INNOVATIVE SOLUTIONS & SUPPORT INC - Quarter Report: 2005 December (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

ý QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended December 31, 2005

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

[For the transition period from to ]

Commission File No. 0-31157

INNOVATIVE SOLUTIONS AND SUPPORT, INC.

(Exact name of registrant as specified in its charter)

PENNSYLVANIA		23-2507402
(State or other jurisdiction		(IRS Employer
of incorporation)		Identification No.)

720 Pennsylvania Drive, Exton, Pennsylvania		19341
(Address of principal executive offices)		(Zip Code)

(610) 646-9800
(Registrant’s telephone number, including area code)

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

Yes ý No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition or “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

o Large accelerated filer ý Accelerated filer o Non-accelerated filer

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No ý

As of February 2, 2006, there were 18,062,807 shares of the Registrant’s Common Stock, with par value of $.001 per share, outstanding.

INNOVATIVE SOLUTIONS & SUPPORT, INC.

FORM 10-Q December 31, 2005

INDEX

		Page No.

PART I.	FINANCIAL INFORMATION	—

Item 1.	Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets – September 30, 2005 and December 31, 2005	3

	Condensed Consolidated Statements of Operations –
	Three Months Ended December 31, 2004 and 2005	4

	Condensed Consolidated Statements of Cash Flows –
	Three Months Ended December 31, 2004 and 2005	5

	Notes to Condensed Consolidated Financial Statements	6 – 9

Item 1A	Risk Factors	9

Item 2.	Managements Discussion and Analysis of Financial Controls and Results of Operations	9 – 14

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	14

Item 4.	Controls and Procedures	14

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings	15

Item 2.	Unregistered Sales of Equity Securities and use of Proceeds	15

Item 3.	Defaults upon Senior Securities	15

Item 4.	Submission of Matters to a Vote of Security Holders	15

Item 5.	Other Information	15

Item 6.	Exhibits	15

SIGNATURES

PART I–FINANCIAL INFORMATION

Item 1–Financial Statements

INNOVATIVE SOLUTIONS AND SUPPORT, INC.

CONDENSED CONSOLIDATED BALANCE SHEET

(unaudited)

	As of September 30, 2005			As of December 31, 2005
ASSETS
Current Assets:
Cash and cash equivalents	$	83,172,582		$	82,631,890
Accounts receivable, less allowance for doubtful accounts of $100,000 at September 30, 2005 and December 31, 2005	5,479,936			5,316,834
Inventories	3,911,626			3,648,493
Deferred income taxes	956,070			701,102
Prepaid expenses and other current assets	4,028,498			4,314,267

Total current assets	97,548,712			96,612,586

Property and Equipment:
Computers and test equipment	4,278,748			4,369,434
Corporate airplane	2,998,161			2,998,161
Furniture and office equipment	734,038			734,038
Manufacturing facility	5,420,741			5,420,741
Land	1,021,245			1,021,245
	14,452,933			14,543,619
Less- Accumulated depreciation and amortization	(5,091,881		)	(5,281,210		)

Net property and equipment	9,361,052			9,262,409

Deposits and other assets	125,114			518,114

Total assets	$	107,034,878		$	106,393,109

LIABILITIES AND SHAREHOLDERS’ EQUITY

CURRENT LIABILITIES:
Current portion of notes payable	$	100,000		$	100,000
Current portion of capitalized lease obligations	7,257			7,257
Accounts payable	305,516			337,265
Accrued expenses	3,503,814			2,561,927
Deferred revenue	176,650			209,611

Total current liabilities	4,093,237			3,216,060

Note payable	4,235,000			4,235,000
Long-term portion of capitalized lease obligations	13,113			10,537
Deferred revenue	191,463			173,845
Deferred income taxes	635,967			581,307
Commitments and contingencies	—			—

Shareholders’ Equity:
Preferred stock, 10,000,000 shares authorized, $.001par value, of which 200,000 shares are authorized as Class A Convertible stock. No shares issued and outstanding at September 30, 2005 and December 31, 2005.	—			—

Common stock, $.001 par value: 75,000,000 shares authorized, 18,047,425 and 18,058,471 shares issued and outstanding at September 30, 2005 and December 31, 2005	18,047			18,058
Additional paid-in capital	41,926,318			42,230,444
Retained earnings	55,921,733			55,927,858

Total shareholders’ equity	97,866,098			98,176,360

Total liabilities and shareholders’ equity	$	107,034,878		$	106,393,109

The accompanying notes are an integral part of these statements.

