10-K/A

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON D.C. 20549

FORM 10-K/A

Amendment No. 2

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the fiscal year ended December 31, 2004

OR

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

For the transition period from              to             

Commission File Number: 001-31783

RAE Systems Inc.

(Exact name of registrant as specified in its charter)

Delaware	77-0588488
(State or other jurisdiction of incorporation)	(I.R.S. Employer Identification No.)

3775 North First Street

San Jose, California 95134

(Address of principal executive offices)

408-952-8200

Registrant’s telephone number, including area code

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name of each exchange on which registered
Common Stock, $.001 par value	The American Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter periods that the registrant was required to file such reports), and (2) has been subject to filing requirements for the past 90 days.    Yes  ¨    No  x

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K/A.  ¨

Indicate by check mark whether the registrant is an accelerated filer.    Yes  x    No  ¨

As of June 30, 2004, the aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $189,903,629, based upon the closing sale price of $5.40 on the American Stock Exchange on June 30, 2004, the last business day of the registrant’s most recently completed second fiscal quarter. As of the close of business on March 27, 2005, the number of shares of registrant’s Common Stock outstanding was 57,632,139.

DOCUMENTS INCORPORATED BY REFERENCE

Definitive Proxy Statement for the Company’s 2005 Annual Meeting of Stockholders—

Part III of this Form 10-K.

EXPLANATORY NOTE

RAE Systems Inc. (the “Company”) is filing this Amendment No. 2 on Form 10-K/A to amend our previously filed Annual Report on Form 10-K for the year ended December 31, 2004, as filed with the Securities and Exchange Commission (the “SEC”) on March 18, 2005 and amended on May 2, 2005 (the “Original Filing”). In connection with the Company’s evaluation of the effectiveness of its internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, and management’s assessment and testing thereof, the Company identified a number of material weaknesses, including inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period. The Company identified a single distributor in Canada, accounting for less than 1% of our annual revenues, who (a) had not signed the Company’s standard distributor agreement sent to the distributor over the last three years and (b) from time to time, placed purchase orders with a “right of return” clause. In addition, the Company identified several U.S. local, state and federal agency purchase orders with freight delivery terms of “FOB destination,” requiring that the Company defer recognition of revenue until the shipments reach the customer, rather than the Company’s standard terms of “FOB factory.” Further, during the course of its review, the Company found a limited number of service contracts that were not properly deferred. After conferring with the Audit Committee of the Company’s Board of Directors and its independent registered public accounting firm on these matters, another independent certified public accounting firm was engaged to conduct an independent study (agreed-upon procedures report) of the impact of the Company’s revenue recognition practices. Based on the findings of the study by the independent certified public accounting firm, management concluded that the Company’s consolidated financial statements as of December 31, 2004, 2003, and 2000 and for each of the years then ended and the Company’s condensed financial data for the interim periods for fiscal years 2004 and 2003 should be restated. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for this amended Form 10-K/A. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), an error which had been previously identified but not considered to be sufficiently material to require correction. The Audit Committee of the Board of Directors concurred with management’s decision. This amendment is being filed to restate the consolidated financial statements for the years ended December 31, 2004, 2003, 2002, 2001 and 2000 and for the interim quarters of 2004 and 2003 therein.

A discussion of the restatement is set forth in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation and in Note 2 to the Consolidated Financial Statements included in this Amendment No. 2 on Form 10-K/A. Changes also have been made to the following items in this Amendment No. 2 on Form 10-K/A as a result of the restatement:

Part II

• Item 6, “Selected Financial Data;”

• Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operation;”

• Item 7A, “Quantitative and Qualitative Disclosures about Market Risk;”

• Item 8, “Financial Statements and Supplementary Data”, including the Notes to the Consolidated Financial Statements for 2004 and 2003;

• Item 9A, “Controls and Procedures;” and

Part IV

• Item 15, “Exhibits, Financial Statement Schedules.”

The other portions of the Original Filing are unaffected by the changes described above and have not been amended. All information in this amendment is as of the date of the Original Filing and does not reflect any subsequent information or events occurring after the date of the Original Filing, except to reflect the corrections noted above. Accordingly, this amendment should be read in conjunction with the Company’s filings made with the SEC subsequent to the filing of the Original Filing.

PART II		1
ITEM 6.	SELECTED FINANCIAL DATA	1
ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF     OPERATION	2
ITEM 7A.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	13
ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA	14
ITEM 9A.	CONTROLS AND PROCEDURES	14
PART IV		18
ITEM 15.	EXHIBITS, FINANCIAL STATEMENT SCHEDULES	18

PART II

ITEM 6.    SELECTED FINANCIAL DATA

SUMMARY FINANCIAL DATA

The selected consolidated financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the Consolidated Financial Statements of RAE Systems Inc. and Notes thereto, and other financial information included elsewhere in this Form 10-K/A. Historical results are not necessarily indicative of results that may be expected for future periods.

	2004		2003		2002			2001			2000
	Restated (1)		Restated (1)		Restated (1)			Restated (1)			Restated (1)
Operating Data:
Net sales	$	45,540,000	$	31,361,000	$	21,828,000		$	19,039,000		$	18,398,000
Gross profit	$	27,036,000	$	19,256,000	$	13,071,000		$	11,999,000		$	11,771,000
Income (loss) from operations	$	3,514,000	$	3,759,000	$	(8,982,000	)	$	(71,000	)	$	1,438,000
Net income (loss)	$	2,335,000	$	2,738,000	$	(9,462,000	)	$	153,000		$	923,000
Basic earnings (loss) per common share	$	0.04	$	0.06	$	(0.24	)	$	0.01		$	0.04
Diluted earnings (loss) per common share	$	0.04	$	0.06	$	(0.24	)	$	—		$	0.03
Weighted-average common shares:
Basic outstanding shares		55,809,638		46,179,770		39,902,169			24,154,797			22,864,656
Diluted outstanding shares		58,581,586		49,457,720		39,902,169			37,067,871			35,436,168
Balance Sheet Data:
Working capital	$	38,857,000	$	12,423,000	$	8,263,000		$	5,005,000		$	4,423,000
Total assets	$	69,115,000	$	20,765,000	$	16,865,000		$	15,216,000		$	12,888,000
Long-term liabilities	$	1,645,000	$	200,000	$	411,000		$	649,000		$	835,000
Total shareholders’ equity	$	52,189,000	$	14,807,000	$	10,747,000		$	3,332,000		$	2,833,000

(1) For additional information regarding the restatement, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations and Note 2 of the Consolidated Financial Statements.

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ITEM 7.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements. In some cases, readers can identify forward-looking statements by terminology such as “may,” “will,” “should,” “could,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue.” These statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from those stated herein. Although management believes that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, performance, or achievements. For further information, refer to the section entitled “Factors That May Affect Future Results” in our Original Filing on Form 10-K. The following discussion should be read in conjunction with the condensed consolidated financial statements and the notes thereto included elsewhere in this Annual Report on Form 10-K/A.

Restatement

In connection with the Company’s evaluation of the effectiveness of its internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, and management’s assessment and testing thereof, the Company identified a number of material weaknesses, including inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period. The Company identified a single distributor in Canada, accounting for less than 1% of our annual revenues, who (a) had not signed the Company’s standard distributor agreement sent to the distributor over the last three years and (b) from time to time, placed purchase orders with a “right of return” clause. In addition, the Company identified several U.S. local, state and federal agency purchase orders with freight delivery terms of “FOB destination,” requiring that the Company defer recognition of revenue until the shipments reach the customer, rather than the Company’s standard terms of “FOB factory.” Further, during the course of its review, the Company found a limited number of service contracts that were not properly deferred. After conferring with the Audit Committee of the Company and its independent registered public accounting firm on these matters, another independent certified public accounting firm was engaged to conduct an independent study (agreed-upon procedures report) of the impact of the Company’s revenue recognition practices. Based on the findings of the study by the independent certified public accounting firm, management concluded that the Company’s consolidated financial statements for the years ended December 31, 2004, 2003 and 2000 and the Company’s condensed financial data for the interim periods for fiscal years 2004 and 2003 should be restated. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for this amended Form 10-K/A. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), which error had been previously identified but not considered to be sufficiently material to require correction. The Audit Committee of the Board of Directors concurred with management’s decision.

The foregoing adjustments did not affect the Company’s reported cash, cash equivalents or short-term and long-term investments during the reporting periods.

Annual Information:

(in dollars)

	Year ended December 31, 2004				Year ended December 31, 2003				Year ended December 31, 2002				Year ended December 31, 2001				Year ended December 31, 2000
	Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated		Previously Reported	Restated
Balance Sheet:
Inventories, net	7,675,000		7,815,000		3,659,000		3,759,000		3,176,000		3,295,000		3,716,000		3,817,000		3,229,000	3,329,000
Deferred income taxes	1,392,000		1,578,000		666,000		768,000		529,000		605,000		501,000		572,000		292,000	373,000
Total Assets	68,789,000		69,115,000		20,563,000		20,765,000		16,670,000		16,865,000		15,043,000		15,216,000		12,706,000	12,888,000
Accrued liabilities	5,643,000		5,582,000		2,159,000		2,159,000		1,690,000		1,689,000		1,235,000		1,235,000		1,522,000	1,522,000
Current portion of deferred revenue	722,000		1,122,000		67,000		324,000		150,000		432,000		249,000		523,000		234,000	521,000
Deferred revenue, net of current portion	119,000		240,000		102,000		113,000		—		14,000		150,000		155,000		383,000	399,000
Other long-term liabilities	—		145,000		—		87,000		—		13,000		—		—		—	—
Total Liabilities	12,033,000		12,638,000		5,603,000		5,958,000		5,810,000		6,118,000		9,163,000		9,442,000		7,355,000	7,658,000
(Accumulated deficit)/Retained earnings	(1,386,000	)	(1,665,000	)	(3,847,000	)	(4,000,000	)	(6,625,000	)	(6,738,000	)	2,830,000		2,724,000		2,693,000	2,571,000
Total Shareholders' Equity	52,468,000		52,189,000		14,960,000		14,807,000		10,860,000		10,747,000		3,438,000		3,332,000		2,955,000	2,833,000
Statement of Operations:
Net Sales	45,794,000		45,540,000		31,333,000		31,361,000		21,845,000		21,828,000		19,014,000		19,039,000		18,194,000	18,398,000
Gross Profit	27,250,000		27,036,000		19,247,000		19,256,000		13,071,000		13,071,000		11,972,000		11,999,000		11,615,000	11,771,000
Total Operating Expenses	23,525,000		23,522,000		15,422,000		15,497,000		22,041,000		22,053,000		12,069,000		12,070,000		10,333,000	10,333,000
Income (Loss) from Operations	3,725,000		3,514,000		3,825,000		3,759,000		(8,970,000	)	(8,982,000	)	(97,000	)	(71,000	)	1,282,000	1,438,000
Net Income (Loss)	2,461,000		2,335,000		2,778,000		2,738,000		(9,455,000	)	(9,462,000	)	137,000		153,000		829,000	923,000
Basic Earnings (Loss) Per Common Share	0.04		0.04		0.06		0.06		(0.24	)	(0.24	)	0.01		0.01		0.04	0.04
Diluted Earnings (Loss) Per Common Share	0.04		0.04		0.06		0.06		(0.24	)	(0.24	)	0.00		0.00		0.02	0.03

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Quarterly Information (Unaudited):

(in dollars)

	Quarter ended December 31, 2004				Quarter ended September 30, 2004				Quarter ended June 30, 2004				Quarter ended March 31, 2004
	Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated
Balance Sheet:
Inventories, net	7,675,000		7,815,000		8,277,000		8,428,000		6,668,000		6,801,000		4,351,000		4,541,000
Deferred income taxes	1,392,000		1,578,000		666,000		895,000		666,000		880,000		666,000		887,000
Total Assets	68,789,000		69,115,000		65,683,000		66,062,000		62,824,000		63,171,000		52,106,000		52,517,000
Accrued liabilities	5,643,000		5,582,000		4,068,000		4,063,000		3,388,000		3,378,000		2,170,000		2,163,000
Current portion of deferred revenue	722,000		1,122,000		1,083,000		1,543,000		648,000		1,047,000		69,000		605,000
Deferred revenue, net of current portion	119,000		240,000		124,000		259,000		117,000		278,000		90,000		200,000
Other long term liabilities	—		145,000		—		132,000		—		117,000		—		102,000
Total Liabilities	12,033,000		12,638,000		11,435,000		12,158,000		9,881,000		10,548,000		4,722,000		5,464,000
Accumulated deficit	(1,386,000	)	(1,665,000	)	(1,701,000	)	(2,044,000	)	(2,752,000	)	(3,073,000	)	(3,662,000	)	(3,993,000
Total Shareholders’ Equity	52,468,000		52,189,000		50,199,000		49,856,000		48,803,000		48,482,000		47,384,000		47,053,000
Statement of Operations:
Net Sales	14,963,000		15,036,000		12,264,000		12,229,000		10,385,000		10,471,000		8,182,000		7,804,000
Gross Profit	8,025,000		8,088,000		7,530,000		7,512,000		6,492,000		6,521,000		5,203,000		4,915,000
Total Operating Expenses	7,600,000		7,556,000		5,885,000		5,905,000		5,341,000		5,353,000		4,699,000		4,708,000
Income from Operations	425,000		532,000		1,645,000		1,607,000		1,151,000		1,168,000		504,000		207,000
Net Income	315,000		379,000		1,051,000		1,029,000		910,000		920,000		185,000		7,000
Basic Earnings Per Common Share	0.01		0.01		0.02		0.02		0.02		0.02		0.00		0.00
Diluted Earnings Per Common Share	0.01		0.01		0.02		0.02		0.02		0.02		0.00		0.00
	Quarter ended December 31, 2003				Quarter ended September 30, 2003				Quarter ended June 30, 2003				Quarter ended March 31, 2003
	Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated
Balance Sheet:
Inventories, net	3,659,000		3,759,000		3,884,000		4,248,000		4,204,000		4,401,000		3,527,000		3,678,000
Deferred income taxes	666,000		768,000		529,000		767,000		529,000		606,000		529,000		600,000
Total Assets	20,563,000		20,765,000		19,205,000		19,807,000		19,096,000		19,369,000		18,077,000		18,300,000
Accrued liabilities	2,159,000		2,159,000		2,045,000		2,031,000		1,700,000		1,696,000		1,677,000		1,676,000
Current portion of deferred revenue	67,000		324,000		51,000		946,000		51,000		373,000		109,000		392,000
Deferred revenue, net of current portion	102,000		113,000		85,000		93,000		27,000		46,000		31,000		47,000
Other long term liabilities	—		87,000		—		70,000		—		51,000		—		32,000
Total Liabilities	5,603,000		5,958,000		5,048,000		6,008,000		5,964,000		6,353,000		6,297,000		6,627,000
Accumulated deficit	(3,847,000	)	(4,000,000	)	(4,330,000	)	(4,688,000	)	(5,055,000	)	(5,170,000	)	(5,850,000	)	(5,956,000	)
Total Shareholders’ Equity	14,960,000		14,807,000		14,157,000		13,799,000		13,132,000		13,016,000		11,780,000		11,673,000
Statement of Operations:
Net Sales	8,565,000		9,202,000		7,969,000		7,406,000		7,459,000		7,416,000		7,340,000		7,337,000
Gross Profit	5,291,000		5,664,000		4,686,000		4,290,000		4,843,000		4,845,000		4,427,000		4,457,000
Total Operating Expenses	4,419,000		4,450,000		3,720,000		3,728,000		3,830,000		3,847,000		3,453,000		3,472,000
Income from Operations	872,000		1,214,000		966,000		562,000		1,013,000		998,000		974,000		985,000
Net Income	483,000		688,000		725,000		482,000		795,000		786,000		775,000		782,000
Basic Earnings Per Common Share	0.01		0.01		0.02		0.01		0.02		0.02		0.02		0.02
Diluted Earnings Per Common Share	0.01		0.01		0.01		0.01		0.02		0.02		0.02		0.02

Overview

We are a leading global developer and manufacturer of rapidly-deployable, multi-sensor chemical detection monitors and networks for homeland security and industrial applications. In addition, we offer a full line of portable single-sensor chemical and radiation detection products. We were founded in 1991 to develop technologies for the detection and early warning of hazardous materials. The market for our products has evolved from being strictly focused on environmental and industrial monitoring to now encompassing public safety and the threat of terrorism.

In May 2004, we invested $9 million in cash for a 64% interest in KLH, a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment. As a result, our sales into the China market increased from 8% in 2003 to 20% in 2004. The sales from our RAE Systems business less sales from KLH (“base business”) in the United States, Europe and Asia continued to grow, primarily from the sales of our patented PID products as well as our integrated wireless technology. Sales from our base business contributed $37.7 million in 2004 as compared to $31.4 million in 2003, an increase of 20%.

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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 and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Estimates are used for, but not limited to, allowance for doubtful accounts, inventory allowances, warranty costs, contingencies and taxes. Actual results could differ materially from those estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.

