 subsequent events january 3 2007 rae systems asia ltd entered agreement purchase intellectual properties tianjin securay technology ltd co renminbi 12 million approximately 15 million transaction rae systems inc notes consolidated financial statements continued together purchase agreements entered 2006 completed purchase tianjin securay technologies ltd co including transactions entered 2006 total purchase price 2 million cash assets purchased 2006 amounting 820000 recorded acquisition progress please see note 2 mergers acquisitions additional information march 14 2007 company signed one year 15 million revolving credit agreement available help fund future growth expansion agreement provides borrowings 7 million based blanket security interest company’s assets additional 8 million borrowing available based percentage qualifying assets company required comply certain bank specific reporting requirements whenever borrowings line credit exceed 3 million addition ongoing requirement submit quarterly financial statements company full compliance borrowing requirements including certain financial covenants full line available present outstanding amounts line credit agreement note 16 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presented 1 company purchased additional 32 ownership rae beijing july 2006 company consolidated rae beijing since 2004 purchase july 2006 minority shareholder’s interest reduced 4 2 second quarter 2005 company abandoned leased facility sunnyvale california moved new headquarters us manufacturing facility result company took beforetax charge approximately 20 million abandonment lease second quarter 2005 rae systems inc notes consolidated financial statements continued 3 gross profit numbers 2005 reclassified order comply 2006 presentation reclassification adjustments impact net income loss quarter 2005 note 17 supplemental disclosures following supplemental disclosures valuation qualifying accountsitem 15 exhibits financial statement schedules 1 financial statements see index consolidated financial statements form 10k 2 financial statement schedules provided absence conditions required information given financial statements notes thereto 3 exhibits see index exhibits page 37 herein signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized march 13 2009 rae systems inc robert chen robert chen president chief executive officer know persons presents person whose signature appears constitutes appoints robert chen randall gausman person’s true lawful attorneysinfact agents full power substitution resubstitution person’s name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated index exhibits 1 previously filed exhibit registrant’s quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 2 previously filed exhibit registrant’s current report form 8k june 19 2007 incorporated herein reference 3 previously filed exhibit registrant’s current report form 8k december 21 2007 incorporated herein reference 4 previously filed august 8 2006 exhibit registrant’s quarterly report form 10q quarter ended june 30 2006 incorporated herein reference 5 previously filed exhibit registrant’s current report form 8k august 8 2006 incorporated herein reference 6 previously filed exhibit registrant’s current report form 8k august 16 2006 incorporated herein reference 7 previously filed exhibit registrant’s current report form 8k october 18 2006 incorporated herein reference 8 previously filed exhibit registrant’s annual report form 10k year ended december 31 2006 incorporated herein reference 9 previously filed exhibit registrant’s annual report form 10k year ended december 31 2007 incorporated herein reference 10 filed herewith rae systems inc consolidated financial statements december 31 2008 2007 report independent registered public accounting firm board directors shareholders rae systems inc audited accompanying consolidated balance sheets rae systems inc subsidiaries collectively “company” december 31 2008 2007 related consolidated statements operations shareholders’ equity comprehensive loss cash flows years ended financial statements responsibility company’s management responsibility express opinion financial statements based audits consolidated financial statements company year ended december 31 2006 effects retrospective adjustments discontinued operations discussed note 3 consolidated financial statements audited auditors whose report dated march 16 2007 expressed unqualified opinion statements conducted audits accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion 2008 2007 consolidated financial statements present fairly material respects financial position company december 31 2008 2007 results operations cash flows years ended conformity accounting principles generally accepted united states america also audited retrospective adjustments 2006 consolidated financial statements operations discontinued 2007 discussed note 3 consolidated financial statements procedures included 1 obtaining company’s underlying accounting analysis prepared management retrospective adjustments discontinued operations comparing retrospectively adjusted amounts per 2006 financial statements analysis 2 comparing previously reported amounts previously issued financial statements years 3 testing mathematical accuracy accounting analysis 4 test basis comparing adjustments retrospectively adjust financial statements discontinued operations company’s supporting documentation opinion retrospective adjustments appropriate properly applied however engaged audit review apply procedures 2006 consolidated financial statements company respect retrospective adjustments accordingly express opinion form assurance 2006 consolidated financial statements taken whole discussed note 6 consolidated financial statements january 1 2007 company changed method accounting uncertain income tax positions accordance guidance provided financial standards accounting board interpretation 48 accounting uncertainty income taxes interpretation fasb statement 109 also audited accordance standards public company accounting oversight board united states company’s internal control financial reporting december 31 2008 based criteria established internal control integrated framework issued committee sponsoring organizations treadway commission report dated march 12 2009 expressed unqualified opinion company’s internal control financial reporting deloitte touche llp san jose california march 12 2009 report independent registered public accounting firm board directors shareholders rae systems inc audited effects adjustments retrospectively account dvr business discontinued operation described notes 3 5 accompanying consolidated statements operations shareholders’ equity cash flows year ended december 31 2006 rae systems inc company financial statements responsibility company’s management responsibility express opinion financial statements based audit conducted audit accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audit provides reasonable basis opinion consolidated financial statements referred effects adjustments retrospectively account dvr business discontinued operation described notes 3 5 present fairly material respects results operations cash flows rae systems inc year ended december 31 2006 conformity accounting principles generally accepted united states america engaged audit review apply procedures adjustments retrospectively account dvr business discontinued operation described notes 3 5 accordingly express opinion form assurance whether adjustments appropriate properly applied adjustments audited deloitte touche llp bdo seidman llp san jose california march 16 2007 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders’ equity comprehensive loss see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements note 1 summary significant accounting policies company founded 1991 rae systems inc “company” “rae” delaware company develops manufactures rapidlydeployable multisensor chemical radiation detection monitors networks industrial applications homeland security company’s products based proprietary technology include portable wireless fixed chemical detection monitors radiation detectors principles consolidation consolidated financial statements prepared accordance accounting principles generally accepted united states include company subsidiaries ownership interest holders consolidated subsidiaries reflected minority interest intercompany balances transactions eliminated use estimates preparation financial statements conformity generally accepted accounting principles united states america requires management make estimates assumptions affect reported amounts assets liabilities disclosures contingent assets liabilities date financial statements reported amounts revenue expenses reporting period company bases estimates historical experience various assumptions believed reasonable based available information actual results may differ materially estimates assumptions revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company generally recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier free board “fob” provides sales returns standard product warranty provisions nonstandard contract terms title goods passes upon delivery customer fob destination revenue recognized company established proof delivery revenues related services performed company’s extended warranty program recognized earned based upon contract terms generally ratably term service company records project installation work asia using percentageofcompletion method net sales also include amounts billed customers shipping handling company’s shipping costs included cost sales cash equivalents company considers highly liquid investments original maturities three months less time purchase cash equivalents allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts based company’s assessment collectability customer accounts company regularly reviews allowance considering factors historical experience credit quality age accounts receivable balances current economic conditions known troubled accounts company generally require collateral sales credit company becomes aware specific customer unable meet financial obligations company records specific rae systems inc notes consolidated financial statements continued allowance reflect level credit risk customer’s outstanding receivable balance addition company records additional allowances based certain percentages aged receivable balances company classifies bad debt expenses selling general administrative expenses company able predict changes financial stability customers material change financial status one group customers could material adverse effect company’s results operations financial condition although losses within management’s expectations date assurance allowances continue adequate customer accounted 10 consolidated net sales period presented trade notes receivable trade notes receivable bank guaranteed promissory notes noninterest bearing generally mature within six months time certain customers china present notes payment outstanding accounts receivable concentration credit risk financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade notes receivable accounts receivable company places domestic foreign cash equivalents large creditworthy financial institutions primarily united states people’s republic china us cash balances insured federal deposit insurance company 250000 per bank december 31 2008 2007 company deposits excess insured limits approximately 10 million 49 million respectively company also deposits several foreign financial institutions insured summed approximately 133 million 108 million december 31 2008 2007 respectively inventories stated lower standard cost approximates actual cost computed firstin firstout basis market company established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded writedowns intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required property equipment property equipment stated cost less accumulated depreciation computed using straightline method estimated useful lives assets follows warranty repairs date shipment company provides 12 24 month repair replacement warranty majority products based primarily historical relationship actual warranty costs sales rae systems inc notes consolidated financial statements continued company accrues reserve estimated future warranty costs time revenue recognized estimated warranty obligation affected product failure rates length warranty period materials usage repair replace defective products service delivery costs incurred correcting product failures addition time specific warranty accruals may made unforeseen technical problems arise company’s actual experience relative factors significantly different estimated company may required adjust provision future periods research development research development costs expensed incurred advertising costs company expenses advertising costs incurred years ended december 31 2008 2007 2006 advertising expense 311000 547000 1029000 respectively income taxes company recognizes income taxes accordance sfas 109 “accounting income taxes” “sfas 109” using asset liability approach requires recognition taxes payable refundable current year deferred tax assets liabilities expected future tax consequences events recognized company’s consolidated financial statements tax returns measurement current deferred taxes based provisions enacted tax law sfas 109 provides recognition deferred tax assets realization assets likely occur otherwise valuation allowance established deferred tax assets may realized company subject income tax audits respective tax authorities jurisdictions operates determination tax liabilities jurisdictions requires interpretation application complex sometimes uncertain tax laws regulations recognition measurement current taxes payable refundable deferred tax assets liabilities requires company make certain estimates judgments changes estimates change judgment may material impact company’s tax provision future period goodwill intangible assets goodwill tested impairment annual basis fourth quarter annual tests events occur circumstances indicate carrying amount goodwill may recoverable impairment losses recorded statement operations “impairment goodwill” purchased intangible assets goodwill amortized estimated useful lives unless lives determined indefinite purchased intangibles carried cost less accumulated amortization generally computed using either straightline method accelerated method based pattern expected usage estimated useful lives respective assets generally two nine years longlived assets company evaluates recoverability longlived assets finite lives accordance sfas 144 “accounting impairment disposal longlived assets” “sfas 144” requires recognition impairment longlived assets whenever events changes circumstances indicate carrying amount asset may recoverable company periodically reviews longlived assets impairment events changes circumstances indicate carrying amount asset may recoverable based rae systems inc notes consolidated financial statements continued estimated undiscounted cash flows impairment loss would measured difference carrying amount assets fair value based present value estimated future cash flows fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments • cash equivalents accounts receivable trade notes receivables accounts receivable affiliate accounts payable accrued expenses inventory purchase obligations carrying amount reported consolidated balance sheets items approximates fair value short maturity instruments addition inventory purchase obligations carrying value approximates fair value based market rates comparable products • notes payable related parties carrying value notes payable related parties approximates fair value company discounted non interest bearing notes payables interest rate commensurate commercial borrowing rates available company china december 31 2008 2007 fair values company’s financial instruments approximate historical carrying amount translation foreign currencies assets liabilities nonus subsidiaries operate local currency environment local currency functional currency translated us dollars exchange rates effect balance sheet date resulting translation adjustments directly recorded separate component accumulated comprehensive income expense accounts translated average exchange rates year gains losses foreign currency transactions recorded income loss net functional currency local currency nonus subsidiaries stockbased compensation expense effective january 1 2006 company adopted fair value recognition provisions sfas 123r “sharebased payment” “sfas 123r” fair value option adjusted reflect shares expected vest november 10 2005 financial accounting standards board “fasb” issued fasb staff position fas 123r3 “transition election related accounting tax effects stockbased payment awards” allows simplified method establish beginning balance additional paidin capital pool “apic pool” related tax effects employee stockbased compensation determine subsequent impact apic pool consolidated statements cash flows tax effects employee stockbased compensation awards outstanding upon adoption sfas 123r january 1 2006 company adopted simplified method computation beginning balance apic pool net loss per share basic loss per share includes dilution computed dividing loss available common shareholders weighted average number common shares outstanding period diluted earnings per share reflects potential dilution common stock equivalents options warrants extent impact dilutive company incurred net losses years ended december 31 2008 2007 2006 potentially dilutive securities excluded diluted net loss per share computations effect antidilutive weightedaverage number potentially dilutive shares excluded diluted net loss per share calculation 2008 2007 2006 3813874 3505491 2953204 respectively rae systems inc notes consolidated financial statements continued retained earnings accordance company law people’s republic china company’s china subsidiaries may required appropriate portion net income determined accounting principles generally accepted china “prc gaap” nondistributable reserves include general reserve enterprise expansion reserve staff welfare bonus reserve reserves restrict portion retained earnings distribution shareholders reserves withdrawn business remain available use operations whollyowned china subsidiaries required make appropriations enterprise expansion reserve however china subsidiaries required appropriate less 10 net income determined prc gaap general reserve appropriations general reserve limited 50 china subsidiary’s registered capital appropriations staff welfare bonus reserve determined board directors total appropriation retained earnings company’s statutory reserves totaled 27 million 17 million december 31 2008 2007 respectively variable interest entities sarl rae france “rae france” identified management variable interest entity company primary beneficiary ownership rae europe aps rae france distributes sells rae products exclusively france rae france total sales 27 million 18 million 17 million 2008 2007 2006 respectively total assets 11 million 07 million december 31 2008 2007 respectively company consolidated rae france since december 2004 segment reporting sfas 131 “disclosures segments enterprise related information” “sfas 131” establishes standards public business enterprises report information operating segments annual financial statements requires enterprises report selected information operating segments subsequent interim financial reports issued shareholders also established standards related disclosure products services geographic areas major customers operating segments components enterprise evaluated regularly chief operating decisionmaker deciding allocate assess resources performance company’s chief operating decisionmakers chief executive officer chief financial officer although company’s operating segments consist entities geographically based americas asia europe company single reporting segment worldwide sale portable wireless gas radiation detection products related services accordingly company operated one reportable segment years ended december 31 2008 2007 2006 recent accounting pronouncements december 2007 fasb issued sfas 141r “business combinations” “sfas 141r” statement changes accounting acquisition transaction costs requiring expensed period incurred also changes accounting contingent consideration acquired contingencies restructuring costs related acquisition sfas 141r effective fiscal years beginning december 15 2008 adoption sfas 141r expected change company’s accounting treatment business combinations prospective basis beginning period adopted december 2007 fasb issued sfas 160 “noncontrolling interests consolidated financial statementsan amendment arb 51” “sfas 160” statement change accounting reporting minority interests recharacterized noncontrolling interests classified component equity sfas 160 effective fiscal years beginning december 15 2008 company believes rae systems inc notes consolidated financial statements continued adoption sfas 160 material impact consolidated financial position results operations cash flows march 2008 fasb issued sfas 161 “disclosures derivative instruments hedging activities amendment fasb statement 133” statement establishes enhanced disclosures entity uses derivative instruments derivative instruments related hedged items accounted sfas 133 “accounting derivative instruments hedging activities” related interpretations derivative instruments related hedged items affect entity’s financial position results operations cash flows effective financial statements issued fiscal years interim periods beginning november 15 2008 early adoption encouraged statement encourages require comparative disclosures earlier periods initial adoption statement expected material effect company’s consolidated financial statements april 2008 fasb issued fasb staff position fas 1423 “determination useful life intangible assets” “fsp 1423” fsp 1423 amends factors considered developing renewal extension assumptions used determine useful life recognized intangible asset sfas 142 “goodwill intangible assets” fsp 1423 also requires expanded disclosure regarding determination intangible asset useful lives fsp 1423 effective fiscal years beginning december 15 2008 earlier adoption permitted management currently evaluating potential impact adoption fsp 1423 company’s consolidated financial position results operations cash flows may 2008 fasb issued sfas 162 “the hierarchy generally accepted accounting principles” “sfas 162” sfas 162 intended improve financial reporting identifying consistent framework hierarchy selecting accounting principles used preparing financial statements presented conformity us generally accepted accounting principles nongovernmental entities effective financial statements issued fiscal years interim periods beginning november 15 2008 company expect adoption sfas 162 material impact consolidated financial statements note 2 mergers acquisitions rae coal mine safety instruments fushun co ltd december 2006 wholly owned subsidiary company rae systems asia ltd “rae asia” agreed form joint venture liaoning coal industry group co ltd “liaoning group” form rae coal mine safety instruments fushun co ltd “rae fushun” limited liability company china duration 50 years result joint venture company obtained control fushun anyi ltd wholly owned subsidiary liaoning group manufacturer distributor safety equipment primarily coal mining industry primary reasons acquisition expand company’s market penetration china capitalize increased demand safety equipment coal mining industry joint venture agreement provided rae asia 70 interest rae fushun would contribute 108 million cash 22 million due immediately upon formation rae fushun remainder payable installments december 2007 30 interest rae fushun payable 39 million liaoning group contributed operating assets fushun anyi ltd book value 85 million december 31 2008 2007 remaining balance due payable liaoning group 64000 609000 respectively total purchase price rae asia’s 70 interest rae fushun follows thousands rae systems inc notes consolidated financial statements continued transaction accounted purchase accordance sfas 141 therefore assets acquired liabilities assumed recorded fair value acquisition date following table summarizes purchase price allocation rae asia’s interest rae fushun’s assets liabilities thousands 1 balance eliminated consolidation purchase price allocation includes adjustments since date purchase acquired tangible intangible assets 2008 company increased value customer list 435000 recognized corresponding deferred tax liability 2007 company reduced value property equipment 11 million reduced allowance doubtful accounts 03 million adjustments estimated fair value acquisition date rae fushun right use predecessor enterprise’s tradenames patents due intangible assets registered rae fushun’s name value assets totaling 06 million written fair value net assets acquired formation rae fushun exceeded purchase price net result purchase price allocation adjustments reduced negative goodwill increased recorded value acquired customer list fair value customer list amortized using accelerated method based pattern expected usage estimated useful life 9 years results operations rae fushun included company’s consolidated financial statements since january 1 2007 unaudited financial information table summarizes combined results operations company rae fushun pro forma basis though companies combined beginning periods presented unaudited pro forma financial information presented informational purposes indicative results operations would achieved merger taken place beginning period presented indicative future results operations pro forma amounts give effect appropriate adjustments fair value assets acquired amortization intangibles income taxes rae systems inc notes consolidated financial statements continued rae beijing acquisition july 2006 rae asia entered four separate agreements purchase aggregate thirtytwo percent 32 outstanding common stock rae klh beijing co ltd “rae beijing” four minority interest holders 32 combined 64 rae beijing acquired may 2004 raises company’s ownership 96 management believes increase company’s rae beijing ownership strengthen company’s ability benefit fastgrowing industrial market china purchase shares accomplished via initial cash payment minority shareholders 48 million 19 total 32 purchased remaining common shares take effect purchase company converted common shares nonvoting redeemable convertible preferred stock preferred stock redeemable accordance following schedule thousands preferred shares contingently convertible option holders event initial public offering china rae beijing subsidiary management believes likelihood initial public offering china remote result believe conversion provision substantive therefore accordance guidance sfas 150 “accounting certain financial instruments characteristics liabilities equity” preferred stock classified liabilities preferred stock also accrues dividends rate 3 per year due classification liability company discounted preferred stock dividends market rate 648 resulting discount 08 million total purchase price 32 minority interest summarized follows thousands since may 2004 company consolidated results rae beijing within publicly reported financial statements rae beijing purchase price additional 32 ownership interest allocated fair value assets acquired liabilities assumed follows represents 32 total fair value thousands rae systems inc notes consolidated financial statements continued acquired intangible assets amortized estimated useful lives presented table 28 million goodwill recorded conjunction rae beijing acquisition deductible income tax purposes customer list amortized using accelerated method represents estimated pattern use intangible assets amortized straight line estimated useful lives acquisitions july 2006 company purchased assets including two pending patents santa clara california based aegison corporation “aegison” supplier fixed mobile digital video surveillance systems approximately 2 million cash direct transaction costs 142000 acquisition accounted business combination following table allocates purchase price fair value assets acquired liabilities assumed thousands following table summarizes components net tangible assets acquired fair value thousands 2007 company increased value investment securay 62000 reflect proceeds actually received subsequent purchase company discussed total purchase price increased 43000 due additional direct transaction costs incurred result goodwill decreased 19000 rae systems inc notes consolidated financial statements continued acquired intangible assets amortized estimated useful lives presented table goodwill represents excess purchase price fair value tangible identified intangible assets acquired expected deductible income tax purposes aegison’s results operations included company’s consolidated financial statements subsequent date acquisition pro forma results operations presented effect acquisition material prior period financial statements august 2007 company discontinued operations aegison see “note 3 discontinued operations” notes consolidated financial statements details january 2007 rae asia entered agreement purchase intellectual property tianjin securay technology ltd co “securay” renminbi 12 million approximately 15 million transaction together purchase agreements entered 2006 completed purchase securay including transactions entered 2006 total purchase price 20 million cash assets purchased 2006 amounting 820000 recorded acquisition progress december 31 2006 acquisition accounted business combination purchase price allocated follows thousands following table summarizes components net tangible assets acquired fair value thousands acquired intangible assets amortized estimated useful lives presented table goodwill represents excess purchase price fair value tangible identified intangible assets acquired expected deductible income tax purposes securay’s results operations included company’s consolidated financial statements subsequent date acquisition pro rae systems inc notes consolidated financial statements continued forma results operations presented effect acquisition material