INNOVATIVE SOLUTIONS AND SUPPORT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

	Three Months Ended December 31, 2004			Three Months Ended December 31, 2005
Net sales	$	18,978,804		$	5,405,387
Cost of sales	6,182,143			2,702,018
Gross profit	12,796,661			2,703,369
Operating expenses:
Research and development	1,271,531			1,535,001
Selling, general and administrative	2,028,467			1,896,836
	3,299,998			3,431,837
Operating income (loss)	9,496,663			(728,468		)
Interest income	283,250			781,445
Interest expense	(39,738		)	(43,512		)
Income before income taxes	9,740,175			9,465
Income taxes	3,547,372			3,340
Net income	$	6,192,803		$	6,125
Net Income Per Common Share:
Basic	$	0.35		$	0.00
Diluted	$	0.34		$	0.00

Weighted Average Shares Outstanding:
Basic	17,752,707			18,055,243
Diluted	18,270,413			18,272,423

The accompanying notes are an integral part of these statements.

INNOVATIVE SOLUTIONS AND SUPPORT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

	For the Three Months Ended December 31, 2004			For the Three Months Ended December 31, 2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	6,192,803		$	6,125
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation and amortization	182,235			201,838
Stock-based compensation expense	—			174,009
Compensation expense for stock issued to directors	57,990			60,048
Loss on Disposal of Fixed Assets	—			156
Excess and obsolete inventory expense	(6,017		)	85,129
Deferred income taxes	—			200,308
Tax benefit from exercise of stock options	116,741			21,378
Excess tax benefits from share-based payment arrangements	—			(8,689		)
(Increase) decrease in:
Accounts receivable	(193,064		)	163,102
Inventories	(346,097		)	178,004
Prepaid expenses and other current assets	84,628			(285,769		)
Increase (decrease) in:
Accounts payable	(348,443		)	31,749
Accrued expenses	1,705,926			(1,088,554		)
Deferred revenue	(19,909		)	15,343
Net cash provided by (used in) operating activities	7,426,793			(245,823		)

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment	(111,122		)	(96,351		)
Purchases of other assets	—			(253,333		)
Net cash used in investing activities	(111,122		)	(349,684		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options	157,848			48,702
Repayment of capitalized lease obligation	—			(2,576		)
Excess tax benefits from share-based payment arrangements	—			8,689
Net cash provided by financing activities	157,848			54,815

Net increase (decrease) in cash and cash equivalents	$	7,473,519		$	(540,692	)

Cash and cash equivalents, beginning of year	$	65,867,167		$	83,172,582

Cash and cash equivalents, end of period	$	73,340,686		$	82,631,890

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest	$	19,257		$	31,101
Cash paid for income taxes	$	998,500		$	435,000

The accompanying notes are an integral part of these statements.

Innovative Solutions & Support Inc.

Notes to Condensed Consolidated Financial Statements

1. Basis of Presentation:

Innovative Solutions and Support, Inc. (the “Company”) was incorporated in Pennsylvania on February 12, 1988. The Company’s primary business is the design, manufacture and sale of flight information computers, flat panel displays and advanced monitoring systems for the military, government, commercial air transport and corporate aviation markets.

The balance sheet as of December 31, 2005, the statement of operations for the three months ended December 31, 2004 and 2005 and the statements of cash flows for the three months ended December 31, 2004 and 2005 have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting of normal and recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows at December 31, 2005 and for all periods presented have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted. It is suggested that these financial statements be read in conjunction with the financial statements and notes thereto included in the Company’s Form 10K for the year ended September 30, 2005 as filed with the Securities and Exchange Commission. The results of operations for the three months ended December 31, 2005 are not necessarily indicative of the operating results for the full year.