We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable and collectibility is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, the Company has experienced an insignificant amount of sales returns. The Company recognizes revenue upon shipment to its distributors in accordance with standard contract terms that pass title to all goods upon delivery to a common carrier (FOB factory) and provides for sales returns under standard product warranty provisions. In connection with the Company’s evaluation of the effectiveness of its internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, and management’s assessment and testing thereof, the Company identified a number of material weaknesses, including inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period. The Company identified a single distributor in Canada, accounting for less than 1% of our annual revenues, who (a) had not signed the Company’s standard distributor agreement sent to the distributor over the last three years and (b) from time to time, placed purchase orders with a “right of return” clause. In addition, the Company identified several U.S. local, state and federal agency purchase orders with freight delivery terms of “FOB destination,” requiring that the Company defer recognition of revenue until the shipments reach the customer, rather than the Company’s standard terms of “FOB factory.” Further, during the course of its review, the Company found a limited number of service contracts that were not properly deferred. After conferring with the Audit Committee of the Company’s Board of Directors and its independent registered public accounting firm on these matters, another independent certified public accounting firm was engaged to conduct an independent study (agreed-upon procedures report) of the impact of the Company’s revenue recognition practices. Based on the findings of the study by the independent certified public accounting firm, the consolidated financial statements have been restated for the years ended 2004, 2003 and 2000 and for the interim periods for fiscal years 2004 and 2003. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for this amended Form 10-K/A. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), an error which had been previously identified but not considered to be sufficiently material to require correction. For additional information regarding the restatement, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation and in Note 2 to the Consolidated Financial Statements.

The allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there were a deterioration of a major customer’s credit worthiness, or if actual defaults were higher than what has been experienced historically, our estimates of the recoverability of amounts due could be overstated and our operating results could be adversely affected.

Inventories are stated at the lower of cost (moving weighted average method) or market. Inventory purchases are typically based on estimated future demand. In the event of a sudden and significant decrease in demand for our products, or if there were a higher occurrence of inventory obsolescence due to changing technology and customer requirements, we could be required to increase our inventory allowances.

We generally provide a one to three year limited warranty on the majority of our products and establish the estimated costs of fulfilling these warranty obligations at the time the related revenue is recorded. Historically, warranty costs have been insignificant. If we were to experience an increase in warranty claims compared to our historical experience, or costs of servicing warranty claims were greater than expectations on which the warranty reserve has been based, our operating results could be adversely affected.

We recognize deferred tax assets (future tax benefits) and liabilities for the expected future tax consequences of temporary differences between the book carrying amounts and the tax basis of assets and liabilities. The deferred tax assets and liabilities represent the expected future tax return consequences of those differences, which are expected to be either deductible or taxable when the assets and liabilities are recovered or settled.

We are subject to various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when management concludes that it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. We regularly evaluate current information available to determine whether such accruals should be adjusted.

We adopted the fair value recognition provisions of SFAS No. 123 for stock-based employee compensation effective January 1, 2003, under the modified prospective method as provided for in SFAS No. 148.

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We consolidate all investments in which we have a controlling financial interest to comply with Financial Accounting Standards Board (“FASB”) Interpretation No. 46R. We also consolidate investments where we are the primary beneficiary of a variable interest entity.

RESULTS OF OPERATIONS

Comparison of Years Ended December 31, 2004 and 2003

Total Net Sales

	Year Ended December 31,				Increase (Decrease)
	2004 (Restated)		2003 (Restated)		Dollar		Percentage
Net sales	$	45,540,000	$	31,361,000	$	14,179,000	45%

Net sales primarily increased due to sales from KLH in the amount of $7.9 million. Net sales also increased due to an increase of approximately $3.4 million in the sales of our integrated systems products, $1.3 million in the sales of our radiation products, $900,000 in the sales of our patented products for homeland security and $600,000 in our service business.

Cost of Sales & Gross Margin

	Years Ended December 31,						Increase (Decrease)
	2004 (Restated)			2003 (Restated)			Dollar		Percentage
Cost of Sales	$	18,504,000		$	12,105,000		$	6,399,000	53%
Gross Profit	$	27,036,000		$	19,256,000		$	7,780,000	40%
Gross Profit as percentage of net sales		59	%		61	%

Cost of sales for the year ended December 31, 2004 increased by $6.4 million over the same period in 2003. Approximately $4.6 million was due to the addition of sales from our KLH investment and $1.8 million was due to an increase in sales volume from our base business. For the base business, gross profit was 63% for the year ended December 31, 2004 and 61% for the year ended December 31, 2003. Gross profit for the base business increased due to the sales of our higher margin integrated systems and patented photoionization detection products. The addition of KLH, predominantly a distribution business with inherently lower margins, was the primary reason our overall gross margin for 2004 was 2% lower than our reported margins in 2003.

Sales and Marketing Expense

	Years Ended December 31,						Increase (Decrease)
	2004 (Restated)			2003 (Restated)			Dollar		Percentage
Sales and marketing expense	$	11,046,000		$	7,278,000		$	3,768,000	52%
Percentage of total net sales		24	%		23	%

The increase in sales and marketing expenses for the year ended December 31, 2004 as compared to the year ended December 31, 2003 was due primarily to expenses attributable to our new ownership in KLH of $1.5 million and to increases personnel in Europe and the United States to build the infrastructure for future growth in the amount of $1.5 million. Sales and marketing expenses also increased due to external commissions from increased sales of our integrated systems solutions in the amount of $263,000, outside services and consulting fees in the amount of $195,000 and travel related expenses in the amount of $133,000.

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Research and Development Expense

	Years Ended December 31,						Increase (Decrease)
	2004			2003			Dollar		Percentage
Research and development expense	$	4,295,000		$	2,983,000		$	1,312,000	44%
Percentage of total net sales		9	%		10	%

The increase in research and development expenses for the year ended December 31, 2004 as compared to the year ended December 31, 2003 was due primarily to increased spending in the United States in the amount of $540,000 to develop the RAEWatch product and enhance our integrated systems products, increased spending in Shanghai to develop the radiation and consumable line of products in the amount of $344,000, the amortization of intangible assets resulting from our acquisition of KLH in the amount of $102,000 as well as the addition of KLH’s research and development expenses of $168,000 for the period from May 2004 through December 2004.

General and Administrative Expense

	Years Ended December 31,						Increase (Decrease)
	2004			2003 (Restated)			Dollar		Percentage
General and administrative expense	$	8,181,000		$	5,236,000		$	2,945,000	56%
Percentage of total net sales		18	%		17	%

General and administrative expenses of the Company for the year ended December 31, 2004 as compared to the year ended December 31, 2003 increased primarily due to an increase in non-cash charges related to the issuances of options and warrants in the amount of $682,000, an increase in legal and professional fees in the amount of $529,000, personnel costs to build the infrastructure in the United States and Shanghai in the amount of $384,000, consulting charges related to compliance with Section 404 of the Sarbanes-Oxley Act in the amount of $366,000, travel expenses in the amount of $186,000 and a rate increase in directors and officers insurance in the amount of $78,000. The addition of KLH to our financial statements as of May 2004 added $429,000 to our general and administrative expenses.

Other Income (Expense)

	Years Ended December 31,						Increase (Decrease)
	2004			2003			Dollar
Interest income	$	333,000		$	31,000		$	302,000
Interest expense		(17,000	)		(32,000	)		15,000
Other, net		194,000			(38,000	)		232,000
Equity in loss of unconsolidated affiliate		(353,000	)		(276,000	)		(77,000	)
Total other income (expense)	$	157,000		$	(315,000	)	$	472,000
Percentage of total net sales		0	%		(1	)%

In 2004, we had total other income of $157,000 as compared to total other expense of $315,000 in 2003. Interest income increased in the amount of $302,000 as a result of interest received from investing the majority of $31.8 million raised through our January 2004 public offering. Other, net increased in the amount of $232,000, $137,000 of which was attributable to consulting income earned from our sales affiliate, TangRAE and approximately $95,000 of which was attributable to foreign exchange gains. Equity in loss of unconsolidated affiliate increased by $77,000, as a result of our share in a larger loss of REnex, our 36%-owned, unconsolidated affiliate.

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Income Taxes

	Year Ended December 31,						Increase (Decrease)
	2004 (Restated)			2003 (Restated)			Dollar		Percentage
Income tax expense	$	983,000		$	706,000		$	277,000	39%
Percent of pretax income		27	%		21	%

For the years ended December 31, 2004 and 2003, we recognized tax expenses of $983,000 and $706,000, respectively. The tax expenses for the year ended December 31, 2004, consisted of a current provision of $1.7 million, reduced by $717,000 primarily from the utilization of research and development credits and a related valuation allowance reduction. During 2004, our income tax expense (and related valuation allowance on certain deferred tax assets) was reduced by $583,000 to reflect our realization during 2004 of the tax benefit of certain capitalized expenditures and foreign losses and the expected future benefit in 2005 of certain capitalized expenditures. At December 31, 2004, based on our recent operating performance, we determined that we now have the ability to reasonably forecast short-term operating performance on a one-year look forward basis; accordingly, we have concluded that it is more-likely-than-not that we will realize the tax benefit attributable to the capitalized expenditures that become available to us in 2005. This determination represents a change in estimate during 2004, which had the effect of reducing the valuation allowance and income tax expense, and increasing net income in 2004 by approximately $200,000. The tax expenses relating to the year ended December 31, 2003, consisted of a current provision of $1.1 million, reduced by $414,000 primarily from a settlement with the Internal Revenue Service of certain outstanding tax assessments originating in prior years and overpayment of the prior year tax liability.

Minority Interest in Income of Consolidated Subsidiaries

	Year Ended December 31,				Increase (Decrease)
	2004		2003		Dollar		Percentage
Minority interest in income of consolidated subsidiaries	$	353,000	$	—	$	353,000	—

For the year ended December 31, 2004, we recognized $364,000 representing the 36% minority interest’s share in the net income of KLH, net of $11,000, representing the 51% majority interest’s share in the net loss of RAE France, a business interest we acquired in fiscal 2004 and consolidate in our financial statements.

Net Income

	Year Ended December 31,				Increase (Decrease)
	2004 (Restated)		2003 (Restated)		Dollar			Percentage
Net income	$	2,335,000	$	2,738,000	$	(403,000	)	(15)%

Net income for the year ended December 31, 2004 was $2.3 million. For the same period in 2003, we had net income of $2.7 million. The decrease was primarily due to a decrease in gross margins for the Company of approximately 2% due to the acquisition of KLH, which is primarily a distribution business with lower margins, as well as from a relative increase in general and administrative and tax expenses from 2003 to 2004.

Comparison of Years Ended December 31, 2003 and 2002

Total Net Sales

	Years Ended December 31,				Increase (Decrease)
($ in thousands)	2003 (Restated)		2002 (Restated)		Dollar		Percentage
Net sales	$	31,361,000	$	21,828,000	$	9,533,000	44%

Net sales increased due to a significant increase in government sales, particularly for homeland security applications where we recognized an increase of approximately $6.0 million in the sales of our integrated systems and patented products and a $3.5 million increase in the sales of our confined space, consumable and radiation products.

7

Cost of Sales & Gross Margin

	Years Ended December 31,						Increase (Decrease)
	2003 (Restated)			2002 (Restated)			Dollar		Percentage
Cost of Sales	$	12,105,000		$	8,757,000		$	3,348,000	38%
Gross Profit	$	19,256,000		$	13,071,000		$	6,185,000	47%
Gross Profit as a percentage of net sales		61	%		60	%

Cost of sales increased due to increases in material and production costs in the amount of $2.5 million resulting from an increase in the sales volume. Cost of sales also increased due to an increase in personnel and personnel related expenses in of approximately $870,000 to support the expanding service business. Gross profit increased due to production efficiencies resulting from the increase in sales volume as well as growth in the sales of our higher margin products, specifically our integrated systems products and our MultiRAE and MiniRAE 2000 portable products.

Sales and Marketing Expense

	Years Ended December 31,						Increase (Decrease)
	2003 (Restated)			2002 (Restated)			Dollar		Percentage
Sales and marketing expense	$	7,278,000		$	5,355,000		$	1,923,000	36%
Percentage of total net sales		23	%		25	%

Sales and marketing expenses increased in the amount of $813,000 due to an increase in our tradeshow and advertising presence to support our homeland defense business, our mobile sensor network solution and our suite of radiation detectors. Additionally, our expenses increased overseas by approximately $700,000 to build the infrastructure to support anticipated growth in Europe and Asia. Commissions to our sales representatives also increased by $495,000 due to the increase in the sales of our integrated systems solutions, which are generally sold through direct sales channels.

Research and Development Expense

	Years Ended December 31,						Increase (Decrease)
	2003			2002			Dollar		Percentage
Research and development expense	$	2,983,000		$	2,531,000		$	452,000	18%
Percentage of total net sales		10	%		12	%

Research and development expenses increased due to an increase in personnel and personnel related expenses in the amount of $261,000 to support the development of a monitor that combines radiological and chemical sensors in a single unit, the development of a solution for cargo container security and inventory tracking, and the further development of our line of consumable products.

General and Administrative Expense

	Years Ended December 31,						Increase (Decrease)
	2003			2002			Dollar			Percentage
General and administrative expense	$	5,236,000		$	5,432,000		$	(196,000	)	(4)%
Percentage of total net sales		17	%		25	%

General and administrative expenses decreased primarily due to reductions to professional fees of approximately $1.0 million due to the settlement of certain lawsuits and the 3-year tax audit of our business in 2002. This was partially offset by accrued management incentives in the amount of $494,000 and non-cash warrant charges in the amount of $294,000.

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Merger Costs

	Years Ended December 31,						Increase (Decrease)
	2003			2002			Dollar			Percentage
Merger costs	$	0		$	8,735,000		$	(8,735,000	)	—  %
Percentage of total net sales		0	%		40	%

We incurred non-cash merger costs of $8.7 million relating to the grant of options and warrants for the year ended December 31, 2002 in connection with our merger transaction with Nettaxi.com.

Other Income (Expense)

	Years Ended December 31,						Increase (Decrease)
	2003			2002			Dollar
Interest income	$	31,000		$	54,000		$	(23,000	)
Interest expense		(32,000	)		(119,000	)		87,000
Other, net		(38,000	)		0			(38,000	)
Equity in loss of unconsolidated affiliate		(276,000	)		(284,000	)		8,000
Total other income (expense)	$	(315,000	)	$	(349,000	)	$	34,000
Percentage of total net sales		(1	)%		(2	)%

Other expenses for the year ended December 31, 2003 was $315,000. For the same period in 2002, we had other expenses of $349,000, a change of $34,000. Other expenses for the year ended December 31, 2003 and 2002 consisted primarily of equity in loss of our unconsolidated affiliate, REnex, in the amount of $276,000 and $284,000, respectively. Interest expense decreased in the amount of $87,000 due to the payment of outstanding loans, partially offset by a decrease in interest income in the amount of $23,000.

Income Taxes

	Years Ended December 31,						Increase (Decrease)
	2003 (Restated)			2002 (Restated)			Dollar		Percentage
Income Taxes	$	706,000		$	131,000		$	575,000	439%
Percentage of pretax income (loss)		21	%		1	%

The tax expense relating to the year ended December 31, 2003, consisted of a provision of $1.5 million relating to the pre-tax income, reduced by $574,000 upon the release of prior year tax liability, including $443,000 relating to the settlement with the Internal Revenue Service of certain outstanding tax assessments originating in prior years. In addition, there was a $222,000 reduction in valuation allowance associated with research and development credits.

Net Income (Loss)

	Year Ended December 31,					Increase (Decrease)
	2003 (Restated)		2002 (Restated)			Dollar		Percentage
Net income (loss)	$	2,738,000	$	(9,462,000	)	$	12,200,000	—	%

Net income for the year ended December 31, 2003 was $2.8 million. For the same period in 2002, we had a net loss of $9.5 million, including $8.7 million in non-cash merger costs. The increase primarily resulted from the elimination of merger costs in 2003 as well as from a $9.5 million increase in sales partially offset by the scaling of expenses to support the increased sales levels.

9

Liquidity and Capital Resources

	Year Ended December 31,
	2004			2003			2002
Net cash provided by (used in):
Operating activities	$	2,687,000		$	981,000		$	1,296,000
Investing activities	$	(21,014,000	)	$	(719,000	)	$	554,000
Financing activities	$	32,251,000		$	50,000		$	1,600,000
Effect of exchange rate changes on cash and cash equivalents	$	130,000		$	7,000		$	—
Net increase in cash and cash equivalents	$	14,054,000		$	319,000		$	3,450,000

To date, we have financed our operations primarily through bank borrowings, revenues from operations and proceeds from the issuances of equity securities. As of December 31, 2004, we had $32.8 million in cash and investments. At December 31, 2004, we had $38.9 million of working capital (current assets less current liabilities) and had a current ratio (current assets divided by current liabilities) of 4.53 to 1.00.

We have two lines of credit available for future growth expansion, which in the aggregate total $10 million. In April 2004, we secured a $3,000,000 line of credit based on the prime-lending rate that will expire in August 2005. In May 2004, we secured an additional $7,000,000 line of credit at a fixed rate of 3.25% that will expire in August 2005. We are currently in compliance with the debt covenants, and as such, have these lines available to us in full. At present, there are no amounts outstanding under these agreements. Prior to the August 2005 expiration of the lines of credit, we expect to renew these lines under substantially the same terms and conditions.