prior period financial statements acquisition aegison securay made company’s mobile digital video recording “dvr” business discontinued august 2007 see “note 3 discontinued operations” notes consolidated financial statements details note 3 discontinued operations august 24 2007 board directors approved discontinuation company’s dvr business order reduce expenses concentrate resources gas radiation detection business company’s mobile dvr business acquired purchases aegison securay see “note 2 mergers acquisitions” notes consolidated financial statements details august 28 2007 company notified dvr customers terminated personnel reassigned continuing operations suspended related production sales activities company retained acquired intellectual property dvr business operated substantial loss management liquidated tangible assets mainly inventories component parts accordingly value assets adjusted reflect disposals result discontinuing dvr business third quarter ended september 30 2007 management impaired remaining value intangible assets goodwill acquired purchases aegison july 2006 securay loss discontinued operations fiscal 2007 totaled 42 million accordance sfas 144 “accounting impairment disposal longlived assets” financial results dvr business reported discontinued operations periods presented financial results included discontinued operations follows current assets current liabilities discontinued operations 59000 63000 respectively december 31 2007 company collected remaining assets settled remaining liabilities third quarter 2008 rae systems inc notes consolidated financial statements continued note 4 balance sheet details allowance doubtful accounts components allowance doubtful accounts follows inventories stated lower cost market include material labor manufacturing overheard costs components inventories follows company recorded writedowns inventory 580000 442000 121000 2008 2007 2006 respectively inventory writedowns predominantly result changes forecasted customer demand technological changes company’s products included primarily raw material finished goods major elements written raw material consists components items entered production finished goods inventory includes cost raw material inputs labor overhead prepaid expenses current assets components prepaid expenses current assets follows rae systems inc notes consolidated financial statements continued property equipment net components property equipment follows construction progress 2008 2007 primarily represented cost build offices manufacturing facilities fushun people’s republic china new manufacturing facilities placed service october 2008 rae plans complete remaining office research development dormitory buildings stages next 12 24 months also december 2008 company purchased land use rights shanghai people’s republic china 12 million purpose building new manufacturing engineering facility december 2007 company sold headquarters building san jose california 127 million leased back facility period 10 years company recognized gain sale 04 million 2007 based difference net gain sale building 67 million net present value future lease payments 63 million net present value future lease payments recorded deferred gain recognized income straightline basis life lease beginning january 2008 deferred gain recognized income 2008 totaled 635000 lease classified operating lease december 31 2008 2007 current portion deferred gain 06 million 05 million respectively included accrued liabilities consolidated balance sheets depreciation expense years ended december 31 2008 2007 2006 22 million 23 million 26 million respectively accrued liabilities accrued liabilities december 31 2008 2007 summarized follows rae systems inc notes consolidated financial statements continued note 5 goodwill intangible assets goodwill represents excess purchase price related costs value assigned net tangible identifiable intangible assets following table presents changes goodwill 2008 2007 goodwill intangibles company also evaluates goodwill impairment whenever events changes circumstances indicate carrying amount may recoverable recoverability goodwill measured reporting unit level comparing reporting unit’s carrying amount including goodwill fair value reporting unit measured based upon among factors market capitalization well forecasted operating results company one reporting unit recorded value assets including goodwill liabilities “net book value” reporting unit exceeds fair value impairment loss may exist extent net book value company whole greater market capitalization significant portion goodwill may considered impaired company experienced significant decline market capitalization fourth quarter decline market capitalization driven largely deteriorating macroeconomic conditions contributed decline company’s forecasted operating results business uncertainties associated current fcpa investigation pursuant guidance sfas 142 goodwill intangible assets “sfas 142” measurement impairment goodwill consists two steps first step fair value company compared carrying value management completed valuation company incorporated existing marketbased considerations well operating information based current results projections concluded estimated fair value company less net book value accordingly guidance sfas 142 requires second step determine implied fair value company’s goodwill compare carrying value company’s goodwill second step includes estimating value tangible intangible assets liabilities company acquired business combination determine implied fair value goodwill result assessment indicated implied fair value goodwill zero result company recognized noncash impairment charge approximately 33 million threemonth period year ended december 31 2008 writeoff entire carrying value goodwill result discontinuing dvr business third quarter 2007 company impaired goodwill acquired purchases aegison securay see “note 3 discontinued operations” detail impairment goodwill 2007 2006 result required annual impairment test rae systems inc notes consolidated financial statements continued following table presents details company’s intangible assets goodwill company’s purchased intangible assets goodwill subject amortization expense years ended december 31 2008 2007 2006 12 million 14 million 07 million respectively 2008 company increased value customer list acquisition rae fushun 435000 recognized corresponding deferred tax liability 2007 company recorded impairment 609000 certain patents held rae beijing related discontinuation related product fourth quarter 2007 impairment analysis performed accordance sfas 144 intangible asset determined carrying value recoverable result discontinuing dvr business third quarter 2007 company impaired remaining balance intangible assets acquired purchases aegison securay impairment charge 16 million recognized quarter ended september 30 2007 included net loss discontinued operations reported company’s consolidated statements operations based carrying amount intangible assets december 31 2008 estimated future amortization follows thousands note 6 income taxes company’s loss continuing operations income taxes minority interest consisted following rae systems inc notes consolidated financial statements continued company’s income tax expense benefit consisted following reconciliation company’s income tax expense benefit federal statutory rate income tax expense benefit effective tax rate follows rae systems inc notes consolidated financial statements continued components company’s net deferred taxes consisted following assessing recoverability deferred tax assets management considers whether likely portion deferred tax assets realized ultimate realization deferred tax assets dependent generation future taxable income periods temporary differences become deductible management considers scheduled reversal deferred tax liabilities historical projected future taxable income tax planning strategies making assessment us income taxes provided deferred taxes undistributed earnings nonus subsidiaries expected permanently reinvested companies provision us income taxes remaining undistributed earnings approximately 40 million december 31 2008 company intends reinvest earnings indefinitely operations outside united states practical determine federal income tax consequences upon repatriation tax reform act 1986 amount benefits net operating loss carry forwards may impaired limited certain circumstances events cause limitations amount net operating loss credit carryforwards company may utilize one year include limited cumulative ownership change 50 defined threeyear period company approximately 50 million federal net operating loss scheduled expire 2027 july 2008 housing economic recovery act 2008 enacted law companies elect accelerate portion unused alternative minimum tax credit increased research activities lieu 50percent “bonus” depreciation enacted february 2008 company analyzed determined significant benefit election december 31 2008 company federal research development credit carryforwards approximately 73000 scheduled expire 2027 utilized california 20082009 budget bill enacted september 30 2008 resulted two temporary changes company’s 2008 california income tax first bill suspends use net operating loss carryovers two years 2008 2009 second bill limits use research development credit carryovers 50 tax liability credits december 31 2008 company research development credit rae systems inc notes consolidated financial statements continued carryforwards approximately 01 million california income tax purposes california credits subject expiration current california tax law change california law resulted income taxes 2008 approximately 8000 company granted tax holiday fushun china subsidiary whereby company entitled full exemption china income tax starting first year positive accumulated earnings 50 reduction statutory rate following three years statutory rate entity currently estimated 25 december 31 2008 entity made cumulative profit thus began first year exemption china income tax 2006 internal revenue service completed examination company’s federal income tax returns years ended december 31 2003 2004 based results examination company paid 391000 irs april 2006 tax authority denmark skat completed audit company’s subsidiary denmark year ended december 31 2004 without adjustment subsequent periods remain subject examination however audits currently process company’s valuation allowance determined accordance provisions sfas 109 requires assessment positive negative evidence determining whether likely deferred tax assets recoverable assessment required jurisdiction basis management believes sufficient uncertainty exists regard realizability tax assets exception 05 million foreign deferred tax assets valuation allowance necessary factors considered providing valuation allowance include lack significant history consistent profits current weakness overall market uncertainty economic fundamentals stabilize thereby potentially impacting company’s ability sustain grow revenues earnings length carryback carryforward periods based absence sufficient positive objective verifiable evidence december 31 2008 company concluded appropriate establish full valuation allowance net deferred tax assets throughout fiscal year 2008 company valuation allowance future tax benefits related certain foreign net operating losses result valuation allowance deferred tax assets increased 10 million 84 million january 1 2008 approximately 94 million december 31 2008 company expects provide full valuation allowance future tax benefits sustain level profitability demonstrates ability utilize assets amount deferred tax asset valuation allowance however could reduced future periods extent future taxable income realized prior 2008 exposures settled primarily settlement audits within individual tax jurisdiction closing statute limitation exposures also affected changes applicable tax law factors may cause management believe revision past estimates appropriate management believes appropriate liability established income tax exposure however actual amounts may differ materially estimates company adopted provisions fasb interpretation 48 “accounting uncertainty income taxes” “fin 48” january 1 2007 fin 48 impact uncertain tax position likely sustained upon audit relevant taxing authority must recognized largest amount likely sustained portion uncertain tax position recognized position less 50 likelihood sustained also fin 48 interest expense recognized full amount deferred benefits uncertain tax positions december 31 2008 company recorded tax contingency reserves approximately 14 million inclusive interest 03 million included within income taxes payable consolidated balance sheet december 31 2008 company 14 million unrecognized tax benefits 11 million would affect effective tax rate recognized company anticipate material changes uncertain tax positions next 12 months rae systems inc notes consolidated financial statements continued reconciliation beginning ending balance unrecognized tax benefits “utb”is follows company recognizes interest penalties associated uncertain tax positions income tax expense december 31 2008 january 1 2008 provision interest penalties 03 million 02 million respectively ultimate amount timing future cash settlements cannot predicted reasonable certainty conduct business globally result one subsidiaries file income tax returns us federal jurisdiction various state foreign jurisdictions normal course business subject examination taxing authorities throughout world including major jurisdictions china hong kong denmark uk france united states longer subject us federal nonus income tax examinations years 2005 many cases company’s uncertain tax positions related tax years remain subject examination tax authorities following describes open tax years major tax jurisdiction december 31 2008 note 7 lines credit company maintains credit facilities support operations united states people’s republic china united states company 150 million revolving credit agreement december 31 2008 december 31 2007 credit facility renewed annually currently expires march 13 2009 company currently renegotiating terms line credit bank march 11 2009 company received extension existing line may 12 2009 also changed certain terms conditions amended credit agreement provides borrowings 100 million based percentage specific qualifying assets blanket security interest company’s assets united states company required comply certain reporting requirements addition ongoing requirement submit quarterly financial statements interest accrues floating prime bank lending rate plus 100 basis points subject minimum total rate 5 addition company pays 30 basis points annually average unused portion facility assurance company successful securing renewed agreement line credit period may 12 2009 december 31 2008 december 31 2007 18 million zero respectively outstanding revolving credit agreement rae systems inc notes consolidated financial statements continued financial covenant revolving credit agreement required company ebitda least 35 million period july 1 2008 december 31 2008 company compliance covenant however lender issued waiver non compliance china december 31 2008 december 31 2007 company two unsecured revolving lines credit amount rmb 20 million approximately 29 million available provide working capital borrowings lines credit generally current market rate fixed rate loans amount duration requested one year credit facilities renewed annually may october respectively december 31 2008 rmb 5 million approximately 07 million outstanding lines credit interest accrues balance fixed rate 63315 outstanding balance due april 30 2009 december 31 2007 rmb 9 million approximately 12 million outstanding lines credit interest accrued balance fixed rate 648 principal payments rmb 5 million rmb 4 million made due march 23 2008 july 24 2008 respectively addition december 31 2007 company fully drawn unsecured line credit china rmb 10 million approximately 14 million interest accrued balance fixed rate 8019 outstanding balance repaid due august 31 2008 note 8 commitments contingencies legal proceedings regulatory compliance fiscal year 2008 company’s internal audit department identified certain payments gifts made certain personnel company’s china operations may violated fcpa following discovery audit committee board directors initiated independent investigation company made voluntary disclosure doj sec regarding results investigation company also implemented additional policies controls respect compliance fcpa related statutes regulations provide potential monetary penalties criminal sanctions cases debarment business us federal government connection fcpa violations company cooperating doj sec connection review matter seeking achieve negotiated resolution matters pertaining transactions question however final outcome future government investigation cannot predicted certainty indictment conviction material fine debarment settlement arising investigations could material adverse affect company’s business financial condition results operation future prospects legal proceedings polimaster ltd et al v rae systems inc united states district court northern district california case 05cv01887jf united states court appeals ninth circuit 0815708 polimaster ltd nase trading company ltd “polimaster” filed complaint company may 9 2005 united states district court northern district california case titled polimaster ltd et al v rae systems inc case 05cv01887jf complaint alleges among things company breached contract polimaster infringed upon polimaster’s intellectual property rights dispute subject contractual arbitration agreement although federal court retained jurisdiction matter pending completion arbitration conducted spring 2007 september 2007 final award issued arbitration arbitrator ruled polimaster failed prove claims entitled relief company proven counterclaims awarded damages approximately 24 million prevailing party company entitled recover costs rae systems inc notes consolidated financial statements continued amount 46000 october 5 2007 rae systems filed motion confirm final award october 17 2007 polimaster filed opposition rae systems’ motion confirm final award filed motion vacate final award motions heard december 7 2007 district court confirmed final award order dated february 25 2008 district court entered judgment favor rae systems polimaster january 23 2009 although company awarded damages attorney’s fees costs time company unable determine whether able collect amounts due uncertainty regarding polimaster’s financial condition factors polimaster appealed portion district court’s order confirming award damages costs company connection counterclaims appeal currently pending united states court appeals ninth circuit briefing appeal completed sides oral argument scheduled time notwithstanding polimaster proceeding described time company engaged various legal proceedings incidental normal business activities although results litigation claims cannot predicted certainty company believes final outcome matters material adverse effect consolidated financial position results operations cash flows leases december 31 2008 company equipment lease san jose california classified capital lease accordance sfas 13 “accounting leases” “sfas 13” december 31 2008 current portion lease matures september 2009 58000 included accrued liabilities consolidated balance sheets equipment lease bears interest rate 97 company subsidiaries lease certain manufacturing warehousing facilities operating leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2008 2007 2006 1760000 1109000 654000 respectively excluding sunnyvale california abandoned building lease described future minimum annual payments noncancellable leases follows december 31 2008 thousands december 2004 company moved current corporate headquarters san jose california abandoned leased facility sunnyvale california second quarter 2005 company accrued restructuring reserve approximately 20 million remaining lease term former headquarters sunnyvale discount rate used 485 liability reduced anticipated future sublease income march 2007 due improved conditions office rentals company revised estimated loss abandonment lease reduced operating expense 595000 second quarter 2007 sublease executed rents commencing june 2007 december 31 2008 future discounted lease rae systems inc notes consolidated financial statements continued payments related sunnyvale building included accrued liabilities totaling 250000 lease expire october 2009 rent payments 2008 2007 2006 490000 396000 366000 respectively sunnyvale building sublease income 176000 97000 2008 2007 respectively future minimum lease payments expiration lease 439000 2009 estimated income generated sublease 136000 purchase obligations although open purchase orders considered enforceable legally binding terms generally allow company option cancel reschedule adjust requirements based business needs prior delivery goods performance services obligations purchase inventory commitments generally expected fulfilled within one year estimated 49 million december 31 2008 2007 company began construct rae fushun’s new manufacturing administrative facility china estimated cost complete project 2009 beyond 23 million deemed contractual obligation underlying contract specify financial commitment guarantees company permitted delaware law required certificate incorporation bylaws indemnify officers directors certain events occurrences subject certain limits officer serving company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director officer insurance policy limits exposure enables recover portion future amounts paid date company incurred losses agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits product warranties company sells majority products 12 24 month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized accrued liabilities consolidated balance sheets following table presents changes company’s warranty reserve 2008 2007 rae systems inc notes consolidated financial statements continued note 9 employee benefit plan company sponsors rae systems 401k plan “plan” defined contribution plan provides retirement benefits eligible employees tax deferred salary deductions plan allows employees contribute 60 annual compensation subject statutory maximum levels plan available employees united states reached age 21 plan provides employer matching contributions 25 employee’s elective contributions first 60 eligible compensation contributed company contributions vest rate 25 per annum first 4 years service employer matching contributions plan totaled 113000 129000 113000 years ended december 31 2008 2007 2006 respectively note 10 stockbased compensation stock option plans june 2007 company’s shareholders approved 2007 equity incentive plan “2007 plan” replace company’s 2002 stock option plan “2002 plan” 2007 plan authorizes grant options employees directors consultants purchase shares company’s common stock four million shares company’s common stock authorized issuance 2007 plan maximum number shares may issued 2007 plan increased time shares subject options granted 2002 plan expire terminated shares acquired 2002 plan forfeited repurchased company option holder’s purchase price however 15 million additional shares may authorized issuance 2007 plan result adjustments year ended december 31 2008 812000 shares added 2007 plan due qualifying adjustments 2002 plan incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share underlying stock date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting prorata monthly following three years exercised options generally expire ten years date grant total intrinsic value options exercised 2008 2007 179000 30000 respectively connection exercises tax benefit realized company full valuation allowance deferred tax assets december 31 2008 unrecognized future estimated stockbased compensation expense related stock options net expected forfeitures 19 million cost expected recorded estimated amortization period 28 years rae systems inc notes consolidated financial statements continued following summary stock option activity thousands except weightedaverage amounts following table summarizes significant ranges outstanding exercisable options december 31 2008 aggregate intrinsic value table represents total pretax intrinsic value based excess company’s closing stock price 054 december 31 2008 options holders’ exercise price would received option holders option holders exercised options date total number inthemoney options exercisable december 31 2008 169000 december 31 2008 stock options outstanding included 3810082 options either vested expected vest weightedaverage exercise price 261 aggregate intrinsic value 56000 remaining contractual term 711 years rae systems inc notes consolidated financial statements continued may 2008 company granted aggregate 150000 shares common stock nonemployee directors 2007 plan weightedaverage grant date fair value awards 140 shares subject vesting compensation expenses 210000 recognized date grant december 31 2008 unvested grants restricted stock outstanding 2007 plan nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares restricted stock weighted average exercise price 099 per share options vested 25 one year remainder vesting prorata monthly following three years vested options exercisable ten years date grant 2008 stockbased compensation expense related nonplan stock options remained recorded following summary activity nonplan stock options thousands except per share amounts following table summarizes outstanding exercisable nonplan stock options december 31 2008 nonplan restricted stock 2006 company granted 536000 shares restricted stock four individuals inducement join company twenty five percent restricted stock 134000 shares vested july 2007 remainder vesting prorata quarterly following three years august 2007 concurrent discontinuing company’s dvr business company terminated two individuals result remainder rae systems inc notes consolidated financial statements continued restricted stock awards 203571 shares vested immediately charge 596000 included loss discontinued operations see “note 3 discontinued operations” detail fair market value company’s common shares dates awards granted represents unrecognized deferred stock compensation amortized straightline basis vesting period underlying stock awards december 31 2008 158000 estimated stockbased compensation expense related restricted stock awards remains recorded cost expected recorded amortization period 15 years following summary activity nonplan awards thousands except per share amounts stockbased compensation expense required sfas 123r management made estimate expected forfeitures recognizing compensation cost equity awards expected vest impact company’s results continuing operations recording stockbased compensation function years ended december 31 2008 2007 2006 follows rae systems inc notes consolidated financial statements continued addition company recorded following stockbased compensation expenses discontinued operations years ended december 31 2007 2006 stockbased compensation expense discontinued operations recorded fiscal 2008 valuation assumptions company estimates fair value stock option date grant using blackscholesmerton bsm valuation model single option award approach fair value option grant amortized straightline basis requisite service period award generally vesting period weightedaverage assumptions applied summarized expected volatility company’s expected volatilities based historical volatility company’s stock adjusted management unusual nonrepresentative stock price activity expected recur expected dividend bsm valuation model calls single expected dividend yield input company paid dividend past anticipate paying dividend near future riskfree interest rate company bases riskfree interest rate implied yield currently available us treasury zerocoupon issues equivalent remaining term expected term company’s stockbased award correspond terms interest rates quoted company performs straightline interpolation available maturities expected term company’s expected term represents weightedaverage period company’s stockbased awards expected outstanding first quarter 2007 company used historical exercise patterns previously granted options relation company’s stock price estimate expected exercise patterns prior 2007 company applied “simplified method” defined sec’s staff accounting bulletin 107 estimated forfeitures estimate forfeitures company applies historical rate option forfeitures estimated forfeiture rates truedup actual forfeiture results stockbased awards vest note 11 related party transactions company accounts 40 ownership renex technologies ltd “renex” hong kong company following equity method company’s total investment renex december 31 2008 2007 448000 405000 respectively company recorded equity interest gain renex 43000 rae systems inc notes consolidated financial statements continued 3000 years ended december 31 2008 2007 respectively loss 194000 year ended december 31 2006 company pays 75 royalty renex modems incorporated certain rae systems products 2008 2007 2006 company made royalty payments amounting zero 84000 91000 respectively company also paid 181000 149000 254000 renex research project 2008 2007 2006 respectively company recorded zero 1000 investment additional paid capital 2008 2007 respectively properly reflect carrying value investment prorated share net equity renex conjunction original subsequent additional investment rae beijing unsecured notes payable established previous rae beijing shareholders part purchase price agreement may 2004 july 2006 december 31 2008 december 31 2007 1329000 191000 respectively included current notes payable related parties 1219000 2370000 respectively included long term notes payable related parties notes issued conjunction original rae beijing purchase may 2004 noninterest bearing recorded net present value using discount rate 55 conjunction additional investment rae beijing july 2006 110 million shares preferred stock issued four shareholders rae beijing accordance fas 150 preferred shares classified liabilities recorded longterm notes payable related parties although preferred shares bear dividend yield rate 3 per annum notes payable discounted using market interest rate 648 scheduled