On June 13, 2005, the Company’s Board of Directors approved a three-for-two split of the Company’s common stock. The stock split was effected in the form of a fifty percent (50%) stock dividend that was paid on July 7, 2005 to shareholders of record on June 23, 2005. The issued and outstanding common stock and all share and per share amounts have been retroactively restated in this report to give effect to this three-for-two stock split.

2. Net income per Share

Net income per share (“EPS”) is calculated using the principles of SFAS No. 128, “Earnings Per Share”.

A reconciliation of weighted average shares outstanding appears below:

	Three Months Ended December 31, 2004	Three Months Ended December 31, 2005
Weighted average number of shares-basic	17,752,707	18,055,243
Effect of dilutive securities:
Employee stock options	517,706	217,180

Weighted average number of shares-diluted	18,270,413	18,272,423

For the three-month periods ended December 31, 2005 and 2004, there were 206,000 and 12,000 options outstanding that were excluded from the computation of diluted earnings per share as the effect would be antidilutive.

3. Concentrations

For the three months ended December 31, 2005, three customers accounted for 28%, 10% and 9% of net sales or 47% on a combined basis. For the three months ended December 31, 2004, three customers accounted for 16%, 15%, and 12% of net sales or 43% on a combined basis.

4. Inventories

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:

	September 30, 2005		December 31, 2005
Raw materials	$	1,696,050	$	1,879,145
Work-in-process	1,151,828		1,050,878
Finished goods	1,063,748		718,470
	$	3,911,626	$	3,648,493

5. Warranty

The Company provides for the estimated cost of product warranties at the time revenue is recognized. Warranty cost is recorded as cost of sales and the reserve balance recorded as an accrued expense in the financial statements. While the Company engages in extensive product quality programs and processes, the Company’s warranty obligation is affected by product failure rates and the related material, labor and delivery costs incurred in correcting a product failure. Should actual product failure rates, material or labor costs differ from the Company’s estimates, further revisions to the estimated warranty liability would be required.

Warranty cost and accrual information for the three months ended December 31, 2005 is highlighted below:

Warranty accrual at September 30, 2005	$	770,845
Accrued expense for the quarter ended December 31, 2005	17,297
Warranty costs for the quarter ended December 31. 2005	(47,166		)

Warranty accrual at December 31, 2005	$	740,976

6. Stock Options

The Company’s 1998 Stock Option Plan (the “Plan”) provides for the granting of incentive and nonqualified stock options to employees, officers, directors and independent contractors and consultants. Through December 31, 2005, no stock options have been granted to independent contractors or consultants under this plan.

Incentive stock options granted under the Plan have exercise prices that must be at least equal to the fair value of the common stock on the date of grant. Nonqualified stock options granted under the Plan have exercise prices that may be less than, equal to or greater than the fair value of the common stock on the date of grant. The Company has reserved 3,389,025 shares of Common Stock for awards under the Plan. As of December 31, 2005 there were 1,703,518 remaining and available for grant.

On December 16, 2004, the FASB finalized SFAS No. 123(R) Share-Based Payment (SFAS 123(R)). SFAS123(R) amends SFAS 123 and supersedes APB25. SFAS 123(R) requires that the cost of share-based payment transactions (including those with employees and non-employee directors’) be recognized in the financial statements. SFAS 123(R) applies to all share-based payment transactions in which an entity acquires goods or services by issuing (or offering to issue) its shares, share options, or other equity instruments (except for those held by an Employee Stock Option Plan (ESOP)) or by incurring liabilities (1) in amounts based (even in part) on the price of the entity’s shares or other equity instruments, or (2) that require (or may require) settlement by the issuance of an entity’s shares or other equity instruments. This statement was effective as of the first annual reporting period beginning after June 15, 2005, or the Company’s period ending December 31, 2005.