Net cash provided by operating activities for the year ended December 31, 2004 was $2.7 million, as compared with net cash provided by operating activities of $981,000 for the year ended December 31, 2003. The favorable effects on operating cash flows for the year ended December 31, 2004 was due primarily to increases to accrued liabilities of $3.0 million, net income of $2.3 million and non-cash adjustments to profit of $1.4 million due to fair value accounting for stock options and warrants, which adds to operating cash flow. Additional cash flow contributions of $1.0 million came from the tax benefit from the disqualification of incentive stock options, $1.0 million from increases to accounts payable and depreciation and amortization of $994,000. These were partially offset by increases to inventories of $2.7 million, accounts receivable of $2.9 million, prepaid expenses of $840,000 and deferred income taxes of $810,000.

Net cash used in investing activities for the year ended December 31, 2004 was $21.0 million as compared with $719,000 for the year ended December 31, 2003. Cash used in investing activities consisted of $11.2 million in long and short term investments and $9.3 million due to the acquisition of property and equipment, $5.0 million of which was used the purchase the future site of RAE Systems’ corporate headquarters in San Jose, California. The remaining $4.3 million was largely invested in manufacturing capacity in Shanghai and Beijing.

Net cash provided by financing activities for the year ended December 31, 2004 was $32.3 million as compared with $50,000 for the year ended December 31, 2003. Cash provided by financing activities for the year ended December 31, 2004 was primarily the result of having raised a net of $31.8 million through a public offering, of 8,050,000 shares of common stock at $4.25 per share less the applicable underwriting discount, which closed on January 28, 2004. The proceeds have been and will continue to be used for potential mergers and acquisitions, working capital and for general corporate purposes. Jefferies Quarterdeck, a division of Jefferies & Company, Inc., led the underwriting team, with Merriman Curhan Ford & Co. as co-manager for the offering.

We believe that our existing balances of cash and cash equivalents, together with cash generated from product sales, will be sufficient to meet our cash needs for working capital and capital expenditures for at least the next twelve months. Our future capital requirements will depend on many factors that are difficult to predict, including the size, timing and structure of any future acquisitions, future capital investments and future results of operations. Any future financing we may require may be unavailable on favorable terms, if at all. Any difficulty in obtaining additional financial resources could force us to curtail our operations or could prevent us from pursuing our growth strategy. Any future funding may dilute the ownership of our stockholders.

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Contractual Obligations

We lease certain manufacturing, warehousing, and other facilities under operating leases expiring in various years through 2009. The leases generally provide for the lessee to pay taxes, maintenance, insurance, and certain other operating costs of the leased property. We have other liabilities, including an employee agreement with a non-executive officer in Europe for which the termination liability is $260,000 for a period of one year. The following table quantifies our known contractual obligations as of December 31, 2004:

	Total		2005		2006		2007		2008		2009		Thereafter
Contractual Obligations:
Operating Lease Obligations	$	3,209,000	$	756,000	$	759,000	$	527,000	$	617,000	$	550,000	$	—
Open Purchase Orders		1,149,000		529,000		212,000		210,000		156,000		42,000		—
Notes Payable - Related Parties		1,683,000		423,000		388,000		388,000		242,000		242,000		—
Other liabilities		197,000		20,000		20,000		20,000		20,000		20,000		97,000
TOTAL	$	6,238,000	$	1,728,000	$	1,379,000	$	1,145,000	$	1,035,000	$	854,000	$	97,000

In December 2004, the Company purchased the property located at 3775 North First Street in San Jose, California for a purchase price of $5.0 million in cash. The Company financed this transaction with available cash. As of May 31, 2005, the majority of the Company’s U.S. operations have been relocated from the Company’s leased facility in Sunnyvale, California to the Company’s new facility in San Jose, California. During June 2005, the Company expects to complete the relocation of its operations to the new facility in San Jose, California and write off its lease obligation which is estimated at $2.3 million.

Transactions with Affiliate

Certain of the Company’s sales made into the China market were made through TangRAE, a China distribution company that is owned by two individuals, one of whom is Kang Lin Liu, our sales representative and one of whom is a former employee of one of the Company’s wholly-owned subsidiaries. TangRAE was organized as a sales office solely to facilitate the sale of the Company’s products into the China market. Total sales made by the Company to TangRAE amounted to $392,000, $479,000, and $351,000 for 2004, 2003 and 2002, respectively. In 2004, consulting fees were paid by TangRAE to RAE Shanghai in the amount of $143,000. Effective December 2004, TangRAE was officially closed as an operating entity.

In September 2004, the Company entered into an agreement with Shanghai Simax Technology Co. Ltd. (“Simax”) to finance the design of a benzene-specific gas detection module (GC-PID) in the amount of $100,000. To date, there have been no payments to Simax. RAE Systems has the right to use the technology in any of our future products. The Company is to pay a royalty fee of 5% of all GC-PID products sold. To date, there have been no royalty payments for this technology. Dr. Peter C. Hsi, the Company’s Chief Technology Officer is the acting general manager for Simax. Dr. Hsi has no equity ownership in Simax.

In June 2004, the Company entered into an agreement with REnex Technologies Ltd. to develop six prototype RAELink modems for a price of $95,000 and to pay a royalty fee of 7.5% for all products sold for which REnex Technology’s intellectual property is used. To date, a payment was made to REnex in the amount of $28,000 to develop the modems. During 2004, the Company did not make any royalty payments. The Company has a 36% interest in REnex Technologies Ltd.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R revises SFAS No. 123, and generally requires the cost associated with employee services received in exchange for an award of equity instruments be measured based on the grant-date fair value of the award and recognized in the financial statements over the period during which employees are required to provide services in exchange for the award. SFAS No. 123R also provides guidance on how to determine the grant-date fair value for awards of equity instruments as well as alternative methods of adopting its requirements. SFAS No. 123R was to be effective for the beginning of the first interim or annual reporting period after June 15, 2005 (the quarter ended September 30, 2005 for the Company) and applies to all outstanding and unvested share-based payment awards at a company’s adoption date. On April 14, 2005, the Securities and Exchange Commission amended the compliance dates for SFAS No. 123R. As a result, SFAS No. 123R will be effective beginning in our first quarter of 2006. We are currently assessing the impact of this statement on our consolidated financial statements.

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In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets”. SFAS No. 153 amends the guidance in Accounting Principles Board (APB) Opinion No. 29, “Accounting for Nonmonetary Transactions” to eliminate certain exceptions to the principle that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged. SFAS No. 153 eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for nonmonetary asset exchanges in fiscal years beginning after June 15, 2005. The adoption of SFAS 153 is not expected to have an impact on our consolidated results of operations or financial position or cash flows.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs,” an amendment of Accounting Research Bulletin (ARB) No. 43, Chapter 4. Under SFAS No. 151, all abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The adoption of this pronouncement is not expected to have a material impact on the Company’s financial statements, results of operations, or cash flows.

In October 2004, the FASB issued FASB Staff Position (FSP) No. 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,” which provides a tax deduction of up to nine percent (when fully phased in) of the lesser of (a) “qualified production activities income” or taxable income (after the deduction for the utilization of any net operating loss carryforwards). The adoption of this pronouncement is not expected to have a material impact on the Company’s financial statements, results of operations, or cash flows.

In October 2004, the FASB issued FSP No. 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” for a special one-time tax deduction of 85 percent of certain foreign earnings that are repatriated in either an enterprise’s last tax year that began before the enactment date, or the first tax year that begins during the one-year period beginning on the date of enactment. The adoption of this pronouncement is not expected to have a material impact on the Company’s financial statements, results of operations, or cash flows.

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ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

The following discussion analyzes our disclosure to market risk related to concentration of credit risk, changes in interest rates and foreign currency exchange rates.

Concentration of Credit Risk

Currently, we have cash and cash equivalents deposited with two large United States financial institutions, one large Hong Kong financial institution, two large Shanghai financial institutions, two local Beijing financial institutions, and one large Danish financial institution. Our deposits generally exceed the amount of insurance available to cover such deposits. To date, we have not experienced any losses of deposits of cash and cash equivalents. Management regularly reviews our deposit amounts and the credit worthiness of the financial institution which hold our deposits.

Interest Rate Risk

As of December 31, 2004, we had cash and cash equivalents of $32.8 million consisting of cash and highly liquid short-term investments. The impact of interest rate fluctuations was immaterial. Changes to interest rates over time may, however, reduce or increase our interest income from our short-term investments. If, for example, there is a hypothetical 150 basis points change in the interest rates in the United States, the approximate impact on our cash and short-term investments would be +/- $100,000.

Foreign Currency Exchange Rate Risk

To date, a substantial portion of our recognized revenue has been denominated in United States dollars generated primarily from customers in the North America (66%). Revenue generated from our European operations (10%) is primarily in euros, revenue generated by our China operations (20%) is in renminbi, and revenue generated from our Hong Kong-based operations (4%) is in both Hong Kong dollars and United States dollars. We manufacture a majority of our component parts at our manufacturing facility in Shanghai, China. Our operations in China have been largely unaffected by currency fluctuations, as China’s currency rate has been fixed relative to the United States dollar.

Our strategy has been and will continue to be to increase our overseas manufacturing and research and development activities to capitalize on low cost intellectual property and efficiency in supply chain management. In 2004, we made a strategic investment in China with the acquisition of KLH, a Beijing-based manufacturer and distributor of environmental safety and security equipment. There has been recent speculation in the financial press that China’s currency, the renminbi, will be subject to a market adjustment relative to the United States dollar and other currencies. If, for example, there is a hypothetical 10% change in the renminbi relative to the United States dollar, the approximate impact on our operating profits would be +/- $500,000.

Furthermore, to the extent that we engage in international sales denominated in United States dollars in countries other than China, any fluctuation in the value of the U.S. dollar relative to foreign currencies could affect our competitive position in the international markets. Although we would continue to monitor our exposure to currency fluctuations and, when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, we cannot be certain that exchange rate fluctuations will not adversely affect our financial results in the future.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Our consolidated financial statements included in this report beginning on page F-1 are incorporated herein by reference.

ITEM 9A.    CONTROLS AND PROCEDURES

Management’s Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting and for the assessment of the effectiveness of internal control over financial reporting. As defined by the SEC, internal control over financial reporting is a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. In order to evaluate the effectiveness of internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, management has conducted an assessment, including testing, using the criteria in Internal Control — Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Because of its inherent limitations, there can be no guarantees that internal control over financial reporting will prevent or detect misstatements. Furthermore, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management has excluded from its assessment, the internal control over financial reporting at RAE KLH (Beijing) Co. Ltd., which was acquired on May 27, 2004 and whose financial statements reflect total assets and revenues of 25% and 17%, respectively, of the Company’s related consolidated financial amounts as of and for the year ended December 31, 2004, as the Company did not have sufficient time to make an assessment of KLH’s internal controls using the COSO criteria in accordance with Section 404 of the Sarbanes-Oxley Act of 2002. In excluding KLH from its assessment, the Company has considered the “Frequently Asked Questions” as set forth by the Office of the Chief Accountant of the Division of Corporate Finance on June 24, 2004 which acknowledges that it may not be possible to conduct an assessment of an acquired business’s internal control over financial reporting in the period between the consummation date and the date of management’s assessment and contemplates that such business would be excluded from management’s assessment in the year of acquisition. Nonetheless, for presentation purposes, the following discussion includes information regarding KLH known to management as of June 6, 2005.

As defined by Public Company Accounting Oversight Board (“PCAOB”) Auditing Standard No. 2, a material weakness is a significant control deficiency, or a combination of significant control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. In connection with the work on the Company’s internal control over financial reporting, the Company has identified the following material weaknesses: (i) inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period; (ii) inadequate training and supervision practices necessary to ensure that all of the Company’s key controls are effective; (iii) inadequate record retention policies and procedures to ensure that all key documents in support of the Company’s transactions are obtained, retained and safeguarded; (iv) inadequate controls pertaining to the segregation of duties relative to certain of the Company’s processes, especially in locations where the Company has limited staff; (v) inadequate controls pertaining to the preparation or maintenance of adequate documentation in support of all disbursements made at the newly acquired KLH subsidiary; (vi) inadequate controls pertaining to the Company’s review and oversight of its subsidiary’s financial information originating at the newly acquired KLH subsidiary; (vii) inadequate controls pertaining to the Company’s information technology infrastructure in the area of security and data protection; and (viii) and inadequate planning, organization and supervision of the Company’s Sarbanes-Oxley 404 process.

The material weakness identified with respect to our revenue recognition practices relates to the following specific circumstances: The Company identified a single distributor in Canada, accounting for less than 1% of our annual revenues, who (a) had not signed the Company’s standard distributor agreement sent to the distributor over the last three years and (b) from time to time, placed purchase orders with a “right of return” clause. The Company’s internal control processes originally failed to identify and consider the accounting impact of this right of return clause. In addition, the Company identified several U.S. local, state and federal agency purchase orders with freight delivery terms of “FOB destination” rather than “FOB factory, “ the Company’s standard terms. Typically, it takes from two to five days for deliveries to reach the Company’s U.S. customers. The Company’s internal control processes originally failed to identify and consider the accounting impact of these non-standard shipping terms. In both cases, revenues were incorrectly recognized in the periods in

14

which shipment took place, when current revenue recognition rules required that the revenues be deferred until certain conditions were met. Under current revenue recognition rules, the revenues from the distribution customer should not have been recognized until the right of return had expired or the customer specifically disclaimed the right of return. In the case of the goods shipped “FOB destination,” the revenues should not have been recognized until proof of delivery was established. Further, during the course of the review, the Company found a limited number of service contracts that were not properly deferred. After conferring with the Audit Committee of the Company’s Board of Directors and its independent registered public accounting firm on these matters, another independent certified public accounting firm was engaged to conduct an independent study (agreed-upon procedures report) of the impact of the Company’s revenue recognition practices. Based on the findings of the study by the independent certified public accounting firm, management concluded that the Company’s consolidated financial statements as of December 31, 2004, 2003 and 2000 and for each of the years then ended and the Company’s condensed financial data for the interim periods for fiscal years 2004 and 2003 should be restated. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for this amended Form 10-K/A. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), an error which had been previously identified but not considered to be sufficiently material to require correction. The Audit Committee of the Board of Directors concurred with management’s decision.

The material weaknesses identified by management could result in a material misstatement to the annual or interim financial statements that would not be prevented or detected. As a result, management has determined these control deficiencies each constituted a material weakness as of December 31, 2004. Because of the material weaknesses described above, management concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2004, based on criteria in Internal Control — Integrated Framework issued by the COSO. Management communicated its conclusions to the Audit Committee of the Company’s Board of Directors.

The Company recently completed its documentation and testing of internal control over financial reporting as of December 31, 2004. The Company’s auditors, BDO Seidman, LLP, have disclaimed an opinion on management’s assessment on the effectiveness of internal control over financial reporting as of the stated period.

Changes in Internal Control Over Financial Reporting

During 2004 and continuing through the date of this filing, the Company implemented a number of compensating internal controls and will continue to remediate controls in an effort to improve the level of assurance regarding the accuracy of the Company’s financial information. These compensating internal controls and remediation efforts include the following:

Controls related to inadequate codification of the Company’s revenue recognition policies and review procedures to ensure revenues are recorded in the proper period:

• During the first quarter of 2005, the Company clarified and re-emphasized its worldwide revenue recognition policy.

• During the same period, a standard process was put in place in the United States to review customer contracts and purchase order terms. This process will be extended worldwide during the second quarter of 2005.

• During the second quarter of 2005, the Company engaged another independent certified public accounting firm to test selective revenue transactions for cutoff issues.

• Based on the findings of the revenue recognition study by the independent certified public accounting firm, the Company decided to restate its consolidated financial statements for years ended December 31, 2004, 2003 and 2000. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for this amended Form 10-K/A. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), an error which had been previously identified but not considered to be sufficiently material to require correction.

Controls related to inadequate training and supervision practices necessary to ensure that all of the Company’s key controls are effective:

• In 2005, the Company will be implementing a series of training programs to educate its employees on the Company’s internal control standards.

Controls related to inadequate record retention policies and procedures to ensure that all key documents in support of the Company’s transactions are obtained, retained and safeguarded.

• During the first quarter of 2005, the Company developed a world-wide records retention policy.

• During the second quarter of 2005, the Company completed an inventory of its North American distributor contracts and identified contracts not yet signed and returned. The Company is currently following-up with distributors who have not returned signed contracts.

15

• During the second quarter of 2005, the Company revised its procedures for retaining its customer purchase orders in the U.S.

Controls pertaining to the segregation of duties relative to a few of the Company’s processes:

• During the first quarter of 2005, the Company implemented additional levels of approval, verification and sign-off processes for the Company’s key controls.

Controls related to the preparation or maintenance of adequate documentation in support of all disbursements made at the newly acquired KLH subsidiary:

• During the fourth quarter of 2004 and continuing into the first quarter of 2005, the Company implemented an enterprise resource planning system in Beijing to improve the reporting and controls over disbursements.