payments principal notes 2009 maturity 2011 1329000 609000 610000 respectively addition 40 ownership renex company investments two distributors rae systems products rae benelux rae spain company owns 10 19 rae benelux rae spain respectively investments accounted cost method liaoning group owns 30 interest rae fushun also supplier rae fushun transactions balances company’s related parties follows company’s director information systems lien chen wife chief executive officer robert chen ms chen paid salary bonus 111000 96000 103000 2008 2007 2006 rae systems inc notes consolidated financial statements continued respectively ms chen also receives standard employee benefits offered fulltime us employees ms chen report robert chen compensation decisions regarding ms chen performed manner us employees robert chen final approval signatory compensation recommendations note 12 fair value measurements company uses following methods assumptions estimating fair value financial assets liabilities cash equivalents bank line credit carrying amounts reported consolidated balance sheets approximate fair value due shortterm maturity instruments notes payable related parties fair value determined discounting noninterest bearing notes payables interest rate commensurate commercial borrowing rates available company china sfas 157 “fair value measurements” requires assets liabilities carried fair value classified disclosed one following three categories level 1 quoted market prices active markets identical assets liabilities level 2 observable market based inputs unobservable inputs corroborated market data level 3 unobservable inputs corroborated market data carrying amounts fair values company’s financial assets liabilities follows note 13 geographic information company operates primarily three geographic regions americas asia europe following tables present net sales identifiable longlived assets geographic region rae systems inc notes consolidated financial statements continued net sales china 381 million 40 391 million 43 239 million 35 total net sales 2008 2007 2006 respectively china held 142 million 95 113 million 92 total net property equipment december 31 2008 2007 respectively majority company’s net sales americas asia customers domiciled united states people’s republic china respectively company performs credit evaluations customers’ financial condition considered necessary generally require cash collateral customers evaluations require significant judgment based variety factors including limited current economic trends historical payments bad debt writeoff experience financial review customer note 14 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presented rae systems inc notes consolidated financial statements continued 1 august 2007 board directors approved discontinuation company’s dvr business impairment expenses recognized fiscal 2007 totaled 42 million prior quarters’ results adjusted reflect discontinued operationsitem 15 exhibits financial statement schedules 1 financial statements see index consolidated financial statements form 10k 2 financial statement schedules provided absence conditions required information given financial statements notes thereto 3 exhibits see index exhibits page 38 herein signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized march 12 2010 rae systems inc robert chen robert chen president chief executive officer know persons presents person whose signature appears constitutes appoints robert chen randall gausman person’s true lawful attorneysinfact agents full power substitution resubstitution person’s name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated index exhibits 1 previously filed exhibit registrant’s quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 2 previously filed exhibit registrant’s current report form 8k june 19 2007 incorporated herein reference 3 previously filed exhibit registrant’s current report form 8k december 21 2007 incorporated herein reference 4 previously filed august 8 2006 exhibit registrant’s quarterly report form 10q quarter ended june 30 2006 incorporated herein reference 5 previously filed exhibit registrant’s current report form 8k august 8 2006 incorporated herein reference 6 previously filed exhibit registrant’s current report form 8k august 16 2006 incorporated herein reference 7 previously filed exhibit registrant’s current report form 8k october 18 2006 incorporated herein reference 8 previously filed exhibit registrant’s annual report form 10k year ended december 31 2006 incorporated herein reference 9 previously filed exhibit registrant’s annual report form 10k year ended december 31 2007 incorporated herein reference 10 previously filed exhibit registrant’s quarterly report form 10q quarter ended june 30 2009 incorporated herein reference 11 filed herewith rae systems inc consolidated financial statements december 31 2009 2008 report independent registered public accounting firm board directors shareholders rae systems inc audited accompanying consolidated balance sheets rae systems inc subsidiaries collectively “company” december 31 2009 2008 related consolidated statements operations shareholders’ equity comprehensive loss cash flows three years period ended december 31 2009 financial statements responsibility company’s management responsibility express opinion financial statements based audits conducted audits accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements present fairly material respects financial position company december 31 2009 2008 results operations cash flows three years period ended december 31 2009 conformity accounting principles generally accepted united states america also audited accordance standards public company accounting oversight board united states company’s internal control financial reporting december 31 2009 based criteria established internal control integrated framework issued committee sponsoring organizations treadway commission report dated march 11 2010 expressed unqualified opinion company’s internal control financial reporting deloitte touche llp san jose california march 11 2010 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders’ equity comprehensive loss see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements note 1 summary significant accounting policies company founded 1991 rae systems inc “company” “rae systems” delaware company develops manufactures rapidlydeployable multisensor chemical radiation detection monitors networks oil gas hazardous material management industrial safety civil defense environmental remediation applications company’s products based proprietary sensor technology include personal breathing zone portable wireless fixed chemical detection monitors radiation detectors result independent investigation conducted audit committee board directors fiscal year 2008 company made voluntary disclosure united states department justice “doj” united states securities exchange commission “sec” company may violated united states foreign corrupt practices act “fcpa” company cooperating doj sec connection review matter actively engaged settlement discussions although assurances given whether matter settle amount settlement company accrued 35 million third quarter 2009 potential settlement matter principles consolidation consolidated financial statements prepared accordance accounting principles generally accepted united states “us gaap” include company subsidiaries intercompany balances transactions eliminated ownership interest holders consolidated subsidiaries reflected noncontrolling interest presentation requirements noncontrolling minority interests follows authoritative guidance promulgated financial accounting standards board “fasb” became effective january 1 2009 periods presented certain prior year amounts reclassified conform current year presentation management considers amounts material use estimates preparation financial statements conformity us gaap requires management make estimates assumptions affect reported amounts assets liabilities disclosures contingent assets liabilities date financial statements reported amounts revenue expenses reporting period company bases estimates historical experience various assumptions believed reasonable based available information actual results may differ materially estimates assumptions revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectability reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company generally recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier free board “fob” provides sales returns standard product warranty provisions nonstandard contract terms title goods passes upon delivery customer fob destination revenue recognized company established proof delivery revenues related services performed company’s extended warranty program recognized earned based upon contract terms generally ratably term service company records project installation work asia using percentageofcompletion method net sales also include amounts billed customers shipping handling company’s shipping costs included cost sales rae systems inc notes consolidated financial statements continued cash equivalents company considers highly liquid investments original remaining maturities three months less time purchase cash equivalents allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts based company’s assessment collectability customer accounts company regularly reviews allowance considering factors historical experience credit quality age accounts receivable balances current economic conditions known troubled accounts company generally require collateral sales credit company becomes aware specific customer unable meet financial obligations company records specific allowance reflect level credit risk customer’s outstanding receivable balance addition company records allowances based certain percentages aged receivable balances company classifies bad debt expenses general administrative expenses consolidated statements operations company able predict changes financial stability customers material change financial status one group customers could material adverse effect company’s results operations financial condition although losses within management’s expectations date assurance allowances continue adequate company sells products direct sales force distributors customer accounted 10 consolidated net sales period presented trade notes receivable trade notes receivable bank guaranteed promissory notes noninterest bearing generally mature within six months time certain customers china present notes payment outstanding accounts receivable concentration credit risk financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade notes receivable accounts receivable company places domestic foreign cash equivalents large creditworthy financial institutions primarily united states people’s republic china us cash balances insured federal deposit insurance company 250000 per bank december 31 2009 2008 company deposits excess insured limits approximately 57 million 10 million respectively company also deposits several foreign financial institutions insured summed approximately 146 million 133 million december 31 2009 2008 respectively inventories stated lower standard cost approximates actual cost computed firstin firstout basis market company establishes inventory provisions conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded writedowns intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required rae systems inc notes consolidated financial statements continued property equipment property equipment stated cost less accumulated depreciation computed using straightline method estimated useful lives assets follows warranty repairs date shipment company provides 12 24 month repair replacement warranty majority products based primarily historical relationship actual warranty costs sales company accrues reserve estimated future warranty costs time revenue recognized estimated warranty obligation affected product failure rates length warranty period materials usage repair replace defective products service delivery costs incurred correcting product failures addition time specific warranty accruals may made unforeseen technical problems arise company’s actual experience relative factors significantly different estimated company may required adjust provision future periods research development research development costs expensed incurred advertising costs company expenses advertising costs incurred years ended december 31 2009 2008 2007 advertising expense 190000 311000 547000 respectively income taxes company accounts income taxes asset liability method requires recognition taxes payable refundable current year deferred tax assets liabilities expected future tax consequences events included company’s consolidated financial statements tax returns measurement current deferred taxes based provisions enacted tax law company records deferred tax assets realization assets likely occur otherwise valuation allowance established deferred tax assets may realized company subject income tax audits respective tax authorities jurisdictions operates determination tax liabilities jurisdictions requires interpretation application complex sometimes uncertain tax laws regulations recognition measurement current taxes payable refundable deferred tax assets liabilities requires company make certain estimates judgments changes estimates change judgment may material impact company’s tax provision future period rae systems inc notes consolidated financial statements continued goodwill intangible assets goodwill tested impairment annual basis fourth quarter annual tests events occur circumstances indicate carrying amount goodwill may recoverable impairment losses recorded consolidated statements operations “impairment goodwill” purchased intangible assets goodwill amortized estimated useful lives unless lives determined indefinite purchased intangibles carried cost less accumulated amortization generally computed using either straightline method accelerated method based pattern expected usage estimated useful lives respective assets currently 15 6 years longlived assets company evaluates recoverability longlived assets finite lives periodically whenever events changes circumstances indicate carrying amount asset may recoverable carrying amount longlived asset recoverable exceeds sum undiscounted cash flows expected result use eventual disposition asset carrying amount longlived asset deemed recoverable impairment loss recognized difference carrying amount asset fair value generally present value estimated future cash flows fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments • cash equivalents accounts receivable trade notes receivables accounts receivable affiliate accounts payable accrued expenses inventory purchase obligations carrying amount reported consolidated balance sheets items approximates fair value short maturity instruments addition inventory purchase obligations carrying value approximates fair value based market rates comparable products • notes payable related parties carrying amount notes payable related parties approximates fair value company discounted noninterest bearing notes payable interest rate commensurate commercial borrowing rates available company china december 31 2009 2008 fair values company’s financial instruments approximate historical carrying amount translation foreign currencies assets liabilities nonus subsidiaries operate local currency environment local currency functional currency translated us dollars exchange rates effect balance sheet date resulting translation adjustments directly recorded separate component accumulated comprehensive income expense accounts translated average exchange rates year gains losses foreign currency transactions recorded income expense net consolidated statements operations functional currency local currency nonus subsidiaries stockbased compensation expense company estimates fair value option award date grant using blackscholesmerton “bsm” valuation model single option award approach accordingly stockbased compensation cost measured grant date based fair value award recognized expense requisite service period generally vesting period rae systems inc notes consolidated financial statements continued net loss per share basic loss per share includes dilution computed dividing loss available common shareholders weightedaverage number common shares outstanding period diluted earnings per common share reflects potential dilution common stock equivalents options warrants extent impact dilutive company incurred net losses years ended december 31 2009 2008 2007 effect potentially dilutive securities diluted net loss per share computations antidilutive weightedaverage number antidilutive shares excluded diluted net loss per common share calculation 2009 2008 2007 5106797 3813874 3505491 respectively retained earnings accordance company law people’s republic china company’s china subsidiaries may required appropriate portion net income determined accounting principles generally accepted china “prc gaap” nondistributable reserves include general reserve enterprise expansion reserve staff welfare bonus reserve reserves restrict portion retained earnings distribution shareholders reserves withdrawn business remain available use operations whollyowned china subsidiaries required make appropriations enterprise expansion reserve however china subsidiaries required appropriate less 10 net income determined prc gaap general reserve appropriations general reserve limited 50 china subsidiary’s registered capital appropriations staff welfare bonus reserve determined board directors total appropriation retained earnings company’s statutory reserves totaled 27 million 27 million december 31 2009 2008 respectively variable interest entities sarl rae france “rae france” identified management variable interest entity company primary beneficiary ownership rae europe aps rae france distributes sells rae products exclusively france rae france total sales 24 million 27 million 18 million 2009 2008 2007 respectively total assets 11 million december 31 2009 2008 company consolidated rae france since december 2004 segment reporting fasb accounting standards codification “asc” topic 280 “segment reporting” establishes standards public business enterprises report information operating segments annual financial statements requires enterprises report selected information operating segments subsequent interim financial reports issued shareholders also established standards related disclosure products services geographic areas major customers operating segments components enterprise evaluated regularly chief operating decisionmaker deciding allocate assess resources performance company’s chief operating decisionmakers chief executive officer chief financial officer although company’s operating segments consist entities geographically based americas asia europe company operates single reporting segment worldwide sale portable wireless chemical radiation detection products related services accordingly company operated one reportable segment years ended december 31 2009 2008 2007 recent accounting pronouncements december 2007 fasb issued authoritative guidance applies business combinations new guidance changes accounting acquisition transaction costs requiring expensed period rae systems inc notes consolidated financial statements continued incurred also changes accounting contingent consideration acquired contingencies restructuring costs related acquisition new guidance effective company beginning january 1 2009 change company’s accounting treatment business combinations prospective basis june 2009 fasb issued authoritative guidance determining whether entity variable interest entity “vie” requires enterprise perform analysis determine whether enterprise’s variable interest interests give controlling financial interest vie guidance enterprise controlling financial interest power direct activities vie significantly impact entity’s economic performance b obligation absorb losses entity right receive benefits entity could potentially significant vie guidance also requires enterprise assess whether implicit financial responsibility ensure vie operates designed determining whether power direct activities vie significantly impact entity’s economic performance guidance effective company january 1 2010 requires ongoing assessments whether enterprise primary beneficiary vie well certain enhanced disclosures company currently evaluating potential impact adoption guidance consolidated financial statements october 2009 fasb issued authoritative guidance revenue recognition become effective company beginning january 1 2011 earlier adoption permitted new guidance arrangements include software elements tangible products software components essential functionality tangible product longer within scope software revenue recognition guidance softwareenabled products subject relevant revenue recognition guidance additionally fasb issued authoritative guidance revenue arrangements multiple deliverables outside scope software revenue recognition guidance new guidance vendor specific objective third party evidence deliverables arrangement cannot determined best estimate selling price required separate deliverables allocate arrangement consideration using relative fair value method new guidance includes new disclosure requirements application relative fair value method affects timing amount revenue recognition company currently assessing potential effect financial statements note 2 business combinations dispositions aegison corporation tianjin securay technology ltd co july 2006 company purchased assets including two pending patents santa clara california based aegison corporation “aegison” supplier fixed mobile digital video surveillance systems approximately 20 million cash direct transaction costs 142000 january 2007 rae asia entered agreement purchase intellectual property tianjin securay technology ltd co “securay” renminbi 12 million approximately 15 million transaction together purchase agreements entered 2006 completed purchase securay including transactions entered 2006 total purchase price 20 million cash acquisition aegison securay made company’s mobile digital video recording “dvr” business august 24 2007 board directors approved discontinuation company’s dvr business order reduce expenses concentrate resources gas radiation detection business august 28 2007 company notified dvr customers terminated personnel reassigned continuing operations suspended related production sales activities company retained acquired intellectual property however dvr business operated substantial loss 2007 management liquidated tangible assets mainly inventories component parts impaired remaining value intangible assets goodwill rae systems inc notes consolidated financial statements continued accordance existing authoritative guidance financial results dvr business reported discontinued operations periods presented financial results included discontinued operations follows assets liabilities related disposal group december 31 2009 2008 note 3 balance sheet details allowance doubtful accounts components allowance doubtful accounts follows inventories stated lower cost market include material labor manufacturing overheard costs components inventories follows company recorded writedowns inventory 777000 580000 442000 2009 2008 2007 respectively inventory writedowns predominantly result changes forecasted customer demand technological changes company’s products included primarily raw material finished goods major elements written raw material consists components items entered production finished goods inventory includes cost raw material inputs labor overhead rae systems inc notes consolidated financial statements continued prepaid expenses current assets components prepaid expenses current assets follows property equipment net components property equipment follows construction progress 2009 2008 primarily represented cost build offices manufacturing facilities fushun china new manufacturing facilities placed service october 2008 rae plans complete remaining office research development dormitory buildings stages next 12 24 months also december 2008 company invested approximately 12 million land use rights shanghai china construct new manufacturing engineering administrative facility second quarter 2009 company entered agreement preconstruction land improvements approximately 263000 company began construction facility first quarter 2010 upon completion company intends vacate existing leased facility shanghai based discussions shanghai government officials landlord existing company facility company believes able terminate lease without penalty assurance given company able arrange financing terms acceptable company would subject lease termination penalties december 2007 company sold headquarters building san jose california 127 million leased back facility period 10 years company recognized gain sale 04 million 2007 based difference net gain sale building 67 million net present value future lease payments 63 million net present value future lease payments recorded deferred gain recognized income straightline basis life lease beginning january 2008 deferred gain recognized income 2009 2008 totaled 06 million 06 million respectively lease classified operating lease december 31 2009 2008 current portion rae systems inc notes consolidated financial statements continued deferred gain 06 million 06 million respectively included accrued liabilities consolidated balance sheets depreciation expense years ended december 31 2009 2008 2007 23 million 22 million 23 million respectively accrued liabilities accrued liabilities december 31 2009 2008 summarized follows note 4 goodwill intangible assets goodwill represents excess purchase price related costs value assigned net tangible identifiable intangible assets following table presents changes goodwill 2007 2008 goodwill impaired company evaluates goodwill impairment whenever events changes circumstances indicate carrying amount may recoverable recoverability goodwill measured reporting unit level comparing reporting unit’s carrying amount including goodwill fair value reporting unit measured based upon among factors market capitalization well forecasted operating results company one reporting unit recorded value assets including goodwill liabilities “net book value” reporting unit exceeds fair value impairment loss may exist extent net book value company whole greater market capitalization significant portion goodwill may considered impaired company experienced significant decline market capitalization fourth quarter 2008 decline market capitalization driven largely deteriorating macroeconomic conditions contributed rae systems inc notes consolidated financial statements continued decline company’s forecasted operating results business uncertainties associated current fcpa investigation pursuant authoritative guidance measurement impairment goodwill consists two steps first step fair value company compared carrying value management completed valuation company incorporated existing marketbased considerations well operating information based current results projections concluded estimated fair value company less net book value result company performed second step determine implied fair value company’s goodwill compare carrying value company’s goodwill second step includes estimating value tangible intangible assets liabilities company acquired business combination determine implied fair value goodwill result assessment indicated implied fair value goodwill zero result company recognized noncash impairment charge approximately 33 million threemonth period year ended december 31 2008 writeoff entire carrying value goodwill result discontinuing dvr business third quarter 2007 company impaired goodwill acquired purchases aegison securay see “note 2 business combinations dispositions” detail impairment goodwill 2007 result required annual impairment test following table presents details company’s intangible assets goodwill company’s purchased intangible assets goodwill subject amortization expense years ended december 31 2009 2008 2007 09 million 12 million 14 million respectively 2008 company increased value customer list acquisition rae fushun 435000 recognized corresponding deferred tax liability 2007 company recorded impairment 609000 certain patents held rae beijing related discontinuation related product fourth quarter 2007 impairment analysis performed intangible asset determined carrying value recoverable result discontinuing dvr business third quarter 2007 company impaired remaining balance intangible assets acquired purchases aegison securay impairment charge 16 million recognized quarter ended september 30 2007 included net loss discontinued operations reported company’s consolidated statements operations rae systems inc notes consolidated financial statements continued based carrying amount intangible assets december 31 2009 estimated future amortization follows thousands note 5 income taxes company’s loss continuing operations income taxes consisted following company’s income tax benefit expense consisted following rae systems inc notes consolidated financial statements continued reconciliation company’s income tax benefit expense federal statutory rate income tax benefit expense effective tax rate follows components company’s net deferred taxes consisted following amounts recorded consolidated balance sheet per following assessing recoverability deferred tax assets management considers whether likely portion deferred tax assets realized ultimate realization deferred tax rae systems inc notes consolidated financial statements continued assets dependent generation future taxable income periods temporary differences become deductible management considers scheduled reversal deferred tax liabilities historical projected future taxable income tax planning strategies making assessment us income taxes provided certain earnings nonus subsidiaries company plan repatriate remaining undistributed earnings nonus subsidiaries december 31 2009 tax reform act 1986 amount benefits net operating loss carryforwards may impaired limited certain circumstances events cause limitations amount net operating loss credit carryforwards company may utilize one year include limited cumulative ownership change 50 