Effective October 1, 2005 the Company adopted the provisions of SFAS 123(R), using the modified prospective approach and now accounts for share-based compensation applying the fair value method for expensing stock options. Accordingly, the adoption of SFAS 123R’s fair value method resulted in compensation costs for the Company’s 1998 Stock Option Plan. The compensation cost that has been charged against income as a result of adoption of SFAS 123R for the plan was $174,009 for the three month period ended December 31, 2005. The total income tax benefit recognized in the statement of operations for share-based compensation arrangements was $61,425 for the three month period ended December 31, 2005.

Share-based compensation costs prior to October 1, 2005 were recognized using the intrinsic value method in accordance with Accounting Principles Board Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees.” For disclosure purposes, pro forma net income and net income per share data were provided in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” as if the fair value method had been applied. Under SFAS No. 123, compensation cost related to stock options granted to employees was computed based on the fair value of the stock option at the date of grant using the Black-Scholes option pricing model. Prior to the adoption of SFAS 123(R) had compensation costs been determined based on the fair market value of the stock options, consistent with the provisions of SFAS 123, the Company’s net income and earnings per share for the three months ended December 31, 2004 would have been as follows:

	Three Months Ended December 31, 2004			Three Months Ended December 31, 2005
Net income as reported	$	6,192,803		$	6,125

Add back fair market value expense:				112,584
Employee stock options (1)

Deduct fair market value expense:
Employee stock options (2)	(183,411		)	(112,584		)

Pro forma net income	$	6,009,392		$	6,125

Basic EPS:
As reported	$	0.35		$	0.00
Pro forma	$	0.34		$	0.00

Diluted EPS:
As reported	$	0.34		$	0.00
Pro forma	$	0.33		$	0.00

(1) Amount represents compensation expense determined under the fair market value method included in reported net income, net of related tax effect.

(2) Amounts represent compensation expense if it had been determined under the fair market value based method, net of related tax effect.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model and the following weighted –average assumptions:

	Three Months Ended December 31, 2004		Three Months Ended December 31, 2005
Expected lives (years)	8.9		9.3
Weighted average risk-free interest rate	1.6	%	1.8	%
Expected volatility	66.8	%	65.8	%
Expected dividend rate	—	%	—	%

New Accounting Pronouncements

principle, such as a change in nondiscretionary profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. SFAS No. 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date this Statement is issued. The Company will adopt the provisions of SFAS No. 154 as applicable beginning in fiscal 2007.

In December 2004, the FASB issued FASB Staff Position (FSP) FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004”. This FSP provides guidance on the application of Statement 109 to the provisions within the American Jobs Creation Act of 2005 (the Act), which provides tax relief to U.S. domestic manufacturers. The FSP states that a manufacturer’s deduction provided for under the Act should be accounted for as a special deduction in accordance with Statement 109 and not as a tax rate reduction. The proposed FSP also reminds preparers that the special deduction should be considered by an enterprise in (a) measuring deferred taxes when the enterprise is subjected to graduated tax rates, and (b) assessing whether a valuation allowance is necessary as required by Statement 109. This statement is effective immediately. The Company has adopted this statement and it did not have a material impact on the Company’s financial position or results of operations.

In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) 151, “Inventory Costs”. This Statement amends the guidance in ARB No. 43, Chapter 4 “Inventory Pricing”, to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4 previously stated that “… under some circumstances, items such as idle facility expense, excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment as current period charges…”. This Statement requires that those items be recognized as current-period charges regardless of whether they meet the criterion of “so abnormal”. In addition, this Statement requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. The Company has adopted this statement and it did not have a material impact on the Company’s financial position or results of operations.

Item 1A. Risk Factors

There are no material changes to the risk factors described under Item 1A of our Form 10-K for the year ended September 30, 2005.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

We design, manufacture and sell flight information computers, flat panel displays and advanced monitoring systems to the Department of Defense (DOD), government agencies, commercial air transport carriers and corporate/general aviation markets.