Controls related to the Company’s review and oversight of its subsidiary’s financial information originating at the newly acquired KLH subsidiary:

• During the fourth quarter of 2004, the Company hired an experienced financial controller with United States accounting experience to manage the Shanghai manufacturing operations and to provide some in-country supervision to the financial manager at the Company’s newly acquired KLH operations in Beijing.

• During the first quarter of 2005, the Company transferred a United States trained accountant to assist in the financial management of the Company’s newly acquired KLH operations.

• Starting with the filing of the 2004 Form 10-K on March 18, 2005, the Company instituted a sub-certification process, including KLH, whereby all key finance and operations personnel within the Company are held accountable for the accuracy of the financial statements.

Controls related to the Company’s information technology infrastructure in the area of data security and data protection:

• During the fourth quarter of 2004, the Company formed a team to select a new enterprise resource planning system to replace the current system that was determined to be inadequate in the area of security and data protection. The implementation effort is scheduled to commence in the second quarter of 2005.

Controls related to inadequate planning, organization and supervision of the Company’s Sarbanes-Oxley 404 process:

• During the first quarter of 2005, the Company supplemented the Sarbanes-Oxley 404 team to include every member of the United States finance department. This team developed and implemented standard documentation and test procedures worldwide to comply with the requirements of Section 404 of the Sarbanes-Oxley Act.

• During the same period, the Company hired an experienced consultant to assist with the Sarbanes-Oxley 404 testing and remediation process.

As reported in the Company’s Form 10-K/A for the year ended December 31, 2004 filed with the SEC on May 2, 2005, management previously concluded that the Company did not maintain effective internal control over financial reporting as of December 31, 2004 because of the material weaknesses identified above. The control deficiencies requiring this restatement were not a result of an additional material weakness and have not caused the Company to modify its previously issued Report on Assessment of Internal Control Over Financial Reporting, except insofar as to restate its financial results for the years ended December 31, 2004, 2003 and 2000 because of inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for this amended Form 10-K/A. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), an error which had been previously identified but not considered to be sufficiently material to require correction. The Company is in the process of developing procedures for the testing of the remediated controls to determine if the control deficiencies have been remediated and expects that testing of these controls will be substantially completed by the end of its fiscal year 2005.

16

Management believes that its controls and procedures will continue to improve as a result of the further implementation of these measures.

Material weaknesses in internal control over financial reporting may materially impact the Company’s reported financial results and the market price of its stock could significantly decline. Since the Company’s auditors have disclaimed an opinion on management’s assessment on the effectiveness of internal control over financial reporting, it is unclear what legal effect this will have on the Company’s compliance with the rules and regulations of the SEC and the continued listing standards of the American Stock Exchange. Additionally, adverse publicity related to a material failure of internal control over financial reporting could have a negative impact on the Company’s reputation and business.

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

Under the supervision and with the participation of the Company’s management, including the Company’s principal executive officer and principal accounting officer, the Company evaluated the effectiveness of its disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Exchange Act. Based upon that evaluation, the Company’s principal executive officer and principal accounting officer concluded that the Company’s disclosure controls and procedures were ineffective as of December 31, 2004 with regard to the material weaknesses identified and discussed above, under “Management’s Report on Internal Control over Financial Reporting.”

Report of Independent Registered Public Accounting Firm

We were engaged to audit management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that the internal control over financial reporting of RAE Systems Inc. and subsidiaries (the “Company”) was not effective as of December 31, 2004, because of the effects of the material weaknesses described below, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Framework”). As described in Management’s Report on Internal Control over Financial Reporting, management excluded from their assessment the internal control over financial reporting at RAE KLH (Beijing) Co. Ltd., which was acquired on May 27, 2004 and whose financial statements reflect total assets and total revenues constituting 25% and 17%, respectively, of related consolidated financial statement amounts as of and for the year ended December 31, 2004. Accordingly, our engagement did not include the internal control over financial reporting at RAE KLH (Beijing) Co. Ltd. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting.

The Company was required to make an assessment of its internal control over financial reporting as of December 31, 2004. During the month of April 2005, the Company completed its documentation, testing and remediation of a significant portion of its internal control processes. This timetable did not enable us to perform all of the procedures necessary in order for us to form an opinion on management’s assessment of internal control over financial reporting and an opinion on the effectiveness of internal control over financial reporting. A material weakness is a significant control deficiency, or combination of significant control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment as of December 31, 2004: (i) inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period; (ii) inadequate training and supervision practices necessary to ensure that all of the Company’s key controls are effective; (iii) inadequate record retention policies and procedures to ensure that all key documents in support of the Company’s transactions are obtained, retained and safeguarded; (iv) inadequate controls pertaining to the segregation of duties relative to certain of the Company’s processes, especially in locations where the Company has limited staff; (v) inadequate controls pertaining to the preparation or maintenance of adequate documentation in support of all disbursements made at the newly acquired KLH subsidiary; (vi) inadequate controls pertaining to the Company’s review and oversight of its subsidiary’s financial information originating at the newly acquired KLH subsidiary; (vii) inadequate controls pertaining to the Company’s information technology infrastructure in the area of security and data protection; and (viii) and inadequate planning, organization and supervision of the Company’s Sarbanes-Oxley 404 process. Except as described in the following sentence, none of the foregoing material weaknesses resulted in adjustments to the annual or interim consolidated financial statements; however, each of the material weaknesses results in more than a remote likelihood that a material misstatement to the Company’s annual or interim financial statements will not be prevented or detected. The material weakness pertaining to the Company’s internal control over revenue recognition resulted in adjustments to the annual financial statements (as restated) for 2004, 2003, 2002, 2001 and 2000 and resulted in adjustments to the interim financial statements (as restated) for each of the quarterly periods in the two-year period ended December 31, 2004. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the Company’s consolidated financial statements as of and for the year ended December 31, 2004 and this report does not affect our report dated June 6, 2005 on those consolidated financial statements.

17

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate.

Since management did not complete its documentation, testing and remediation of a significant portion of its internal control processes on a timely basis and we were unable to apply other procedures to satisfy ourselves as to the effectiveness of the Company’s internal control over financial reporting, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion either on management’s assessment or on the effectiveness of the Company’s internal control over financial reporting.

We do not express an opinion or any other form of assurance on management’s statements regarding corrective action taken by the Company after December 31, 2004.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of RAE Systems Inc. and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2004, as restated, and our report dated June 6, 2005 expressed an unqualified opinion thereon.

/s/ BDO Seidman, LLP

San Jose, California

June 6, 2005

PART IV.

ITEM 15.    EXHIBITS, FINANCIAL STATEMENT SCHEDULES

(a) (1)            Financial Statements

See the index of the Consolidated Financial Statements of this Form 10-K.

(2) Financial Statement Schedules

Schedules are not provided because of the absence of conditions under which they are required or because the required information is given in the financial statements or the notes thereto.

(3) Exhibits

See Index to Exhibits.

18

INDEX TO EXHIBITS

Exhibit Number	Description of Document
2.1	Merger Agreement and Plan of Reorganization by and between RAE Systems Inc., RAES Acquisition Corporation and Nettaxi.com dated January 9, 2002 (1)
2.2	Joint Venture Contract between Registrant and KLH dated May 27, 2004 (2)
2.3	Subscription Agreement between Registrant and KLH dated May 27, 2004 (2)
3.1	Certificate of Incorporation of Registrant (3)
3.2	Bylaws of Registrant (3)
4.1	Specimen certificate representing the common stock of Registrant (3)
4.2	Registration Rights Agreement by and between RGC International Investors, LDC and Nettaxi.com, dated as of April 28, 2000 (4)
10.0	Purchase and Sale Agreement dated November 1, 2004 by and between RAE Systems Inc. and CarrAmerica Realty Operating Partnership, L.P. (5)
10.1	Form of Indemnity Agreement between the Registrant and the Registrant’s directors and officers (3)
10.2	RAE Systems Inc. 2002 Stock Option Plan (3)
10.3	RAE Systems Inc. 1993 Stock Plan (3)
10.8	Lease Agreement by and between Aetna Life Insurance Company and the Registrant dated June 1, 1999 (3)
10.9	First Amendment to Lease by and between Moffett Office Park Investors LLC and the Registrant dated effective November 1, 2002 amending Lease Agreement between Aetna Life Insurance Company and the Registrant dated June 1, 1999 (6)
10.10	Manufacturing Building Lease Agreement by and between Shanghai China Academic Science High Tech Industrial Park Development Co., Ltd. and RAE Systems (Asia), Ltd., incorporated in Hong Kong, dated September 15, 2001 (3)
10.11	Lease Agreement by and between Shanghai Institute of Metallurgy Research, Chinese Academy of Sciences and WARAE Instrument (Shanghai) Incorporated, incorporated in Jiading, Shanghai, dated January 8, 1999 (3)
10.14	Warrant Agreement by and between Nettaxi.com and Mr. Michael Gardner dated April 9, 2002 (7)
21.1	Subsidiaries of the Registrant (8)
23.1	Consent of BDO Seidman, LLP
24.1	Power of Attorney (included on signature page)
31.1	Certification of Robert I. Chen, President and Chief Executive Officer of Registrant pursuant to Rule 13a-14 adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley Act of 2002.

19

31.2	Certification of Donald W. Morgan, Vice President and Chief Financial Officer of Registrant pursuant to Rule 13a-14 adopted under the Securities Exchange Act of 1934, as amended, and Section 302 of the Sarbanes-Oxley act of 2002.
32.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1) Previously filed on January 10, 2002 as an exhibit to Nettaxi.com’s Current Report on Form 8-K and incorporated herein by reference.

(2) Previously filed on June 9, 2004 as an exhibit to the Registrant’s Current Report on Form 8-K and incorporated herein by reference.

(3) Previously filed as an exhibit to the Registrant’s quarterly report on Form 10-Q, for the quarter ended March 31, 2002 and incorporated herein by reference.

(4) Previously filed on June 2, 2000 as an exhibit to Nettaxi.com’s Registration Statement on Form S-1 and incorporated herein by reference.

(5) Previously filed on November 2, 2004 as an exhibit to the Registrant’s Current Report on Form 8-K and incorporated herein by reference.

(6) Previously filed on February 28, 2003 as an exhibit to the Registrant’s annual report on Form 10-K, for the year ended December 31, 2002 and incorporated herein by reference.

(7) Previously filed on April 8, 2002 as an exhibit to Nettaxi.com’s Registration statement on Form S-8 and incorporated herein by reference.

(8) Previously filed on March 18, 2005 as an exhibit to the Registrant’s annual report on Form 10-K for the year ended December 31, 2004 and incorporated herein by reference.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on June 6, 2005.

RAE SYSTEMS INC.
By:	/s/ ROBERT I. CHEN
	Robert I. Chen President and Chief Executive Officer

21

RAE Systems Inc.  

Consolidated Financial Statements

As of December 31, 2004 and 2003

Report of Independent Registered Public Accounting Firm	F-2
Consolidated Financial Statements
Consolidated balance sheets	F-3
Consolidated statements of operations	F-4
Consolidated statements of shareholders’ equity	F-5
Consolidated statements of cash flows	F-6
Notes to consolidated financial statements	F-7 – F-31

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Shareholders

RAE Systems Inc. and subsidiaries

We have audited the accompanying consolidated balance sheets of RAE Systems Inc. and subsidiaries (the Company) as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of RAE Systems Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1(p) to the consolidated financial statements, effective January 1, 2003, the Company adopted the fair value method of accounting for stock-based compensation.

As discussed in Note 2, the Company’s financial statements as of December 31, 2004 and 2003, and for each of the three years in the period ended December 31, 2004, have been restated.

We were also engaged to audit, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and in our report dated June 6, 2005, we disclaimed an opinion on management’s assessment of the effectiveness of internal control over financial reporting and disclaimed an opinion on the effectiveness of internal control over financial reporting due to management’s inability to complete its documentation, testing and remediation of a significant portion of its internal control processes on a timely basis and our inability to apply other procedures to satisfy ourselves as to the effectiveness of the Company’s internal control over financial reporting.

/s/ BDO Seidman, LLP

San Jose, California

June 6, 2005

F-2

RAE SYSTEMS INC.

CONSOLIDATED BALANCE SHEETS

	December 31, 2004 (Restated)			December 31, 2003 (Restated)
Assets
Current Assets:
Cash and cash equivalents	$	21,566,000		$	7,512,000
Short-term investments		6,745,000			—
Notes receivable		535,000			—
Accounts receivable, net of allowance for doubtful accounts of $665,000 and $176,000, respectively		9,934,000			5,380,000
Accounts receivable from affiliate		119,000			—
Inventories, net		7,815,000			3,759,000
Prepaid expenses and other current assets		1,558,000			762,000
Deferred income taxes		1,578,000			768,000
Total Current Assets		49,850,000			18,181,000
Property and Equipment, net		11,287,000			1,748,000
Long-Term Investments		4,500,000			—
Intangible Assets, net		2,150,000			—
Deposits and Other Assets		1,172,000			327,000
Investment in Unconsolidated Affiliate		156,000			509,000
Total Assets	$	69,115,000		$	20,765,000
Liabilities, Minority Interest in Consolidated Entities and Shareholders’ Equity
Current Liabilities:
Accounts payable	$	3,449,000		$	1,611,000
Accounts payable to affiliate		—			594,000
Accrued liabilities		5,582,000			2,159,000
Notes payable—related parties		423,000			—
Income taxes payable		417,000			948,000
Current portion of deferred revenue		1,122,000			324,000
Current portion of capital lease obligations		—			122,000
Total Current Liabilities		10,993,000			5,758,000
Deferred Revenue, net of current portion		240,000			113,000
Other Long-Term Liabilities		145,000			87,000
Long-Term Notes Payable—Related Parties		1,260,000			—
Total Liabilities		12,638,000			5,958,000
Commitments and Contingencies
Minority Interest in Consolidated Entities		4,288,000			—
Shareholders’ Equity:
Common stock, $0.001 par value; 200,000,000 shares authorized; 57,315,175 and 46,824,626 shares issued and outstanding, respectively		57,000			47,000
Additional paid-in capital		53,660,000			18,753,000
Cumulative other comprehensive income		137,000			7,000
Accumulated deficit		(1,665,000	)		(4,000,000	)
Total Shareholders’ Equity		52,189,000			14,807,000
Total Liabilities, Minority Interest in Consolidated Entities and Shareholders' Equity	$	69,115,000		$	20,765,000

See accompanying notes to consolidated financial statements.

F-3

RAE SYSTEMS INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

	Year ended December 31,
	2004 (Restated)			2003 (Restated)			2002 (Restated)
Net Sales	$	45,540,000		$	31,361,000		$	21,828,000
Cost of Sales		18,504,000			12,105,000			8,757,000
Gross Profit		27,036,000			19,256,000			13,071,000
Operating Expenses:
Sales and marketing		11,046,000			7,278,000			5,355,000
Research and development		4,295,000			2,983,000			2,531,000
General and administrative		8,181,000			5,236,000			5,432,000
Merger costs		—			—			8,735,000
Total Operating Expenses		23,522,000			15,497,000			22,053,000
Income (Loss) from Operations		3,514,000			3,759,000			(8,982,000	)
Other Income (Expense):
Interest income		333,000			31,000			54,000
Interest expense		(17,000	)		(32,000	)		(119,000	)
Other, net		194,000			(38,000	)		—
Equity in loss of unconsolidated affiliate		(353,000	)		(276,000	)		(284,000	)
Total Other Income (Expense)		157,000			(315,000	)		(349,000	)
Income (Loss) Before Income Taxes and Minority Interest		3,671,000			3,444,000			(9,331,000	)
Income Taxes		983,000			706,000			131,000
Income (Loss) Before Minority Interest		2,688,000			2,738,000			(9,462,000	)
Minority interest in income of consolidated subsidiaries		(353,000	)		—			—
Net Income (Loss)	$	2,335,000		$	2,738,000		$	(9,462,000	)
Basic Earnings (Loss) Per Common Share	$	0.04		$	0.06		$	(0.24	)
Diluted Earnings (Loss) Per Common Share	$	0.04		$	0.06		$	(0.24	)
Weighted-average common shares outstanding		55,809,638			46,179,770			39,902,169
Stock options		2,771,948			3,277,950			—
Diluted weighted-average common shares outstanding		58,581,586			49,457,720			39,902,169

See accompanying notes to consolidated financial statements.