defined three year period company approximately 25 million 3 million federal california net operating losses scheduled expire 2027 2029 respectively november 2009 worker homeownership business assistance act 2009 enacted law companies may elect increase carryback period net operating loss tax year ending december 31 2007 beginning january 1 2010 3 4 5 years accordingly company elected carry 2008 net operating loss back 2003 result refund approximately 659000 july 2008 housing economic recovery act 2008 enacted law companies elect accelerate portion unused alternative minimum tax credit increased research activities lieu 50percent “bonus” depreciation enacted february 2008 company determined would receive significant benefit election december 31 2009 company federal research development credit carryforwards approximately 200000 scheduled expire 2022 utilized california 20082009 budget bill enacted september 30 2008 resulted two temporary changes company’s california income tax first bill suspends use net operating loss carryovers two years 2008 2009 second bill limits use research development credit carryovers 50 tax liability credits december 31 2009 company research development credit carryforwards approximately 02 million california income tax purposes california credits subject expiration current california tax law company granted tax holiday subsidiary fushun china whereby company entitled full exemption china income tax first year positive accumulated earnings 50 reduction statutory rate following three years statutory rate china 25 tax purposes rae fushun reached cumulative profitability december 31 2008 declared first year exemption corporate income tax china tax savings company approximately 511000 taxable income subject tax 125 2009 2011 company anticipate tax liability 2009 2006 internal revenue service completed examination company’s federal income tax returns years ended december 31 2003 2004 based results examination company paid 391000 irs april 2006 tax authority denmark skat completed audit company’s subsidiary denmark year ended december 31 2004 without adjustment subsequent periods remain subject examination however audits currently process company’s valuation allowance determined accordance authoritative accounting guidance requires assessment positive negative evidence determining whether likely deferred tax assets recoverable assessment required jurisdiction basis management believes sufficient uncertainty exists regard realizability tax assets exception 09 million foreign deferred tax assets valuation allowance necessary factors considered providing valuation allowance include lack significant history consistent profits current weakness overall market uncertainty economic fundamentals stabilize rae systems inc notes consolidated financial statements continued thereby potentially impacting company’s ability sustain grow revenues earnings length carryback carryforward periods based absence sufficient positive objective verifiable evidence december 31 2009 company concluded appropriate establish full valuation allowance net federal state deferred tax assets throughout fiscal year 2009 company valuation allowance future tax benefits related certain foreign net operating losses result valuation allowance deferred tax assets decreased 01 million 94 million january 1 2009 approximately 93 million december 31 2009 company expects provide full valuation allowance future tax benefits sustain level profitability demonstrates ability utilize assets amount deferred tax asset valuation allowance however could reduced future periods extent future taxable income realized prior 2009 exposures settled primarily settlement audits within individual tax jurisdiction closing statute limitation exposures also affected changes applicable tax law factors may cause management believe revision past estimates appropriate management believes appropriate liability established income tax exposure however actual amounts may differ materially estimates impact uncertain tax position likely sustained upon audit relevant taxing authority must recognized largest amount likely sustained portion uncertain tax position recognized position less 50 likelihood sustained also interest expense recognized full amount deferred benefits uncertain tax positions december 31 2009 2008 company recorded tax contingency reserves approximately 15 million 14 million respectively balances include accrued interest penalties 03 million 03 million respectively december 31 2009 2008 tax contingency reserves included component income taxes payable consolidated balance sheets december 31 2009 company 15 million unrecognized tax benefits 05 million would affect effective tax rate recognized company anticipate material changes uncertain tax positions next 12 months reconciliation beginning ending balance unrecognized tax benefits “utb” follows company recognizes interest penalties associated uncertain tax positions income tax expense december 31 2008 2009 provision interest penalties 03 million 03 million respectively ultimate amount timing future cash settlements cannot predicted reasonable certainty conduct business globally result one subsidiaries file income tax returns us federal jurisdiction various state foreign jurisdictions normal course business subject rae systems inc notes consolidated financial statements continued examination taxing authorities throughout world including major jurisdictions china hong kong denmark uk france united states longer subject us federal nonus income tax examinations years 2003 many cases company’s uncertain tax positions related tax years remain subject examination tax authorities following describes open tax years major tax jurisdiction december 31 2009 note 6 bank debt company maintains credit facilities support operations united states china united states company 100 million revolving credit agreement december 31 2009 credit facility renewed annually currently expires may 15 2010 available credit based percentage specific qualifying assets total facility collateralized blanket security interest company’s assets united states company required comply certain reporting requirements addition ongoing requirement submit quarterly financial statements interest accrues floating prime bank lending rate plus 100 basis points subject minimum total rate 5 addition company pays 30 basis points annually average unused portion facility required maintain compensating balance least 20 million times compensating balance included restricted cash consolidated balance sheets december 31 2009 december 31 2008 18 million outstanding revolving credit agreement assurance company successful securing renewed agreement line credit period may 15 2010 fourth quarter 2009 company obtained amendment financial covenants revolving credit agreement result noncompliance amended financial covenants revolving credit agreement 1 require company maintain specified trailing twoquarter minimum earnings interest depreciation amortization noncash stock compensation expenses 2 limits size potential monetary penalties fcpa 35 million company compliance covenants december 31 2009 china company maintains unsecured revolving lines credit provide working capital borrowings lines credit generally current market rate fixed rate loans amount duration requested one year lines credit renewed annually may september respectively rae systems inc notes consolidated financial statements continued following table presents company’s total lines credit china working capital balances drawn december 31 2009 december 31 2008 millions term loan november 9 2009 company borrowed rmb 100 million approximately 15 million provide working capital 70 owned subsidiary fushun china “rae fushun” loan due april 26 2011 bears interest fixed rate 81 12 months interest rate reset november 2010 15 times people’s bank china benchmark rate loan repayment guaranteed unrelated third party rae fushun granted lien wholly owned plant associated land rights condition loan lending bank required deposit approximately 01 million guarantor deposit funded rae fushun loan proceeds included restricted cash consolidated balance sheets note 7 commitments contingencies legal proceedings regulatory compliance fiscal year 2008 company’s internal audit department identified certain payments gifts made certain personnel company’s china operations may violated fcpa following discovery audit committee board directors initiated independent investigation company made voluntary disclosure doj sec regarding results investigation company also implemented additional policies controls respect compliance fcpa related statutes regulations provide potential monetary penalties criminal sanctions cases debarment business us federal government connection violations company cooperating doj sec connection review matter actively engaged settlement discussions although assurances given whether matter settle amount settlement company recorded accrual 35 million third quarter 2009 relating potential settlement matter timing final outcome future government investigation cannot predicted certainty indictment conviction material fine debarment settlement arising investigations could material adverse affect company’s business financial condition results operation future prospects rae systems inc notes consolidated financial statements continued legal proceedings polimaster ltd et al v rae systems inc united states district court northern district california case 05cv01887jf united states court appeals ninth circuit nos 0815708 0915369 polimaster ltd nase trading company ltd “polimaster” filed complaint company may 9 2005 united states district court northern district california case titled polimaster ltd et al v rae systems inc case 05cv01887jf complaint alleges among things company breached contract polimaster infringed upon polimaster’s intellectual property rights dispute subject contractual arbitration agreement although federal court retained jurisdiction matter pending completion arbitration conducted spring 2007 september 2007 final award issued arbitration arbitrator ruled polimaster failed prove claims entitled relief company proven counterclaims awarded damages approximately 24 million prevailing party company entitled recover costs amount 46000 october 5 2007 rae systems filed motion confirm final award october 17 2007 polimaster filed opposition rae systems’ motion confirm final award filed motion vacate final award motions heard december 7 2007 district court confirmed final award order dated february 25 2008 polimaster appealed district court’s order confirming arbitration award polimaster ltd et al v rae systems inc 0815708 appeal currently pending united states court appeals ninth circuit briefing appeal completed sides appeal argued submitted ninth circuit decision january 15 2010 district court confirmed final award favor rae systems enter judgment omission district court described nonsubstantive clerical error september 9 2008 court appeal granted leave district court correct clerical error january 23 2009 district court entered judgment favor rae systems polimaster included judgment postarbitrationprejudgment interest postjudgment interest polimaster appealed inclusion two interest components judgment polimaster ltd et al v rae systems inc 0915369 briefing appeal completed sides appeal argued submitted ninth circuit decision january 15 2010 may 14 2009 polimaster rae systems entered first amended restated stipulation order stay execution judgment favor rae systems inc “stipulation” pursuant polimaster wire transferred 14 million client trust account rae systems’ counsel mcleod witham flynn llp agreed wire transfer additional 11622425 per month entire amount deposited equals amount judgment approximately 28 million plus accrued interest judgment rate 043 percent per annum pursuant stipulation amounts transferred polimaster maintained client trust account mcleod witham flynn llp shall distributed rae systems polimaster ninth circuit ruled polimaster’s appeal nos 0815708 0915369 mcleod witham flynn llp shall release funds account rae systems andor polimaster within seven days ninth circuit’s final ruling appeal accordance ninth circuit’s decision polimaster currently compliance payment schedule provided stipulation rae systems successful appeal expected company would receive approximately 16 million net attorneys’ fees expenses timing final ruling appeal currently determinable notwithstanding polimaster proceeding described time company engaged various legal proceedings incidental normal business activities although results litigation claims cannot predicted certainty company believes final outcome matters material adverse effect consolidated financial position results operations cash flows rae systems inc notes consolidated financial statements continued leases company subsidiaries lease certain manufacturing warehousing facilities operating leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2009 2008 2007 1480000 1760000 1109000 respectively future minimum annual payments noncancellable leases follows december 31 2009 thousands december 2004 company moved current corporate headquarters san jose california abandoned leased facility sunnyvale california second quarter 2005 company accrued restructuring reserve approximately 20 million remaining lease term former headquarters sunnyvale discount rate used 485 liability reduced anticipated future sublease income march 2007 due improved conditions office rentals company revised estimated loss abandonment lease reduced operating expense 595000 second quarter 2007 sublease executed rents commencing june 2007 master lease sublease expired october 2009 rent payments 2009 2008 2007 439000 490000 396000 respectively sunnyvale building sublease income 136000 176000 97000 2009 2008 2007 respectively purchase obligations although open purchase orders considered enforceable legally binding terms generally allow company option cancel reschedule adjust requirements based business needs prior delivery goods performance services obligations purchase inventory commitments generally expected fulfilled within one year estimated 45 million december 31 2009 2007 company began construct rae fushun’s new manufacturing administrative facility china company occupied factory buildings october 2008 estimated cost complete project 2010 beyond 04 million deemed contractual obligation underlying contract specify financial commitment first quarter 2010 company began construct new manufacturing engineering facility shanghai china estimated cost complete project approximately 53 million work scheduled completed soon year end project deemed contractual obligation underlying contract specify financial commitment upon completion construction company would vacate existing leased facility shanghai based discussions shanghai government officials landlord existing company facility company believes able terminate lease without penalty however assurance given time company subject lease termination penalty rae systems inc notes consolidated financial statements continued guarantees company permitted delaware law required certificate incorporation bylaws indemnify officers directors certain events occurrences subject certain limits officer serving company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director officer insurance policy limits exposure enables recover portion future amounts paid date company incurred losses agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits product warranties company sells majority products 12 24 month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized accrued liabilities consolidated balance sheets following table presents changes company’s warranty reserve 2009 2008 note 8 employee benefit plan company sponsors rae systems 401k plan “plan” defined contribution plan provides retirement benefits eligible employees tax deferred salary deductions plan allows employees contribute 60 annual compensation subject statutory maximum levels plan available employees united states reached age 21 plan provides employer matching contributions 25 employee’s elective contributions first 60 eligible compensation contributed company contributions vest rate 25 per annum first 4 years service employer matching contributions plan totaled 122000 113000 129000 years ended december 31 2009 2008 2007 respectively note 9 stockbased compensation stock option plans june 2007 company’s shareholders approved 2007 equity incentive plan “2007 plan” replace company’s 2002 stock option plan “2002 plan” 2007 plan authorizes grant options employees directors consultants purchase shares company’s common stock four million shares company’s common stock authorized issuance 2007 plan maximum number shares may issued 2007 plan increased time shares rae systems inc notes consolidated financial statements continued subject options granted 2002 plan expire terminated shares acquired 2002 plan forfeited repurchased company option holder’s purchase price however 15 million additional shares may authorized issuance 2007 plan result adjustments december 31 2009 1250376 shares added 2007 plan due qualifying adjustments 2002 plan incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share underlying stock date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting prorata monthly following three years exercised options generally expire ten years date grant total intrinsic value options exercised 2009 2008 zero 179000 respectively connection exercises tax benefit realized company full valuation allowance deferred tax assets december 31 2009 unrecognized future estimated compensation expense related stock options net expected forfeitures 18 million cost expected recorded estimated amortization period 28 years following summary stock option activity thousands except weightedaverage amounts rae systems inc notes consolidated financial statements continued following table summarizes significant ranges outstanding exercisable options december 31 2009 aggregate intrinsic value table represents total pretax intrinsic value based excess company’s closing stock price 110 december 31 2009 options holders’ exercise price would received option holders option holders exercised options date total number inthemoney options exercisable december 31 2009 800000 december 31 2009 stock options outstanding included 4953177 options either vested expected vest weightedaverage exercise price 204 aggregate intrinsic value 302000 remaining contractual term 693 years may 2008 company granted aggregate 150000 shares common stock nonemployee directors 2007 plan weightedaverage grant date fair value awards 140 shares subject vesting compensation expenses 210000 recognized date grant december 31 2009 unvested grants restricted stock outstanding 2007 plan nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares restricted stock weighted average exercise price 099 per share options vested 25 one year remainder vesting prorata monthly following three years 2002 2006 company issued 300000 shares common stock due exercise options grants exercises cancellations december 31 2009 total outstanding nonplan stock options december 31 2009 100000 weighted average exercise price 106 vested options exercisable ten years date grant 2009 stockbased compensation expense related nonplan stock options remained recorded rae systems inc notes consolidated financial statements continued following table summarizes outstanding exercisable nonplan stock options december 31 2009 nonplan restricted stock 2006 company granted 536000 shares restricted stock four individuals inducement join company twenty five percent restricted stock 134000 shares vested july 2007 remainder vesting prorata quarterly following three years august 2007 concurrent discontinuing company’s dvr business company terminated two individuals result remainder restricted stock awards 203571 shares vested immediately charge 596000 included loss discontinued operations see “note 3 discontinued operations” detail fair market value company’s common shares dates awards granted represents unrecognized deferred stock compensation amortized straightline basis vesting period underlying stock awards december 31 2009 50000 estimated stockbased compensation expense related restricted stock awards remains recorded cost expected recorded amortization period 05 years following summary activity nonplan awards thousands except per share amounts stockbased compensation expense fair value option award estimated date grant using blackscholesmerton valuation method accordingly stockbased compensation cost measured grant date based fair value award recognized expense requisite service generally vesting period impact rae systems inc notes consolidated financial statements continued company’s results continuing operations recording stockbased compensation function years ended december 31 2009 2008 2007 follows addition company recorded following stockbased compensation expenses discontinued operations year ended december 31 2007 stockbased compensation expense discontinued operations recorded fiscal 2008 2009 valuation assumptions company estimates fair value stock option date grant using blackscholesmerton valuation model single option award approach fair value option grant amortized straightline basis requisite service period award generally vesting period weightedaverage assumptions applied summarized expected volatility company’s expected volatilities based historical volatility company’s stock adjusted management unusual nonrepresentative stock price activity expected recur management determined historical stock price volatility period april 11 2002 commencement public trading common stock december 31 2002 likely representative future excluded period management also applies mean reversion techniques historical stock prices results emphasis recent activity distant past determining expected volatility rate included blackscholesmerton valuation model expected dividend bsm valuation model calls single expected dividend yield input company paid dividend past anticipate paying dividend near future rae systems inc notes consolidated financial statements continued riskfree interest rate company bases riskfree interest rate implied yield currently available us treasury zerocoupon issues equivalent remaining term expected term company’s stockbased award correspond terms interest rates quoted company performs straightline interpolation available maturities expected term company’s expected term represents weightedaverage period company’s stockbased awards expected outstanding company uses historical exercise patterns previously granted options relation company’s stock price estimate expected exercise patterns estimated forfeitures estimate forfeitures company applies historical rate option forfeitures estimated forfeiture rates truedup actual forfeiture results stockbased awards vest note 10 related party transactions company accounts 40 ownership renex technologies ltd “renex” hong kong company following equity method company’s total investment renex december 31 2009 2008 339000 448000 respectively company recorded loss 109000 equity interest renex year ended december 31 2009 gains 43000 3000 years ended december 31 2008 2007 respectively company pays 75 royalty renex modems incorporated certain rae systems products 2009 2008 2007 company made royalty payments amounting zero 84000 respectively company also paid 95000 181000 149000 renex research projects 2009 2008 2007 respectively conjunction original subsequent additional investment rae beijing unsecured notes payable established previous rae beijing shareholders part purchase price agreement may 2004 july 2006 december 31 2009 december 31 2008 370000 1329000 respectively included current notes payable related parties 363000 1219000 respectively included long term notes payable related parties notes issued conjunction original rae beijing purchase may 2004 noninterest bearing recorded net present value using discount rate 55 conjunction additional investment rae beijing july 2006 110 million shares preferred stock issued four shareholders rae beijing accordance authoritative accounting guidance preferred shares classified liabilities recorded longterm notes payable related parties although preferred shares bear dividend yield rate 3 per annum notes payable discounted using market interest rate 648 scheduled payments principal accrued interest notes 2010 maturity 2011 370000 363000 respectively addition 40 ownership renex company investments three distributors rae systems products rae australia rae benelux rae spain company owns 19 10 19 rae australia rae benelux rae spain respectively investments accounted cost method liaoning coal industry group ltd “liaoning group” owns 30 interest rae fushun also supplier rae fushun rae systems inc notes consolidated financial statements continued transactions balances company’s related parties follows company’s director information systems lien chen wife chief executive officer robert chen ms chen paid salary bonus 128000 111000 96000 2009 2008 2007 respectively ms chen also receives standard employee benefits offered fulltime us employees ms chen report robert chen compensation decisions regarding ms chen performed manner us employees robert chen final approval signatory compensation recommendations note 11 fair value measurements company uses following methods assumptions estimating fair value financial assets liabilities cash equivalents bank line credit carrying amounts reported consolidated balance sheets approximate fair value due shortterm maturity instruments notes payable related parties fair value determined discounting noninterest bearing notes payable interest rate commensurate commercial borrowing rates available company china intangible assets net fair value evaluated whenever events changes circumstances indicate carrying value asset may recoverable existing authoritative guidance requires assets liabilities carried fair value classified disclosed one following three categories level 1 quoted market prices active markets identical assets liabilities level 2 observable market based inputs unobservable inputs corroborated market data level 3 unobservable inputs corroborated market data rae systems inc notes consolidated financial statements continued carrying amounts fair values company’s financial assets liabilities follows note 12 geographic information company operates primarily three geographic regions americas asia europe following tables present net sales identifiable longlived assets geographic region net sales china 280 million 34 381 million 40 391 million 43 total net sales 2009 2008 2007 respectively china held 151 million 97 142 million 95 total net property equipment december 31 2009 2008 respectively majority company’s net sales americas asia customers domiciled united states people’s republic china respectively company performs credit evaluations customers’ financial condition considered necessary generally require cash collateral customers evaluations require significant judgment based variety factors including limited current economic trends historical payments bad debt writeoff experience financial review customer rae systems inc notes consolidated financial statements continued note 13 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presenteditem 15 exhibits financial statement schedules 1 financial statements see index consolidated financial statements form 10k 2 financial statement schedules provided absence conditions required information given financial statements notes thereto 3 exhibits see index exhibits page 39 herein signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized march 31 2011 rae systems inc robert chen robert chen president chief executive officer know persons presents person whose signature appears constitutes appoints robert chen randall gausman person’s true lawful attorneysinfact agents full power substitution resubstitution person’s name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated index exhibits 1 previously filed exhibit registrant’s quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 2 previously filed exhibit registrant’s current report form 8k june 19 2007 incorporated herein reference 3 previously filed exhibit registrant’s current report form 8k december 21 2007 incorporated herein reference 4 previously filed august 8 2006 exhibit registrant’s quarterly report form 10q quarter ended june 30 2006 incorporated herein reference 5 previously filed exhibit registrant’s current report form 8k august 8 2006 incorporated herein reference 6 previously filed exhibit registrant’s current report form 8k august 16 2006 incorporated herein reference 7 previously filed exhibit registrant’s current report form 8k october 18 2006 incorporated herein reference 8 previously filed exhibit registrant’s annual report form 10k year ended december 31 2006 incorporated herein reference 9 previously filed exhibit registrant’s annual report form 10k year ended december 31 2007 incorporated herein reference 10 previously filed exhibit registrant’s quarterly report form 10q quarter ended june 30 2009 incorporated herein reference 11 filed herewith rae systems inc consolidated financial statements december 31 2010 2009 report independent registered public accounting firm board directors shareholders rae systems inc audited accompanying consolidated balance sheets rae systems inc subsidiaries collectively “company” december 31 2010 2009 related consolidated statements operations shareholders’ equity comprehensive loss cash flows three years period ended december 31 2010 financial statements responsibility company’s management responsibility express opinion financial statements based audits conducted audits accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement company required engaged perform audit internal control financial reporting december 31 2010 audit included consideration internal control financial reporting basis designing audit procedures appropriate circumstances purpose expressing opinion effectiveness company’s internal control financial reporting accordingly express opinion audit also includes examining test basis evidence supporting amounts disclosures financial statements assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements present fairly material respects financial position company december 31 2010 2009 results operations cash flows three years