Our revenues are derived from the sale of our products to the retrofit market and, to a lesser extent, original equipment manufacturers (OEMs). Our customers include government and military entities and their commercial contractors, aircraft operators, aircraft modification centers and various OEMs. Although we occasionally sell our products directly to government entities, we primarily sell our products to commercial customers for end use in government and military programs.

Since fiscal 1997, the majority of our revenues have come from the sale of Reduced Vertical Separation Minimum (RVSM) compliant air data systems.

We continue to invest in and seek additional opportunities for our Flat Panel Display product line. In October 2005, the FAA awarded the Company a second Technical Standard Order (TSO) for the flat panel display or COCKPIT/IP®. This TSO establishes our flat panel display system as meeting FAA requirements that have been put in place to ensure safe flight on a variety of aircraft types and, additionally, it addresses the most stringent Commercial Air Transport market requirements as provided in Title 14 of the Code of Federal Regulation, subpart 25, Commercial Air Transport. The TSO states “It has been noted that this display system employs an integrity monitoring system that assures integrity to a catastrophic/Level A design condition with the use of commercial graphic processors’.

In October 2005, the Company in a teaming arrangement with ABX Air, received FAA Supplemental Type Certification (STC) of its Flat Panel Display System for use on B-767 aircraft. The STC provides B-767 operators with a low cost, rapidly implemented retrofit of their cockpit avionics with a modern pilot and copilot suite of high resolution multi-color LCD flat panel displays. Operators will benefit from improved dispatch reliability, logistics savings and adaptability to future requirements. The receipt of the STC positions the Company to pursue more than 1,700 B-757 and B-767 aircraft with similar needs for Flat Panel Display System upgrades. The STC also provides a foundation for incorporating the product into other airplanes as well.

Our “cost of sales” is comprised of material components purchased through our supplier base and direct in-house assembly labor and overhead costs. Many of the components we use in assembling our products are standard, although certain parts are manufactured to meet our specifications. The overhead portion of cost of sales is primarily comprised of salaries and benefits, building occupancy, supplies, and outside service costs related to our production, purchasing, customer service, material control and quality departments as well as warranty costs.

We intend to continue investing in the development of new products and the enhancement of our existing product line. We expense research and development costs related to future product development as they are incurred.

Our selling, general, and administrative expenses consist of marketing and business development expenses, professional expenses, salaries and benefits for executive and administrative personnel, facility costs, recruiting, legal, accounting, and other general corporate expenses.

Three Months Ended December 31, 2005 Compared to the Three Months Ended December 31, 2004

Net sales. Net sales decreased $13.6 million, or 71.6%, to $5.4 million for the three months ended December 31, 2005 from $19.0 million in the three months ended December 31, 2004. This decrease in net sales was mainly due to a decrease in demand for our RVSM system. Sales for the three months ended December 31, 2004 reflected an industry wide response to a Federal Aviation Administration (FAA) mandate that required the installation of RVSM equipment on aircraft flying between 29,000 and 41,000 by January 20, 2005. The peak demand for the RVSM system declined after this date.

Cost of sales. Cost of sales decreased $3.5 million or 56.3%, to $2.7 million, or 50% of net sales in the three months ended December 31, 2005 from $6.2 million, or 33 % of net sales in the three months ended December 31, 2004. The absolute dollar decrease in cost of sales was related to our decrease in net sales. As a percentage, the increase was the result of fixed operating costs not being absorbed over lower net sales in the current period.

Research and development. Research and development expenses increased $0.3 million or 21% to $1.5 million or 28% of net sales in the three months ended December 31, 2005 from $1.3 million or 7% of net sales in the three months ended December 31, 2004. The increase in dollar spending reflects our sustained new product development effort. The percent increase was mostly due to lower sales in the period.

Selling, general, and administrative. Selling, general, and administrative expenses decreased $0.1 million, or 7.0%, to $1.9 million, or 35% of net sales in the three months ended December 31, 2005 from $2.0 million or 11% of net sales in the three months ended December 31, 2004. The decrease in the dollar amount was primarily the result of lower commissions. The increase as a percent of net sales was the result of lower net sales in the period.