F-4

RAE SYSTEMS INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

	Common Stock				Additional Paid-in Capital			Deferred Compensation			Accumulated Other Comprehensive Income		Retained Earnings (Accumulated Deficit)			Total
	Shares		Amount
Balances, December 31, 2001	25,542,482		$	25,000	$	1,301,000		$	(718,000	)	$	—	$	2,830,000		$	3,438,000
Adjustments to accumulated deficit in connection with restatement (See Note 2)	—			—		—			—			—		(106,000	)		(106,000	)
Balances, December 31, 2001 (Restated)	25,542,482		$	25,000	$	1,301,000		$	(718,000	)	$	—	$	2,724,000		$	3,332,000
Common stock issued in connection with merger, net of offering costs of $762,000	7,896,764			8,000		6,197,000			—			—		—			6,205,000
Conversion of preferred stock to common stock	10,531,092			11,000		1,289,000			—			—		—			1,300,000
Common stock issued for services	960,000			1,000		2,120,000			—			—		—			2,121,000
Common stock purchase rights granted for services	—			—		2,308,000			—			—		—			2,308,000
Common stock warrants granted for services	—			—		4,306,000			—			—		—			4,306,000
Common stock options granted for services	—			—		16,000			(16,000	)		—		—			—
Issuance of common stock due to exercise of stock options	586,337			1,000		44,000			—			—		—			45,000
Compensation expense under variable accounting of common stock options	—			—		375,000			—			—		—			375,000
Amortization of deferred compensation	—			—		—			217,000			—		—			217,000
Net loss (Restated)	—			—		—			—			—		(9,462,000	)		(9,462,000	)
Balances, December 31, 2002 (Restated)	45,516,675			46,000		17,956,000			(517,000	)		—		(6,738,000	)		10,747,000
Components of comprehensive income:
Net income (Restated)	—			—		—			—			—		2,738,000			2,738,000
Foreign currency translation adjustments	—			—		—			—			7,000		—			7,000
Total comprehensive income (Restated)																	2,745,000
Issuance of common stock due to exercise of stock options	692,775			1,000		128,000			—			—		—			129,000
Issuance of common stock due to exercise of warrants	632,814			—		66,000			—			—		—			66,000
Cancellation of shares	(17,638	)		—		—			—			—		—			—
Common stock warrants granted for services	—			—		331,000			—			—		—			331,000
Adoption of fair value recognition provisions for stock-based employee compensation	—			—		(517,000	)		517,000			—		—			—
Compensation expense under fair value accounting of common stock options	—			—		789,000			—			—		—			789,000
Balances, December 31, 2003 (Restated)	46,824,626			47,000		18,753,000			—			7,000		(4,000,000	)		14,807,000
Components of comprehensive income:
Net income (Restated)	—			—		—			—			—		2,335,000			2,335,000
Foreign currency translation adjustments	—			—		—			—			130,000		—			130,000
Total comprehensive income (Restated)																	2,465,000
Issuance of common stock due to exercise of stock options	1,338,471			1,000		618,000			—			—		—			619,000
Issuance of common stock due to exercise of warrants	1,039,078			1,000		12,000			—			—		—			13,000
Proceeds from the sale of common stock, net of offering costs of $370,000	8,050,000			8,000		31,782,000			—			—		—			31,790,000
Compensation expense under fair value accounting of common stock options	—			—		1,404,000			—			—		—			1,404,000
Issuance of common stock due to exercise of restricted stock	63,000			—		50,000			—			—		—			50,000
Disqualifying disposition of incentive stock options	—			—		1,041,000			—			—		—			1,041,000
Balances, December 31, 2004 (Restated)	57,315,175		$	57,000	$	53,660,000		$	—		$	137,000	$	(1,665,000	)	$	52,189,000

See accompanying notes to consolidated financial statements.

F-5

RAE SYSTEMS INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Year ended December 31,
	2004 (Restated)			2003 (Restated)			2002 (Restated)
Increase (Decrease) in Cash and Cash Equivalents
Cash Flows From Operating Activities:
Net Income (Loss)	$	2,335,000		$	2,738,000		$	(9,462,000	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		994,000			753,000			583,000
Provision for doubtful accounts		489,000			38,000			50,000
Inventory reserve		428,000			253,000			235,000
Amortization of deferred compensation		—			—			217,000
Compensation expense under variable accounting for common stock options		—			—			375,000
Compensation expense under fair value accounting for common stock options		1,404,000			789,000			—
Common stock issued for services		—			—			2,121,000
Common stock purchase rights granted for services		—			—			2,308,000
Common stock warrants granted for services		165,000			331,000			4,306,000
Equity in loss of unconsolidated affiliate		353,000			276,000			284,000
Minority interest in income of consolidated entities		353,000			—			—
Stock options income tax benefits		1,041,000			—			—
Deferred income taxes		(810,000	)		(441,000	)		(198,000	)
Changes in operating assets and liabilities, net of effects of acquisition and deconsolidation:		—
Accounts receivable		(2,852,000	)		(2,942,000	)		(127,000	)
Accounts receivable from affiliate		(119,000	)		—			—
Notes receivable		(535,000	)		—			—
Inventories		(2,666,000	)		(717,000	)		287,000
Prepaid expenses and other current assets		(840,000	)		(360,000	)		(135,000	)
Accounts payable		1,035,000			669,000			100,000
Accounts payable to affiliate		(594,000	)		(164,000	)		60,000
Accrued liabilities		3,024,000			470,000			454,000
Notes payable—related parties		(435,000	)		—			—
Income taxes payable		(580,000	)		(778,000	)		56,000
Deferred revenue		439,000			(9,000	)		(231,000	)
Other long-term liabilities		58,000			75,000			13,000
Net Cash Provided By Operating Activities		2,687,000			981,000			1,296,000
Cash Flows From Investing Activities:
Cash relinquished in deconsolidation		—			—			(878,000	)
Investments		(11,245,000	)		—			—
Proceeds from business acquisition		377,000			—			—
Restricted cash		—			—			3,000,000
Investment in affiliate		—			—			(500,000	)
Acquisition of property and equipment		(9,278,000	)		(474,000	)		(1,160,000	)
Purchased intangibles		(77,000	)		—			—
Deposits and other		(791,000	)		(245,000	)		92,000
Net Cash (Used In) Provided By Investing Activities		(21,014,000	)		(719,000	)		554,000
Cash Flows From Financing Activities:
Proceeds from the exercise of stock options and warrants		682,000			195,000			45,000
Proceeds from the sale of common stock		32,160,000			—			—
Proceeds from merger/reorganization		—			—			6,967,000
Payment of merger costs		—			—			(762,000	)
Bank borrowing		(120,000	)		—			—
Offering costs		(370,000	)		—			—
Payments on notes payable and lines of credit		—			—			(4,426,000	)
Payment on capital lease obligation		(122,000	)		(145,000	)		(224,000	)
Proceeds from minority shareholder investment		21,000			—			—
Net Cash Provided By Financing Activities		32,251,000			50,000			1,600,000
Effect of exchange rate changes		130,000			7,000			—
Net Increase in Cash and Cash Equivalents		14,054,000			319,000			3,450,000
Cash and Cash Equivalents, beginning of period		7,512,000			7,193,000			3,743,000
Cash and Cash Equivalents, end of period	$	21,566,000		$	7,512,000		$	7,193,000
Supplemental Disclosure of Cash Flow Information:
Cash Paid:
Income taxes	$	726,000		$	1,893,000		$	274,000
Interest	$	17,000		$	26,000		$	119,000
Noncash Investing and Financing Activities:
Exchange of warrants for common stock	$	1,532,000		$	988,000			—
Capital leases entered into for equipment	$	217,000		$	—		$	341,000
Acquisitions:
Fair value of assets acquired	$	7,890,000		$	—		$	—
Liabilities assumed	$	3,976,000		$	—		$	—
Minority interest	$	3,914,000		$	—		$	—

See accompanying notes to consolidated financial statements

F-6

RAE SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Summary of Significant Accounting Policies

(a) The Company

RAE Systems Inc. (“the Company”) develops and manufactures chemical and radiation detection monitors and networks for homeland security and industrial applications. RAE Systems’ products are based on proprietary technology, and include portable, wireless and fixed chemical detection monitors and gamma and neutron detectors.

(b) Principles of Consolidation

The Consolidated Financial Statements include the accounts of RAE Systems Inc. and its subsidiaries as described below. RAE Systems Inc. owns 100% of RAE Systems Europe ApS (“RAE Europe”) and RAE Systems (Asia) Limited (“RAE Asia”). RAE Europe is a Denmark corporation which distributes and provides services for RAE Systems’ products in Europe, Australia and New Zealand, and throughout the Middle East. RAE Europe owns (i) 100% of RAE United Kingdom Limited (“RAE UK”) and (ii) 49% of RAE France. Both RAE UK and RAE France are distribution companies. RAE Asia is a Hong Kong holding company. RAE Asia owns (i) 100% of RAE Systems Shanghai Incorporated (“RAE Shanghai”), formerly known as Wa-RAE Science Instruments, Ltd, (ii) 100% of RAE Systems Hong Kong Limited (“RAE Hong Kong”), (iii) 64% of RAE KLH (Beijing) Co. Ltd formerly known as Beijing Ke Li Heng Security Equipment Co., Ltd. (“KLH”), and (iv) 36% of REnex Technology Ltd (“REnex”). RAE Shanghai, which is incorporated in Jiading, Shanghai, designs and manufactures RAE’s products for final assembly and testing in the United States. RAE Hong Kong distributes and provides services for RAE Systems’ products in Asia and the Pacific Rim. KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment. REnex, a Hong Kong based research and development corporation, designs and develops a wireless platform for detection and monitoring.

All significant intercompany accounts and transactions have been eliminated.

(c) Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

(d) Revenue Recognition

The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. A provision for estimated product returns is established at the time of sale based upon historical return rates adjusted for current economic conditions. Historically, the Company has experienced an insignificant amount of sales returns. The Company recognizes revenue upon shipment to its distributors in accordance with standard contract terms that pass title to all goods upon delivery to a common carrier (FOB factory) and provides for sales returns under standard product warranty provisions Service revenues relating to maintenance services performed by the Company, which represent less than 5% of net revenues in each of 2004, 2003, and 2002, are recognized as earned based upon contract terms, which is generally ratably over the term of service. Net revenues include amounts billed to customers in sales transactions for shipping and handling, as prescribed by the Emerging Issues Task Force Issue (“EITF”) No. 00-10 Accounting for Shipping and Handling Fees and Costs. Shipping fees represent less than 1% of net revenues in each of 2004, 2003, and 2002. Shipping costs are included in the cost of goods sold. For the years ended December 31, 2004, 2003 and 2000 and for the interim periods for fiscal years 2004 and 2003, the Company restated its financial results. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for this amended Form 10-K/A. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), an error which had been previously identified but not considered to be sufficiently material to require correction. For additional details, see Note 2.

F-7

(e) Cash and Cash Equivalents

The Company considers all highly liquid investments having original maturities of 90 days or less to be cash equivalents.

(f) Accounts Receivable and Allowance for Doubtful Accounts

The Company grants credit to its customers after undertaking an investigation of credit risk for all significant amounts. An allowance for doubtful accounts is provided for estimated credit losses at a level deemed appropriate to adequately provide for known and inherent risks related to such amounts. The allowance is based on reviews of loss, adjustments history, current economic conditions and other factors that deserve recognition in estimating potential losses. While management uses the best information available in making its determination, the ultimate recovery of recorded accounts receivable is also dependent upon future economic and other conditions that may be beyond management’s control. If there were a deterioration of a major customer’s credit worthiness, or if actual defaults were higher than what has been experienced historically, the Company’s estimates of the recoverability of amounts due could be overstated. The Company’s operating results could be adversely affected.

(g) Inventories

Inventories are stated at the lower of cost (moving weighted average method) or market. Inventory purchases are typically based on estimated future demand. In the event of a sudden and significant decrease in demand for the Company’s products, or if there were a higher occurrence of inventory obsolescence due to changing technology and customer requirements, RAE Systems’ gross margins could be adversely affected.

(h) Property and Equipment

Property and equipment are stated at cost net of accumulated depreciation. Depreciation is provided using the straight–line method over the related estimated useful lives, as follows:

Buildings	20 years
Equipment	5 to 7 years
Furniture and fixtures	5 to 7 years
Computers equipment	5 years
Automobiles	5 years
Building improvements	Lesser of useful life or remaining lease term

(i) Warranty Repairs

The Company generally provides a one to three year limited warranty on the majority of its products and establishes a provision for the estimated costs of fulfilling these warranty obligations at the time the related revenue is recorded. Historically, warranty costs have been insignificant.

(j) Research and Development

Research and development costs incurred by the Company are expensed as incurred.

F-8

(k) Advertising Costs

The Company expenses the costs of advertising as incurred. During the years ended December 31, 2004, 2003, and 2002, advertising expense was $1,026,000, $1,062,000, and $322,000, respectively.

(l) Income Taxes

The Company reports income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which requires an asset and liability approach. This approach results in the recognition of deferred tax assets (future tax benefits) and liabilities for the expected future tax consequences of temporary differences between the book carrying amounts and the tax basis of assets and liabilities. The deferred tax assets and liabilities represent the future tax return consequences of those differences, which will either be deductible or taxable when the assets and liabilities are recovered or settled. A valuation allowance is provided against the deferred tax assets to the extent that management is unable to conclude that it is more likely than not that the deferred tax assets will be realized.

(m) Long–Lived Assets

The Company periodically reviews its long–lived assets for impairment. When events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable, the Company writes the asset down to its estimated fair value.

(n) Fair Values of Financial Instruments

The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:

• Cash and Cash Equivalents, Accounts Receivable, Accounts Payable and Accrued Liabilities:

The carrying amount reported in the balance sheet for these items approximates fair value because of the short maturity of these instruments.

• Investments:

The Company’s investments consist of debt securities, which management classifies and accounts for as held-to-maturity. The fair value of investments is determined using quoted market prices for those securities or similar financial instruments. At December 31, 2004, the fair value of the investments amounted to $11,160,000 (carrying value of $11,245,000).

• Lines of Credits:

The Company has two lines of credit available for future growth, which in the aggregate total $10 million. In April 2004, the Company secured a $3,000,000 line of credit based on the prime-lending rate. In May 2004, the Company secured an additional $7,000,000 line of credit at a fixed rate of 3.25%. RAE Systems is currently in compliance with the debt covenants, and as such, has these lines available to it in full.

As of December 31, 2004 and 2003, the fair values of the Company’s financial instruments approximate their historical carrying amounts.

(o) Translation of Foreign Currencies

Assets and liabilities of non-U.S. subsidiaries are translated to U.S. dollars at exchange rates in effect at the balance sheet date, with the resulting translation adjustments directly recorded to the accumulated other comprehensive income of shareholders’ equity. Income and expense accounts are translated at average exchange rates during each period. Translation gains and losses are recorded in other income (loss), net. The functional currency is the local currency for all non-U.S. subsidiaries.

F-9

(p) Stock-Based Incentive Programs

SFAS No. 123, Accounting for Stock–Based Compensation, encourages entities to recognize compensation costs for stock–based employee compensation plans using the fair value based method of accounting defined in SFAS No. 123, but allows for the continued use of the intrinsic value based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Prior to January 1, 2003, the Company used the accounting prescribed by APB Opinion No. 25, and provided footnote disclosure of pro forma net income and earnings per share as if the fair value based method of accounting had been applied.

In March 2000, the Financial Accounting Standards Board (FASB) issued Interpretation (Interpretation) No. 44, Accounting for Certain Transactions involving Stock Compensation, an Interpretation of APB Opinion No. 25, which became effective July 1, 2000. Interpretation No. 44 clarifies (a) the definition of employee for purposes of applying Opinion 25, (b) the criteria for determining whether a stock compensation plan qualifies as a noncompensatory plan, (c) the accounting consequences of various modifications to the terms of a previously fixed stock option or award, and (d) the accounting for an exchange of stock compensation awards in a business combination. Adoption of the provisions of the Interpretation had no significant impact on the Company’s consolidated financial statements.

In connection with becoming a public company through a reverse merger transaction, certain options granted under the Company’s 1993 Stock Option Plan became subject to variable accounting in accordance with Interpretation No. 44. As of December 31, 2002, there were 2,014,941 options outstanding under the 1993 Stock Option Plan that we became subject to variable accounting.

In December 2002, the FASB issued statements of SFAS No. 148, Accounting for Stock-Based Compensation, Transition and Disclosure, an amendment of FASB Statement No. 123. This statement provides alternative methods of transition for an entity that voluntary changes to the fair value based method of accounting for stock based compensation. It also amends the disclosure provisions of SFAS No. 123 to require prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. Further, SFAS No. 148 amends APB No. 28, Interim Financial Reporting to require disclosure about those effects in interim financial information. Effective January 1, 2003, the Company elected to adopt the fair value recognition provisions of SFAS No. 123 for stock-based employee compensation under the modified prospective method as provided for in SFAS No. 148. The effects of the adoption of SFAS No. 123 in accordance with SFAS No. 148 in the Company’s financial statements for the year ended December 31, 2003 consist of a reversal of $517,000 of deferred compensation with an offsetting adjustment to additional paid-in-capital in the consolidated statements of shareholders’ equity.

SFAS No. 123 requires the Company to provide pro forma information regarding net income and earnings per share as if compensation cost for the Company’s stock option plan had been determined in accordance with the fair value based method prescribed in SFAS No.123. The Company estimates the fair value of stock options at the grant date by using the Black–Scholes option valuation model with the following weighted average assumptions used for grants in 2004, 2003, and 2002: dividend yield of 0%; expected volatility of 124%, 91%, and 63%, respectively; risk–free interest rates of 3.20%, 3.20%, and 5.01%, respectively, and expected lives of five years for all plan options.