period ended december 31 2010 conformity accounting principles generally accepted united states america deloitte touche llp san jose california march 31 2011 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders’ equity comprehensive loss see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements note 1 summary significant accounting policies company founded 1991 rae systems inc “company” “rae systems” delaware company develops manufactures rapidlydeployable multisensor chemical radiation detection monitors networks oil gas hazardous material management industrial safety civil defense environmental remediation applications company’s products based proprietary sensor technology include personal breathing zone portable wireless fixed chemical detection monitors radiation detectors result independent investigation conducted audit committee board directors fiscal year 2008 company made voluntary disclosure united states department justice “doj” united states securities exchange commission “sec” company may violated united states foreign corrupt practices act “fcpa” company cooperated doj sec connection review matter accrued 35 million third quarter 2009 potential settlement matter december 2010 company settled outstanding issues regard matter separate agreements doj sec pursuant agreements company agreed pay 17 million criminal penalty doj 13 million restitution interest sec company also agreed advise doj sec periodically december 2013 ongoing efforts ensure continued compliance fcpa principles consolidation consolidated financial statements prepared accordance accounting principles generally accepted united states “us gaap” include company subsidiaries intercompany balances transactions eliminated ownership interest holders consolidated subsidiaries reflected noncontrolling interest presentation requirements noncontrolling minority interests follows authoritative guidance promulgated financial accounting standards board “fasb” became effective january 1 2009 periods presented use estimates preparation financial statements conformity us gaap requires management make estimates assumptions affect reported amounts assets liabilities disclosures contingent assets liabilities date financial statements reported amounts revenue expenses reporting period company bases estimates historical experience various assumptions believed reasonable based available information actual results may differ materially estimates assumptions revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectability reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company generally recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier free board “fob” provides sales returns standard product warranty provisions nonstandard contract terms title goods passes upon delivery customer fob destination revenue recognized company established proof delivery revenues related services performed company’s extended warranty program recognized earned based upon contract terms generally ratably term service company records project installation work rae systems inc notes consolidated financial statements continued asia using percentageofcompletion method net sales also include amounts billed customers shipping handling company’s shipping costs included cost sales company introduced software product late 2010 prorae guardian represents advanced generation realtime wireless threat detection solutions company sells product timebased license standalone basis recognizes related revenue ratably contractual period customer revenue recognized sale product 2010 material company’s financial statements cash equivalents company considers highly liquid investments original remaining maturities three months less time purchase cash equivalents allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts based company’s assessment collectability customer accounts company regularly reviews allowance considering factors historical experience credit quality age accounts receivable balances current economic conditions known troubled accounts company generally require collateral sales credit company becomes aware specific customer unable meet financial obligations company records specific allowance reflect level credit risk customer’s outstanding receivable balance addition company records allowances based certain percentages aged receivable balances company classifies bad debt expenses general administrative expenses consolidated statements operations company able predict changes financial stability customers material change financial status one group customers could material adverse effect company’s results operations financial condition although losses within management’s expectations date assurance allowances continue adequate company sells products direct sales force distributors customer accounted 10 consolidated net sales period presented trade notes receivable trade notes receivable bank guaranteed promissory notes noninterest bearing generally mature within six months time certain customers china present notes payment outstanding accounts receivable concentration credit risk financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade notes receivable accounts receivable company places domestic foreign cash equivalents large creditworthy financial institutions primarily united states people’s republic china us cash balances insured federal deposit insurance company 250000 per bank december 31 2010 2009 company deposits excess insured limits approximately 109 million 57 million respectively company also deposits several foreign financial institutions insured summed approximately 71 million 132 million december 31 2010 2009 respectively inventories stated lower standard cost approximates actual cost computed firstin firstout basis market company establishes inventory provisions conditions exist suggest rae systems inc notes consolidated financial statements continued inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded writedowns intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional writedowns may required property equipment property equipment stated cost less accumulated depreciation computed using straightline method estimated useful lives assets follows warranty repairs date shipment company provides 12 24 month repair replacement warranty majority products based primarily historical relationship actual warranty costs sales company accrues reserve estimated future warranty costs time revenue recognized estimated warranty obligation affected product failure rates length warranty period materials usage repair replace defective products service delivery costs incurred correcting product failures addition time specific warranty accruals may made unforeseen technical problems arise company’s actual experience relative factors significantly different estimated company may required adjust provision future periods research development research development costs expensed incurred advertising costs company expenses advertising costs incurred years ended december 31 2010 2009 2008 advertising expense 80000 190000 300000 respectively income taxes company accounts income taxes asset liability method requires recognition taxes payable refundable current year deferred tax assets liabilities expected future tax consequences events included company’s consolidated financial statements tax returns measurement current deferred taxes based provisions enacted tax law company records deferred tax assets realization assets likely occur otherwise valuation allowance established deferred tax assets may realized company subject income tax audits respective tax authorities jurisdictions operates determination tax liabilities jurisdictions requires interpretation application complex sometimes uncertain tax laws regulations recognition measurement current taxes payable refundable deferred tax assets liabilities requires company make certain estimates judgments changes estimates change judgment may material impact company’s tax provision future period rae systems inc notes consolidated financial statements continued goodwill intangible assets goodwill tested impairment annual basis fourth quarter annual tests events occur circumstances indicate carrying amount goodwill may recoverable impairment losses recorded consolidated statements operations “impairment goodwill” purchased intangible assets goodwill amortized estimated useful lives unless lives determined indefinite purchased intangibles carried cost less accumulated amortization generally computed using either straightline method accelerated method based pattern expected usage estimated useful lives respective assets currently 5 months 25 years longlived assets company evaluates recoverability longlived assets finite lives periodically whenever events changes circumstances indicate carrying amount asset may recoverable carrying amount longlived asset recoverable exceeds sum undiscounted cash flows expected result use eventual disposition asset carrying amount longlived asset deemed recoverable impairment loss recognized difference carrying amount asset fair value generally present value estimated future cash flows fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments • cash equivalents accounts receivable trade notes receivables accounts receivable affiliate accounts payable accrued expenses inventory purchase obligations carrying amount reported consolidated balance sheets items approximates fair value short maturity instruments addition inventory purchase obligations carrying value approximates fair value based market rates comparable products • notes payable related parties carrying amount notes payable related parties approximates fair value company discounted noninterest bearing notes payable interest rate commensurate commercial borrowing rates available company china december 31 2010 2009 fair values company’s financial instruments approximate historical carrying amount translation foreign currencies assets liabilities nonus subsidiaries operate local currency environment local currency functional currency translated us dollars exchange rates effect balance sheet date resulting translation adjustments directly recorded separate component accumulated comprehensive income expense accounts translated average exchange rates year gains losses foreign currency transactions recorded income expense net consolidated statements operations functional currency local currency nonus subsidiaries stockbased compensation expense company estimates fair value option award date grant using blackscholesmerton “bsm” valuation model single option award approach accordingly stockbased compensation cost measured grant date based fair value award recognized expense requisite service period generally vesting period rae systems inc notes consolidated financial statements continued net earnings per share basic earnings per share includes dilution computed dividing net income loss available common shareholders weightedaverage number common shares outstanding period diluted earnings per common share reflects potential dilution common stock equivalents options warrants extent impact dilutive 2010 company earned income continuing operations loss discontinued operations net loss available common shareholders number antidilutive shares excluded diluted earnings per share calculations 2010 5221584 company incurred net losses years ended december 31 2009 2008 effect potentially dilutive securities diluted net loss per share computations antidilutive number antidilutive shares excluded diluted net loss per common share calculation 2009 2008 5539961 4402461 respectively retained earnings accordance company law people’s republic china company’s china subsidiaries may required appropriate portion net income determined accounting principles generally accepted china “prc gaap” nondistributable reserves include general reserve enterprise expansion reserve staff welfare bonus reserve reserves restrict portion retained earnings distribution shareholders reserves withdrawn business remain available use operations whollyowned china subsidiaries required make appropriations enterprise expansion reserve however china subsidiaries required appropriate less 10 net income determined prc gaap general reserve appropriations general reserve limited 50 china subsidiary’s registered capital appropriations staff welfare bonus reserve determined board directors total appropriation retained earnings company’s statutory reserves totaled 27 million 27 million december 31 2010 2009 respectively variable interest entities sarl rae france “rae france” exclusive distributor rae systems products france rae systems owns 49 rae france’s common stock distributor’s largest shareholder although operations rae france generally independent rae systems governance rights company may direct rae france’s business strategies company identified rae france variable interest entity rae systems primary beneficiary since inception fourth quarter 2004 accordingly company consolidated rae france since december 2004 rae systems inc notes consolidated financial statements continued rae france total sales 27 million 24 million 27 million 2010 2009 2008 respectively carrying amounts major classes rae france assets liabilities included company’s consolidated balance sheets follows restrictions special conditions assets liabilities rae france segment reporting fasb accounting standards codification “asc” topic 280 “segment reporting” establishes standards public business enterprises report information operating segments annual financial statements requires enterprises report selected information operating segments subsequent interim financial reports issued shareholders also established standards related disclosure products services geographic areas major customers operating segments components enterprise evaluated regularly chief operating decisionmaker deciding allocate assess resources performance company’s chief operating decisionmakers chief executive officer chief financial officer although company’s operating segments consist entities geographically based americas asia europe company operates single reporting segment worldwide sale portable wireless chemical radiation detection products related services accordingly company operated one reportable segment years ended december 31 2010 2009 2008 recent accounting pronouncements october 2009 financial accounting standards board “fasb” issued accounting standards update “asu” 200913 multipledeliverable revenue arrangements amendments fasb accounting standards codification “asc” topic 605 revenue recognition “asu 200913” asu 200914 certain arrangements include software elements amendments fasb asc topic 985 software “asu 200914” asu 200913 requires entities allocate revenue arrangement using estimated selling prices delivered goods services based selling price hierarchy amendments eliminate residual method revenue allocation require revenue allocated using relative selling price method asu 200914 removes tangible products scope software revenue guidance provides guidance determining whether software deliverables arrangement includes tangible product covered scope software revenue guidance asu 200913 asu 200914 applied prospective basis revenue arrangements entered materially modified fiscal years beginning june 15 2010 early adoption permitted adoption guidance expected material impact company’s consolidated financial statements rae systems inc notes consolidated financial statements continued january 2010 fasb issued guidance amend disclosure requirements related recurring nonrecurring fair value measurements guidance requires new disclosures transfers assets liabilities level 1 quoted prices active market identical assets liabilities level 2 significant observable inputs fair value measurement hierarchy including reasons timing transfers additionally guidance requires roll forward activities purchases sales issuance settlements assets liabilities measured using significant unobservable inputs level 3 fair value measurements guidance became effective entities reporting period beginning january 1 2010 except disclosure roll forward activities level 3 fair value measurements become effective reporting period beginning january 1 2011 adoption changes material impact company’s consolidated financial statements december 2010 fasb issued asu 201029 disclosure supplementary pro forma information business combinations amendments fasb asc topic 805 business combinations guidance asu 201029 provides amendments clarify acquisition date used reporting pro forma financial information disclosures topic 805 comparative financial statements presented amendments also improve usefulness pro forma revenue earnings disclosures requiring description nature amount material nonrecurring pro forma adjustments directly attributable business combinations amendments update effective prospectively business combinations acquisition date beginning first annual reporting period beginning december 15 2010 early adoption permitted adoption guidance expected material impact company’s consolidated financial statements december 2010 fasb issued asu 201028 perform step 2 goodwill impairment test reporting units zero negative carrying amounts amendments fasb asc topic 350 intangibles goodwill objective asu address diversity practice application goodwill impairment testing entities reporting units zero negative carrying amounts eliminating entity’s ability assert reporting unit required perform step 2 carrying amount reporting unit zero negative despite existence qualitative factors indicate goodwill likely impaired asu effective interim periods january 1 2011 adoption asu expected material impact company’s consolidated financial statements note 2 discontinued operation december 22 2010 board directors approved management’s plan pursue sale company’s 70 interest rae coal mine safety instruments fushun co ltd “rae fushun” sinoforeign joint venture china rae fushun met company’s revenue earnings expectations joint venture well positioned capitalize company’s future strategies january 12 2011 company signed definitive agreement sell 70 interest shenyang research institute china coal research institute “shenyang institute” stateowned enterprise zero proceeds however terms agreement shenyang institute assumes documented joint venture liabilities pay approximately rmb 1225 million approximately 185 million intercompany balances owed rae shanghai rae beijing products services previously provided joint venture march 15 2011 shenyang institute made scheduled payments rae systems totaling rmb 6 million approximately 09 million company expects receive rmb 2 million approximately 03 million monthly paid full purchase agreement rae systems shenyang institute subject customary closing conditions china includes obtaining certain government approvals company shenyang institute anticipate receiving necessary approvals final transfer shares within six months signing definitive agreement therefore rae systems provided shenyang institute complete operating control rae fushun january 12 2011 rae systems involved daytoday management operating activities rae fushun company still retains 70 ownership entity time regulatory rae systems inc notes consolidated financial statements continued approvals obtained however company anticipate providing financial support management support entity time asc topic 360 “property plant equipment” provides disposal group classified held sale measured lower carrying amount fair value less cost sell based rae fushun’s sales price carrying amount net assets exceeded fair value december 31 2010 accordingly company recorded impairment expense fourth quarter 2010 totaling 46 million includes 02 million estimated direct transaction costs impairment included reported loss discontinued operations company’s consolidated statements operations accordance asc subtopic 20520 “discontinued operations” financial results rae fushun reported discontinued operations periods presented financial results included discontinued operations follows third quarter 2010 company evaluated carrying values customer list longlived assets rae fushun revenues declined significantly quarter year date company expect nearterm recovery coal mine safety equipment business company determined carrying value customer list estimated undiscounted cash flows generated use eventual disposition assets accordingly company estimated fair value customer list using discounted cash flow analysis recorded impairment charge 15 million remaining carrying amount asset impairment included reported loss discontinued operations company’s consolidated statements operations longlived assets consisted principally land use rights buildings company current appraisals indicating held used fair market value excess carrying amount result longterm assets impaired september 30 2010 discounted cash flow analysis required use significant unobservable inputs level 3 inputs included forecasted revenues earned listed customers estimated remaining useful life asset approximately 5 years cost generating revenues attrition rate customer group forecasted earnings would discounted using riskweighted interest rate based historical experience company estimated likely would able generate positive returns rae fushun’s acquired customer list due primarily insufficient sales volumes rae systems inc notes consolidated financial statements continued carrying amounts major classes assets liabilities included part disposal group follows november 9 2009 rae fushun borrowed rmb 100 million approximately 15 million provide working capital loan due april 26 2011 bore interest fixed rate 81 first 12 months interest rate reset november 2010 84 15 times people’s bank china benchmark rate loan repayment guaranteed unrelated third party rae fushun granted lien wholly owned plant associated land rights condition loan lending bank required deposit approximately 01 million guarantor deposit funded rae fushun loan proceeds included restricted cash presentation disposal group’s assets liabilities note 3 balance sheet details allowance doubtful accounts components allowance doubtful accounts follows rae systems inc notes consolidated financial statements continued inventories stated lower cost market include material labor manufacturing overheard costs components inventories follows company recorded writedowns inventory 11 million 08 million 06 million 2010 2009 2008 respectively inventory writedowns predominantly result changes forecasted customer demand technological changes company’s products included primarily raw material finished goods major elements written raw material consists components items entered production finished goods inventory includes cost raw material inputs labor overhead prepaid expenses current assets components prepaid expenses current assets follows property equipment net components property equipment follows rae systems inc notes consolidated financial statements continued construction progress 2010 2009 respectively primarily represented cost build new manufacturing engineering administrative facility shanghai china company invested approximately 12 million december 2008 land use rights shanghai 2009 company paid approximately 03 million preconstruction land improvements construction facility began first quarter 2010 december 31 2010 estimated remaining cost complete project approximately 30 million work scheduled concluded first half 2011 upon completion construction company intends vacate existing leased facility shanghai based discussions shanghai government officials landlord existing company facility company believes able terminate lease without penalty however assurance given time company subject lease termination penalty december 2007 company sold headquarters building san jose california 127 million leased back facility period 10 years company recognized gain sale 04 million 2007 based difference net gain sale building 67 million net present value future lease payments 63 million net present value future lease payments recorded deferred gain recognized income straightline basis life lease since january 2008 06 million deferred gain recognized income 2010 2009 2008 respectively lease classified operating lease december 31 2010 2009 current portion deferred gain 06 million 06 million respectively included accrued liabilities consolidated balance sheets depreciation expense years ended december 31 2010 2009 2008 13 million 18 million 20 million respectively interest capitalized years ended december 31 2010 2009 2008 totaled 01 million zero respectively accrued liabilities accrued liabilities december 31 2010 2009 summarized follows 17 million accrued fcpa settlement paid january 2011 rae systems inc notes consolidated financial statements continued note 4 goodwill intangible assets goodwill represents excess purchase price related costs value assigned net tangible identifiable intangible assets following table presents change goodwill 2008 goodwill impaired company evaluates goodwill impairment whenever events changes circumstances indicate carrying amount may recoverable recoverability goodwill measured reporting unit level comparing reporting unit’s carrying amount including goodwill fair value reporting unit measured based upon among factors market capitalization well forecasted operating results company one reporting unit recorded value assets including goodwill liabilities “net book value” reporting unit exceeds fair value impairment loss may exist extent net book value company whole greater market capitalization significant portion goodwill may considered impaired company experienced significant decline market capitalization fourth quarter 2008 decline market capitalization driven largely deteriorating macroeconomic conditions contributed decline company’s forecasted operating results business uncertainties associated current fcpa investigation pursuant authoritative guidance measurement impairment goodwill consists two steps first step fair value company compared carrying value management completed valuation company incorporated existing marketbased considerations well operating information based current results projections concluded estimated fair value company less net book value result company performed second step determine implied fair value company’s goodwill compare carrying value company’s goodwill second step includes estimating value tangible intangible assets liabilities company acquired business combination determine implied fair value goodwill result assessment indicated implied fair value goodwill zero result company recognized noncash impairment charge approximately 33 million threemonth period year ended december 31 2008 writeoff entire carrying value goodwill following table presents details company’s intangible assets goodwill company’s purchased intangible assets goodwill subject amortization expense years ended december 31 2010 2009 2008 04 million 04 million 04 million respectively rae systems inc notes consolidated financial statements continued based carrying amount intangible assets december 31 2010 estimated future amortization follows thousands note 5 income taxes company’s income loss continuing operations income taxes consisted following company’s income tax expense benefit consisted following company recorded tax benefit approximately 06 million fourth quarter 2010 related expiration hightech status shanghai beijing entities expiration resulted increase tax rate used establish deferred tax assets 15 25 company applied renewal hightech status respective jurisdictions obtain 15 tax rate however certainty renewal granted hightech status granted company calculate deferred tax assets lower rate would result tax expense period new status granted rae systems inc notes consolidated financial statements continued reconciliation company’s income tax expense benefit federal statutory rate income tax expense benefit effective tax rate follows components company’s net deferred taxes consisted following assessing recoverability deferred tax assets management considers whether likely portion deferred tax assets realized ultimate realization deferred tax assets dependent generation future taxable income periods temporary differences become deductible management considers scheduled reversal deferred tax liabilities historical projected future taxable income tax planning strategies making assessment us income taxes provided certain earnings nonus subsidiaries company plan repatriate remaining undistributed earnings nonus subsidiaries december 31 2010 rae systems inc notes consolidated financial statements continued tax reform act 1986 amount benefits net operating loss carryforwards may impaired limited certain circumstances events cause limitations amount net operating loss credit carryforwards company may utilize one year include limited cumulative ownership change 50 defined three year period company federal approximately 3 million california net operating losses scheduled expire 2028 december 31 2009 company federal research development credit carryforwards approximately 148000 scheduled expire 2022 utilized california 20102011 budget bill enacted october 19 2010 extended suspension net operating loss another two years 2010 2011 december 31 2010 company research development credit carryforwards approximately 01 million california income tax purposes california credits subject expiration current california tax law 2006 internal revenue service completed examination company’s federal income tax returns years ended december 31 2003 2004 based results examination company paid 391000 irs april 2006 tax authority denmark skat completed audit company’s subsidiary denmark year ended december 31 2004 without adjustment subsequent periods remain subject examination however audits currently process company’s valuation allowance determined accordance authoritative accounting guidance requires assessment positive negative evidence determining whether likely deferred tax assets recoverable assessment required jurisdiction basis management believes sufficient uncertainty exists regard realizability tax assets exception 15 million foreign deferred tax assets valuation allowance necessary factors considered providing valuation allowance include lack significant history consistent profits current weakness overall market uncertainty economic fundamentals stabilize thereby potentially impacting company’s ability sustain grow revenues earnings