Interest income. Interest income was $781,000 in the three months ended December 31, 2005 as compared to interest income of $283,000 in the three months ended December 31, 2004. The increase in interest income in the three months ended December 31, 2005 was primarily the result of higher interest rates in the current period and an increase in our cash balance over the prior period.

Interest expense. Interest expense was $44,000 in the three months ended December 31, 2005 as compared to interest expense of $39,000 in the three months ended December 31, 2004. The increase in interest expense in the three months ended December 31, 2005 was primarily the result of higher interest rates in the period.

Income tax expense. Income tax expense for the three months ended December 31, 2005 was $3,000. The income tax expense for the three months ending December 31, 2004 was $3.5 million. The decrease in tax expense was primarily due to lower income in the period. The effective tax rate in the December 31, 2005 quarter was 35.3%. In the December 31, 2004 quarter the effective tax rate was 36.4%. In each quarter, the effective tax rate differs from the statutory rate due to the utilization of research and development tax credits.

Net income. As a result of the factors described above, our net income in the three months ended December 31, 2005 decreased $6.2 million, or approximately 100%, to $6,125 or 0.1% of net sales, from $6.2 million or 33% of net sales in the three months ended December 31, 2004.

Liquidity and Capital Resources

Our main source of liquidity has been cash flows from operations. We require cash principally to finance inventory, accounts receivable and payroll.

Our cash flow from operating activities was a negative $246,000 for the three months ended December 31, 2005 as compared to a positive $7.4 million for the three months ended December 31, 2004. The decrease was due primarily to lower net income ($6.2 million) and reduced accrued expenses ($2.8 million) which were partially offset by reduced inventories ($0.5 million) and an increase in accounts payable ($0.4 million).

Our cash used in investing activities was $350,000 for the three months ended December 31, 2005. This primarily consisted of spending for product certification, production equipment and laboratory test equipment. Cash used in investing activities was $111,000 for the three months ended December 31, 2004 and primarily consisted of production equipment, laboratory test equipment, computer equipment and office furniture.

Net cash flow from financing activities was $55,000, for the three months ended December 31, 2005 as compared to $158,000 in the three months ended December 31, 2004. In both periods the primary source of cash was from proceeds from the exercise of stock options.

Our future capital requirements depend on numerous factors, including market acceptance of our products, the timing and rate of expansion of our business, acquisitions, joint ventures and other factors. We have experienced increases in our expenditures since our inception consistent with growth in our operations, personnel and product line, and we anticipate that our expenditures will continue to increase in the foreseeable future. We believe that our cash and cash equivalents will provide sufficient capital to fund our operations for at least the next twelve months. However, we may need to raise additional funds through public or private financings or other arrangements in order to support more rapid expansion of our business than we now anticipate either through acquisitions or organic growth. Further, we may need to develop and introduce new or enhanced products, respond to competitive pressures, invest in or acquire businesses or technologies or respond to unanticipated requirements or developments. If additional funds are raised through the issuance of equity securities, dilution to existing shareholders may result. If insufficient funds are available, we may not be able to introduce new products or compete effectively in any of our markets, which could hurt our business.

Backlog

As of December 31, 2005 and 2004, our backlog was $18.2 million and $36.2 million, respectively. The period over period decline in backlog principally reflects the passing of peak demand for RVSM related Air data products.

Sequentially, our 1^st quarter backlog grew by $5.3 million or 41% when compared to the prior quarter ( the 4^th quarter of fiscal 2005). The flat panel system component of backlog was $5.9 million in the 4^th quarter of fiscal 2005 and increased to $12.1 million in the 1^st quarter of fiscal 2006, representing an increase of $6.2 million or 105%.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. The Company’s most critical accounting policies are revenue recognition, income taxes, allowance for doubtful accounts, inventory valuation, share-based compensation and warranty reserves.