F-10

Under the accounting provisions of SFAS No. 123, the Company’s net income (loss) and the basic and diluted net income (loss) per common share would have been adjusted to the pro forma amounts below:

	December 31,
	2004 Restated			2003 Restated			2002 Restated
Net income (loss), as reported	$	2,335,000		$	2,738,000		$	(9,462,000	)
Add:
Stock-based employee compensation expense included in reported income, net of related tax effects		363,000			789,000			592,000
Deduct:
Total stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax effects		(363,000	)		(789,000	)		(806,000	)
Pro forma net income (loss)	$	2,335,000		$	2,738,000		$	(9,676,000	)
Basic earnings (loss) per share:
As reported	$	0.04		$	0.06		$	(0.24	)
Pro forma	$	0.04		$	0.06		$	(0.24	)
Diluted earnings (loss) per share:
As reported	$	0.04		$	0.06		$	(0.24	)
Pro forma	$	0.04		$	0.06		$	(0.24	)

(q) Earnings Per Share

The Company applies the provisions of SFAS No. 128, Earnings Per Share. SFAS No. 128 provides for the calculation of basic and diluted earnings per share. Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution of securities that could share in the earnings of an entity. Anti-dilution provisions of SFAS No. 128 require consistency between diluted per-common-share amounts and basic per-common share amounts in loss periods. The following table describes the outstanding options and warrants:

	2004	2003	2002
Total outstanding options and warrants	7,335,786	9,696,540	9,726,187
Out-of-the-money options and warrants	3,257,012	4,083,050	6,272,746
In-the-money options and warrants	4,078,774	5,613,490	3,453,441
Diluted, net of repurchase	2,771,948	3,277,950	543,660

In fiscal 2004, warrants and options to purchase shares of common stock at prices between $6.46 per share and $22.68 per share were not included in the computation of diluted earnings per share because the exercise prices were greater than the average market price of the common stock. Similarly, in fiscal 2003 and 2002, warrants and options to purchase shares of common stock at prices between $1.98 per share and $24.83 per share, and $0.98 per share and $70.17 per share, respectively, were not included in the computation of diluted earnings per share.

F-11

(r) Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment.” SFAS No. 123R revises SFAS No. 123, “Accounting for Stock-Based Compensation” and generally requires the cost associated with employee services received in exchange for an award of equity instruments be measured based on the grant-date fair value of the award and recognized in the financial statements over the period during which employees are required to provide services in exchange for the award. SFAS No. 123R also provides guidance on how to determine the grant-date fair value for awards of equity instruments as well as alternative methods of adopting its requirements. SFAS No. 123R was to be effective for the beginning of the first interim or annual reporting period after June 15, 2005 (the quarter ended September 30, 2005 for the Company) and applies to all outstanding and unvested share-based payment awards at a company’s adoption date. On April 14, 2005, the Securities and Exchange Commission amended the compliance dates for SFAS No. 123R. As a result, SFAS No. 123R will be effective beginning in our first quarter of 2006. The Company is currently assessing the impact of this statement on the Company’s consolidated financial statements.

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets” (“SFAS No. 153”). SFAS No. 153 amends the guidance in APB Opinion No. 29, “Accounting for Nonmonetary Transactions” to eliminate certain exceptions to the principle that exchanges of nonmonetary assets be measured based on the fair value of the assets exchanged. SFAS No. 153 eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. This statement is effective for nonmonetary asset exchanges in fiscal years beginning after June 15, 2005. The adoption of SFAS No. 153 is not expected to have an impact on the Company’s consolidated results of operations or financial position or cash flows.

In November 2004, the Financial Accounting Statements Board (FASB) issued SFAS Statement No. 151, “Inventory Costs,” an amendment of the Accounting Research Bulletin (ARB) No. 43, Chapter 4. Under FASB Statement No. 151, all abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges by requiring the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The adoption of this pronouncement is not expected to have a material impact on the Company’s financial statements, results of operations, or cash flows.

In October 2004, the FASB issued FASB Staff Position (FSP) No. 109-1, Application of FASB Statement No. 109, “Accounting for Income Taxes,” to the Tax Deduction on Qualified Production Activities Provided by the American Job Creation Act of 2004, which provides a tax deduction of up to nine percent (when fully phased in) of the lesser of (a) “qualified production activities income” or taxable income (after the deduction for the utilization of any net operating loss carryforwards). The adoption of this pronouncement is not expected to have a material impact on the Company’s financial statements, results of operations, or cash flows.

In October 2004, the FASB issued FSP No. 109-2 Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Job Creations Act of 2004 for a special one-time tax deduction of 85 percent of certain foreign earnings that are repatriated in either an enterprise’s last tax year that began before the enactment date, or the first tax year that begins during the one-year period beginning on the date of enactment. The adoption of this pronouncement is not expected to have a material impact on the Company’s financial statements, results of operations, or cash flows.

In December 2003, the FASB revised Interpretation No. (FIN) 46, Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, which requires an investor who absorbs the majority of the expected losses, receives a majority of its expected returns, or both, (primary beneficiary) of a variable interest entity (“VIE”) to consolidate the assets, liabilities, and results of operations of the entity. A VIE is an entity in which the equity investors do not have a controlling interest or the equity investment at risk is sufficient to finance the entity’s activities without receiving additional subordinated financial support from other parties. FIN 46R replaces FIN 46, which was issued in January 2003. Application by public entities for all other types of entities is required in financial statements for periods ending after March 15, 2004. The adoption of this pronouncement did not have a material impact on the Company’s financial statements, results of operations, or cash flows.

F-12

In December 2003, the Staff of the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (SAB) 104, Revenue Recognition, which supersedes SAB 101, Revenue Recognition in Financial Statements. SAB 104’s primary purpose is to rescind the accounting guidance contained in the SAB 101 related to multiple-element revenue arrangements that was superseded as a result of the issuance of Emerging Issues Task Force (EITF) 00-21, Accounting for Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). Additionally, SAB 104 rescinds the SEC’s related Revenue Recognition in Financial Statements Frequently Asked Questions and Answers issued with SAB 101 that had been codified in SEC Topic 13, Revenue Recognition. While the wording of SAB 104 has changed to reflect the issuance of EITF 00-21, the revenue recognition principles of SAB 101 remain largely unchanged by the issuance of SAB 104, which was effective upon issuance. The adoption of this pronouncement did not have a material impact on the Company’s financial statements, results of operations, or cash flows.

2. Restatement

In connection with the Company’s evaluation of the effectiveness of its internal control over financial reporting, as required by Section 404 of the Sarbanes-Oxley Act, and management’s assessment and testing thereof, the Company identified a number of material weaknesses, including inadequate codification of the Company’s revenue recognition policies and review procedures to ensure that revenues are recorded in the proper period. The Company identified a single distributor in Canada, accounting for less than 1% of our annual revenues, who (a) had not signed the Company’s standard distributor agreement sent to the distributor over the last three years and (b) from time to time, placed purchase orders with a “right of return” clause. In addition, the Company identified several U.S. local, state and federal agency purchase orders with freight delivery terms of “FOB destination,” requiring that the Company defer recognition of revenue until the shipments reach the customer, rather than the Company’s standard terms of “FOB factory.” Further, during the course of its review, the Company found a limited number of service contracts that were not properly deferred. After conferring with the Audit Committee of the Company and its independent registered public accounting firm on these matters, another independent certified public accounting firm was engaged to conduct an independent study (agreed-upon procedures report) of the impact of the Company’s revenue recognition practices. Based on the findings of the study by the independent certified public accounting firm, management concluded that the Company’s consolidated financial statements for the years ended December 31, 2004, 2003 and 2000 and for the interim quarters of 2004 and 2003 therein should be restated. In addition, although the reporting errors in 2002 and 2001 were not considered material, the Company decided to restate these years as well to ensure consistency in reporting for this amended Form 10-K/A. Furthermore, as part of the restatement process, the Company made corrections to recognize rent expense on a straight-line basis with a corresponding adjustment to deferred rent (a liability), an error which had been previously identified but not considered to be sufficiently material to require correction. The Audit Committee of the Board of Directors concurred with management’s decision.

The foregoing adjustments did not affect the Company’s reported cash, cash equivalents, short-term and long-term investments during the reporting periods.

The effect of these errors is detailed, by reporting period, below.

Annual Information:

(in dollars)

	Year ended December 31, 2004				Year ended December 31, 2003				Year ended December 31, 2002				Year ended December 31, 2001				Year ended December 31, 2000
	Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated		Previously Reported	Restated
Balance Sheet:
Inventories, net	7,675,000		7,815,000		3,659,000		3,759,000		3,176,000		3,295,000		3,716,000		3,817,000		3,229,000	3,329,000
Deferred income taxes	1,392,000		1,578,000		666,000		768,000		529,000		605,000		501,000		572,000		292,000	373,000
Total Assets	68,789,000		69,115,000		20,563,000		20,765,000		16,670,000		16,865,000		15,043,000		15,216,000		12,706,000	12,888,000
Accrued liabilities	5,643,000		5,582,000		2,159,000		2,159,000		1,690,000		1,689,000		1,235,000		1,235,000		1,522,000	1,522,000
Current portion of deferred revenue	722,000		1,122,000		67,000		324,000		150,000		432,000		249,000		523,000		234,000	521,000
Deferred revenue, net of current portion	119,000		240,000		102,000		113,000		—		14,000		150,000		155,000		383,000	399,000
Other long-term liabilities	—		145,000		—		87,000		—		13,000		—		—		—	—
Total Liabilities	12,033,000		12,638,000		5,603,000		5,958,000		5,810,000		6,118,000		9,163,000		9,442,000		7,355,000	7,658,000
(Accumulated deficit)/Retained earnings	(1,386,000	)	(1,665,000	)	(3,847,000	)	(4,000,000	)	(6,625,000	)	(6,738,000	)	2,830,000		2,724,000		2,693,000	2,571,000
Total Shareholders' Equity	52,468,000		52,189,000		14,960,000		14,807,000		10,860,000		10,747,000		3,438,000		3,332,000		2,955,000	2,833,000
Statement of Operations:
Net Sales	45,794,000		45,540,000		31,333,000		31,361,000		21,845,000		21,828,000		19,014,000		19,039,000		18,194,000	18,398,000
Gross Profit	27,250,000		27,036,000		19,247,000		19,256,000		13,071,000		13,071,000		11,972,000		11,999,000		11,615,000	11,771,000
Total Operating Expenses	23,525,000		23,522,000		15,422,000		15,497,000		22,041,000		22,053,000		12,069,000		12,070,000		10,333,000	10,333,000
Income (Loss) from Operations	3,725,000		3,514,000		3,825,000		3,759,000		(8,970,000	)	(8,982,000	)	(97,000	)	(71,000	)	1,282,000	1,438,000
Net Income (Loss)	2,461,000		2,335,000		2,778,000		2,738,000		(9,455,000	)	(9,462,000	)	137,000		153,000		829,000	923,000
Basic Earnings (Loss) Per Common Share	0.04		0.04		0.06		0.06		(0.24	)	(0.24	)	0.01		0.01		0.04	0.04
Diluted Earnings (Loss) Per Common Share	0.04		0.04		0.06		0.06		(0.24	)	(0.24	)	0.00		0.00		0.02	0.03

F-13

Quarterly Information (Unaudited):

(in dollars)

	Quarter ended December 31, 2004				Quarter ended September 30, 2004				Quarter ended June 30, 2004				Quarter ended March 31, 2004
	Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated
Balance Sheet:
Inventories, net	7,675,000		7,815,000		8,277,000		8,428,000		6,668,000		6,801,000		4,351,000		4,541,000
Deferred income taxes	1,392,000		1,578,000		666,000		895,000		666,000		880,000		666,000		887,000
Total Assets	68,789,000		69,115,000		65,683,000		66,062,000		62,824,000		63,171,000		52,106,000		52,517,000
Accrued liabilities	5,643,000		5,582,000		4,068,000		4,063,000		3,388,000		3,378,000		2,170,000		2,163,000
Current portion of deferred revenue	722,000		1,122,000		1,083,000		1,543,000		648,000		1,047,000		69,000		605,000
Deferred revenue, net of current portion	119,000		240,000		124,000		259,000		117,000		278,000		90,000		200,000
Other long term liabilities	—		145,000		—		132,000		—		117,000		—		102,000
Total Liabilities	12,033,000		12,638,000		11,435,000		12,158,000		9,881,000		10,548,000		4,722,000		5,464,000
Accumulated deficit	(1,386,000	)	(1,665,000	)	(1,701,000	)	(2,044,000	)	(2,752,000	)	(3,073,000	)	(3,662,000	)	(3,993,000
Total Shareholders’ Equity	52,468,000		52,189,000		50,199,000		49,856,000		48,803,000		48,482,000		47,384,000		47,053,000
Statement of Operations:
Net Sales	14,963,000		15,036,000		12,264,000		12,229,000		10,385,000		10,471,000		8,182,000		7,804,000
Gross Profit	8,025,000		8,088,000		7,530,000		7,512,000		6,492,000		6,521,000		5,203,000		4,915,000
Total Operating Expenses	7,600,000		7,556,000		5,885,000		5,905,000		5,341,000		5,353,000		4,699,000		4,708,000
Income from Operations	425,000		532,000		1,645,000		1,607,000		1,151,000		1,168,000		504,000		207,000
Net Income	315,000		379,000		1,051,000		1,029,000		910,000		920,000		185,000		7,000
Basic Earnings Per Common Share	0.01		0.01		0.02		0.02		0.02		0.02		0.00		0.00
Diluted Earnings Per Common Share	0.01		0.01		0.02		0.02		0.02		0.02		0.00		0.00
	Quarter ended December 31, 2003				Quarter ended September 30, 2003				Quarter ended June 30, 2003				Quarter ended March 31, 2003
	Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated		Previously Reported		Restated
Balance Sheet:
Inventories, net	3,659,000		3,759,000		3,884,000		4,248,000		4,204,000		4,401,000		3,527,000		3,678,000
Deferred income taxes	666,000		768,000		529,000		767,000		529,000		606,000		529,000		600,000
Total Assets	20,563,000		20,765,000		19,205,000		19,807,000		19,096,000		19,369,000		18,077,000		18,300,000
Accrued liabilities	2,159,000		2,159,000		2,045,000		2,031,000		1,700,000		1,696,000		1,677,000		1,676,000
Current portion of deferred revenue	67,000		324,000		51,000		946,000		51,000		373,000		109,000		392,000
Deferred revenue, net of current portion	102,000		113,000		85,000		93,000		27,000		46,000		31,000		47,000
Other long term liabilities	—		87,000		—		70,000		—		51,000		—		32,000
Total Liabilities	5,603,000		5,958,000		5,048,000		6,008,000		5,964,000		6,353,000		6,297,000		6,627,000
Accumulated deficit	(3,847,000	)	(4,000,000	)	(4,330,000	)	(4,688,000	)	(5,055,000	)	(5,170,000	)	(5,850,000	)	(5,956,000	)
Total Shareholders’ Equity	14,960,000		14,807,000		14,157,000		13,799,000		13,132,000		13,016,000		11,780,000		11,673,000
Statement of Operations:
Net Sales	8,565,000		9,202,000		7,969,000		7,406,000		7,459,000		7,416,000		7,340,000		7,337,000
Gross Profit	5,291,000		5,664,000		4,686,000		4,290,000		4,843,000		4,845,000		4,427,000		4,457,000
Total Operating Expenses	4,419,000		4,450,000		3,720,000		3,728,000		3,830,000		3,847,000		3,453,000		3,472,000
Income from Operations	872,000		1,214,000		966,000		562,000		1,013,000		998,000		974,000		985,000
Net Income	483,000		688,000		725,000		482,000		795,000		786,000		775,000		782,000
Basic Earnings Per Common Share	0.01		0.01		0.02		0.01		0.02		0.02		0.02		0.02
Diluted Earnings Per Common Share	0.01		0.01		0.01		0.01		0.02		0.02		0.02		0.02

3. Mergers and Acquisitions

On April 9, 2002, the merger between RAE Systems Inc., a California corporation, (“RAE-California”), and Nettaxi.com, a Delaware corporation, (“Nettaxi”) was consummated. Nettaxi, as the surviving entity to the merger and the Registrant, changed its name to RAE Systems Inc. The stockholders of RAE-California received approximately 80% of the common stock of RAE Systems Inc. at the effective time of the merger and the RAE-California management team continued in their existing roles at RAE Systems Inc. Accordingly, the merger transaction has been accounted for as a reverse merger whereby, for accounting purposes, RAE Systems is deemed to be the acquirer and Nettaxi is deemed to be the acquired entity. As Nettaxi had effectively ceased all revenue generating activities nine months prior to the merger and had planned to abandon (and did abandon) its business model with effect from the consummation of the merger, Nettaxi was deemed to be in substance a shell company. Accordingly, the merger has been treated as a recapitalization of RAE Systems with no goodwill. For this reason, pro forma information giving effect to the merger is not presented.

On May 27, 2004, the Company invested $9 million in cash for a 64% interest in Beijing Ke Li Heng Security Equipment Co., Ltd. (“KLH”). KLH is a Beijing-based manufacturer and distributor of security, environmental and personal safety monitors and equipment. The results of KLH’s operations have been included in the consolidated financial statements of the Company since May 27, 2004.