length carryback carryforward periods based absence sufficient positive objective verifiable evidence december 31 2010 company concluded appropriate establish full valuation allowance net federal state deferred tax assets throughout fiscal year 2010 company valuation allowance future tax benefits related certain foreign net operating losses result valuation allowance deferred tax assets decreased 05 million 86 million january 1 2010 approximately 81 million december 31 2010 company expects provide full valuation allowance future tax benefits sustain level profitability demonstrates ability utilize assets amount deferred tax asset valuation allowance however could reduced future periods extent future taxable income realized prior 2009 exposures settled primarily settlement audits within individual tax jurisdiction closing statute limitation exposures also affected changes applicable tax law factors may cause management believe revision past estimates appropriate management believes appropriate liability established income tax exposure however actual amounts may differ materially estimates impact uncertain tax position likely sustained upon audit relevant taxing authority must recognized largest amount likely sustained portion uncertain tax position recognized position less 50 likelihood sustained also interest expense recognized full amount deferred benefits uncertain tax positions december 31 2010 2009 company recorded tax contingency reserves approximately 14 million 15 million respectively balances include accrued interest penalties 04 million 03 million respectively december 31 2010 2009 tax contingency reserves included component income taxes payable consolidated balance sheets rae systems inc notes consolidated financial statements continued december 31 2010 company 14 million unrecognized tax benefits 12 million would affect effective tax rate recognized company anticipate material changes uncertain tax positions next 12 months reconciliation beginning ending balance unrecognized tax benefits “utb” follows company recognizes interest penalties associated uncertain tax positions income tax expense years ended december 31 2010 2009 2008 provision interest penalties 03 million 03 million 03 million respectively ultimate amount timing future cash settlements cannot predicted reasonable certainty conduct business globally result one subsidiaries file income tax returns us federal jurisdiction various state foreign jurisdictions normal course business subject examination taxing authorities throughout world including major jurisdictions china hong kong denmark uk france united states longer subject us federal nonus income tax examinations years 2003 many cases company’s uncertain tax positions related tax years remain subject examination tax authorities following describes open tax years major tax jurisdiction december 31 2010 note 6 bank debt company maintains credit facilities support operations united states china united states company 100 million revolving credit agreement december 31 2010 credit facility renewed annually december 31 2010 line scheduled mature may 14 2011 available credit based percentage specific qualifying assets total facility collateralized blanket security interest company’s assets united states company required comply certain reporting requirements addition ongoing requirement submit quarterly financial statements rae systems inc notes consolidated financial statements continued interest accrues floating prime bank lending rate plus 100 basis points subject minimum total rate 5 addition company pays 30 basis points annually average unused portion facility december 31 2010 2009 company required maintain compensating balance least 20 million times compensating balance included restricted cash consolidated balance sheets compensating balance requirement released january 2011 december 31 2010 2009 18 million outstanding revolving credit agreement interest accruing 5 per annum financial covenants revolving credit agreement 1 require company maintain specified trailing twoquarter minimum earnings interest depreciation amortization noncash stock compensation expenses 2 limits size potential monetary penalties fcpa 35 million result impairment expense incurred discontinue operations fushun china company default trailing twoquarter minimum earnings requirement period ended december 31 2010 however lender issued waiver non compliance march 2011 company amended credit facility extend maturity date earlier june 15 2011 consummation merger vector capital exclude assets liabilities held sale rae fushun financial covenants refer “note 13 subsequent event” details merger agreement amendment also allows borrowings 2 million nonformula basis increases interest rate borrowings floating prime bank lending rate plus 400 basis points china company time maintains one unsecured revolving lines credit provide working capital borrowings lines credit generally current market rate fixed rate loans amount duration requested one year december 31 2010 company line credit bank debt china repaid december 31 2009 company unsecured revolving line credit amount rmb 20 million approximately 29 million outstanding balance rmb 15 million approximately 22 million accruing interest fixed rate 504 loan repaid maturity october 2010 note 7 commitments contingencies legal proceedings regulatory compliance fiscal year 2008 internal audit department identified certain payments gifts made certain personnel china operations may violated fcpa following discovery audit committee board directors initiated independent investigation made voluntary disclosure doj sec regarding results investigation also implemented additional policies controls respect compliance fcpa related statutes regulations provide potential monetary penalties criminal sanctions cases debarment business us federal government connection fcpa violations cooperated doj sec connection review matter recorded accrual 35 million third quarter 2009 relating potential settlement matter subsequently settled outstanding issues regard matter december 2010 pursuant separate agreements doj sec agreed pay 17 million criminal penalty doj 115 million restitution plus 01 million interest sec company also agreed advise doj sec periodically december 2013 ongoing efforts ensure continued compliance fcpa legal proceedings polimaster ltd et al v rae systems inc united states district court northern district california case 05cv01887jf united states court appeals ninth circuit nos 0815708 0915369 rae systems inc notes consolidated financial statements continued polimaster ltd nase trading company ltd “polimaster” filed complaint company may 9 2005 united states district court northern district california case titled polimaster ltd et al v rae systems inc case 05cv01887jf complaint alleges among things company breached contract polimaster infringed upon polimaster’s intellectual property rights dispute subject contractual arbitration agreement although federal court retained jurisdiction matter pending completion arbitration conducted spring 2007 september 2007 final award issued arbitration arbitrator ruled polimaster failed prove claims entitled relief company proven counterclaims awarded damages approximately 24 million prevailing party company entitled recover costs amount 46000 october 5 2007 rae systems filed motion confirm final award october 17 2007 polimaster filed opposition rae systems’ motion confirm final award filed motion vacate final award motions heard december 7 2007 district court confirmed final award order dated february 25 2008 polimaster appealed district court’s order confirming arbitration award polimaster ltd et al v rae systems inc 0815708 appeal currently pending united states court appeals ninth circuit briefing appeal completed sides appeal argued submitted ninth circuit decision january 15 2010 district court confirmed final award favor rae systems enter judgment omission district court described nonsubstantive clerical error september 9 2008 court appeal granted leave district court correct clerical error january 23 2009 district court entered judgment favor rae systems polimaster included judgment postarbitrationprejudgment interest postjudgment interest polimaster appealed inclusion two interest components judgment polimaster ltd et al v rae systems inc 0915369 briefing appeal completed sides appeal argued submitted ninth circuit decision january 15 2010 may 14 2009 polimaster rae systems entered first amended restated stipulation order stay execution judgment favor rae systems inc “stipulation” pursuant polimaster wire transferred 14 million client trust account rae systems’ counsel mcleod witham flynn llp agreed wire transfer additional 11622425 per month entire amount deposited equaled amount judgment approximately 28 million plus accrued interest judgment rate 043 percent per annum pursuant stipulation amounts transferred polimaster maintained client trust account rae systems’ counsel mcleod witham flynn llp held ninth circuit ruled polimaster’s appeal nos 0815708 0915369 appeals argued threejudge panel submitted ninth circuit decision january 15 2010 september 28 2010 ninth circuit issued divided panel opinion finding polimaster established defense enforcement arbitration award favor rae systems article v 1d convention recognition enforcement foreign arbitral awards “new york convention” ground arbitrator’s decision permitting rae systems assert counterclaims arbitration accordance agreement parties october 12 2010 rae systems petitioned ninth circuit rehearing en banc ie reconsideration appeal larger panel 11 judges november 12 2010 ninth circuit denied rae systems’ petition judgment ninth circuit final escrowed funds returned polimaster shareholder lawsuits california state court actions september 20 2010 putative class action suit entitled foley v rae systems inc et al 110cv182985 filed superior court california county santa clara company members board directors company’s chief financial officer entities affiliated battery rae systems inc notes consolidated financial statements continued ventures suit alleges summary connection proposed acquisition company affiliate battery ventures individual defendants breached fiduciary duties conducting unfair sale process agreeing unfair price would purportedly receive improper personal benefits connection proposed acquisition aided abetted defendants plaintiff seeks among things declaration suit maintained class action injunction proposed merger rescission merger agreement directive defendants exercise fiduciary duties implement process secure best possible consideration stockholders imposition constructive trust allegedly improper benefits fees costs four lawsuits making similar allegations also filed superior court state california county santa clara company board directors battery ventures affiliates angles v rae systems inc et al 110cv183606 greenbaum v chen et al 110cv183814 ac photonics inc v rae systems inc et al 110cv183942 mann v rae systems inc et al 110cv183960 october 28 2010 california court consolidated five california actions caption rae systems inc shareholder litigation lead case 110cv182985 december 15 2010 plaintiffs mann angles filed amended complaint continuing set forth claims set forth including additional disclosure claims based allegations company’s proxy filings contain materially false statements fail disclose material facts regarding among things special committee holders rollover shares process events leading proposed acquisition fcpa investigation communications battery ventures potential bidders work performed ubs data underlying analyses december 17 2010 california court issued order staying proceedings california state court favor litigation pending delaware chancery court actions addition four putative class action suits similar allegations filed delaware chancery court nelson v rae systems inc et al ca 5848vcs venton v rae systems inc et al ca 5854vcs quintanilla v rae systems inc et al ca 5872 villeneuve v rae systems inc et al ca 5877 delaware actions consolidated caption rae systems inc shareholder litigation consolidated ca 5848vcs plaintiffs filed verified consolidated amended class action complaint october 28 2010 pleading plaintiffs continued assert claims set forth addition alleged company’s preliminary proxy statement filed sec october 21 2010 contained materially false statements failed disclose material facts regarding among things special committee holders rollover shares process events leading proposed acquisition fcpa investigation communications battery ventures potential bidders work performed ubs data underlying analyses plaintiffs requested various forms injunctive relief well money damages allegedly suffered putative class december 17 2010 two plaintiffs stayed california action mann angles also filed complaint delaware chancery court making essentially allegations amended california complaint described plaintiffs mann angles subsequently voluntarily dismissed delaware complaint february 24 2011 remaining delaware plaintiffs filed motion requesting leave file supplemental amended verified class action complaint delaware chancery court granted plaintiffs’ leave amend complaint march 2 2011 supplemental amended verified class action complaint asserts claims company members board directors entities affiliated vector capital alleges summary connection proposed acquisition company affiliate vector capital individual defendants breached fiduciary duties conducting unfair sale process agreeing unfair price purportedly receiving improper personal benefits aided abetted defendants complaint also alleges company’s preliminary proxy statement filed sec february 22 2011 contains materially false statements fails disclose material facts regarding among things special committee holders rollover shares process events leading proposed acquisition work performed ubs data underlying analyses communications battery rae systems inc notes consolidated financial statements continued ventures vector capital potential bidders plaintiffs request various forms injunctive relief well money damages allegedly suffered putative class federal court actions two actions filed united states district court northern district california company members board directors company’s chief financial officer andor battery ventures rudy merger sub corp rudy acquisition corp actions entitled laplante v rae systems inc et al cv104944 mabry v chen et al cv 105328 make allegations similar lawsuits add claims alleged violation federal securities laws connection preparation proxy statement filed company connection proposed acquisition affiliates battery ventures january 10 2011 federal court issued order pursuant stipulation parties staying proceedings laplante action favor litigation pending delaware similar order entered federal court mabry action january 21 2011 pursuant stipulation parties company believes claims shareholder lawsuits without merit intends vigorously defend however assurances outcome litigation company process assessing matters consulting external legal counsel technical experts amount loss related matters estimable time accordingly company accrued amount loss related matters leases company subsidiaries lease certain manufacturing warehousing facilities operating leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2010 2009 2008 13 million 14 million 15 million respectively future minimum annual payments noncancellable leases follows december 31 2010 thousands december 2004 company moved current corporate headquarters san jose california abandoned leased facility sunnyvale california second quarter 2005 company accrued restructuring reserve approximately 20 million remaining lease term former headquarters sunnyvale discount rate used 485 liability reduced anticipated future sublease income march 2007 due improved conditions office rentals company revised estimated loss abandonment lease reduced operating expense 595000 second quarter 2007 sublease executed rents commencing june 2007 master lease sublease expired october 2009 rent payments 2009 2008 439000 490000 respectively sunnyvale building sublease income 136000 176000 2009 2008 respectively rae systems inc notes consolidated financial statements continued purchase obligations although open purchase orders considered enforceable legally binding terms generally allow company option cancel reschedule adjust requirements based business needs prior delivery goods performance services obligations purchase inventory commitments generally expected fulfilled within one year estimated 72 million december 31 2010 first quarter 2010 company began construct new manufacturing engineering facility shanghai china estimated cost complete project approximately 30 million work scheduled completed second quarter 2011 project deemed contractual obligation underlying contract specify financial commitment upon completion construction company would vacate existing leased facility shanghai based discussions shanghai government officials landlord existing company facility company believes able terminate lease without penalty however assurance given time company subject lease termination penalty guarantees company permitted delaware law required certificate incorporation bylaws indemnify officers directors certain events occurrences subject certain limits officer serving company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director officer insurance policy limits exposure enables recover portion future amounts paid date company incurred losses agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits product warranties company sells majority products 12 24 month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized accrued liabilities consolidated balance sheets following table presents changes company’s warranty reserve 2010 2009 note 8 employee benefit plan company sponsors rae systems 401k plan “plan” defined contribution plan provides retirement benefits eligible employees tax deferred salary deductions plan allows employees contribute 60 annual compensation subject statutory maximum levels plan available employees united states reached age 21 plan provides employer matching rae systems inc notes consolidated financial statements continued contributions 25 employee’s elective contributions first 60 eligible compensation contributed company contributions vest rate 25 per annum first 4 years service employer matching contributions plan totaled 136000 122000 113000 years ended december 31 2010 2009 2008 respectively note 9 stockbased compensation stock option plans june 2007 company’s shareholders approved 2007 equity incentive plan “2007 plan” replace company’s 2002 stock option plan “2002 plan” 2007 plan authorizes grant options employees directors consultants purchase shares company’s common stock four million shares company’s common stock authorized issuance 2007 plan maximum number shares may issued 2007 plan increased time shares subject options granted 2002 plan expire terminated shares acquired 2002 plan forfeited repurchased company option holder’s purchase price however 15 million additional shares may authorized issuance 2007 plan result adjustments december 31 2010 1264541 shares added 2007 plan due qualifying adjustments 2002 plan incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share underlying stock date grant determined board directors committee thereof except options granted person owning greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting prorata monthly following three years exercised options generally expire ten years date grant total intrinsic value options exercised 2010 2009 2008 62000 zero 179000 respectively connection exercises tax benefit realized company full valuation allowance deferred tax assets december 31 2010 unrecognized future estimated compensation expense related stock options net expected forfeitures 10 million cost expected recorded estimated amortization period 21 years following summary stock option activity thousands except weightedaverage amounts rae systems inc notes consolidated financial statements continued following table summarizes significant ranges outstanding exercisable options december 31 2010 aggregate intrinsic value table represents total pretax intrinsic value based excess company’s closing stock price 161 december 31 2010 options holders’ exercise price would received option holders option holders exercised options date total number inthemoney options exercisable december 31 2010 1791673 december 31 2010 stock options outstanding included 5072060 options either vested expected vest weightedaverage exercise price 202 aggregate intrinsic value 1518000 remaining contractual term 591 years may 2008 company granted aggregate 150000 shares common stock nonemployee directors 2007 plan weightedaverage grant date fair value awards 140 shares subject vesting compensation expenses 210000 recognized date grant december 31 2010 unvested grants restricted stock outstanding 2007 plan nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares restricted stock weighted average exercise price 099 per share options vested 25 one year remainder vesting prorata monthly following three years 2002 2006 company issued 300000 shares common stock due exercise options grants exercises cancellations december 31 2010 total outstanding nonplan stock options december 31 2010 100000 weighted average exercise price 106 vested options exercisable ten years date grant 2010 stockbased compensation expense related nonplan stock options remained recorded rae systems inc notes consolidated financial statements continued following table summarizes outstanding exercisable nonplan stock options december 31 2010 nonplan restricted stock 2006 company granted 536000 shares restricted stock four individuals inducement join company twenty five percent restricted stock 134000 shares vested july 2007 remainder vesting prorata quarterly following three years august 2007 concurrent discontinuing company’s dvr business company terminated two individuals result remainder restricted stock awards 203571 shares vested immediately charge 596000 included loss discontinued operations 2007 fair market value company’s common shares dates awards granted represents unrecognized deferred stock compensation amortized straightline basis vesting period underlying stock awards december 31 2010 stockbased compensation expense related restricted stock awards remained recorded following summary activity nonplan awards thousands except per share amounts stockbased compensation expense fair value option award estimated date grant using blackscholesmerton valuation method accordingly stockbased compensation cost measured grant date based fair value award recognized expense requisite service generally vesting period impact rae systems inc notes consolidated financial statements continued company’s results continuing operations recording stockbased compensation function years ended december 31 2010 2009 2008 follows stockbased compensation expense discontinued operations recorded fiscal 2010 2009 2008 valuation assumptions company estimates fair value stock option date grant using blackscholesmerton valuation model single option award approach fair value option grant amortized straightline basis requisite service period award generally vesting period weightedaverage assumptions applied summarized expected volatility company’s expected volatilities based historical volatility company’s stock adjusted management unusual nonrepresentative stock price activity expected recur management determined historical stock price volatility period april 11 2002 commencement public trading common stock december 31 2002 likely representative future excluded period management also applies mean reversion techniques historical stock prices results emphasis recent activity distant past determining expected volatility rate included blacksholesmerton valuation model expected dividend bsm valuation model calls single expected dividend yield input company paid dividend past anticipate paying dividend near future riskfree interest rate company bases riskfree interest rate implied yield currently available us treasury zerocoupon issues equivalent remaining term expected term company’s stockbased award correspond terms interest rates quoted company performs straightline interpolation available maturities expected term company’s expected term represents weightedaverage period company’s stockbased awards expected outstanding company uses historical exercise patterns previously granted options relation company’s stock price estimate expected exercise patterns estimated forfeitures estimate forfeitures company applies historical rate option forfeitures estimated forfeiture rates truedup actual forfeiture results stockbased awards vest rae systems inc notes consolidated financial statements continued note 10 related party transactions company accounts 40 ownership renex technologies ltd “renex” hong kong company following equity method company’s total investment renex december 31 2010 2009 166000 339000 respectively company recorded losses 173000 109000 equity interest renex years ended december 31 2010 2009 respectively income 43000 year ended december 31 2008 company royalty agreement renex modems incorporated certain rae systems products however 2010 2009 2008 company incurred expenses royalty agreement company paid 31000 95000 181000 renex research projects 2010 2009 2008 respectively conjunction company’s investment rae beijing unsecured notes payable established previous rae beijing shareholders part purchase price agreement july 2006 although notes bear stated interest rate 3 per annum notes discounted using market interest rate 648 december 31 2010 december 31 2009 278000 370000 respectively included current notes payable related parties zero 363000 respectively included long term notes payable related parties final scheduled payment principal accrued interest notes due maturity july 2011 addition 40 ownership renex company investments three distributors rae systems products rae australia rae benelux rae spain company owns 19 10 19 rae australia rae benelux rae spain respectively investments accounted cost method transactions balances company’s related parties follows company’s director information systems lien chen wife chief executive officer robert chen ms chen paid salary bonus 127000 128000 111000 2010 2009 2008 respectively ms chen also receives standard employee benefits offered fulltime us employees ms chen report robert chen compensation decisions regarding ms chen performed manner us employees robert chen final approval signatory compensation recommendations rae systems inc notes consolidated financial statements continued note 11 fair value measurements company uses following methods assumptions estimating fair value financial assets liabilities cash equivalents bank line credit carrying amounts reported consolidated balance sheets approximate fair value due shortterm maturity instruments notes payable related parties fair value determined discounting noninterest bearing notes payable interest rate commensurate commercial borrowing rates available company china intangible assets net fair value evaluated whenever events changes circumstances indicate carrying value asset may recoverable existing authoritative guidance requires assets liabilities carried fair value classified disclosed one following three categories level 1 quoted market prices active markets identical assets liabilities level 2 observable market based inputs unobservable inputs corroborated market data level 3 unobservable inputs corroborated market data note 12 geographic information company operates primarily three geographic regions americas asia europe following tables present net sales identifiable longlived assets geographic region net sales china 177 million 20 199 million 26 257 million 31 total net sales 2010 2009 2008 respectively china held 103 million 96 70 million 94 80 million 91 total net property equipment december 31 2010 2009 2008 respectively company’s intangible assets located china consist purchased customer lists trade names net carrying amount longlived assets 02 million 05 million 09 million december 31 2010 2009 2008 respectively rae systems inc notes consolidated financial statements continued majority company’s net sales americas asia customers domiciled united states people’s republic china respectively company performs credit evaluations customers’ financial condition considered necessary generally require cash collateral customers evaluations require significant judgment based variety factors including limited current economic trends historical payments bad debt writeoff experience financial review customer note 13 subsequent event september 19 2010 company signed definitive agreement acquired battery ventures 160 cash per share certain shares held founders robert chen peter hsi affiliated entities transaction subject customary closing conditions including approval rae systems’ shareholders subsequently january 12 2011 company received letter vector capital setting forth offer acquire outstanding shares common stock 175 per share cash certain shares held robert chen peter hsi affiliated entities extensive consideration special committee board directors company terminated battery merger agreement january 18 2011 paid termination fee 339 million battery ventures accordance terms battery merger agreement signed merger agreement vector capital terms described transaction also subject customary closing conditions including approval rae systems’ shareholders note 14 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presented rae systems inc notes consolidated financial statements continueditem 15 exhibits financial statement schedules 1 financial statements see index consolidated financial statements form 10k 2 financial statement schedules provided absence conditions required information given financial statements notes thereto 3 exhibits see index exhibits page 37 herein signatures pursuant requirements section 13 15d securities exchange act 1934 registrant duly caused report signed behalf undersigned thereunto duly authorized march 17 2008 rae systems inc robert chen robert chen president chief executive officer know persons presents person whose signature appears constitutes appoints robert chen randall gausman person’s true lawful attorneysinfact agents full power