10-K

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended	Commission File Number:
December 31, 2003	0-10211

INTER-TEL, INCORPORATED

Incorporated in the State of Arizona I.R.S. No. 86-0220994

1615 S. 52^nd Street
Tempe, Arizona 85281
(480) 449-8900

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

Common Stock
(25,626,871 shares outstanding as of March 5, 2004)

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

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (S 229.405 of this chapter) 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 - [X].

     Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [  ].

The aggregate market value of the voting stock held by non-affiliates of the registrant, based upon the last reported sales price of Inter-Tel’s Common Stock reported on the Nasdaq National Market System on June 30, 2003 was approximately $417.0 million. Shares of Common Stock held by each executive officer and director have been excluded in that such persons may be deemed to be affiliates.

Selected portions of Item 10, and Items 11, 12, 13 and 14 of Part III incorporate by reference information from the Registrant’s Proxy Statement relating to its 2004 Annual Meeting of Shareholders. The Proxy Statement relating to the Registrant’s 2004 Annual Meeting of Shareholders will be filed within 120 days of the Registrant’s fiscal year ended December 31, 2003.

TABLE OF CONTENTS

PART I
	ITEM 1. BUSINESS
	ITEM 2. PROPERTIES
	ITEM 3. LEGAL PROCEEDINGS
	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
PART II
	ITEM 5. MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
	ITEM 6. SELECTED FINANCIAL DATA
	ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
	ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
	ITEM 9A. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
PART III
	ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
	ITEM 11. EXECUTIVE COMPENSATION
	ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
	ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
	ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
PART IV
	ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
SIGNATURES
Exhibit Index
EX-10.63
EX-10.64
EX-13.0
EX-21
EX-23
EX-31.1
EX-31.2
EX-32.1
EX-32.2

INTER-TEL, INCORPORATED
2003 FORM 10-K ANNUAL REPORT

TABLE OF CONTENTS

		Page
	PART I
Item 1	Business		3
Item 2	Properties		23
Item 3	Legal Proceedings		23
Item 4	Submission of Matters to a Vote of Security Holders		23
	PART II
Item 5	Market for the Registrant’s Common Stock and Related Shareholder Matters		24
Item 6	Selected Financial Data		25
Item 7	Management’s Discussion and Analysis of Financial Condition and Results of Operations		26
Item 7A	Quantitative and Qualitative Disclosures About Market Risk		43
Item 8	Financial Statements and Supplementary Data		44
Item 9	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		44
Item 9A	Evaluation of Disclosure Controls and Procedures		44
	PART III
Item 10	Directors and Executive Officers of the Registrant		44
Item 11	Executive Compensation		46
Item 12	Security Ownership of Certain Beneficial Owners and Management		46
Item 13	Certain Relationships and Related Transactions		46
Item 14	Principal Accountant Fees and Services		46
	PART IV
Item 15	Exhibits, Financial Statement Schedule and Reports on Form 8-K		47
	Signatures		50

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     PART I

ITEM 1. BUSINESS

The Company

     This Annual Report to Shareholders on Form 10-K (“10-K”) contains forward-looking statements that involve risks and uncertainties. The statements contained in this 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including without limitation statements regarding the Company’s expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. The cautionary statements made in this 10-K should be read as being applicable to all related forward-looking statements wherever they appear in this document. The Company’s actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth under “Factors That May Affect Future Operating Results” below and elsewhere in this document. In evaluating the Company’s business, shareholders and prospective investors should consider carefully the following factors in addition to the other information set forth in this document.

     Inter-Tel, incorporated in 1969, is a single point of contact, full-service provider of converged voice and data business communications systems; related networking applications; and presence management, collaboration, and messaging applications. Our diverse suite of applications includes unified communications; voice processing and unified messaging software; audio, video and Web conferencing applications; workgroup and call center management solutions; Internet Protocol (IP) telephony software; Computer Telephony Integration (CTI) applications; and other communications services. Our communications platforms include Inter-Tel Axxess® and EncoreCX® business communication systems. We also provide managed services such as, local and long distance calling services; networking; maintenance; leasing; and support services for our products. Our customers include business enterprises, government agencies and non-profit organizations. Our common stock is quoted on the Nasdaq National Market under the symbol “INTL.”

     We have developed a distribution network of direct sales offices, dealers and value added resellers (VARs), which sell our products to organizations throughout the United States and internationally, primarily targeting small-to-medium enterprises, service organizations and governmental agencies. As of March 5, 2004, we had fifty (50) direct sales offices in the United States, one (1) in Japan, and a network of hundreds of dealers and VARs primarily in the United States, that purchase directly from us. Included in our sales office in Phoenix is the primary location for our national and government accounts division, as well as our local, long distance and network services divisions. Our wholesale distribution center is located in Tempe, Arizona, which is the primary location from which we distribute products to our network of direct sales offices, dealers and VARs. In addition, we maintain a wholesale distribution office in the United Kingdom that supplies Inter-Tel’s dealers and distributors throughout the UK and other parts of Europe, and we have dealers in Japan and Mexico. We also maintain a research and development and software sales office in the United Kingdom.

PRODUCTS AND SERVICES

     Inter-Tel is focused on the enterprise telecommunications market and has a track record of technological innovation and leadership. Inter-Tel serves business enterprise customers, such as manufacturers, healthcare providers, the automotive industry, financial institutions, government agencies, non-profit organizations and other service organizations with value-driven solutions. Our core products include converged business communications systems supporting scalable networked installations, IP telephony products and services, audio, video and Web conferencing solutions, computer telephony applications, unified messaging and voice processing software.

     Inter-Tel addresses current industry-standard terminology by categorizing its software and endpoints under the following four technology categories: Infrastructure, Presence, Collaboration and Messaging.

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     We also offer a complete line of managed services, including custom development, local and long distance calling services, network design and implementation services, maintenance services, leasing and support services. In addition, we resell peripheral data and telecommunications products.

Infrastructure

     Axxess® Converged Communications Platform

     Designed for business enterprises, the Axxess converged communications platform provides tightly integrated voice processing, IP telephony functionality and transparent networking throughout an organization. With an Inter-Tel converged system, our customers can network up to 63 systems together with full-feature transparency, allowing customers to choose between traditional T-1 lines, frame relay, managed bandwidth or the Internet to network sites. Our commercially available systems support up to 40,000 ports, which enables flexible growth options up to this level.

     The Axxess platform incorporates open interfaces, employs the standard programming languages C++ and JAVA, and is built on a computer telephony interface, which enables the seamless integration of Computer Telephony (CT) applications, development and customization. The modular platform can be tailored around the way an organization does business with the flexibility to modify the solution with growth or change.

     Our converged system combines Internet Protocol (IP), digital, analog and wireless into a single platform—giving our customers a choice of technologies based on their organizations’ needs. Whether our customers want to blend traditional and IP solutions or deploy full IP solutions, Inter-Tel offers a collection of applications and endpoints that enable them to benefit from IP telephony. The distributed architecture enables the connectivity of several phones in an office, of hundreds of phones in a building or on a campus, for remote and telecommuting associates, or even for geographically-dispersed offices. All advanced features of the Axxess system, such as Automated Call Distribution (ACD) hunt groups, call center applications, paging zones, centralized attendants and tightly integrated voice mail, remain in place even when an organization is networking over IP.

     By using IP-based endpoints and data networks, our customers can connect their local employees, remote staff and satellite offices as if they were all located in a single site. Our IP phones enable remote users to have access to advanced features, such as transferring calls, conferencing, accessing voice mail, record-a-call and more. Even call center agents working off-site do not sacrifice functionality. They can be members of ACD hunt groups or call routing patterns, and supervisors can monitor their calls as if they were in the same office. Additionally, our IP phones eliminate the need for a separate phone system in geographically dispersed locations.

     Inter-Tel’s IP Resource Card (IPRC) allows our customers to transparently network their locations over IP or Frame Relay networks. The IPRC is a multipurpose card for IP-based communications. Controlled through software, the IPRC can be used to network multiple locations without the need for a separate gateway, to connect IP endpoints or to connect remote IP gateways. In November 2003, Inter-Tel incorporated numerous enhancements to the IPRC. The IPRC now supports up to 32 IP devices, effectively doubling the capacity of each modular slot within the chassis.

     As businesses move toward the converged communications model, a common concern remains—how best to leverage existing hardware and software. Connectivity protocols—SIP (Session Initiation Protocol) in particular—provide the architecture of how infrastructure and applications connect. SIP’s primary role is that of a communications path—connecting diverse communication tools together so that they can “speak” to each other. SIP enables simple, flexible connectivity that allows infrastructures, applications and endpoints to interact in a standard manner.

     Standards-based convergence solutions enable businesses to maintain their current communications investments during transition to the converged model. The open nature of SIP presents interoperability opportunities that make transport and connectivity transparent. SIP provides immediate impact and enhancement to existing communications platforms, leveraging the benefits of today’s integrated applications.

     Inter-Tel’s convergence approach to communications enables us to deliver dynamic, blended, custom-tailored communications solutions that address unique enterprise needs.