F-14

The KLH investment costs were allocated to the fair value of the assets acquired, including management’s estimate for developed technologies and liabilities assumed. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition:

Current assets	$	13,814,000
Intangible assets	$	2,347,000
Non-current assets	$	54,000
Property and equipment, net	$	981,000
Assets	$	17,196,000
Current liabilities	$	(2,867,000	)
Long-term liabilities	$	(1,109,000	)
Liabilities	$	(3,976,000	)
Minority interest	$	(3,914,000	)
Purchase price (including transactions costs of $306,000)	$	9,306,000

In connection with the acquisition, the Company is obligated to make payments to the former KLH owners aggregating to $2.1 million (including $435,000 paid during 2004) as follows: 2005 – $423,000; 2006 – $388,000; 2007 – $388,000; 2008 – $242,000 and 2009 – $242,000.

The pro forma information is not necessarily indicative of what would have occurred had the acquisition been made as of such periods, nor is it indicative of future results of operations. The pro forma amounts give effect to appropriate adjustments for the fair value of the assets acquired, amortization of intangibles, and income taxes.

	Years Ended December 31,
Pro Forma Information (Unaudited)	2004 Restated		2003 Restated
Revenue	$	48,452,000	$	39,993,000
Net income	$	2,349,000	$	2,808,000
Earnings per share-basic	$	0.04	$	0.06
Earnings per share-diluted	$	0.04	$	0.06

4. Investments

Management accounts for its investments in debt securities as held-to-maturity. These include United States Treasury Bills, United States Corporate Bonds and Notes, United States Government Agencies, and United States Treasury Notes ranging in maturity dates from March 2005 through September 2006.

	Short-Term Maturity Date	Par Value		Long-Term Maturity Date	Par Value
U.S. Treasury Bonds and Notes	3/2005–6/2005	$	2,145,000	5/2006	$	500,000
U.S. Government Agencies	3/2005–10/2005	$	3,900,000	4/2006–5/2006	$	1,300,000
FNMA/FHLMC		$	—	3/2006–9/2006	$	1,700,000
Corporate Bonds and Notes	10/2005	$	700,000	4/2006	$	1,000,000
		$	6,745,000		$	4,500,000

F-15

5. Inventories

Inventories consist of the following:

December 31,	2004 Restated		2003 Restated
Raw materials	$	4,001,000	$	2,654,000
Work-in-progress		544,000		621,000
Finished goods		3,270,000		484,000
	$	7,815,000	$	3,759,000

KLH contributed $319,000 in raw materials and $2.0 million in finished goods to year-end 2004 balances.

6. Property and Equipment

A summary of property and equipment follows:

December 31,	2004		2003
Equipment	$	2,734,000	$	1,959,000
Computer equipment		1,577,000		1,217,000
Building and building improvements		8,390,000		574,000
Furniture and fixtures		573,000		325,000
Automobiles		1,245,000		185,000
		14,519,000		4,260,000
Less: accumulated depreciation		3,232,000		2,512,000
	$	11,287,000	$	1,748,000

7. Intangible Assets

The Company has intangible assets as a result of investments in KLH in May 2004 and RAE UK Limited in October 2004 in the amount of $2,424,000. The intangible assets consist of technology, customer base and trade name and are being amortized over their estimated useful life of 5 years. As of December 31, 2004, the Company had net intangible assets in the amount of $2,150,000.

The future annual amortization expense for intangible assets, based upon their current useful lives, is estimated to be the following as of December 31, 2004:

2005	$	484,000
2006	$	484,000
2007	$	484,000
2008	$	484,000
2009	$	214,000
Total	$	2,150,000

F-16

8. Accrued Liabilities

Accrued liabilities as of December 31, 2004 and 2003 are summarized as follows:

December 31,	2004 Restated		2003
Compensation and related benefits	$	2,373,000	$	1,171,000
Accrued commissions		391,000		196,000
Legal and professional		705,000		182,000
Warranty reserve		490,000		358,000
KLH building		730,000		—
Other		893,000		252,000
	$	5,582,000	$	2,159,000

9. Income Taxes

Income (loss) before income taxes and minority interest comprises:

Years ending December 31	2004 Restated		2003 Restated			2002 Restated
Domestic	$	2,503,000	$	2,607,000		$	(9,523,000	)
Foreign		1,168,000		837,000			192,000
		3,671,000	$	3,444,000		$	(9,331,000	)
Income tax expense (benefit) comprises:
2004 Restated	Current		Deferred			Total
Federal	$	1,190,000	$	(839,000	)	$	351,000
State		1,000		58,000			59,000
Foreign		604,000		(31,000	)		573,000
	$	1,795,000	$	(812,000	)	$	983,000
2003 Restated	Current		Deferred			Total
Federal	$	923,000	$	(488,000	)	$	435,000
State		2,000		48,000			50,000
Foreign		221,000		—			221,000
	$	1,146,000	$	(440,000	)	$	706,000
2002	Current		Deferred			Total
Federal	$	240,000	$	(37,000	)	$	203,000
State		1,000		(162,000	)		(161,000	)
Foreign		89,000		—			89,000
	$	330,000	$	(199,000	)	$	131,000

F-17

The following summarizes the differences between the income tax expense and the amount computed by applying the Federal income tax rate in 2004, 2003, and 2002 to income before income taxes:

Years ending December 31,	2004 Restated			2003 Restated			2002 Restated
Federal income tax (benefit) at statutory rate	$	1,115,000		$	1,167,000		$	(3,174,000	)
Nondeductible expenses		248,000			360,000			3,194,000
Effects of foreign operations		296,000			(12,000	)		280,000
Release of prior year tax liability		—			(574,000	)		—
Change in valuation allowance		(583,000	)		(222,000	)		—
Federal tax credits		(132,000	)		(47,000	)		(100,000	)
State income taxes, net of federal benefit		39,000			294,000			3,000
State tax credits		—			(260,000	)		(72,000	)
	$	983,000		$	706,000		$	131,000

Deferred tax assets and liabilities as of December 31, 2004 and 2003 were comprised of the following:

December 31,	2004 Restated			2003 Restated
Deferred tax assets:
Allowance for doubtful accounts	$	76,000		$	72,000
Inventories		160,000			175,000
Accrued vacation		169,000			185,000
Other accruals		1,015,000			258,000
Capitalized research and development		1,126,000			1,772,000
Unrealized foreign losses		320,000			430,000
State income taxes and credits		35,000			156,000
		2,901,000			3,048,000
Valuation allowance		(1,253,000	)		(2,202,000	)
Total deferred tax assets	$	1,648,000		$	846,000
Deferred tax liabilities:
Fixed assets	$	(70,000	)	$	(78,000	)
Total deferred tax liabilities		(70,000	)		(78,000	)
Net deferred tax assets	$	1,578,000		$	768,000

F-18

In assessing the recoverability of its deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of the deferred tax assets is dependent on the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, historical and projected future taxable income, and tax planning strategies in making this assessment.

At December 31, 2004, a valuation allowance in the amount of $1,253,000 has been established against the deferred tax assets as management is unable to conclude at this time that it is more likely than not that the Company will realize the tax benefit of all of its deferred tax assets. During 2004, the valuation allowance was reduced by $949,000 to reflect the Company’s realization during 2004 of the tax benefit of certain capitalized expenditures and foreign losses, the expected future benefit in 2005 of certain capitalized expenditures, and the effects of true-up adjustments to certain deferred tax assets that did not impact the income tax provision. At December 31, 2004, based on the Company’s recent operating performance, management determined that it now has the ability to reasonably forecast short-term operating performance on a one-year look forward basis; accordingly, management has concluded that it is more-likely-than-not that the Company will realize the tax benefit attributable to the capitalized expenditures that become available to the Company in 2005. This determination represents a change in estimate during 2004, which had the effect of reducing the valuation allowance, reducing the income tax expense, and increasing net income in 2004 by approximately $200,000. Management will continue to evaluate the appropriateness of its valuation allowance in light of current and anticipated future taxable income.

F-19

U.S. income taxes were provided for deferred taxes on undistributed earnings of non-U.S. subsidiaries that are not expected to be permanently reinvested in such companies. There has been no provision for U.S. income taxes for the remaining undistributed earnings of approximately $3,586,000 as of December 31, 2004, because the Company intends to reinvest these earnings indefinitely in operations outside the United States.

In accordance with SFAS No. 5, the Company maintains reserves for estimated income tax exposures for various tax jurisdictions when the exposure item becomes probable and estimable. Exposures are settled primarily through the settlement of audits within each individual tax jurisdiction or the closing of a statute of limitation. Exposures can also be affected by changes in applicable tax law or other factors, which may cause management to believe a revision of past estimates is appropriate. Management believes that an appropriate liability has been established for income tax exposure; however, actual amounts may differ materially from these estimates. As of December 31, 2004, the Company has recorded tax contingency reserves of approximately $1.0 million, which are included within income taxes payable in the consolidated balance sheet.

As of December 31, 2004, the Company had research credit carryforwards of approximately $0 for the federal income tax purposes and $135,000 for California income tax purposes. The California credits are not subject to expiration under current California tax law.

10. Lease Commitments

The Company and its subsidiaries lease certain manufacturing, warehousing, and other facilities under operating leases expiring in various years through 2009. The leases generally provide for the lessee to pay taxes, maintenance, insurance, and certain other operating costs of the leased property. Total rent expense for the years ended December 31, 2004, 2003, and 2002 was $809,000, $666,000, and $657,000, respectively. As of December 31, 2004, the Company had no outstanding capital leases. The future minimum lease commitments required as of December 31, 2004 are as follows:

	Total		2005		2006		2007		2008		2009		Thereafter
Contractual Obligations:
Operating Lease Obligations	$	3,209,000	$	756,000	$	759,000	$	527,000	$	617,000	$	550,000	$	—

In December 2004, the Company purchased the property located at 3775 North First Street in San Jose, California for a purchase price of $5.0 million in cash. The Company financed this transaction with available cash. As of May 31, 2005, the majority of the Company’s U.S. operations have been relocated from the Company’s leased facility in Sunnyvale, California to the Company’s new facility in San Jose, California. During June 2005, the Company expects to complete the relocation of its operations to the new facility in San Jose, California and write off its lease obligation which is estimated at $2.3 million.

F-20

11. Employee Benefit Plans

The Company has a defined contribution 401(k) plan (the Plan) for its domestic employees. The Plan is available to all employees who have reached the age of twenty–one and who have completed three months of service with the Company. Under the Plan, eligible employees may contribute a portion of their salaries to the Plan. The Company’s contributions are determined based on matching 25% of the first 6% of the covered employee’s salary, subject to statutory maximum levels. Contributions to the Plan totaled $92,000, $74,000, and $60,000, for the years ended December 31, 2004, 2003, and 2002, respectively.

12. Concentrations

Financial instruments, which potentially subject the Company to concentration of credit risk, consist principally of cash and cash equivalents and trade receivables. The Company places its domestic and foreign cash and cash equivalents with large financial institutions. Domestic cash balances are insured by the Federal Deposit Insurance Company up to $100,000 per bank. As of December 31, 2004 and 2003, the Company had deposits at several domestic financial institutions in excess of insured limits of $11,566,000 and $3,856,000, respectively. The Company also had deposits at several foreign financial institutions, which are not insured, that aggregated $9,900,000 and $3,356,000 as of December 31, 2004 and 2003, respectively.

A significant portion of the Company’s revenues and accounts receivable are derived from sales made to distributors located primarily throughout North America, as well as Asia and Europe. The following table presents certain data by geographic area:

December 31,	2004 Restated		2003 Restated		2002 Restated
Net sales to customers:
United States	$	28,215,000	$	21,870,000	$	14,038,000
International:
China		9,141,000		2,447,000		1,637,000
Rest of Asia		1,949,000		1,623,000		1,761,000
Europe		4,549,000		3,526,000		2,156,000
Canada and Mexico		1,372,000		1,260,000		1,290,000
All other		314,000		635,000		946,000
		17,325,000		9,491,000		7,790,000
Total consolidated net sales to customers	$	45,540,000	$	31,361,000	$	21,828,000
Property and equipment, net:
United States	$	5,805,000	$	624,000	$	815,000
Europe		49,000		8,000		—
China		5,396,000		1,063,000		1,157,000
Rest of Asia		37,000		53,000		55,000
Total property and equipment, net	$	11,287,000	$	1,748,000	$	2,027,000

During fiscal 2004, 2003, and 2002, 20%, 8%, and 7% of our revenues were derived from our sales to China. No other country generated more than 10% of our revenue. No individual customer comprised more than 10% of consolidated net sales in 2004, 2003, and 2002. The Company believes any risk of loss is significantly reduced due to the diversity in customers, geographic sales areas and the Company’s credit policy of establishing payment terms and credit limits based on a risk analysis. The Company performs credit evaluations of its customers’ financial condition whenever necessary, and generally does not require cash collateral.

F-21

In 2004, approximately 51% of the property and equipment is located in the United States and 48% is located in China.

13. Shareholders’ Equity

Common Stock

On April 9, 2002, the merger between RAE-California and Nettaxi was consummated (See Note 3). Nettaxi, as the surviving entity to the merger and the Registrant, changed its name to RAE Systems Inc. Pursuant to the merger, each outstanding share of RAE-California common stock was exchanged for 1.54869 shares of RAE Systems Inc. common stock and each outstanding option and warrant to purchase shares of RAE-California common stock was exchanged for 1.54869 options and warrants to purchase shares of RAE Systems Inc. common stock. All share and per share data prior to the merger have been restated to reflect the stock split.

In connection with the merger, the Company received $6,967,000 in cash from Nettaxi in exchange for the issuance of 7,896,764 shares of the Company’s common stock. These proceeds were reduced by $762,000 to reflect cash expenses incurred that were directly attributable to the merger. As discussed more fully below, the Company also incurred a total of $8,735,000 in merger costs attributable to the fair value of certain equity instruments issued in connection with the merger. The $8,735,000 has been included in operating expenses in the accompanying Consolidated Statements of Operations for the year ended December 31, 2002.

The shares of the Company’s preferred stock outstanding at the time of the merger were automatically converted into common stock at the rate of four shares of common stock for each share of preferred stock.

In connection with the closing of the merger, the Company recorded a $2,121,000 non-cash compensation charge for 960,000 shares of common stock issued to a financial adviser for services rendered.

On January 28, 2004, the Company closed its public offering of 8,050,000 shares of its common stock at $4.25 per share, less the applicable underwriting discount. The net proceeds, which approximated $31.8 million, have been and will continue to be used for potential mergers and acquisitions, working capital, and for general corporate purposes.

Common Stock Purchase Rights

In December 2001, the Company issued 1,084,083 non-plan stock purchase rights, which vested and were exercisable immediately, to an officer, a director and a consultant at an exercise price of approximately $0.08 per share. Under the terms of the stock purchase agreement with these individuals, the shares were placed in escrow and were earned upon consummation of the merger with Nettaxi.com. On April 9, 2002, the effective date of the merger, the fair value of the Company’s stock was $2.21. Based on the fair value of the respective equity instruments as of April 9, 2002, the Company recorded a non-cash compensation charge of $2,308,000 relating to these stock purchase rights. All of the non-plan stock purchase rights were exercised in December 2001.

F-22

Warrants

A summary of the Company’s warrants as of December 31, 2004, 2003 and 2002, and changes during 2004 and 2003 are presented in the following tables:

Exercise price	Warrants outstanding as of December 31, 2003	Cancelled 2004		Exercised 2004		Warrants outstanding as of December 31, 2004	Expire date
$  0.54	24,000	—		(24,000	)	—	Apr-07
$  0.74	264,551	—		—		264,551	Apr-05
$  1.07	450,000	—		—		450,000	Jun-07
$  1.19	1,295,000	—		(1,285,000	)	10,000	Apr-05
$  1.98	61,729	—		—		61,729	Oct-05
$  8.51	388,008	—		—		388,008	Jun-05
$22.68	2,719,004	—		—		2,719,004	Jan-05
$24.83	47,565	(47,565	)	—		—	Aug-04
	5,249,857	(47,565	)	(1,309,000	)	3,893,292

Exercise price	Warrants outstanding as of December 31, 2002	Issued 2003	Cancelled 2003		Exercised 2003		Warrants outstanding as of December 31, 2003	Expire date
$  0.54	—	24,000	—		—		24,000	Apr-07
$  0.57	61,729	—	—		(61,729	)	—	Dec-03
$  0.68	97,002	—	—		(97,002	)	—	Jun-03
$  0.74	282,188	—	—		(17,637	)	264,551	Apr-05
$  1.07	—	450,000	—		—		450,000	Jun-07
$  1.13	352,734	—	—		(352,734	)	—	Apr-12
$  1.19	1,750,000	—	—		(455,000	)	1,295,000	Apr-05
$  1.98	61,729	—	—		—		61,729	Oct-05
$  8.51	388,008	—	—		—		388,008	Jun-05
$15.65	68,694	—	(68,694	)	—		—	Jan-03
$22.68	2,754,278	—	(35,274	)	—		2,719,004	Jan-05
$24.83	47,565	—	—		—		47,565	Aug-04
$70.17	8,819	—	(8,819	)	—		—	Jan-03
	5,872,746	474,000	(112,787	)	(984,102	)	5,249,857

In April 2002, in connection with the closing of the merger, the Company issued warrants to purchase 1,750,000 shares of common stock at $1.19 per share, exercisable over three years. The Company has the option to redeem these warrants, at a redemption price of $0.05 per share, if the Company’s common stock trades at a price equal to or greater than $6.00 per share

F-23

for 20 consecutive days. In 2003, 455,000 of these warrants were exchanged for 221,130 shares of common stock based on a cashless exercise. In 2004, 1,285,000 of these warrants were exchanged for 1,015,078 shares of common stock based on a cashless exercise. In April 2002, the Company also issued warrants to purchase 352,734 shares of common stock at $1.13 per share, exercisable over ten years. In 2003, all of these 352,734 warrants were exchanged for 251,468 shares of common stock based on a cashless exercise.