substitution resubstitution person’s name place stead capacities sign amendments report form 10k file exhibits thereto documents connection therewith securities exchange commission granting unto said attorneysinfact agents full power authority perform every act thing requisite necessary done connection therewith fully intents purposes person might could person hereby ratifying confirming said attorneysinfact agents substitute substitutes may lawfully cause done virtue hereof pursuant requirements securities exchange act 1934 report signed following persons capacities dates indicated index exhibits 1 previously filed exhibit registrant’s quarterly report form 10q quarter ended march 31 2002 incorporated herein reference 2 previously filed exhibit registrant’s current report form 8k june 19 2007 incorporated herein reference 3 previously filed exhibit registrant’s current report form 8k december 21 2007 incorporated herein reference 4 previously filed august 8 2006 exhibit registrant’s quarterly report form 10q quarter ended june 30 2006 incorporated herein reference 5 previously filed exhibit registrant’s current report form 8k august 8 2006 incorporated herein reference 6 previously filed exhibit registrant’s current report form 8k august 16 2006 incorporated herein reference 7 previously filed exhibit registrant’s current report form 8k october 18 2006 incorporated herein reference 8 previously filed exhibit registrant’s annual report form 10k year ended december 31 2006 incorporated herein reference 9 filed herewith rae systems inc consolidated financial statements december 31 2007 2006 report independent registered public accounting firm board directors shareholders rae systems inc audited accompanying consolidated balance sheet rae systems inc subsidiaries collectively “company” december 31 2007 related consolidated statements operations shareholders’ equity cash flow year ended financial statements responsibility company’s management responsibility express opinion financial statements based audit consolidated financial statements company year ended december 31 2006 effects retrospective adjustments discontinued operations discussed notes 3 consolidated financial statements audited auditors whose report dated march 16 2007 expressed unqualified opinion statements includes explanatory paragraph regarding company’s adoption statement financial accounting standards 123 revised 2004 share based payment conducted audit accordance standards public company accounting oversight board united states standards require plan perform audit obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audit provides reasonable basis opinion 2007 consolidated financial statements present fairly material respects financial position company december 31 2007 results operations cash flows year ended conformity accounting principles generally accepted united states america also audited retrospective adjustments 2006 consolidated financial statements operations discontinued 2007 discussed note 3 consolidated financial statements procedures included 1 obtaining company’s underlying accounting analysis prepared management retrospective adjustments discontinued operations comparing retrospectively adjusted amounts per 2006 financial statements analysis 2 comparing previously reported amounts previously issued financial statements years 3 testing mathematical accuracy accounting analysis 4 test basis comparing adjustments retrospectively adjust financial statements discontinued operations company’s supporting documentation opinion retrospective adjustments appropriate properly applied however engaged audit review apply procedures 2006 consolidated financial statements company respect retrospective adjustments accordingly express opinion form assurance 2006 consolidated financial statements taken whole discussed note 1 consolidated financial statements effective january 1 2006 company changed method accounting stockbased compensation accordance statement financial accounting standards 123 revised 2004 share based payment discussed note 7 consolidated financial statements january 1 2007 company changed method accounting uncertain income tax positions accordance guidance provided financial standards accounting board interpretation 48 accounting uncertainty income taxes interpretation fasb statement 109 also audited accordance standards public company accounting oversight board united states company’s internal control financial reporting december 31 2007 based criteria established internal control integrated framework issued committee sponsoring organizations treadway commission report dated march 17 2008 expressed unqualified opinion company’s internal control financial reporting deloitte touche llp san jose california march 17 2008 report independent registered public accounting firm board directors shareholders rae systems inc audited effects adjustments retrospectively account dvr business discontinued operation described notes 3 6 accompanying consolidated balance sheet rae systems inc company december 31 2006 related consolidated statements operations shareholders’ equity cash flows years ended december 31 2006 2005 financial statements responsibility company’s management responsibility express opinion financial statements based audits conducted audits accordance standards public company accounting oversight board united states standards require plan perform audits obtain reasonable assurance whether financial statements free material misstatement audit includes examining test basis evidence supporting amounts disclosures financial statements audit also includes assessing accounting principles used significant estimates made management well evaluating overall financial statement presentation believe audits provide reasonable basis opinion consolidated financial statements referred effects adjustments retrospectively accounts dvr business discontinued operation described notes 3 6 present fairly material respects financial position rae systems inc december 31 2006 results operations cash flows years ended december 31 2006 2005 conformity accounting principles generally accepted united states america discussed note 1 effective january 1 2006 company adopted statement financial accounting standards 123r “sharebased payment” engaged audit review apply procedures adjustments retrospectively account dvr business discontinued operation described notes 3 6 accordingly express opinion form assurance whether adjustments appropriate properly applied adjustments audited deloitte touche llp bdo seidman llp san jose california march 16 2007 rae systems inc consolidated balance sheets see accompanying notes consolidated financial statements rae systems inc consolidated statements operations see accompanying notes consolidated financial statements rae systems inc consolidated statements shareholders’ equity see accompanying notes consolidated financial statements rae systems inc consolidated statements cash flows see accompanying notes consolidated financial statements rae systems inc notes consolidated financial statements note 1 summary significant accounting policies company founded 1991 rae systems inc “company” “rae” delaware company develops manufactures rapidlydeployable multisensor chemical radiation detection monitors networks industrial applications homeland security company’s products based proprietary technology include portable wireless fixed chemical detection monitors radiation detectors principles consolidation consolidated financial statements prepared accordance accounting principles generally accepted united states include company subsidiaries ownership interest holders consolidated subsidiaries reflected minority interest intercompany balances transactions eliminated use estimates preparation financial statements conformity generally accepted accounting principles united states america requires management make estimates assumptions affect reported amounts assets liabilities disclosures contingent assets liabilities date financial statements reported amounts revenue expenses reporting period company bases estimates historical experience various assumptions believed reasonable based available information actual results may differ materially estimates assumptions revenue recognition company recognizes revenue persuasive evidence arrangement exists delivery occurred fee fixed determinable collectibility reasonably assured provision estimated product returns established time sale based upon historical return rates adjusted current economic conditions historically company experienced insignificant amount sales returns company generally recognizes revenue upon shipment distributors accordance standard contract terms pass title goods upon delivery common carrier free board “fob” factory provides sales returns standard product warranty provisions nonstandard contract terms title goods passes upon delivery customer fob destination revenue recognized company established proof delivery revenues related services performed company’s extended warranty program recognized earned based upon contract terms generally ratably term service company records project installation work asia using percentageofcompletion method net sales also include amounts billed customers shipping handling company’s shipping costs included cost sales cash equivalents company considers highly liquid investments original maturities 90 days less time purchase cash equivalents allowance doubtful accounts company grants credit customers undertaking investigation credit risk significant amounts allowance doubtful accounts based company’s assessment collectability customer accounts company regularly reviews allowance considering factors historical experience credit quality age accounts receivable balances current economic conditions known troubled accounts company generally require collateral sales credit company becomes aware specific customer unable meet financial obligations company records specific rae systems inc notes consolidated financial statements continued allowance reflect level credit risk customer’s outstanding receivable balance addition company records additional allowances based certain percentages aged receivable balances company classifies bad debt expenses selling general administrative expenses company able predict changes financial stability customers material change financial status one group customers could material adverse effect company’s results operations financial condition although losses within management’s expectations date assurance allowances continue adequate customer accounted 10 consolidated net sales 2007 2006 2005 trade notes receivable trade notes receivable bank guaranteed promissory notes noninterest bearing generally mature within six months time certain customers china present notes payment outstanding accounts receivable concentration credit risk financial instruments potentially subject company concentration credit risk consist principally cash equivalents trade receivables company places domestic foreign cash equivalents large creditworthy financial institutions primarily united states peoples’ republic china us cash balances insured federal deposit insurance company 100000 per account december 31 2007 2006 company deposits excess insured limits approximately 49 million 79 million respectively company also deposits several foreign financial institutions insured aggregated approximately 108 million 102 million december 31 2007 2006 respectively inventories stated lower standard cost approximates actual cost computed firstin firstout basis market company established inventory reserves conditions exist suggest inventory may excess anticipated demand obsolete based upon assumptions future demand products market conditions recorded writedowns intended reduce carrying value inventory net realizable value actual demand specified products deteriorates market conditions less favorable projected additional reserves may required property equipment property equipment stated cost less accumulated depreciation computed using straight line method estimated useful lives assets follows warranty repairs date shipment company provides 12 24 month repair replacement warranty majority products based primarily historical relationship actual warranty costs sales rae systems inc notes consolidated financial statements continued company accrues reserve estimated future warranty costs time revenue recognized estimated warranty obligation affected product failure rates length warranty period materials usage repair replace defective products service delivery costs incurred correcting product failures addition time specific warranty accruals may made unforeseen technical problems arise company’s actual experience relative factors significantly different estimated company may required adjust provision future periods research development research development costs expensed incurred advertising costs company expenses advertising costs incurred years ended december 31 2007 2006 2005 advertising expense 547000 1029000 1086000 respectively income taxes company recognizes income taxes accordance sfas 109 using asset liability approach requires recognition taxes payable refundable current year deferred tax assets liabilities expected future tax consequences events recognized company’s consolidated financial statements tax returns measurement current deferred taxes based provisions enacted tax law sfas 109 provides recognition deferred tax assets realization assets likely occur otherwise valuation allowance established deferred tax assets may realized company subject income tax audits respective tax authorities jurisdictions operates determination tax liabilities jurisdictions requires interpretation application complex sometimes uncertain tax laws regulations recognition measurement current taxes payable refundable deferred tax assets liabilities requires company make certain estimates judgments changes estimates change judgment may material impact company’s tax provision future period effective january 1 2007 company adopted fin 48 requires morelikelythannot threshold financial statement recognition measurement tax positions taken expected taken tax return company records liability difference benefit recognized measured pursuant fin 48 tax position taken expected taken tax return extent company’s assessment tax positions changes change estimate recorded period determination made adoption fin 48 company also began reporting taxrelated interest penalties component income tax expense goodwill intangible assets goodwill tested impairment annual basis fourth quarter annual tests events occur circumstances indicate carrying amount goodwill may recoverable impairment losses recorded statement operations “impairment goodwill” purchased intangible assets goodwill amortized estimated useful lives unless lives determined indefinite purchased intangibles carried cost less accumulated amortization generally computed using straightline method estimated useful lives respective assets generally two seven years rae systems inc notes consolidated financial statements continued long lived assets company evaluates recoverability longlived assets finite lives accordance sfas 144 requires recognition impairment longlived assets whenever events changes circumstances indicate carrying amount asset may recoverable company periodically reviews long lived assets impairment events changes circumstances indicate carrying amount asset may recoverable based estimated undiscounted cash flows impairment loss would measured difference carrying amount assets fair value based present value estimated future cash flows fair values financial instruments following methods assumptions used company estimating fair value disclosures financial instruments • cash equivalents accounts receivable trade notes receivables accounts receivable affiliate accounts payable accrued expenses inventory purchase obligations carrying amount reported balance sheet items approximates fair value short maturity instruments addition inventory purchase obligations carrying value approximates fair value based market rates comparable products • investments fair value investments determined using quoted market prices securities similar financial instruments management accounts debt investments availableforsale • notes payable related parties carrying value notes payable related parties approximates fair value company discounted non interest bearing notes payables interest rate commensurate commercial borrowing rates available company china december 31 2007 2006 fair values company’s financial instruments approximate historical carrying amount translation foreign currencies assets liabilities nonus subsidiaries operate local currency environment local currency functional currency translated us dollars exchange rates effect balance sheet date resulting translation adjustments directly recorded separate component accumulated comprehensive income expense accounts translated average exchange rates year gains losses foreign currency transactions recorded income loss net functional currency local currency nonus subsidiaries stockbased compensation expense january 1 2003 company adopted sfas 123 recognition stockbased compensation cost statement operations fair value option award estimated date grant using blackscholesmerton valuation method fair value amortized compensation expense straight line basis requisite service periods awards generally vesting period effective january 1 2006 company adopted fair value recognition provisions sfas 123r fair value option adjusted reflect shares expected vest company’s implementation sfas 123r applied modified prospective transition method compensation cost related unvested option january 1 2006 recalculated necessary adjustment recorded first quarter adoption rae systems inc notes consolidated financial statements continued november 10 2005 financial accounting standards board “fasb” issued fasb staff position fas 123r3 “transition election related accounting tax effects stockbased payment awards” allows simplified method establish beginning balance additional paidin capital pool “apic pool” related tax effects employee stockbased compensation determine subsequent impact apic pool consolidated statements cash flows tax effects employee stockbased compensation awards outstanding upon adoption sfas 123r january 1 2006 company adopted simplified method computation beginning balance apic pool net loss per share basic earnings per share includes dilution computed dividing income available common shareholders weighted average number common shares outstanding period diluted earnings per share reflects potential dilution common stock equivalents options warrants extent impact dilutive company incurred net losses years ended december 31 2007 2006 2005 potentially dilutive securities excluded diluted net loss per share computations effect deemed antidilutive weightedaverage number potentially dilutive shares excluded diluted net loss per share calculation 2007 2006 2005 3505491 2953204 6765118 respectively retained earnings accordance company law people’s republic china company’s china subsidiaries may required appropriate portion net income determined accounting principles generally accepted china “prc gaap” nondistributable reserves include general reserve enterprise expansion reserve staff welfare bonus reserve reserves restrict portion retained earnings distribution shareholders reserves withdrawn business remain available use operations whollyowned china subsidiaries required make appropriations enterprise expansion reserve however china subsidiaries required appropriate less 10 net income determined prc gaap general reserve appropriations general reserve limited 50 china subsidiary’s registered capital appropriations staff welfare bonus reserve determined board directors total appropriation retained earnings company’s statutory reserves totaled 17 million 17 million december 31 2007 2006 respectively variable interest entities sarl rae france “rae france” identified management variable interest entity company primary beneficiary ownership rae europe aps rae france distributes sells rae products exclusively france rae france total sales 18 million 17 million 09 million 2007 2006 2005 respectively total assets 07 million 07 million december 31 2007 2006 respectively company consolidated rae france since december 2004 segment reporting sfas 131 establishes standards public business enterprises report information operating segments annual financial statements requires enterprises report selected information operating segments subsequent interim financial reports issued shareholders also established standards related disclosure products services geographic areas major customers operating segments components enterprise evaluated regularly chief operating decisionmaker deciding allocate assess resources performance company’s chief operating decisionmakers chief executive officer chief financial officer although company’s operating segments consist entities geographically based americas asia europe company single reporting segment worldwide rae systems inc notes consolidated financial statements continued sale portable wireless gas radiation detection products related services accordingly company operated one reportable segment years ended december 31 2007 2006 2005 recent accounting pronouncements september 2006 fasb issued statement 157 “fair value measurements” “sfas 157” sfas 157 defines fair value establishes framework gives guidance regarding methods used measuring fair value expands disclosures fair value measurements sfas 157 applicable whenever another accounting pronouncement requires permits assets liabilities measured fair value sfas 157 expand require new fair value measures however application statement may change current practice sfas 157 effective fiscal years beginning november 15 2007 result effective company’s fiscal year beginning january 1 2008 management currently evaluating impact adopting sfas 157 related fasb staff positions company’s consolidated financial statements february 2007 fasb issued sfas 159 “the fair value option financial assets financial liabilitiesincluding amendment fasb statement 115” statement permits entities choose measure many financial instruments certain items fair value fair value option may elected instrumentbyinstrument basis exceptions sfas 159 also establishes presentation disclosure requirement facilitate comparisons companies choose different measurement attributes similar assets liabilities sfas 159 effective fiscal years beginning november 15 2007 company currently evaluating impact adopting sfas 159 management expect material effect company’s financial condition results operations december 2007 fasb issued sfas 141r “business combinations” “sfas 141r” statement changes accounting acquisition transaction costs requiring expensed period incurred also changes accounting contingent consideration acquired contingencies restructuring costs related acquisition sfas 141r effective fiscal years beginning december 15 2008 company currently evaluation impact adopting sfas 141r management expect material impact financial condition results operations december 2007 fasb issued sfas 160 “noncontrolling interests consolidated financial statementsan amendment arb 51” “sfas 160” statement change accounting reporting minority interests recharacterized noncontrolling interests classified component equity sfas 160 effective fiscal years beginning december 15 2008 company currently evaluating impact adopting sfas 160 management expect material effect financial condition results operations note 2 mergers acquisitions rae coal mine safety instruments fushun co ltd december 2006 wholly owned subsidiary company rae systems asia ltd “rae asia” agreed form joint venture liaoning coal industry group co ltd “liaoning group” form rae coal mine safety instruments fushun co ltd “rae fushun” limited liability company china duration 50 years result joint venture company obtained control fushun anyi ltd wholly owned subsidiary liaoning group manufacturer distributor safety equipment primarily coal mining industry primary reasons acquisition expand company’s market penetration china capitalize increased demand safety equipment coal mining industry joint venture agreement provided rae asia 70 interest rae fushun would contribute 108 million cash 22 million due immediately upon formation rae fushun remainder payable installments december 2007 30 interest rae fushun payable 39 million liaoning group contributed operating assets fushun anyi ltd book value 85 million rae systems inc notes consolidated financial statements continued december 31 2007 remaining balance due payable liaoning group 609000 total purchase price rae asia’s 70 interest rae fushun follows thousands transaction accounted purchase accordance sfas 141 therefore assets acquired liabilities assumed recorded fair value acquisition date following table summarizes purchase price allocation rae asia’s interest rae fushun’s assets liabilities thousands 1 balance eliminated consolidation purchase price allocation includes adjustments since date purchase acquired tangible intangible assets 2007 company reduced value property equipment 11 million reduced allowance doubtful accounts 03 million adjustments estimated fair value acquisition date rae fushun right use predessor enterprise’s tradenames patents due intangible assets registered rae fushun’s name value assets totaling 06 million written fair value net assets acquired formation rae fushun exceeded purchase price net result purchase price allocation adjustments reduced negative goodwill increased recorded value acquired customer list fair value customer list amortized using accelerated method based pattern expected usage estimated useful life 9 years rae systems inc notes consolidated financial statements continued results operations rae fushun included company’s consolidated financial statements since january 1 2007 unaudited financial information table summarizes combined results operations company rae fushun pro forma basis though companies combined beginning periods presented unaudited pro forma financial information presented informational purposes indicative results operations would achieved merger taken place beginning period presented indicative future results operations pro forma amounts give effect appropriate adjustments fair value assets acquired amortization intangibles income taxes rae beijing acquisition july 2006 rae asia entered four separate agreements purchase aggregate thirtytwo percent 32 outstanding common stock rae klh beijing co ltd “rae beijing” four minority interest holders 32 combined 64 rae beijing acquired may 2004 raises company’s ownership 96 management believes increase company’s rae beijing ownership strengthen company’s ability benefit fastgrowing industrial market china purchase shares accomplished via initial cash payment minority shareholders 48 million 19 total 32 purchased remaining common shares effect purchase company converted common shares nonvoting redeemable convertible preferred stock preferred stock redeemable accordance following schedule thousands preferred shares contingently convertible option holders event initial public offering china rae beijing subsidiary management believes likelihood initial public offering china remote result believe conversion provision substantive therefore accordance guidance statement financial accounting standards 150 “accounting certain financial instruments characteristics liabilities equity” company classified preferred stock liability preferred stock also accrues dividends rate 3 per year due classification liability company discounted preferred stock dividends market rate 648 resulting discount 08 million total purchase price 32 minority interest summarized follows thousands rae systems inc notes consolidated financial statements continued since may 2004 company consolidated results rae beijing within publicly reported financial statements rae beijing purchase price additional 32 ownership interest allocated fair value assets acquired liabilities assumed follows represents 32 total fair value thousands acquired intangible assets amortized estimated useful lives presented table 28 million goodwill recorded conjunction rae beijing acquisition deductible income tax purposes customer list amortized using accelerated method represents estimated pattern use intangible assets amortized straight line estimated useful lives rae systems inc notes consolidated financial statements continued acquisitions july 2006 company purchased assets including two pending patents santa clara california based aegison corporation “aegison” supplier fixed mobile digital video surveillance systems approximately 2 million cash direct transaction costs 142000 acquisition constitutes business combination accordance criteria defined emerging issues task force 983 “determining whether nonmonetary transaction involves receipt productive assets business” following table allocates purchase price fair value assets acquired liabilities assumed thousands following table summarizes components net tangible assets acquired fair value thousands 2007 company increased value investment securay 62000 reflect proceeds actually received subsequent purchase company discussed total purchase price increased 43000 due additional direct transaction costs incurred result goodwill decreased 19000 acquired intangible assets amortized estimated useful lives presented table goodwill represents excess purchase price fair value tangible identified intangible assets acquired expected deductible income tax purposes aegison’s results operations included company’s consolidated financial statements subsequent date acquisition pro forma results operations presented effect acquisition material prior period financial statements august 2007 company discontinued operations aegison see “note 3 discontinued operations” notes consolidated financial statements details january 2007 rae asia entered agreement purchase intellectual property tianjin securay technology ltd co “securay” renminbi 12 million approximately 15 million transaction together rae systems inc notes consolidated financial statements continued purchase agreements entered 2006 completed purchase securay including transactions entered 2006 total purchase price 20 million cash assets purchased 2006 amounting 820000 