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  Standards-based Architecture

     Inter-Tel’s CT Enablers, Open Architecture Interface (OAI), TAPI Service Provider, Intel/Dialogic CT-Connect interface and Computer Supported Telephony Application (CSTA) Service Provider, allow for smooth integrations with “off-the-shelf”, shrink-wrapped applications or custom developed software packages that help organizations increase customer satisfaction and employee productivity.

     Open Architecture Interfaces allow our converged systems to easily integrate with off-the-shelf or custom software applications. There are two types of Open Architecture Interfaces: Desktop OAI and System OAI. The flexibility of our open platform allows for seamless integration of CT applications, customization and development, which protect our customers’ investments as technology evolves and their needs change.

     Inter-Tel’s support for industry standards, such as CSTA, TAPI and Intel/Dialogic CT-Connect allow our Converged Communications Systems to integrate with Customer Relationship Management (CRM) database software applications in order to maximize telephony features such as screen pops, outbound dialing, etc.

     Inter-Tel is committed to developing standards-based IP telephony solutions. In the first quarter of 2003, Inter-Tel introduced support of Media Gateway Control Protocol (MGCP) and Session Initiation Protocol (SIP) in our Axxess communications platform. SIP and MGCP are industry-standard protocols for transmitting voice over IP networks. Through our support of these two standard protocols, Axxess can interoperate with other industry-standard devices such as SIP and MGCP gateways for converting IP voice calls to standard telephone lines, and for using standard SIP telephones as extension numbers on the system. Support of SIP also allows our Axxess system to interoperate with public SIP networks and services like MSN Passport and to use Microsoft® Messenger as an extension number on the system.

     Inter-Tel adopted several other standard protocols this year as well, including IEEE standards, such as 802.11b and 802.3af. Inter-Tel’s adoption of 802.11b enables our customers to access system features from devices, such as the Inter-Tel Model 8601 SIP SoftPhone for Pocket PC or Models 8664 and 8665 wireless endpoints, while they’re mobile within their enterprise’s 802.11b network. The IEEE standard 802.3af enables customers to implement power over Ethernet, eliminating the need for customers to supply power to their IP phones at their desktops.

     This year, Inter-Tel incorporated other enabling technologies as well, such as Wireless Application Protocol (WAP) and ActiveX, which format the Web experience for various end-user tools. Additionally, Inter-Tel continued to develop products that leverage LDAP, a protocol for accessing database information in a standard format, as well as adopted .NET, Microsoft’s development framework.

     Standards-based convergence solutions enable businesses to maintain their current communications investments during their transition to the converged model. Our future product strategy is focused on continuing to provide support for these and other industry-standard interfaces.

  Endpoints

     Tightly integrated with the Axxess converged platform, our suite of IP systems, software and digital endpoints deliver exceptional voice quality, powerful features and intuitive interfaces. Whether our customers have associates onsite, mobile, or working from remote locations, our endpoints help them to perform their functions with continuity.

     Inter-Tel added several new IP endpoints to its suite in December 2003. Our powerful, IP endpoints connect local employees, remote staff and satellite offices as if they were all in the same building. Inter-Tel’s IP endpoints are available in two modes: Axxess® IP mode or SIP mode. Axxess IP mode enables an IP endpoint access to the features and functionality of a traditional Inter-Tel endpoint. Implementing SIP mode allows an enterprise to access the Shared Extension feature, which allows multiple endpoints to use the same extension number on the Axxess converged system. Incoming calls to a shared extension are sent to SIP endpoints simultaneously; offering customers dynamic mobility when they’re away from their main desks. Additionally, SIP mode enables IP endpoints to interoperate with third-party SIP solutions. Inter-Tel’s diverse suite of IP endpoints include advanced functionality and one-touch access to frequently used features.

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     Inter-Tel also released wireless solutions, such as the Models 8664 and 8665, in early 2004, as well as Inter-Tel’s Model 8601 SIP SoftPhone for Pocket PC, in 2003. Users can receive and initiate calls and access features and messages from these handheld devices, while mobile within an 802.11b wireless network.

     Additionally, Inter-Tel’s Model 8690 multi-protocol, multimedia endpoint (released in March 2004) is designed to enable users to access systems features and integrated Unified Communicator software, as well as manage messages via a touch-screen. Model 8690 was designed to allow users to initiate, hold, transfer and conference calls with the soft phone interface. The Integrated Unified Communicator software was designed to enable users to control their presence and availability status, monitor the status of coworkers, speed-dial contacts, conference associates and clients, and view call history and messages.

     Inter-Tel offers several software-based endpoint solutions that increase the productivity and enhance the communications of mobile and remotely-based employees. Whether our customers are deploying IP or traditional telephony, our soft phones give users control of the features and functionality of the Axxess system on desktop PCs or laptops. Users can initiate, answer, transfer, conference and forward calls and more—all with the click of a mouse.

     To complement our Axxess converged system, Inter-Tel offers a variety of fully-featured digital endpoints to suit most organizations’ needs. Our digital phones deliver exceptional voice quality, advanced digital features and a range of programmable keys for high-speed, high-quality call processing. The user-friendly, liquid crystal displays (LCDs), with up to 6-by-16 characters, lead users through system features and capabilities—serving as built-in user guides. Menu-driven, one-touch “soft keys” allow users to reduce the time it takes to initiate and receive calls, retrieve messages, leave messages and access features.

Presence Tools

     Inter-Tel’s Presence tools enable our customers to control how, when and where they communicate. Since many enterprises have multiple locations or campuses, and require their employees to be connected while mobile, the ability to control and view information about individuals’ availability is important. Inter-Tel’s Presence tools, such as Unified Communicator® software, Connection Assistant™ and Enterprise™ Instant Messaging, facilitate communications among individuals and groups and can convey the individual’s availability, location and the tools currently available to him or her. These tools also allow employees to have communications controlled or enhanced on his or her behalf—streamlining the communication process. Businesses can use presence tools most appropriate to enterprise goals. Users can stay connected to geographically separated associates, customers, partners and vendors, creating a virtual enterprise.

Collaboration Tools

     Inter-Tel’s Collaboration tools enable real-time interaction among two or more people. A business and its resources face many challenges in the pursuit to share ideas, exchange pertinent information, make critical business decisions and respond to customer needs. Connectivity offers our customers’ enterprises better collaboration with their distributed work forces, partners, suppliers and customers. Inter-Tel provides many tools that enable businesses to collaborate cost-effectively and easily, such as Enterprise™ Conferencing, Enterprise™ Instant Messaging, Call Center Suite and Connection Assistant™.

Messaging Tools

     Messaging Tools facilitate the exchange of information between people and locations. Enterprises need to be able to respond uniquely to employees, suppliers, partners and customers, as well as offer 24/7 coverage to capture incoming requests from external sources. Inter-Tel’s Messaging tools, such as Enterprise™ Instant Messaging, Enterprise™ Conferencing, Unified Messaging and Voice Processing, can address the challenges faced by enterprises with distributed resources and customers across state, national and international boundaries. Complex information can be exchanged via video or through graphics instead of voice. Inter-Tel offers flexible choices to provide channels of communication no matter the time of day or geographic location.

Inter-Tel’s Complete Suite of Presence, Collaboration & Messaging Tools (Business Applications for the Enterprise)

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     As an integral part of our Managed Services offerings, Inter-Tel provides an extensive lineup of applications designed for business use, enhanced productivity and operational performance. Inter-Tel’s applications can facilitate audio conferencing and real-time document sharing; automate repetitive tasks, enable call handling tasks from a personal computer (PC), generate historical and real time call statistics, enable intelligent call routing, manage communications via Web browser or Wireless Application Protocol (WAP) device and more. Specific applications are highlighted in additional detail below.

     Enterprise™ Conferencing

     Released in October 2003, Enterprise Conferencing is a SIP-based audio conferencing and Web presentation solution. This collaboration tool features an intuitive, browser-based control interface, which allows users to create and manage conferences, meetings, training sessions and more. Call leaders can navigate the interface to perform various tasks using drop-down menus, type-in text fields and check boxes. Users can initiate and set-up a variety of conference calls such as ad hoc, reoccurring or one-time only. Once a conference is set up, call leaders can e-mail an invitation to conference participants, containing all of the necessary information for a hassle-free conference. When a conference is in progress, the leader has control over each call participant. Call control buttons allow the call leader to mute, hold and drop each participant or the collective group of participants.

     Enterprise Conferencing also allows users to instantly set-up presentations, web-based seminars or training sessions that require little coordination. Call leaders can present information to fellow co-workers, customers or vendors, allowing customers to reduce travel expenses.

     Enterprise™ Instant Messaging

     Also released in October 2003, this browser-based instant messaging (IM) tool for the business environment seamlessly integrates with Inter-Tel’s Enterprise Conferencing, creating a powerful solution. The intuitive user interface enables users to create a list of contacts or groups to communicate more efficiently. From the same interface, users can send e-mails or conduct business chat sessions, as well as send documents to quickly address changing business situations. This solution enables busy employees to better manage their work flows and respond to imperative business matters. When integrated with Enterprise Conferencing, users can quickly escalate IM sessions into conference calls and Web presentation sessions.