The Company recognized a total of $4,306,000 in non-cash compensation for the warrants issued above, based on the estimated fair value of the warrants at date of grant. The Company estimated the fair value of warrants at the grant date by using the Black-Scholes valuation model with the following weighted-average assumptions used for grants in 2002: dividend yield of 0%; expected volatility of 174%; risk-free interest rate of 5.62%; and the contractual lives of the warrant.

F-24

In 2003, the Company issued 63,214 shares of common stock in exchange for 79,366 warrants based on cashless exercises and issued 97,002 shares of common stock for cash proceeds of $66,000 due to the exercise of warrants.

In April 2003, the Company issued warrants to purchase 24,000 shares of the Company’s common stock at an exercise price of $0.54. The warrants vest ratably over a 12 month period and are exercisable over a four year period. In 2004, these warrants were exercised. The Company issued 24,000 shares of common stock for cash proceeds of $13,000.

In June 2003, the Company issued warrants to purchase 450,000 shares of the Company’s common stock at an exercise price of $1.07 per share to a third party for financial advisory services. The warrants vested immediately, are non-forfeitable and are exercisable over a four year period. These warrants remain outstanding.

Non-Plan Stock Options

In 2002, the Company granted certain of its Directors Non-Plan Options to purchase 400,000 shares of non-plan restricted stock at a weighted-average exercise price of $0.985. The options vest 25% after one year with the remainder vesting monthly over the following three years and are exercisable over ten years. In 2004, the Company issued 63,000 shares of non-plan restricted stock due the exercise of such options. As of December 31, 2004, the Company had 337,000 non-plan options outstanding with a weighted average exercise price of $1.02.

Stock Option Plan

In August 1993, the Company’s Board of Directors adopted the 1993 Stock Option Plan and in May 2002, the Board of Directors adopted the 2002 Stock Option Plan (collectively “the Plans”). The Plans authorize the grant of options to purchase shares of common stock to employees, directors, and consultants of the Company and its affiliates. The options are a combination of both incentive and non-statutory options.

Incentive options may be granted at not less than 100% of the fair market value per share, and non-statutory options may be granted at not less than 85% of the fair market value per share at the date of grant as determined by the Board of Directors or committee thereof, except for options granted to a person owning greater than 10% of the outstanding stock, for which the exercise price must not be less than 110% of the fair market value. Options granted under the Plans generally vest 25% after one year with the remainder vesting monthly over the following three years and are exercisable over ten years.

As of December 31, 2004, the Company has reserved 544,509 shares of common stock for issuance under the 1993 Stock Option Plan and 4,358,745 shares of common stock for issuance under the 2002 Stock Option Plan. As of December 31, 2004, the Company had 1,797,760 shares of common stock available for future grant under the 2002 Stock Option Plan.

F-25

A summary of the status of the Company’s stock option plan as of December 31, 2004, 2003, and 2002, and changes during the years then ended is presented in the following table:

	Options Outstanding
	December 31, 2004				December 31, 2003				December 31, 2002
	Shares		Weighted- Average Exercise Price		Shares		Weighted- Average Exercise Price		Shares		Weighted- Average Exercise Price
Beginning	4,046,683		$	1.18	3,453,441		$	0.45	2,693,974		$	0.07
Granted	1,004,000		$	5.40	1,705,244		$	2.19	1,669,500		$	0.99
Exercised	(1,338,471	)	$	0.46	(692,775	)	$	0.19	(586,337	)	$	0.08
Cancelled	(606,718	)	$	2.63	(419,227	)	$	0.88	(323,696	)	$	0.91
Ending	3,105,494		$	2.57	4,046,683		$	1.18	3,453,441		$	0.45
Exercisable at year-end:	1,285,604				1,521,968				1,148,699
Weighted-average fair value of options granted during the period:			$	4.59			$	1.68			$	0.56

The following table summarizes information about stock options outstanding as of December 31, 2004:

	Options Outstanding				Options Exercisable
Range of Exercise Prices	Number Outstanding	Weighted-Average Remaining Contractual Life (Years)	Weighted- Average Exercise Prices		Number Exercisable	Weighted- Average Exercise Prices
$ 0.01-0.50	552,253	6.00	$	0.07	493,911	$	0.07
$ 0.51-1.00	237,385	7.96	$	0.59	121,325	$	0.60
$ 1.01-1.50	879,158	7.53	$	1.08	542,553	$	1.07
$ 1.51-3.00	—	—	$	—	—	$	—
$ 3.01-3.50	439,198	8.84	$	3.29	127,815	$	3.28
$ 3.51-4.50	—	—	$	—	—	$	—
$ 4.51-5.00	517,500	9.25	$	4.93	—	$	—
$ 5.01-5.50	330,000	9.24	$	5.29	—	$	—
$ 5.51-6.00	—	—	$	—	—	$	—
$ 6.01-6.50	50,000	9.81	$	6.46	—	$	—
$ 6.51-7.50	—	—	$	—	—	$	—
$ 7.51-8.00	100,000	9.98	$	7.81	—	$	—
	3,105,494		$	2.57	1,285,604	$	0.86

The Company historically accounted for its stock-based awards using the intrinsic value method in accordance with APB No. 25. Prior to January 1, 2003, compensation cost was recognized for stock options in the accompanying financial

F-26

statements if, on the date of grant, the current market value of the underlying common stock exceeded the exercise price of the stock options at the date of grant. In connection with the merger with Nettaxi, which was completed in April 2002, certain options granted under the Company’s 1993 Stock Option Plan were subject to variable accounting. During the year ended December 31, 2002, the Company recognized non-cash compensation in the amount of $375,000 relating to options that were subject to variable accounting. Effective January 1, 2003, the Company adopted the fair value recognition provision of SFAS No. 123 for stock-based employee compensation. In connection with the adoption of SFAS No. 123, effective January 1, 2003, the unamortized deferred compensation balance of $517,000 was eliminated against additional paid-in-capital in accordance with SFAS No. 148.

F-27

14. Commitments and Contingencies

Royalty

Commencing January 1, 2001 and continuing through December 31, 2009, the Company is required to pay Dragerwerk, a German-based competitor, a royalty equal to 7.5% of net sales of certain licensed products manufactured or imported for sale by or for the Company in the United States. The royalty relates to U.S. Patent No. 5,654,498 issued August 5, 1997 and entitled “Device for the Selective Detection of a Component in a Gas Mixture.” During the years ended December 31, 2004, 2003, and 2002, the Company incurred royalty expense of $46,000, $60,000, and $51,000, respectively.

Litigation

From time to time, the Company is engaged in various legal proceedings incidental to its normal business activities. Although the results of litigation and claims cannot be predicted with certainty, the Company believes the final outcome of such matters will not have a material adverse effect on its financial position, results of operations or cash flows.

15. Guarantees

The Company has contractual obligations under its operating leases in the amount of $3.2 million. The Company has not recorded any liabilities for these future payments because they have not as yet been incurred.

The Company is permitted under Delaware law and in accordance with its Bylaws to indemnify its officers and directors for certain events or occurrences, subject to certain limits, while the officer is or was serving at the Company’s request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, the Company has a Director and Officer Insurance Policy that limits its exposure and enables it to recover a portion of any future amounts paid. As a result of our insurance policy coverage, the Company believes the fair value of these indemnification agreements is minimal.

In the Company’s sales agreements, the Company typically agrees to indemnify its customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date, the Company has not paid any amounts to settle claims or defend lawsuits.

F-28

16. Related Party Transactions

(a) Renex Technologies, Ltd.

In June 2004, the Company entered into an agreement with REnex Technologies Ltd. to develop six prototype RAELink modems for a price of $95,000 and to pay a royalty fee of 7.5% for all products sold for which REnex Technology’s intellectual property is used. To date, the Company has made a payment to REnex in the amount of $28,000 to develop the modems. During 2004, the Company did not make any royalty payments. The Company has a 36% interest in REnex Technologies Ltd. and accounts for it under the equity method with effect from January 1, 2002. The summarized financial data for REnex as of and for the year ended December 31, 2004 and 2003 is as follows:

	December 31,
	2004			2003
Cash and cash equivalents	$	1,378,000		$	1,523,000
Other current assets		175,000			211,000
Total current assets		1,553,000			1,734,000
Due from affiliates		—			594,000
Other noncurrent assets		385,000			456,000
	$	1,938,000		$	2,784,000
Due to affiliates	$	119,000		$	—
Other current liabilities		40,000			13,000
Total current liabilities		159,000		$	13,000
Total shareholders’ equity		1,779,000			2,771,000
	$	1,938,000		$	2,784,000
	Years Ended December 31,
	2004			2003
Revenues	$	216,000		$	59,000
Cost of Sales		82,000			27,000
Operating expenses		1,117,000			798,000
Operating net loss	$	(983,000	)	$	(766,000	)
Other, net	$	2,000		$	1,000
Net loss	$	(981,000	)	$	(765,000	)

(b) TangRAE

Certain of the Company’s sales made into the China market were made through TangRAE, a China distribution company that is owned by two individuals, one of whom is Kang Lin Liu, our sales representative and one of whom is a former employee of one of the Company’s wholly-owned subsidiaries. TangRAE was organized as a sales office solely to facilitate the sale of the Company’s products into the China market. Total sales made by the Company to TangRAE amounted to $392,000, $479,000, and $351,000 for 2004, 2003 and 2002, respectively. In 2004, consulting fees were paid by TangRAE to RAE Shanghai in the amount of $143,000. Effective December 2004, TangRAE was officially closed as an operating entity.

F-29

(c) Shanghai Simax Technology Co. Ltd (“Simax”)

In September 2004, the Company entered into an agreement with Shanghai Simax Technology Co. Ltd. (“Simax”) to finance the design of a benzene-specific gas detection module (GC-PID) in the amount of $100,000. To date, there have been no payments to Simax. RAE Systems has the right to use the technology in any of our future products. The Company is to pay a royalty fee of 5% of all GC-PID products sold. To date, there have been no royalty payments for this technology. Dr. Peter C. Hsi, the Company’s Chief Technology Officer is the acting general manager for Simax. Dr. Hsi has no equity ownership in Simax.

17. Quarterly Information (Unaudited)

The summarized quarterly financial data presented below reflect all adjustments, which, in the opinion of management, are of a normal and recurring nature necessary to present fairly the results of operations for the periods presented.

2004	First Quarter Restated		Second Quarter Restated		Third Quarter Restated		Fourth Quarter Restated		2004 Restated
Net revenues	$	7,804,000	$	10,471,000	$	12,229,000	$	15,036,000	$	45,540,000
Gross profit		4,915,000		6,521,000		7,512,000		8,088,000		27,036,000
Income from operations		207,000		1,168,000		1,607,000		532,000		3,514,000
Net income	$	7,000	$	920,000	$	1,029,000	$	379,000	$	2,335,000
Earnings per common share:
Basic:	$	0.00	$	0.02	$	0.02	$	0.01	$	0.04
Diluted:	$	0.00	$	0.02	$	0.02	$	0.01	$	0.04
2003	First Quarter Restated		Second Quarter Restated		Third Quarter Restated		Fourth Quarter Restated		2003 Restated
Net revenues	$	7,337,000	$	7,416,000	$	7,406,000	$	9,202,000	$	31,361,000
Gross profit		4,457,000		4,845,000		4,290,000		5,664,000		19,256,000
Income from operations		985,000		998,000		562,000		1,214,000		3,759,000
Net income	$	782,000	$	786,000	$	482,000	$	688,000	$	2,738,000
Earnings per common share:
Basic:	$	0.02	$	0.02	$	0.01	$	0.01	$	0.06
Diluted:	$	0.02	$	0.02	$	0.01	$	0.01	$	0.06

F-30

18. Supplemental Disclosures

The following is supplemental disclosure of valuation and qualifying accounts.

Description	Balance as of Beginning of Year		Additions Charged to Expenses		Deductions			Balance as of End of Year
2004:
Allowance for doubtful accounts	$	176,000	$	489,000	$	—		$	665,000
2003:
Allowance for doubtful accounts	$	176,000	$	38,000	$	(38,000	)	$	176,000
2002:
Allowance for doubtful accounts	$	200,000	$	50,000	$	(74,000	)	$	176,000
Description	Balance as of Beginning of Year		Additions Charged to Expenses		Deductions			Balance as of End of Year
2004:
Inventory reserve	$	275,000	$	428,000	$	—		$	703,000
2003:
Inventory reserve	$	365,000	$	253,000	$	(343,000	)	$	275,000
2002:
Inventory reserve	$	130,000	$	235,000	$	—		$	365,000
Description	Balance as of Beginning of Year		Additions Charged to Expenses		Deductions			Balance as of End of Year
2004:
Warranty reserve	$	358,000	$	332,000	$	(200,000	)	$	490,000
2003:
Warranty reserve	$	206,000	$	311,000	$	(159,000	)	$	358,000
2002:
Warranty reserve	$	111,000	$	95,000	$	—		$	206,000

19. Subsequent Events

On May 9, 2005, Polimaster, Ltd. filed a complaint against the Company in the U.S. District Court for the Northern District of California alleging that the Company had misappropriated and misused technological and proprietary information developed by Polimaster to manufacture the GammaRAE II hand-held radiation detection unit. Polimaster Ltd. is seeking a preliminary injunction against sales of RAE Systems’ radiation detection equipment, pending completion of arbitration. While management believes that Polimaster’s claims are entirely without merit and will defend the matter vigorously, any claims of this type, regardless of merit, could be time-consuming to defend, result in costly litigation, divert management’s attention and resources or require us to enter into royalty or license agreements. The terms of any such license agreements may not be available on reasonable terms, if at all, and the assertion or prosecution of any infringement claims could significantly harm our business.

F-31

EX-23.1

Exhibit 23.1

Consent of Independent Registered Public Accounting Firm

RAE Systems Inc.

San Jose, California

We hereby consent to the incorporation by reference in the Registration Statements on Form S-3 (Nos. 333-113437 and 333-109840) and Form S-8 (Nos. 333-105368, 333-88684, 333-85720, and 333-32678) of RAE Systems Inc. of our reports dated June 6, 2005, relating to the consolidated financial statements of RAE Systems Inc. and the effectiveness of RAE Systems Inc.’s internal control over financial reporting, which appear in this Annual Report on Form 10-K/A No. 2. In our report on the effectiveness of internal control over financial reporting, we disclaim an opinion on management’s assessment and on the effectiveness of RAE Systems Inc.’s internal control over financial reporting.

/s/ BDO SEIDMAN, LLP

BDO Seidman, LLP

San Jose, California

June 6, 2005

EX-31.1

EXHIBIT 31.1

CERTIFICATION

I, Robert I. Chen, certify that:

1. I have reviewed this Amendment No. 2 to the annual report on Form 10-K/A of RAE Systems Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

June 6, 2005

By:	/s/ Robert I. Chen
	Robert I. Chen
	President, Chief Executive Officer and Chairman of the Board

EX-31.2

EXHIBIT 31.2

CERTIFICATION

I, Donald W. Morgan, certify that:

1. I have reviewed this Amendment No. 2 to the annual report on Form 10-K/A of RAE Systems Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors:

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

June 6, 2005

By:	/s/ Donald W. Morgan
	Donald W. Morgan
	Vice President and Chief Financial Officer

EX-32.1

EXHIBIT 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with Amendment No. 2 to the Annual Report of RAE Systems Inc. (the “Company”) on Form 10-K/A for the period ended December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, in the capacities and on the date indicated below, hereby certifies pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

	By:	/s/ Robert I. Chen
June 6, 2005		Robert I. Chen
		President, Chief Executive Officer
		and Chairman of the Board

A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.

EX-32.2

EXHIBIT 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with Amendment No. 2 to the Annual Report of RAE Systems Inc. (the “Company”) on Form 10-K/A for the period ended December 31, 2004, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), the undersigned, in the capacities and on the date indicated below, hereby certifies pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)); and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

	By:	/s/ Donald W. Morgan
June 6, 2005		Donald W. Morgan
		Vice President and
		Chief Financial Officer

A signed original of this written statement required by Section 906, or other document authenticating, acknowledging, or otherwise adopting the signature that appears in typed form within the electronic version of this written statement required by Section 906, has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request.