The Company recognizes sales for products when the following revenue recognition criteria are met: persuasive evidence of an arrangement exists, product delivery and acceptance has occurred, pricing is fixed or determinable, and collection is reasonably assured. The Company recognizes sales upon shipment of products to customers.

Sales related to certain long-term contracts requiring development and delivery of products over several years are accounted for under the American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We consider the nature of these contracts as well as the types of products and services provided when determining the appropriate accounting treatment for a particular contract. Certain long-term contracts are recorded on a percentage of completion basis using cost-to-cost methodology to measure progress towards completion.

The Company offers its customers extended warranties for additional fees. These warranty sales are recorded as deferred revenue and recognized as sales on a straight-line basis over the warranty period.

The Company enters into certain sales arrangements that include multiple deliverables as defined in Emerging Issues Task Force (EITF) Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. Effective July 1, 2003, the Company identifies all goods and/or services that are to be delivered separately under a sales arrangement and allocates revenue to each deliverable based on fair value that is established with the customer during contract negotiations. In general, revenues are separated

between product sales and non-recurring engineering services. The allocated revenue for each deliverable is then recognized using appropriate revenue recognition methods. Effective for transactions entered into after October 1, 2003, the Company accounts for transactions with software and non-software components under EITF Issue 03-5, “Applicability of AICPA Statement of Position 97-2, Software Revenue Recognition, to Non-Software Deliverables in an Arrangement Containing More-Than-Incidental Software.”

Income taxes are recorded in accordance with SFAS No. 109, Accounting for Income Taxes. Provisions for federal and state income taxes are calculated on reported financial statement pre-tax income based on current tax law. The Company recognizes deferred tax assets and liabilities for temporary differences between the financial reporting basis and the tax basis of the Company’s assets and liabilities and expected benefits of utilizing net operating loss carryforwards. The impact on deferred taxes of changes in tax rates and laws, if any, applied to the years during which temporary differences are expected to be settled, are reflected in the consolidated financial statements in the period of enactment.

We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. These allowances are determined by analyzing historical data and trends. If actual losses are greater than estimated amounts or if the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, future results from operations could be adversely affected.

Inventories are written down for estimated obsolescence equal to the difference between the cost of inventory and the estimated net realizable value based upon assumptions about future market conditions. If actual future demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

We offer warranties on some products of various lengths. At the time of shipment, we establish a reserve for the estimated cost of warranties based on our best estimate of the amounts necessary to settle future and existing claims using historical data on products sold as of the balance sheet date. The length of the warranty period, the product’s failure rates and the customer’s usage affects warranty cost. If the actual cost of warranties differs from our estimated amounts, future results of operations could be adversely affected.

Effective October 1, 2005 the Company adopted the provisions of SFAS 123R, using the modified prospective approach and now accounts for share-based compensation applying the fair value method for expensing stock options. Accordingly, the adoption of SFAS 123R’s fair value method results in compensation costs for the Company’s 1998 Stock Option Plan.

Business Segments

We operate in one principal business segment which designs, manufactures and sells flight information computers, flat panel displays and advanced monitoring systems to the Department of Defense, government agencies, commercial air transport carriers and corporate/general aviation markets. We currently derive virtually all our net sales from the sale of this equipment. Almost all of the net sales, operating results and identifiable assets are in the United States.

New Accounting Pronouncements

In May 2005, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 154, “Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 also requires that retrospective application of a change in accounting principle be limited to the direct effects of the change. Indirect effects of a change in accounting principle, such as a change in nondiscretionary profit-sharing payments resulting from an accounting change, should be recognized in the period of the accounting change. SFAS No. 154 also requires that a change in depreciation, amortization, or depletion method for long-lived, non-financial assets be accounted for as a change in accounting estimate effected by a change in accounting principle. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Early adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after the date this Statement is issued. The Company will adopt the provisions of SFAS No. 154 as applicable beginning in fiscal 2007.