     Unified Communicator® v2.1 Software/SIP Server v1.1

     In July 2003, Inter-Tel released Unified Communicator v2.1 software, which provides our customers with control of their endpoints through multiple user interfaces including speech recognition, touch-tone, PC Web browser and WAP devices. Unified Communicator provides users with a powerful set of tools designed to enhance the control and flexibility of the desktop environment. Users can manage their presence by controlling how and where they can be reached—routing calls to their current location, or by forwarding calls to a specified number. They can access their personal address book and the System Directory, control availability and location, check availability of colleagues and initiate calls from a Web browser or WAP-enabled device. Our mobile customers can manage communications through speech recognition or with a touch-tone phone if a Web browser is unavailable. In 2003, Inter-Tel combined the Unified Communicator and the SIP Server to provide an integrated SIP and presence management platform.

     Applications Platform: IVR

     Inter-Tel’s Applications Platform is a scaleable, flexible platform that enables the customization of applications according to the specific needs of an organization. It includes a signaling and services engine, plus a graphical service creation environment. Inter-Tel’s Interactive Voice Response (IVR) integrates computer, telephony, Automatic Speech Recognition (ASR) and Text-To-Speech (TTS) capabilities, and allows for customization for different types of environment. Inter-Tel’s IVR platform includes a starter pack with two IVR applications for general business purposes, and can be expanded or customized. Our customers have the choice of having their custom applications developed by an authorized Inter-Tel reseller or engaging Inter-Tel’s Custom Solutions group.

Interactive Voice Response can be deployed as a front-end to Automatic Call Distribution (ACD) systems, which can ask questions that help routing and enable more intelligent and informed call processing. By using IVRs as front-ends, recordings can be used for repetitive messages, and transactions can even be performed without involving customer service personnel.

     Connection Assistant™

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     Released in April 2003, Connection Assistant enables work group members to receive screen pops of key client or customer information, applications, and Web applications, designed to enable individuals to provide personalized service and enhance productivity levels. Work group members can receive call notes from their group members, automatically displaying pertinent customer and account information. Connection Assistant also provides group members with the ability to view the programmed status of any colleague. Call control buttons allow users to quickly call colleagues, pickup inbound calls and perform blind or screened transfers. Additionally, Connection Assistant provides users with flexible control of their extensions to better manage communications. Using a rules-based system, users can assign actions to specific events occurring at their extensions. Associates can divert unidentified calls at a particular time or from a specific number to another extension or to voice mail.

     Call Center Suite

     Call Center Suite is a collection of modular CT software applications that help businesses optimize call center and workgroup performance. Whether an organization has a department workgroup environment with extensions or a call center with agents at a single or multiple locations, Call Center Suite offers a variety of solutions. Combined with a flexible infrastructure, the suite of applications encompasses Management Tools for reporting and activity monitoring, plus Agent and Workgroup Tools to aid in increasing productivity and delivering consistent customer service.

     Attendant Console

     Inter-Tel’s Attendant Console, provides attendants and employees with knowledge of station and hunt group status, such as Do-Not-Disturb messages, forwarding information and busy or available status. The unique user-friendly interface allows users to view the real-time status of employees, enabling them to process calls quickly via touch screen, mouse or keyboard.

     Voice Processing

     Integrated with the Axxess Converged Communications Platform, our Voice Processing software provides an automated attendant to guide callers to the person or information they need. This “electronic employee” answers incoming calls, transfers calls, records messages, screens calls and returns calls using caller identification software. The Voice Processing software provides Call Routing Announcements, voice mail, the ability to record a call and various call handling functions. Additionally, voice mail messages can be retrieved using the Voice Processing software from any location using a touch-tone phone. Inter-Tel offers Voice Processing in two varieties—embedded in the chassis and in an external server.

     Unified Messaging

     Designed to run in a Microsoft® Windows® environment, our Unified Messaging software combines e-mail, voice mail and fax into a single, mail management program. Depending on the level of integration our customers choose, messages are either converted to standard file formats, or seamlessly integrated so that users can view, access and process messages through a variety of devices, including Microsoft’s Exchange messaging application, Lotus Notes and cc:Mail and Novell’s GroupWise, as well as other Internet mail applications.

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Small Business Communications Systems

     EncoreCX

     In the fourth quarter of 2003, Inter-Tel launched EncoreCX, a converged voice and data telephone system designed for businesses with up to 40 employees, or large residences. The EncoreCX includes feature-rich telephones that have a large intuitive display. The flexible EncoreCX system allows our customers to integrate a mix of standard analog devices, such as cordless telephones and fax machines. In addition, EncoreCX can be programmed and maintained remotely, minimizing the costs associated with on-site technician visits. The EncoreCX is targeted for retail or small business, multi-branch businesses, or even home-based businesses.

Other Services and Products

     Inter-Tel offers a broad range of products and a complete and comprehensive Managed Services program that incorporates advanced technologies while providing customers a single source provider and designed to cost-effectively fulfill their business communications needs. The Inter-Tel Managed Services program offers business solutions for professional services, provisioning and facilities management, and custom development services.

     We couple this solution-oriented approach with a high level of customer service and support and a commitment to quality throughout our operations. Our business communications systems are integrated with our integrated computer-telephone applications and include voice mail, auto attendant, unified messaging, call center applications, Interactive Voice Response (IVR), wireless applications, Automatic Call Distribution (ACD), long distance and networking services, together with a variety of other communications applications.

     Because of the modular design of our systems and the high level of software content in our products, customers can readily increase the size and functionality of their systems as their needs change by adding new services, software and hardware applications, or by upgrading to new systems or advanced versions of their existing systems.

     We believe our customers prefer to purchase business communications systems and services from a single-source because of the convenience, consistency of service, ease of upgrade, availability of financing alternatives and confidence in the performance of integrated systems and services all incorporated into a total managed services solution package.

     Network, Local and Long Distance Services

     Through our subsidiary, Inter-Tel NetSolutions, we resell a variety of telecommunications services, including local communications services, domestic and international long distance services, calling card services, 800 services, dedicated data services, Internet, frame-relay and voice and video conferencing, disaster recovery solutions, and network monitoring and management. We resell these services through our agreements with major U.S. long distance carriers. These services are then billed to the end-user customer by Inter-Tel NetSolutions.

     Through our subsidiary, Inter-Tel Network Services Agency (INSA), we sell services as an Agent of various Regional Bell Operating Companies (RBOCs) and Competitive Local Exchange Carriers (CLECs). These services include primarily local communications services, data services and Internet access. These services are billed to the end user by the Local Exchange Carrier (LEC) or CLEC, providing they and INSA receive compensation from the provider for marketing these services.

     We support telecommunications applications such as T-1 access for incoming toll-free traffic at call centers, switched long distance and frame relay networks linking together multiple offices of an enterprise. Customers who desire the convenience of acquiring long distance and other related calling services through the same vendor they use to purchase separate telephony equipment and services can do so with Inter-Tel.

     Networking Technologies Integration

     Inter-Tel DataNet designs, installs and supports an integrated, comprehensive solution for our customers’ complex data and telecommunications networks, from local area networks, or LANs, to geographically dispersed wide area networks, or WANs.

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     By forming relationships with major manufacturers of hardware and software technologies, Inter-Tel provides the routers, ATM, LAN and WAN switches, wire-less WAN connections, file servers, intelligent hubs and other devices required for the customer’s intranet or for access to the Internet. We offer pre-sale design support, project coordination for implementation, and installation support on our full line of server-based telephony products and IP telephony products and services.

     Custom Professional Services and Solutions

     Inter-Tel Custom Solutions (ICS) is an Inter-Tel division that delivers professional services to our customers a variety of custom IVR and CT solutions built with our industry-leading software and hardware products. ICS can also customize CT applications and extend the capabilities of existing Inter-Tel converged platforms and Call Center Suite installations, as well as assist in the integration of third-party hardware and software that may be required to deliver complete call center telephony solutions.

     ICS is also a resource for pre-sales help, specifying and selling the Inter-Tel Applications Platform, or IVR product line, the foundation on which both ICS and our channel partners can deploy flexible and customized speech-enabled IVR solutions for market sectors and business applications. Additionally, the ICS team provides support and coordination of on-site installations and/or remote installation support, as well as comprehensive sales engineering and sales support services for all of the above, including customer calls, visits and videoconferences, product demonstrations, request for proposal and requirements analysis, functional specification development, quotations and full sales cycle support.

     Leasing Services

     Inter-Tel offers its Total Solutions (formerly TotaLease) program through our subsidiary, Inter-Tel Leasing, Inc. The Total Solutions program enables end users to acquire a full range of business communications systems and applications designed and manufactured by Inter-Tel, as well as maintenance and support services. This program provides a total system financing package to the customer at a set monthly cost, with system expansion available for an additional fee. The typical Total Solutions contract has a term of 60 months, and allows the customer to renew the contract at a specified price for up to an additional 36 months.