recorded acquisition progress december 31 2006 acquisition constitutes business combination accordance criteria defined emerging issues task force 983 “determining whether nonmonetary transaction involves receipt productive assets business” purchase price allocated follows thousands following table summarizes components net tangible assets acquired fair value thousands acquired intangible assets amortized estimated useful lives presented table goodwill represents excess purchase price fair value tangible identified intangible assets acquired expected deductible income tax purposes securay’s results operations included company’s consolidated financial statements subsequent date acquisition pro forma results operations presented effect acquisition material prior period financial statements acquisition aegison securay made company’s mobile digital video recording “dvr” business discontinued august 2007 see “note 3 discontinued operations” notes consolidated financial statements details note 3 discontinued operations august 24 2007 board directors approved discontinuation company’s dvr business order reduce expenses concentrate resources gas radiation detection business company’s mobile dvr business acquired purchases aegison securay see “note 2 mergers acquisitions” notes consolidated financial statements details august 28 2007 company notified dvr customers terminated personnel reassigned continuing operations suspended related production sales activities company intends keep acquired intellectual property dvr business operates substantial loss management intends rae systems inc notes consolidated financial statements continued liquidate tangible assets mainly inventories component parts accordingly value assets adjusted reflect anticipated disposals result discontinuing dvr business third quarter ended september 30 2007 management impaired remaining value intangible assets goodwill acquired purchases aegison july 2006 securay loss discontinued operations fiscal 2007 totaled 42 million accordance sfas 144 “accounting impairment disposal longlived assets” financial results dvr business reported discontinued operations periods presented financial results included discontinued operations follows carrying amounts major classes assets liabilities included part disposal group follows note 4 investments accordance sfas 115 company changed classification investments “heldtomaturity” “availableforsale” second quarter 2006 resulting fairvalue adjustment company’s investments led net 23000 reduction carrying value investments date change components company’s availableforsale investments follows rae systems inc notes consolidated financial statements continued cost estimated fair value company’s availableforsale investments december 31 2006 follows company’s unrealized losses investments temporary nature due company’s intent ability hold investments maturity par value realized based review securities including assessment duration severity related unrealized losses company record otherthantemporary impairments securities unrealized losses recovered 2007 note 5 balance sheet details allowance doubtful accounts components allowance doubtful accounts follows inventories stated lower cost market include material labor manufacturing overheard costs components inventories follows company recorded writedowns 442000 121000 127000 2007 2006 2005 respectively inventory writedowns predominantly result changes forecasted customer demand technological changes company’s products inventory written included raw material finished goods major elements written raw material consists components items entered production finished goods inventory includes cost raw material inputs labor overhead rae systems inc notes consolidated financial statements continued property plant equipments net components property plant equipment follows significant construction progress 2007 primarily represented cost build offices manufacturing facilities fushun people’s republic china new buildings expected placed service 2008 december 2007 company sold headquarters building san jose california 127 million leased back facility period 10 years company recognized gain sale 04 million 2007 based difference net gain sale building 67 million net present value future lease payments 63 million net present value future lease payments recorded deferred gain recognized income straightline basis life lease beginning january 2008 lease classified operating lease december 31 2007 current portion deferred gain 05 million included accrued liabilities noncurrent portion 58 million included longterm liabilities consolidated balance sheets depreciation expense years ended december 31 2007 2006 2005 23 million 26 million 16 million respectively accrued liabilities accrued liabilities december 31 2007 2006 summarized follows rae systems inc notes consolidated financial statements continued note 6 goodwill intangible assets goodwill represents excess purchase price related costs value assigned net tangible identifiable intangible assets following table presents changes goodwill 2007 2006 result discontinuing dvr business third quarter 2007 company impaired goodwill acquired purchases aegison securay see “note 3 discontinued operations” detail impairment goodwill 2007 2006 2005 result required annual impairment test december 31 2007 company’s remaining goodwill attributable investment rae beijing following table presents details company’s intangible assets goodwill company’s purchased intangible assets goodwill subject amortization expense years ended december 31 2007 2006 2005 14 million 07 million 05 million respectively 2007 company recorded impairment 609000 certain patents held rae beijing related discontinuation related product fourth quarter 2007 impairment analysis performed accordance sfas 144 intangible asset determined carrying value recoverable result discontinuing dvr business third quarter 2007 company impaired remaining balance intangible assets acquired purchases aegison securay impairment charge 16 million recognized quarter ended september 30 2007 included net loss discontinued operations reported company’s consolidated statements operations rae systems inc notes consolidated financial statements continued based carrying amount intangible assets december 31 2007 estimated future amortization follows thousands note 7 income taxes company’s income loss continuing operations income taxes minority interest consisted following company’s income tax expense benefit consisted following rae systems inc notes consolidated financial statements continued reconciliation company’s income tax expense benefit federal statutory rate income tax expense benefit effective tax rate follows components company’s net deferred taxes consisted following assessing recoverability deferred tax assets management considers whether likely portion deferred tax assets realized ultimate realization deferred tax assets dependent generation future taxable income periods temporary differences become deductible management considers scheduled reversal deferred tax liabilities historical projected future taxable income tax planning strategies making assessment us income taxes provided deferred taxes undistributed earnings nonus subsidiaries expected permanently reinvested companies provision us income taxes remaining undistributed earnings approximately 24 million december 31 2007 company intends reinvest earnings indefinitely operations outside united states practical determine federal income tax consequences upon repatriation rae systems inc notes consolidated financial statements continued 2006 internal revenue service completed examination federal income tax returns years ended december 31 2003 2004 based results examination company paid 391000 irs april 2006 tax authority denmark skat completed audit company’s subsidiary denmark year ended december 31 2004 without adjustment subsequent periods remain subject examination however audits currently process december 31 2007 company research development credit carryforwards approximately 01 million federal 04 million california income tax purposes california credits subject expiration current california tax law company’s valuation allowance determined accordance provisions sfas 109 requires assessment positive negative evidence determining whether likely deferred assets recoverable assessment required jurisdiction basis management believes sufficient uncertainty exists regard realizability tax assets valuation allowance necessary factors considered providing valuation allowance include lack significant history consistent profits current believe continued weakness overall market thereby potentially impacting company’s ability sustain grow revenues earnings length carryback carryforward periods based absence sufficient positive objective verifiable evidence december 31 2007 company concluded appropriate establish full valuation allowance net deferred tax assets throughout fiscal year 2007 company valuation allowance future tax benefits related certain foreign net operating losses result valuation allowance deferred tax assets increased 73 million 11 million january 1 2007 approximately 84 million december 31 2007 company reduce portions valuation allowance 2006 2007 company expects provide full valuation allowance future tax benefits sustain level profitability demonstrates ability utilize assets amount deferred tax asset valuation allowance however could reduced future periods extent future taxable income realized prior 2007 exposures settled primarily settlement audits within individual tax jurisdiction closing statute limitation exposures also affected changes applicable tax law factors may cause management believe revision past estimates appropriate management believes appropriate liability established income tax exposure however actual amounts may differ materially estimates company adopted provisions fin 48 january 1 2007 fin 48 impact uncertain tax position likely sustained upon audit relevant taxing authority must recognized largest amount likely sustained portion uncertain tax position recognized position less 50 likelihood sustained also fin 48 interest expense recognized full amount deferred benefits uncertain tax positions december 31 2007 company recorded tax contingency reserves approximately 14 million included within income taxes payable consolidated balance sheet result adoption fin 48 company recognized cumulative adjustment liability unrecognized income tax benefits amount 146000 accounted reduction january 1 2007 balance retained earnings included 203000 increase taxes payable 57000 increase deferred tax assets uncertain tax positions adoption date january 1 2007 company 08 million unrecognized tax benefits entire amount would affect effective tax rate recognized december 31 2007 company 12 million unrecognized tax benefits 11 million would affect effective tax rate recognized company anticipate material changes uncertain tax positions next 12 months rae systems inc notes consolidated financial statements continued reconciliation beginning ending balance unrecognized tax benefits follows company recognizes interest penalties associated uncertain tax positions income tax expense december 31 2007 january 1 2007 provision interest penalties 167000 66000 respectively ultimate amount timing future cash settlements cannot predicted reasonable certainty conduct business globally result one subsidiaries file income tax returns us federal jurisdiction various state foreign jurisdictions normal course business subject examination taxing authorities throughout world including major jurisdictions china hong kong denmark uk france united states exceptions longer subject us federal state local nonus income tax examinations years 2004 many cases company’s uncertain tax positions related tax years remain subject examination tax authorities following describes open tax years major tax jurisdiction december 31 2007 note 8 lines credit company maintains lines credit support operations united states china united states company two lines credit totaling 10 million december 31 2006 march 2007 agreements replaced single 150 million revolving credit agreement expires june 2008 revolving credit agreement provides borrowings 50 million based blanket security interest company’s us assets additional 100 million borrowings available based percentage specific qualifying assets company required comply certain reporting requirements whenever outstanding loan balance exceeds 30 million addition ongoing requirement submit quarterly financial statements december 31 2007 company full compliance borrowing requirements including certain financial covenants december 31 2007 2006 amounts outstanding loan agreements united states interest accrues floating prime bank lending rate minus 50 basis points addition company pays 025 annually average unused portion facility may 2007 company obtained unsecured line credit renminbi 20 million approximately 27 million provide working capital china december 31 2007 renminbi 9 million approximately 12 million outstanding line credit interest accrues balance fixed rate 648 principal payments renminbi 5 million renminbi 4 million due march 23 2008 july 24 2008 respectively rae systems inc notes consolidated financial statements continued october 2007 company obtained second unsecured line credit renminbi 10 million approximately 14 million provide working capital china december 31 2007 renminbi 10 million approximately 14 million outstanding line credit interest accrues balance fixed rate 8019 outstanding balance due august 31 2008 note 9 commitments contingencies legal proceedings polimaster ltd v rae systems inc united states district court northern district california case 05cv01887jf polimaster ltd “polimaster” filed complaint company may 9 2005 united states district court northern district california case titled polimaster ltd v rae systems inc case 05cv01887jf complaint alleges among things company breached contract polimaster infringed upon polimaster’s intellectual property rights dispute subject contractual arbitration agreement although federal court retained jurisdiction matter pending completion arbitration polimaster initiated arbitration june 12 2006 demand arbitration asserting alleged damages totaling 132 million seeking injunction sales company’s gamma rae ii neutron rae ii radiation detection products company asserted counterclaims polimaster breach contract among things sought monetary damages arbitration conducted auspices judicial arbitration mediation services inc jams california july 13 2007 company announced arbitration interim award dated july 5 2007 arbitrator ruled polimaster failed prove claims entitled relief company proven counterclaims awarded damages approximately 24 million prevailing party company entitled file application attorney’s fees costs july 20 2007 interim award unsealed pursuant stipulation order dated july 24 2007 final award arbitration issued september 20 2007 incorporating contents interim award awarding rae recoverable costs amount 46000 october 5 2007 rae filed motion confirm final award october 17 2007 polimaster filed opposition rae’s motion confirm final award filed motion vacate final award motions heard december 7 2007 court taken matter submission although company awarded damages attorney’s fees costs time company unable determine whether able collect amounts due uncertainty regarding polimaster’s financial condition factors notwithstanding polimaster proceeding described time company engaged various legal proceedings incidental normal business activities although results litigation claims cannot predicted certainty company believes final outcome matters material adverse effect financial position results operations cash flows leases december 31 2007 company equipment lease san jose california classified capital lease accordance sfas 13 “accounting leases” “sfas 13” december 31 2007 current portion lease 69000 included accrued liabilities long term portion lease 56000 included longterm liabilities consolidated balance sheets equipment lease bears interest rate 97 rae systems inc notes consolidated financial statements continued company subsidiaries lease certain manufacturing warehousing facilities operating leases generally provide lessee pay taxes maintenance insurance certain operating costs leased property total rent expense years ended december 31 2007 2006 2005 1109000 654000 624000 respectively excluding sunnyvale california abandoned building lease described future minimum annual payments noncancellable leases follows december 31 2007 thousands december 2004 company moved current corporate headquarters san jose california abandoned leased facility sunnyvale california second quarter 2005 company accrued restructuring reserve approximately 20 million remaining lease term former headquarters sunnyvale discount rate used 485 liability reduced anticipated future sublease income march 2007 due improved conditions office rentals company revised estimated loss abandonment lease reduced operating expense 595000 second quarter 2007 sublease executed rents commencing june 2007 december 31 2007 future discounted lease payments related sunnyvale building included accrued liabilities totaling 271000 longterm liabilities totaling 250000 rent payments 2007 2006 2005 396000 366000 349000 respectively sunnyvale building sublease income 97000 2007 future minimum lease payments expiration lease 490000 439000 2008 2009 respectively estimated income generated sublease 311000 purchase obligations although open purchase orders considered enforceable legally binding terms generally allow company option cancel reschedule adjust requirements based business needs prior delivery goods performance services obligations purchase inventory commitments generally expected fulfilled within one year estimated 71 million december 31 2007 company began construct rae fushun’s new manufacturing administrative facility china estimated cost complete project 2008 28 million deemed contractual obligation underlying contract specify financial commitment guarantees company permitted delaware law accordance bylaws indemnify officers directors certain events occurrences subject certain limits officer serving company’s request capacity term indemnification period officer’s director’s lifetime maximum amount potential future indemnification unlimited however company director rae systems inc notes consolidated financial statements continued officer insurance policy limits exposure enables recover portion future amounts paid date company incurred losses agreements company typically agrees indemnify customers expenses liability resulting claimed infringements patents trademarks copyrights third parties terms indemnification agreements generally perpetual time execution agreement maximum amount potential future indemnification unlimited date company paid amounts settle claims defend lawsuits product warranties company sells majority products 12 24 month repair replacement warranty date shipment company provides accrual estimated future warranty costs based upon historical relationship warranty costs sales estimated future warranty obligations related product sales recorded period related revenue recognized following table presents changes company’s warranty reserve 2007 2006 note 10 employee benefit plan company defined contribution 401k plan “plan” domestic employees plan available employees reached age 21 completed three months service company plan eligible employees may contribute portion salaries plan company’s contributions determined based matching 25 first 6 covered employee’s salary subject statutory maximum levels contributions plan totaled 129000 113000 108000 years ended december 31 2007 2006 2005 respectively note 11 stockbased compensation stock option plans june 2007 company’s shareholders approved 2007 equity incentive plan “2007 plan” replace company’s 2002 stock option plan “2002 plan” 2007 plan authorizes grant options employees directors consultants purchase shares company’s common stock four million shares company’s common stock authorized issuance 2007 plan maximum number shares may issued 2007 plan increased time shares subject options granted 2002 plan expire terminated shares acquired 2002 plan forfeited repurchased company option holder’s purchase price however 15 million additional shares may authorized issuance 2007 plan result adjustments year ended december 31 2007 206000 shares added 2007 plan due qualifying adjustments 2002 plan incentive options may granted less 100 fair market value per share nonstatutory options may granted less 85 fair market value per share underlying stock date grant determined board directors committee thereof except options granted person owning rae systems inc notes consolidated financial statements continued greater 10 outstanding stock exercise price must less 110 fair market value options granted plans generally vest 25 one year remainder vesting prorata monthly following three years exercised options generally expire ten years date grant total intrinsic value options exercised 2007 2006 30000 840000 respectively connection exercises tax benefit realized company full valuation allowance deferred tax assets december 31 2007 28 million estimated stockbased compensation expense related stock options remains recorded cost expected recorded estimated amortization period 29 years following summary stock option activity thousands except weightedaverage amounts following table summarizes significant ranges outstanding exercisable options december 31 2007 rae systems inc notes consolidated financial statements continued aggregate intrinsic value table represents total pretax intrinsic value based excess company’s closing stock price 270 december 31 2007 options holders’ strike price would received option holders option holders exercised options date total number inthemoney options exercisable december 31 2007 787000 december 31 2007 stock options outstanding included 3358627 options either vested expected vest weightedaverage exercise price 303 aggregate intrinsic value 16 million remaining contractual term 641 years nonplan stock options 2002 company granted certain directors nonplan options purchase 400000 shares restricted stock weighted average exercise price 099 per share options vested 25 one year remainder vesting prorata monthly following three years vested options exercisable ten years date grant 2007 stockbased compensation expense related nonplan stock options remained recorded following summary activity nonplan stock options thousands except per share amounts following table summarizes outstanding exercisable nonplan stock options december 31 2007 rae systems inc notes consolidated financial statements continued nonplan restricted stock 2006 company granted 536000 shares restricted stock four individuals inducement join company twenty five percent restricted stock 134000 shares vested july 2007 remainder vesting prorata quarterly following three years august 2007 concurrent discontinuing company’s dvr business company terminated two individuals result remainder restricted stock awards 203571 shares vested immediately charge 596000 included loss discontinued operations see “note 3 discontinued operations” detail difference exercise price stock grants fair market value company’s common shares dates awards granted represents unrecognized deferred stock compensation amortized straightline basis vesting period underlying stock awards december 31 2007 349000 estimated stockbased compensation expense related restricted stock awards remains recorded cost expected recorded amortization period 25 years following summary activity nonplan awards thousands except per share amounts warrant 2006 450000 warrants purchase company’s common stock exercised 107 per share warrants outstanding december 31 2007 2006 stockbased compensation expense required fas 123r management made estimate expected forfeitures recognizing compensation cost equity awards expected vest impact company’s results continuing rae systems inc notes consolidated financial statements continued operations recording stockbased compensation function years ended december 31 2007 2006 2005 follows addition company recorded following stockbased compensation expenses discontinued operations years ended december 31 2007 2006 valuation assumptions company estimates fair value stock option date grant using blackscholesmerton bsm valuation model single option award approach fair value option grant amortized straightline basis requisite service period award generally vesting period weightedaverage assumptions applied summarized expected volatility company’s expected volatilities based historical volatility company’s stock adjusted management unusual nonrepresentative stock price activity expected recur expected dividend bsm valuation model calls single expected dividend yield input company paid dividend past anticipate paying dividend near future riskfree interest rate company bases riskfree interest rate implied yield currently available us treasury zerocoupon issues equivalent remaining term expected term company’s stockbased award correspond terms interest rates quoted company performs straightline interpolation available maturities expected term company’s expected term represents weightedaverage period company’s stockbased awards expected outstanding first quarter 2007 company used historical exercise patterns previously granted options relation company’s stock price estimate rae systems inc notes consolidated financial statements continued expected exercise patterns prior 2007 company applied “simplified method” defined securities exchange commission’s staff accounting bulletin 107 estimated forfeitures estimate forfeitures company applies historical rate option forfeitures estimated forfeiture rates truedup actual forfeiture results stockbased awards vest note 12 related party transactions company accounts 40 ownership renex technologies ltd“renex” hong kong company using equity method starting january 1 2002 company’s total investment renex december 31 2007 2006 405000 402000 respectively company recorded income 3000 renex year ended december 31 2007 losses 194000 196000 renex years ended december 31 2006 2005 respectively company pays 75 royalty renex using certain modems developed renex 2007 2006 2005 company made royalty payments amounting 84000 91000 70000 respectively company also paid 149000 254000 139000 renex research project 2007 2006 2005 respectively company recorded 1000 146000 investment additional paid capital 2007 2006 respectively properly reflect carrying value investment prorated share net equity renex conjunction original subsequent additional investment rae beijing unsecured notes payable established previous rae beijing shareholders part purchase price agreement may 2004 july 2006 december 31 2007 december 31 2006 191000 822000 respectively included notes payable related parties 2370000 3222000 respectively included long term notes payable related parties notes issued conjunction original rae beijing purchase may 2004 noninterest bearing recorded net present value using discount rate 55 conjunction additional investment rae beijing july 2006 110 million shares preferred stock issued four shareholders rae beijing accordance fas 150 preferred shares classified liabilities recorded longterm notes payable related parties although preferred shares bear dividend yield rate 3 per annum notes payable discounted using market interest rate 648 scheduled payments principal notes 2008 maturity 2011 191000 1082000 633000 655000 respectively addition 40 ownership renex company investments two distributors rae systems products rae benelux rae spain company owns 10 19 rae benelux rae spain respectively investments accounted cost method liaoning group owns 30 interest rae fushun also supplier rae fushun rae systems inc notes consolidated financial statements continued transactions balances company’s related parties follows company’s director information systems lien chen wife chief executive officer robert chen ms chen paid salary bonus 96000 103000 96000 2007 2006 2005 respectively ms chen also receives standard employee benefits offered fulltime us employees ms chen report robert chen compensation decisions regarding ms chen performed manner us employees robert chen final approval signatory compensation recommendations january 14 2006 lien chen sandy hsi wife chief technology officer peter c hsi signed promissory note lend 200000 aegison corporation interest rate 10 per year july 11 2006 company purchased assets including two pending patents aegison corporation total purchase price 2 million cash time promissory note held lien chen sandy hsi repaid aegison corporation note 13 geographic information company operates primarily three geographic regions americas asia europe following tables present net sales identifiable longlived assets geographic region rae systems inc notes consolidated financial statements continued net sales china 391 million 43 239 million 35 182 million 30 total net sales 2007 2006 2005 respectively china held 113 million 92 79 million 52 total net property plant equipment december 31 2007 2006 respectively majority company’s net sales americas asia customers domiciled united states people’s republic china respectively company performs credit evaluations customers’ financial condition considered necessary generally require cash collateral customers evaluations require significant judgment based variety factors including limited current economic trends historical payments bad debt writeoff experience financial review customer note 14 quarterly information unaudited summarized quarterly financial data presented reflect adjustments opinion management normal recurring nature necessary present fairly results operations periods presented rae systems inc notes consolidated financial statements continued 1 net income loss per share computed independently quarters presented therefore sum quarterly net loss per share may equal annual net loss per share 2 company purchased additional 32 ownership rae beijing july 2006 company consolidated rae beijing since 2004 purchase july 2006 minority shareholder’s interest reduced 4 3 august 2007 board directors approved discontinuation company’s dvr business impairment expenses recognized fiscal 2007 totaled 42 million prior quarters’ results adjusted reflect discontinued operations