In December 2004, the FASB issued FASB Staff Position (FSP) FAS 109-1, “Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004”. This FSP provides guidance on the application of Statement 109 to the provisions within the American Jobs Creation Act of 2005 (the Act), which provides tax relief to U.S. domestic manufacturers. The FSP states that a manufacturer’s deduction provided for under the Act should be accounted for as a special deduction in accordance with Statement 109 and not as a tax rate reduction. The FSP also reminds preparers that the special deduction should be considered by an enterprise in (a) measuring deferred taxes when the enterprise is subjected to graduated tax rates, and (b) assessing whether a valuation allowance is necessary as required by Statement 109. This statement is effective immediately. The Company has adopted this statement and it did not have a material impact on the Company’s

financial position or results of operations.

FORWARD-LOOKING STATEMENTS

This Form 10-Q contains statements, which, to the extent that they are not recitations of historical fact, constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934. The words “believe,” “estimate,” “anticipate,” “project,” “intend,” “expect,” “plan,” “outlook,” “forecast” and similar expressions are intended to identify forward-looking statements. Numerous factors, including potentially the following factors, could affect the Company’s forward-looking statements and actual performance:

• continued market acceptance of our air data systems products;

• the ability to obtain future contracts and awards;

• the availability of government funding and customer requirements;

• difficulties in developing and producing our flat panel display systems (CIP) or other planned products or product enhancements;

• market acceptance of our CIP system or other planned products or product enhancements;

• our ability to gain regulatory approval of our products in a timely manner;

• delays in receiving components from third party suppliers;

• the competitive environment;

• the termination of programs or contracts for convenience by customers;

• failure to retain key personnel;

• new product offerings from competitors;

• potential future acquisitions;

• protection of intellectual property rights;

• our ability to service the international market, and

• other factors disclosed from time to time in our filings with the Securities and Exchange Commission.

Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q. The Company does not undertake any obligation to publicly release any revisions to these forward-looking statements to reflect events, circumstances or changes in expectations after the date of this Form 10-Q, or to reflect the occurrence of unanticipated events. The forward-looking statements in this document are intended to be subject to the safe harbor protection provided by Sections 27A of the Securities Act and 21E of the Exchange Act.

For a discussion identifying some important factors that could cause actual results to vary materially from those anticipated in the forwardlooking statements, see the Company’s Securities and Exchange Commission filings including, but not limited to, the

discussions of “Risk Factors” contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2005.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The Company’s operations are exposed to market risks primarily as a result of changes in interest rates. The Company does not use derivative financial instruments for speculative or trading purposes. The Company’s exposure to market risk for changes in interest rates relates to its cash equivalents and an industrial revenue bond. The Company’s cash equivalents consist of funds invested in money market accounts, which bear interest at a variable rate, while the industrial revenue bond carries an interest rate that is consistent with 30-day, tax-exempt commercial paper. As the interest rates are variable, and we do not engage in hedging activities, a change in interest rates earned on the cash equivalents or paid on the industrial revenue bond would impact interest income and expense along with cash flows, but would not impact the fair market value of the related underlying instruments.

Item 4. Controls and Procedures

(a) An evaluation was performed under the supervision and with the participation of the Company’s management, including its Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, of the effectiveness of the Company’s disclosure controls and procedures, as such term is defined under Rule 13a-15e under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) as of December 31, 2005. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported as specified in Securities and Exchange Commission rules and forms.

(b) There were no changes in the Company’s internal control over financial reporting identified in connection with the evaluation of such controls that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II–OTHER INFORMATION

Item 1. Legal Proceedings

In the ordinary course of our business, we are at times subject to various legal proceedings. We do not believe that any current legal proceedings will have a material adverse effect on our results of operations or financial position.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

None

Item 3. Defaults upon Senior Securities

None

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

No matters were submitted to a vote of our shareholders during the three months ended December 31, 2005.

Item 5. Other Information

None

Item 6. Exhibits

(a)	Exhibits

	31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)

	31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)

	32.1	Certification Pursuant to U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	INNOVATIVE SOLUTIONS AND SUPPORT, INC.


Date: February 3, 2006	By:	/s/ JAMES J. REILLY
		James J. Reilly Chief Financial Officer