     Inter-Tel also offers a line of low-cost lease purchase financing. Lease terms range from 24 to 84 months with $1.00, fixed and fair market value purchase options. Inter-Tel can also customize financing packages to suit customers with special financial needs. By offering this type of financing to acquire our products and services, our customers are able to lease directly from Inter-Tel or an authorized third-party leasing company supporting an Inter-Tel dealer, thereby allowing us, or one of our dealers to maintain a direct relationship with our customers. This direct relationship allows Inter-Tel to provide maintenance and support services and information regarding other Inter-Tel products and services.

     Peripheral Products

     Through our CommSource division, Inter-Tel distributes peripheral telecommunications products, applications and services developed by third parties to our direct sales offices, dealers and VARs. We offer a selection of products including the following: analog and cordless telephones; audio-conferencing, bridges and accessories; call accounting; call logging/recording; CT Products; data equipment; headsets; installation equipment; message-on-hold; paging equipment; power protection and backup; premise wireless and videoconferencing systems and other accessories. Our CommSource division sells and distributes products we have endorsed as leading communications peripherals widely deployed within organizations. Many of these products and services interface with our telephone systems.

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SALES AND DISTRIBUTION

     We have developed a distribution network of direct sales offices, dealers and value added resellers (VARs), which sell our products to organizations throughout the United States and internationally, primarily targeting small-to-medium enterprises, service organizations and governmental agencies. As of March 5, 2004, we had 50 direct sales offices in the United States, one in Japan, and a network of hundreds of dealers and VARs primarily in the United States, that purchase directly from us. We also have a sales office in Phoenix that is the primary location for our national and government accounts division, as well as our local, long distance and network services divisions. Our wholesale distribution center is located in Tempe, Arizona, which is the primary location from which we distribute products to our network of direct sales offices, dealers and VARs. In addition, we maintain a wholesale distribution office in the United Kingdom that supplies Inter-Tel’s dealers and distributors throughout the UK and other parts of Europe, and we have dealers in Japan and Mexico. We also maintain a research and development and software sales office in the United Kingdom.

Distribution Channels

     Our success depends in part upon the strength of our distribution channels and our ability to maintain close access to our end user customers through our distribution channels. In recent periods, we have sought to improve our access to end users through strategic acquisitions of resellers of telephony products and services, some of which are located in markets in which we have existing direct sales offices. As of December 31, 2003, Inter-Tel’s direct sales office personnel and national and government accounts personnel consisted of 1056 and 55 persons, respectively.

     Direct dealers and VARs enter into reseller agreements with us for a term of one or more years. These agreements often include requirements that the reseller meet, or use their best efforts to meet, minimum annual purchase quotas. We generally provide support and other services to our resellers under the terms of the agreements. We face intense competition from other telephone system and voice processing system manufacturers, as many of our dealers carry other products that compete with our products.

     We offer additional incentives, programs and support resources to dealers that agree to sell Inter-Tel systems and solutions on an exclusive basis. We launched an exclusive business partner program during 2001. This program was designed to reward dealers who sell only Inter-Tel products to all new prospects and aggressively seek to upgrade their non-Inter-Tel customer base. For this commitment from the dealers, we have offered our expertise to help them manage their business. This includes operational business reviews, shared human resource forms and policies, additional sales, marketing and training support, enhanced co-op benefits as well as special sales promotions and awards. In addition, we allow exclusive dealers to use our branch sales offices and demonstration rooms to help them in the sales process. We believe this program offers us an opportunity to expand our wholesale channel of distribution.

National, Government and Education Accounts

     Inter-Tel’s National, Government, and Education Accounts Division (NGEA) services large commercial companies; the Federal Government and its agencies; state, municipal and local governments; and educational institutions throughout the United States. NGEA offers the full line of Inter-Tel converged communications solutions to its customers, as well as consulting, financial planning and assistance.

     NGEA support programs, including the Special Handling ® Program and Managed Services Rental Program, are comprehensive and flexible, providing companies, government agencies, and educational organizations technical solutions, with a level of support provided to allow them to concentrate on building future infrastructure needs, with support for previously installed products.

Lease Financing Services

     Inter-Tel offers lease financing options, including its Total Solutions (formerly TotaLease) program through our subsidiary, Inter-Tel Leasing, Inc. and a line of low-cost lease purchase financing from Inter-Tel or an authorized third-party leasing company supporting Inter-Tel dealers. These programs enable end users to acquire a full range of telephony systems and applications designed and manufactured by Inter-Tel, as well as maintenance and support services. Please refer to “Leasing Services” in “PRODUCTS AND SERVICES” above for additional information regarding these programs.

International Sales

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     We currently have dealers in the UK, parts of Europe, Japan and Mexico, and we are currently working to expand our international dealer network. International sales, which include business communications systems and IP telephony and peripheral products, accounted for approximately 3.0% and 2.7% of our net sales in 2003 and 2002, respectively. In order to sell our products to customers in other countries, Inter-Tel must comply with local telecommunications standards. Our Axxess system and IP telephony products can be modified using our software to facilitate compliance with these local regulations. In addition, the Axxess platform has been designed to support multi-lingual functionality, and both currently support American English, British English, Japanese and Spanish languages.

Customer Service and Support

     Customer service and support are critical components of customer satisfaction and the success of our business. We operate a technical support group that provides a range of support services to our distributors, dealers and end user customers through the Internet and through a toll-free telephone number. Inter-Tel provides on-site customer support through our direct sales offices and dealers and, using remote diagnostic procedures, we have the ability to detect and correct system problems from our technical support facilities. In 2000, Inter-Tel began an initiative to greatly enhance our Internet, intranet and extranet capabilities. Through this initiative, we re-designed our Web site to offer to our direct sales offices and dealer channel support for sales and technical support activities. Our Web site also offers a wide array of sales and technical information, including an on-line product and service catalog, efficient order processing, portable-document-format sales brochures, competitive information, on-line technical manuals and frequently-asked-questions on important topics. In 2003, Inter-Tel enhanced the ability to initiate and track the status of tech support tickets from our web site and continued to develop and enhance our sales proposal platform. We intend to further develop our Web site to add additional information and services.

     We analyze feedback from our customer service call records to provide direction for product and service enhancements. Our direct sales offices and resellers can receive service activity reports summarizing the reasons that technicians are asking for assistance and common issues that give rise to technical inquiries. This allows our direct sales offices and resellers to track trends in their service operations and to thereby provide better customer service.

     We believe we can best serve our customers by continually improving the quality of our systems, customer service and support, and other aspects of our organization. Through our continuous improvement process initiated in 1991, Inter-Tel implements quality processes throughout its business operations. We have established formal procedures to provide responsiveness to customer requests, monitor response times and measure customer satisfaction. We have also established means by which all end users, including customers of our resellers, can request product enhancements directly from us. Inter-Tel supports its dealers and VARs through extensive training programs offered at Inter-Tel’s facilities and through virtual remote training courses tied into Inter-Tel University. Inter-Tel also provides a toll-free telephone number for sales and technical support, an extranet site offering up-to-date sales and support information, and end-user marketing materials. We typically provide a one-year warranty on our systems to end users. We offer eighteen-month warranties on our systems to our dealers, which in turn are responsible for providing a warranty to their end users.

RESEARCH AND DEVELOPMENT

     We believe that our ability to enhance our current products, develop and introduce new products on a timely basis, maintain technological competitiveness and meet customer requirements is essential to our success. Inter-Tel’s research and development efforts over the last several years have been focused primarily on the development of, and enhancements to, our Axxess system, including adding new applications, enhancing our IP convergence applications and IP endpoints, developing Unified Communications applications, developing presence management applications, and developing speech-recognition and text-to-speech applications. More recently, Inter-Tel’s research and development efforts have been focused on the development of Session Initiation Protocol (SIP) interfaces and application as well as the development and a new line of multi-protocol SIP IP endpoints.

     As of December 31, 2003, we had a total of 230 personnel engaged in research and development and related technical service and support functions. Research and development expenses were $21,978,000; $19,340,000; and $17,556,000, 2003, 2002, and 2001, respectively.

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MANUFACTURING

     Inter-Tel manufactures substantially all of its systems through third party subcontractors located in the United States, Mexico, the People’s Republic of China and the United Kingdom. These subcontractors use both standard and proprietary integrated circuits and other electronic devices and components to produce our communications systems, physical endpoints and printed circuit boards to our engineering specifications and designs. In some cases, our suppliers perform systems integration, software loads, perform functional tests and make final shipment. Varian, Inc., a multinational electronics company, currently manufactures a significant portion of our products, including substantially all of the printed circuit boards used in the Axxess platform, at Varian’s Tempe, Arizona facility. We provide our manufacturing contractors with forecasted schedules of our manufacturing needs and revise the forecasts on a periodic basis. We continuously monitor the quality of the products produced on our behalf by our manufacturing subcontractors.

COMPETITION

     The market for our products is highly competitive and has in recent periods been characterized by rapid technological change, business consolidations and decreasing prices. Competitors for our converged communication products geared toward the enterprise market include Avaya, Nortel Networks, 3Com, Altigen, Cisco Systems, Comdial, Iwatsu America, Inc., Mitel Networks, NEC Corporation, Panasonic, Shoreline, Siemens, Toshiba and Vodavi, among numerous other resellers of these and similar products. Several of these competitors have been active in developing and marketing IP networking products and have established relationships with customers within their markets. During the later half of 2003, Microsoft released the Microsoft Live Communications Server, which is proprietary software that facilitates voice communication and collaboration over IP networks. This platform could be further enhanced in the future to compete with our IP convergence products. We also compete against the RBOCs, which typically offer systems produced by one or more of our competitors listed above and also typically offer Centrex systems in which automatic calling facilities are provided through equipment located in the telephone company’s central office. We also compete with RBOC’s and next-generation service providers, such as DSL providers and cable companies, that offer IP Centrex services as well as bundled telephony and data services in an application service provider telephony model.

     In the market for voice processing applications, including voice mail, we compete against Captaris, Active Voice (subsidiary of NEC America), InterVoice-Brite, Avaya, Nortel Networks, Comdial and other competitors. In the market for long distance services, we compete against AT&T, Sprint, Qwest and others. We also expect to compete with RBOCs, cable television companies, satellite and other wireless broadband service providers for long distance business. Key competitive factors in the sale of converged communications systems and related applications include price, performance, features, reliability, service and support, brand recognition and distribution capability. We believe that we compete favorably in our markets with respect to the price, performance and features of our systems, as well as the level of service and support that we provide to our customers. However, certain of our competitors have significantly greater resources, brand recognition and distribution capabilities than we do.

     As we compete for local telephone service, long distance service and IP network access, we face additional competition from established foreign and domestic long distance carriers, RBOCs and other providers. Many of these competitors have larger marketing and sales organizations, significantly greater financial and technical resources and a larger and more established customer base than we do. In addition, RBOCs and other providers have greater name recognition, more established positions in the market and long standing relationships with customers.

INTELLECTUAL PROPERTY RIGHTS

     We currently hold patents for 23 telecommunications and unified messaging products. The remaining life of these patents ranges from six months to 14 years in duration. We have also applied to the U.S. Patent and Trademark Office for 13 additional patents. We also rely on copyright, trademark, trade secret law and contractual provisions to protect our intellectual property.

EMPLOYEES

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     As of December 31, 2003, we had a total of 1,817 employees, of whom 678 were engaged in sales, marketing, e-business and customer support; 244 in direct sales office and wholesale administrative and other management personnel; 553 in manufacturing, quality and related operations, including direct sales office operations personnel; 230 in research and development and related technical service and support functions; and 112 in finance, information systems, administration and executive management. We believe our relations with our employees are good.

ACCESS TO INFORMATION

     Our Internet address is www.inter-tel.com. We make available at this address, free of charge, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. We will also provide paper copies of this annual report on Form 10-K, available upon written request to Shareholder Relations, 1615 S. 52nd Street, Tempe, Arizona 85281.

Factors That May Affect Future Operating Results

     This Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. Actual results could differ materially from those projected in the forward-looking statements as a result of many risk factors including, without limitation, those set forth under “Factors That May Affect Future Results Of Operations” below. In evaluating Inter-Tel’s business, shareholders and prospective investors should consider carefully the following factors in addition to the other information set forth in this document.

Risks Related to Our Business

Our operating results have historically depended on a number of factors, and these factors may cause our operating results to fluctuate in the future.

     Our quarterly operating results have historically depended on, and may fluctuate in the future as a result of, many factors including:

• volume and timing of orders received during the quarter;

• gross margin fluctuations associated with the mix of products sold;

• the mix of distribution channels;

• general economic conditions and the condition of the markets our business addresses;

• patterns of capital spending by customers;

• the timing of new product announcements and releases by us and our competitors;

• pricing pressures;

• the cost and effect of acquisitions;

• the availability and cost of products and components from our suppliers; and

• national and regional weather patterns.

     In addition, we have historically operated with a relatively small backlog, with sales and operating results in any quarter depending principally on orders booked and shipped in that quarter. In the past, we have recorded a substantial portion of our net sales for a given quarter in the third month of that quarter, with a concentration of such net sales in the last two weeks of the quarter. Market demand for investment in capital equipment such as business communications systems and associated call processing and voice processing software applications depends largely on general economic conditions, and can vary significantly as a result of changing conditions in the economy as a whole. We cannot assure you that we can continue to be successful operating with a small backlog or whether historical backlog trends will continue in the future.

     Our expense levels are based in part on expectations of future sales and, if sales levels do not meet expectations, our operating results could be harmed. In addition, because sales of business communications systems through our dealers typically produce lower gross margins than sales through our direct sales organization, operating results have varied, and will continue to vary based upon the mix of sales through direct and indirect channels. In addition, in the past we have derived a significant part of our revenue from recurring revenue streams, which typically produce higher gross margins. If we do not maintain recurring

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revenue streams at current or historic levels, our operating results will suffer if we do not significantly increase sales to new customers. For example, in the most recent quarter ended December 31, 2003, sales to new customers through our direct sales offices, dealer network, network services and leasing divisions declined as a percentage of total sales, resulting in decreased net sales and operating income compared to the quarter ended December 31, 2002. Moreover, particularly in an environment of fluctuating interest rates, the timing and profitability of lease resales from quarter to quarter could impact operating results. Long distance and Datanet sales, which typically have lower gross margins than our core business, have grown in recent periods at a faster rate than our overall net sales. Consolidated gross margins could be harmed if long distance calling services continue to increase as a percentage of net sales. We also experience seasonal fluctuations in our operating results, as net sales for the first quarter is frequently less than the fourth quarter and the third quarter is frequently less than the second quarter. As a result of these and other factors, we have historically experienced, and could continue to experience in the future, fluctuations in net sales and operating results on a quarterly basis.

Our market is subject to rapid technological change and to compete successfully, we must continually introduce new and enhanced products and services that achieve broad market acceptance.

     The market for our products and services is characterized by rapid technological change, evolving industry standards and vigorous customer demand for new products, applications and services. To compete successfully, we must continually enhance our existing telecommunications products, related software and customer services, and develop new technologies and applications in a timely and cost-effective manner. If we fail to introduce new products and services that achieve broad market acceptance, or if we do not adapt our existing products and services to customer demands or evolving industry standards, our business could be significantly harmed. Problems and delays associated with new product development have in the past contributed to lost sales. In addition, current competitors or new market entrants may offer products, applications or services that are better adapted to changing technology or customer demands and that could render our products and services unmarketable or obsolete.

     In addition, if the markets for computer-telephony applications, Internet Protocol network products, or related products fail to develop or continue to develop more slowly than we anticipate, or if we are unable for any reason to capitalize on any of these emerging market opportunities, our business, financial condition and operating results could be significantly harmed.

Our future success largely depends on increased commercial acceptance of our Axxess system, EncoreCX products, speech recognition, Interactive Voice Response, presence management, collaboration, messaging products, and related computer-telephony products.

     Over the past 18 months, we have introduced Unified Communicator, a web-based, speech-recognition, wireless PDA, and Wireless Application Protocol (WAP) software application for controlling and managing your calls, contacts and presence status; Inter-Tel Application Platform, a highly flexible speech-recognition, text-to-speech and CTI application generation platform; enhanced convergence features on the Axxess system, including support of standard Session Initiation Protocol (SIP) endpoints and trunk gateways; and several other telephony-related products. During the past 12 months, sales of our Axxess business communications systems and related software have comprised a substantial portion of our net sales. Our future success depends, in large part, upon increased commercial acceptance and adoption of the Axxess system, the Application Platform, the Unified Communicator and related computer-telephony products, EncoreCX products, SIP standards-based applications and devices, new speech recognition and Interactive Voice Response products, as well as future upgrades and enhancements to these products and networking platforms. We cannot assure you that these products or platforms will achieve commercial acceptance in the future.

Our products are complex and may contain errors or defects that are detected only after their release, which may cause us to incur significant unexpected expenses and lost sales.

     Our telecommunications products and software are highly complex. Although our new products and upgrades are examined and tested prior to release, they can only be fully tested when used by a large customer base. Consequently, our customers have in the past and may in the future discover program errors, or “bugs,” or other defects after new products and upgrades have been released. Some of these bugs may result from defects contained in component parts or software from our suppliers or other third parties that are intended to be compatible with our products and over which we have little or no control. Although we have test procedures and quality control standards in place designed to minimize the number of errors and defects in our products, we cannot assure you that our new products and upgrades will be free of

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bugs when released. If we are unable to quickly or successfully correct bugs identified after release, we could experience the following, any of which would harm our business:

• costs associated with the remediation of any problems;

• costs associated with design modifications;

• loss of or delay in revenues;

• loss of customers;

• failure to achieve market acceptance or loss of market share;

• increased service and warranty costs;

• liabilities to our customers; and

• increased insurance costs.

The complexity of our products could cause delays in the development and release of new products and services. As a result, customer demand for our products could decline, which could harm our business.

     Due to the complexity of our products and software, we have in the past experienced and expect in the future to experience delays in the development and release of new products or product enhancements. If we fail to introduce new software, products or services in a timely manner, or fail to release upgrades to our existing systems or products and software on a regular and timely basis, customer demand for our products and software could decline, which would harm our business.

Business acquisitions, new business ventures, dispositions or joint ventures entail numerous risks and may disrupt our business, dilute shareholder value and distract management attention.

     As part of our business strategy, we consider acquisitions of, or significant investments in, businesses that offer products, services and technologies complementary to ours. Such acquisitions could materially adversely affect our operating results and/or the price of our common stock. Acquisitions also entail numerous risks, some of which we have experienced and may continue to experience, including:

• unanticipated costs and liabilities;

• difficulty of assimilating the operations, products and personnel of the acquired business;

• difficulties in managing the financial and strategic position of acquired or developed products, services and technologies;

• difficulties in maintaining customer relationships;

• difficulties in servicing and maintaining acquired products, in particular where a substantial portion of the target’s sales were derived from our competitor’s products and services;

• difficulty of assimilating the vendors and independent contractors of the acquired business;

• the diversion of management’s attention from the core business;

• inability to maintain uniform standards, controls, policies and procedures; and

• impairment of relationships with acquired employees and customers occurring as a result of integration of the acquired business.

     In particular, in recent years our operating results were materially adversely affected by several of the factors described above, including substantial acquisition-related charges, operating losses or impairment losses from the Executone acquisition and Inter-Tel.NET operations. Refer to Management’s Discussion and Analysis and notes to the consolidated financial statements for additional information regarding these transactions.

     We completed four acquisitions during 2001 and 2002, and one acquisition during December 2003. During 2001, we acquired certain assets and assumed certain liabilities of Convergent Communication Services and Mastermind Technologies. During 2002, we acquired certain assets and assumed certain liabilities of McLeodUSA Integrated Business Systems and we acquired 100% of the stock of Swan Solutions Limited (Swan) in the United Kingdom. In December 2003, we acquired selected assets and assumed certain liabilities of a former Inter-Tel dealer in the Philadelphia metropolitan area. These acquisitions are subject to risks and uncertainties including those indicated above.

     Finally, to the extent that shares of our stock or the rights to purchase stock are issued in connection with any future acquisitions, dilution to our existing shareholders will result and our earnings per share may

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suffer. Any future acquisitions may not generate additional revenue or provide any benefit to our business, and we may not achieve a satisfactory return on our investment in any acquired businesses.

We may not be able to adequately protect our proprietary technology and may be infringing upon third-party intellectual property rights.

     Our success depends upon our proprietary technology. We currently hold patents for twenty-three (23) telecommunication and messaging products and have also applied to the U.S. Patent and Trademark Office for thirteen (13) additional patents. We also rely on copyright and trade secret law and contractual provisions to protect our intellectual property. Despite these precautions, third parties could copy or otherwise obtain and use our technology without authorization, or develop similar technology independently.

     Any patent, trademark or copyright that we own or have applied to own is subject to being invalidated, circumvented or challenged by a third party. Effective protection of intellectual property rights may be unavailable or limited in foreign countries. We cannot assure that the protection of our proprietary rights will be adequate or that competitors will not independently develop similar technology, duplicate our services or design around any patents or other intellectual property rights we hold. Litigation may be necessary in the future to enforce our intellectual property rights, to protect our trade secrets, to determine the validity and scope of the proprietary rights of others, or to defend against claims of infringement or invalidity. Litigation could be costly, absorb significant management time and harm our business.

     We are also subject to third party claims that our current or future products or services infringe upon the rights of others. For example, we are subject to proceedings initiated by Avaya, alleging that certain of our key products infringe upon their intellectual property rights, including patents, trademarks, copyrights or other intellectual property rights. We have viewed presentations from Avaya, one of our primary competitors, alleging that our Axxess business communications system and associated applications utilize inventions covered by certain of their patents. We are continuing the process of investigating this matter and we have made claims against Avaya for infringement of our patents. The ultimate outcomes by their nature are uncertain and we cannot assure you that these matters, individually or collectively, would not have a material adverse impact on our financial position and future results of operations.

     When any such claims are asserted against us, among other means to resolve the dispute, we may seek to license the third party’s intellectual property rights. Purchasing such licenses can be expensive, and we cannot assure you that a license will be available on prices or other terms acceptable to us, if at all. Alternatively, we could resort to litigation to challenge such a claim. Litigation could require us to expend significant sums of cash and divert our management’s attention. In the event a court renders an enforceable decision with respect to our intellectual property, we may be required to pay significant damages, develop non-infringing technology or acquire licenses to the technology subject to the alleged infringement. Any of these actions or outcomes could harm our business. If we are unable or choose not to license technology, or decide not to challenge a third party’s rights, we could encounter substantial and costly delays in product introductions. These delays could result from efforts to design around asserted third party rights or our discovery that the development, manufacture or sale of products requiring these licenses could be foreclosed.

We have many competitors and expect new competitors to enter our market, which could increase price competition and spending on research and development and which may impair our ability to compete successfully.

     The markets for our products and services are extremely competitive and we expect competition to increase in the future. Our current and potential competitors in our primary business segments include:

• PABX and converged systems providers, distributors, or resellers such as Alcatel, Altigen, Avaya, Cisco Systems, Comdial, 3Com, Iwatsu, Mitel, NEC, Nortel, Panasonic, Shoreline, Siemens, Toshiba, Vertical Networks and Vodavi;

• large data routing and convergence companies such as 3Com and Cisco Systems;

• voice processing applications providers such as ADC, InterVoice-Brite, Active Voice (a subsidiary of NEC America), Avaya, and Captaris (formerly AVT);

• long distance services providers such as AT&T, MCI, Qwest and Sprint;

• large computer and software corporations such as IBM, HP, Intel and Microsoft;

• regional Bell operating companies, or RBOCs, cable television companies, IP Centrex service providers, and satellite and other wireless broadband service providers; and

• independent leasing companies that provide telecom equipment financing.

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     These and other companies may form strategic relationships with each other to compete with us. These relationships may take the form of strategic investments, joint-marketing agreements, licenses or other contractual arrangements. Strategic relationships and business combinations could increase our competitors’ ability to address customer needs with their product and service offerings.

     Many of our competitors and potential competitors have substantially greater financial, customer support, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we do. We cannot be sure that we will have the resources or expertise to compete successfully. Compared to us, our competitors may be able to:

• develop and expand their product and service offerings more quickly;

• offer greater price discounts or make substantial product promotions;

• adapt to new or emerging technologies and changing customer needs faster;

• take advantage of acquisitions and other opportunities more readily;

• negotiate more favorable licensing agreements with vendors;

• devote greater resources to the marketing and sale of their products; and

• address customers’ service-related issues more adequately.

     Some of our competitors may also be able to provide customers with additional benefits at lower overall costs or to reduce their gross margins aggressively in an effort to increase market share. We cannot be sure we will be able to match cost reductions by our competitors. In recent periods, due to competitive pressures we have discounted pricing on our telephone systems and offered promotions. In addition, we believe there is likely to be further consolidation in our markets, which could lead to having even larger and more formidable competition and other forms of competition that could cause our business to suffer.

Our reliance on a limited number of suppliers for key components and our dependence on contract manufacturers could impair our ability to manufacture and deliver our products and services in a timely and cost-effective manner.

We currently obtain certain key components for our digital communication platforms, including certain microprocessors, integrated circuits, power supplies, voice processing interface cards and IP telephony cards, from a limited number of suppliers and manufacturers. Our reliance on these limited suppliers and contract manufacturers involves risks and uncertainties, including the possibility of a shortage or delivery delay for some key components. We currently manufacture our products through third-party subcontractors located in the United States, Mexico, the People’s Republic of China and the United Kingdom. Varian, Inc. currently manufactures a significant portion of our products at Varian’s Tempe, Arizona facility, including substantially all of the printed circuit boards used in the Axxess systems. Foreign manufacturing facilities are subject to changes in governmental policies, imposition of tariffs and import restrictions and other factors beyond our control. We have experienced occasional delays in the supply of components and finished goods that have harmed our business. If inventory levels are not adequately maintained and managed we are at risk of not having the appropriate inventory quantities on hand to meet sales demand. We may experience similar delays in the future.

     Our reliance on third party manufacturers and OEM partners involves a number of additional risks, including reduced control over delivery schedules, quality assurance and costs. Our business may be harmed by any delay in delivery or any shortage of supply of components or finished goods from a supplier. Our business may also be harmed if we are unable to develop alternative or additional supply sources as necessary. To date, we have been able to obtain supplies of components and products in a timely manner even though we do not have long-term supply contracts with any of our contract manufacturers. However, we cannot assure you we will be able to continue to obtain components or finished goods in sufficient quantities or quality or on favorable pricing or delivery terms in the future.

We derive a substantial portion of our net sales from our dealer network and if these dealers do not effectively promote and sell our products, our business and operating results could be harmed.

     We derive a substantial portion of our net sales through our network of independent dealers. We face intense competition from other telephone, voice processing, and voice and data router system manufacturers for these dealers’ business, as most of our dealers carry other products that compete with our products. Our dealers may choose to promote the products of our competitors to our detriment. We have developed programs and expended capital as incentives to our dealers to promote our products, and we cannot assure you that these techniques will continue to be successful. The loss of any significant dealer or group of

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dealers, or any event or condition harming our dealer network, could harm our business, financial condition and operating results.

We are currently the target of government investigations and in the future we may be subject to litigation, which if they result in any convictions, sanctions or penalties against us, could harm our business.

     Divisions of the United States Department of Justice are investigating other companies’ and Inter-Tel’s participation in a federally funded “E-Rate program” to connect schools and libraries to the Internet. The Justice Department has provided Inter-Tel with only a limited description of the evidence on which the investigations are based.

     Inter-Tel is presently unable to predict or determine the final outcome of, or to estimate the potential range of loss with respect to, the investigations. If Inter-Tel is convicted of any crime or subjected to sanctions, or debarred from certain government contracts or if penalties, damages or other monetary remedies are assessed against Inter-Tel in connection with these and other investigations, our business and operating results could be materially and adversely affected. The existence and disclosure of the investigations may have already caused competitive harm to Inter-Tel, and any unfavorable resolution to these matters may further harm Inter-Tel’s business.

     Inter-Tel is also subject to litigation in the ordinary course of business. We cannot assure you that any adverse outcome in connection with such litigation would not impair our business or financial condition.

Managing our international sales efforts may expose us to additional business risks, which may result in reduced sales or profitability in our international markets.

     We are currently expending resources to maintain and expand our international dealer network in the countries in which we already have a presence and in new countries and regions. International sales are subject to a number of risks, including changes in foreign government regulations and telecommunication standards, export license requirements, tariffs and taxes, other trade barriers, difficulties in protecting our intellectual property, fluctuations in currency exchange rates, difficulty in collecting receivables, difficulty in staffing and managing foreign operations, and political and economic instability. In particular, the terrorist acts of September 11, 2001, continued hostilities in Iraq and turmoil in the Middle East and North Korea, have created an uncertain international economic environment and we cannot predict the impact of these acts, any future terrorist acts or any related military action on our efforts to expand our international sales. Fluctuations in currency exchange rates could cause our products to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. In addition, the costs associated with developing international sales or an international dealer network may not be offset by increased sales in the short term, or at all. Any of these risks could cause our products to become relatively more expensive to customers in a particular country, leading to reduced sales or profitability in that country.

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to achieve our objectives.

     We depend on the continued service of, and our ability to attract and retain, qualified technical, marketing, sales and managerial personnel, many of whom would be difficult to replace. Competition for qualified personnel is intense, and we have historically had difficulty in hiring employees in the timeframe we desire, particularly skilled engineers or sales personnel. The loss of any of our key personnel or our failure to effectively recruit additional key personnel could make it difficult for us to manage our business, complete timely product introductions or meet other critical business objectives. In addition, our operating results could be impaired if we lose a substantial number of key employees from acquisitions, as was the case in our acquisition of Executone. Moreover, our operating results could be impaired if we lose a substantial number of key employees from recent acquisitions, including personnel from McLeod, Swan, Mastermind, Convergent and our recent Philadelphia and Tennessee office acquisitions. We cannot assure you we will be able to continue to attract and retain the qualified personnel necessary for the development of our business.

Our IP network products may be vulnerable to viruses, other system failure risks and security concerns, which may result in lost customers or slow commercial acceptance of our IP network products.

     Inter-Tel’s IP telephony and network products may be vulnerable to computer viruses or similar disruptive problems. Computer viruses or problems caused by third parties could lead to interruptions, delays

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or cessation of service that could harm our operations and revenues. In addition, we may lose customers if inappropriate use of the Internet or other IP networks by third parties jeopardizes the security of confidential information, such as credit card or bank account information or the content of conversations over the IP network. In addition, user concerns about privacy and security may cause IP networks in general to grow more slowly, and impair market acceptance of our IP network products in particular, until more comprehensive security technologies are developed.

We may be unable to achieve or manage our growth effectively, which may harm our business.

     The ability to operate our business in an evolving market requires an effective planning and management process. Our efforts to achieve growth in our business have placed, and are expected to continue to place, a significant strain on our personnel, management systems, infrastructure and other resources. In addition, our ability to manage any potential future growth effectively will require us to successfully attract, train, motivate and manage new employees, to integrate new employees into our overall operations and to continue to improve our operational, financial and management controls and procedures. Furthermore, we expect we will be required to manage an increasing number of relationships with suppliers, manufacturers, customers and other third parties. If we are unable to implement adequate controls or integrate new employees into our business in an efficient and timely manner, our operations could be adversely affected and our growth could be impaired.

The introduction of new products and services has lengthened our sales cycles, which may result in significant sales and marketing expenses.

     In the past few years, we introduced the Axxess ATM business communications system and multiple versions of our IP networking software, which are typically sold to larger customers at a higher average selling price and often represent a significant expenditure in communications infrastructure by the prospective enterprise customer. Accordingly, the purchase of our products typically involves numerous internal approvals relating to the evaluation, testing, implementation and acceptance of new technologies. This evaluation process frequently results in a lengthy sales process, which can range from a few months to more than 12 months, thereby subjecting our sales cycle to a number of significant uncertainties concerning budgetary constraints and internal acceptance reviews. The length of our sales cycle also may vary substantially from customer to customer and along product lines. While our customers are evaluating our products before placing an order with us, we may incur substantial sales and marketing expenses and expend significant management effort. In addition, installation of multiple systems for large, multi-site customers may occur over an extended period of time, and depending on the contract terms with these customers, revenues may be recognized over more than one quarter, as systems are completed in separate phases and accepted by the customers. Consequently, if sales forecasted from a specific customer for a particular quarter are not realized in that quarter, our operating results could be materially adversely affected.

We rely heavily upon third-party packaged software systems to manage and run our business processes and to produce our financial statements. From time to time we upgrade these systems to ensure continuation of support and to expand the functionality of the systems to meet our business needs. The risks associated with the upgrade process include disruption of our business processes, which could harm our business.

     We currently run third-party applications for data processing in our distribution center operations, shipping, materials movement, customer service, invoicing, financial record keeping and reporting, and for other operations and administrative functions. The nature of the software industry is to upgrade software systems to make architectural changes, increase functionality and address software bugs. Over time, older versions of the software become less supported by our vendors for financial and other reasons and eventually become obsolete. Oracle, the primary supplier of our third-party applications, provides notice of the dates that Oracle will de-support the software and companies are expected to either make plans to upgrade to newer versions or operate without Oracle support. While Oracle and other third-party vendors may provide advanced notice of product upgrade schedules and take other steps to make the upgrade process as straight-forward as possible, we are subject to risks associated with the process. Our software systems could become unstable following an upgrade process and impact our ability to process data properly in these systems, including timely and accurate shipment of products, invoicing our customers properly and the production of accurate and timely financial statements. We also cannot assure you these software upgrades or enhancements will operate as intended or be free from bugs. We upgraded our Oracle applications during the fourth quarter of 2002 and expect to affect similar software upgrades in the future. If

20

we are unable to successfully integrate the new software into our information systems, our operations, customer service and financial reporting could be adversely affected and could harm our business.

Our stock price has been and may continue to be volatile, impairing your ability to sell your shares at or above purchase price.

     The market price for our common stock has been highly volatile. The volatility of our stock could be subject to continued wide fluctuations in response to many risk factors listed in this section, and others beyond our control, including:

• announcements of developments relating to our business;

• fluctuations in our operating results;

• shortfalls in revenue or earnings relative to securities analysts’ expectations;

• announcements of technological innovations or new products or enhancements by us or our competitors;

• announcements of acquisitions or planned acquisitions of other companies or businesses;

• investors’ reactions to acquisition announcements or our forecasts of future results;

• general economic conditions in the telecommunications industry;

• the market for Internet-related voice and data products and services;

• changes in the national or worldwide economy;

• changes in legislation or regulation affecting the telecommunications industry;

• threats of or outbreaks of war, hostilities or terrorist acts;

• developments relating to our intellectual property rights and the intellectual property rights or third parties;

• litigation or governmental investigations of our business practices;

• changes in our relationships with our customers and suppliers; and

• national and regional weather patterns.

     In addition, stock prices of technology companies in general, and for voice and data communications companies in particular, have experienced extreme price fluctuations in recent years which have often been unrelated to the operating performance of affected companies. We cannot assure you the market price of our common stock will not experience significant fluctuations in the future, including fluctuations unrelated to our performance.

The Chairman of our Board of Directors, CEO and President controls 20.2% of our Common Stock as of March 5, 2004 and is able to significantly influence matters requiring shareholder approval.

     As of March 5, 2004, Steven G. Mihaylo, Inter-Tel’s Chairman of the Board of Directors, Chief Executive Officer and President, beneficially owned approximately 20.2% of the existing outstanding shares of the common stock. As a result, he has the ability to exercise significant influence over all matters requiring shareholder approval. In addition, the concentration of ownership could have the effect of delaying or preventing a change in control of Inter-Tel.

Risks Related to Our Industry

Reductions in spending on enterprise communications equipment may materially and adversely affect our business.

     The overall economic slowdown has had and continues to have a harmful effect on the market for enterprise communications equipment. Our customers have reduced significantly their capital spending on communications equipment in an effort to reduce their own costs. The market for enterprise communications equipment may only grow at a modest rate or possibly not grow at all, and our financial performance has been and may continue to be materially and adversely affected by the reductions in spending on enterprise communications equipment.

The emerging market for IP network telephony is subject to market risks and uncertainties that could cause significant delays and expenses.

     The market for IP network voice communications products is evolving rapidly and is characterized by an increasing number of market entrants who have introduced or developed products and services for Internet or other IP network voice communications. As is typical of a new and rapidly evolving industry, the demand for and market acceptance of recently introduced IP network products and services are highly uncertain. We

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cannot assure you that IP voice networks will become widespread. Even if IP voice networks become more widespread in the future, we cannot assure that our products, including the IP telephony features of the Axxess systems and our IP endpoints and related applications, will successfully compete against other market players and attain broad market acceptance.

     Moreover, the adoption of IP voice networks and importance of development of products using industry standards such as SIP, generally require the acceptance of a new way of exchanging information. In particular, enterprises that have already invested substantial resources in other means of communicating information may be reluctant or slow to adopt a new approach to communications. If the market for IP network voice communications fails to develop or develops more slowly than we anticipate, our IP network telephony products could fail to achieve market acceptance, which in turn could significantly harm our business, financial condition and operating results. This growth may be inhibited by a number of factors, such as quality of infrastructure; security concerns; equipment, software or other technology failures; regulatory encroachments; inconsistent quality of service; poor voice quality over IP networks as compared to circuit-switched networks; and lack of availability of cost-effective, high-speed network capacity. Moreover, as IP-based data communications and telephony usage grow, the infrastructure used to support these IP networks, whether public or private, may not be able to support the demands placed on them and their performance or reliability may decline. The technology that allows voice and facsimile communications over the Internet and other data networks, and the delivery of other value-added services, is still in the early stages of development.

Government regulation of third party long distance and network service entities on which we rely may harm our business.

     Our supply of telecommunications services and information depends on several long distance carriers, RBOCs, local exchange carriers, or LECs, and competitive local exchange carriers, or CLECs. We rely on these carriers to provide network services to our customers and to provide us with billing information. Long distance services are subject to extensive and uncertain governmental regulation on both the federal and state level. We cannot assure the increase in regulations will not harm our business. Our current contracts for the resale of services through long distance carriers include multi-year periods during which we have minimum use requirements and/or costs. The market for long distance services is experiencing, and is expected to continue to experience significant price competition, and this may cause a decrease in end-user rates. We cannot assure you we will meet minimum use commitments, that we will be able to negotiate lower rates with carriers if end-user rates decrease or that we will be able to extend our contracts with carriers at favorable prices. If we are unable to secure reliable long distance and network services from certain long distance carriers, RBOCs, LECs and CLECs, or if these entities are unwilling or unable to provide telecommunications services and billing information to us on favorable terms, our ability to expand our own long distance and network services will be harmed. Carriers that provide telecommunications services to us may also experience financial difficulties, up to and including bankruptcies, which could harm our ability to offer telecommunications services.

Consolidation within the telecommunications industry could increase competition and reduce our customer base.

     There has been a trend in the telecommunications industry towards consolidation and we expect this trend to continue as the industry evolves. As a result of this consolidation trend, new stronger companies may emerge that have improved financial resources, enhanced research and development capabilities and a larger and more diverse customer base. The changes within the telecommunications industry may adversely affect our business, operating results and financial condition.

lerrorist activities and resulting military and other actions could harm our business.

     Terrorist attacks in New York and Washington, D.C. in September of 2001 disrupted commerce throughout the world. The continued threat of terrorism, the conflict in Iraq and the potential for additional military action and heightened security measures in response to these threats may continue to cause significant disruption to commerce throughout the world. To the extent that disruptions result in a general decrease in corporate spending on information technology or communications solutions, our business and results of operations could be harmed. We are unable to predict whether the conflict in Iraq and its aftermath, the threat of terrorism or the responses thereto will result in any long-term commercial disruptions or if such activities or responses will have a long-term adverse effect on our business, results of operations or financial condition. Additionally, if any future terrorist attacks were to affect the operation of the Internet or key

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data centers, our business could be harmed. These and other developments arising out of the potential attacks may make the occurrence of one or more of the factors discussed herein more likely to occur.

ITEM 2. PROPERTIES

     Our corporate headquarters in Tempe, Arizona is located in a 22,600 square foot building pursuant to a lease that expires in May 2008. Our 68,000 square foot operations and distribution center is also located in Tempe, Arizona pursuant to a lease that expires in March 2006. The principal product development and support operations remain in a 96,000 square foot building located in Chandler, Arizona pursuant to a lease that expires in May 2008. We also own a 74,000 square foot facility located in Reno, Nevada, which includes portions of our credit and lease finance facilities, executive and administrative functions, a business development center and a sales office. We also lease sales and support offices and warehouses in a total of 55 lease locations in the United States, including approximately 147,000 square feet of office space in Milford, Connecticut that we acquired in the Executone acquisition (a portion of which has been subleased), and three locations overseas. In February 2003, we consolidated three Phoenix, Arizona area offices with an aggregate of 31,300 square feet into a single Phoenix location of 35,000 square feet pursuant to a lease, which expires in July 2008. Our aggregate monthly payments under these leases were approximately $794,000 at December 31, 2003. We believe our facilities will be adequate to meet our current needs and that additional or alternative space will be available as necessary in the future on commercially reasonable terms.

ITEM 3. LEGAL PROCEEDINGS

     We are involved from time to time in litigation incidental to our business. We believe the outcome of current litigation will not have a material adverse effect upon our business, financial condition or results of operations.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     None.

PART II

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON STOCK AND RELATED SHAREHOLDER MATTERS

     Inter-Tel Common Stock is traded over-the-counter (Nasdaq symbol: INTL) and since February 1983 has been included in the Nasdaq National Market System. As of March 5, 2004 there were of record approximately 1,054 registered shareholders of our Common Stock. The following table sets forth high and low sales prices reported by Nasdaq for each quarter in the last two years.

2003	High		Low		2002	High		Low
First Quarter		26.590		14.255	First Quarter		22.77		14.98
Second Quarter		22.240		12.850	Second Quarter		21.70		15.57
Third Quarter		28.350		20.790	Third Quarter		27.00		15.65
Fourth Quarter		29.560		21.950	Fourth Quarter		28.98		17.03

     Dividends. From December 31, 1997 through the third quarter of 2001, we paid quarterly cash dividends (the “cash dividend”) of $0.01 for every share of Common Stock, to shareholders of record. On October 23, 2001, our Board of Directors increased the cash dividend from $0.01 to $0.02 for every share of Common Stock, payable quarterly to shareholders of record beginning December 31, 2001. On July 16, 2002, our Board of Directors increased the cash dividend from $0.02 to $0.03 for every share of Common Stock, payable quarterly to shareholders of record beginning September 30, 2002. On July 21, 2003, our Board of Directors increased the cash dividend from $0.03 to $0.06 for every share of Common Stock, payable quarterly to shareholders of record beginning September 30, 2003. Dividend payments commence on or about 15 days after the end of each fiscal quarter. Attached below is a summary of our dividends accrued and paid since December 31, 1997, the date we first declared cash dividends on our Common Stock. The Company currently anticipates paying cash dividends in the foreseeable future on its common stock.

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Period	Q1		Q2		Q3		Q4		Totals
1997		—		—		—	$	0.01	$	0.01
1998	$	0.01	$	0.01	$	0.01	$	0.01	$	0.04
1999	$	0.01	$	0.01	$	0.01	$	0.01	$	0.04
2000	$	0.01	$	0.01	$	0.01	$	0.01	$	0.04
2001	$	0.01	$	0.01	$	0.01	$	0.02	$	0.05
2002	$	0.02	$	0.02	$	0.03	$	0.03	$	0.10
2003	$	0.03	$	0.03	$	0.06	$	0.06	$	0.18

No Sales of Unregistered Securities

     We have not made any sales of unregistered securities during the past three years, except for sales of our common stock to employees exercising their stock options during the period prior to the effectiveness of a registration statement on Form S-8 relating to such sales.

Equity Compensation Plan Information

     Information regarding Inter-Tel’s equity compensation plans, including both shareholder approved plans and non-shareholder approved plan, is set forth in the section entitled “Equity Compensation Plan Information” in Inter-Tel’s Notice of Annual Meeting of Shareholders and Proxy Statement, to be filed within 120 days after Registrant’s fiscal year end of December 31, 2003. The table required by Item 201(d) of Regulation S-K referred to under Item 12 herein is incorporated by reference to the proxy statement.

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ITEM 6. SELECTED FINANCIAL DATA

Financial Summary

     The following selected consolidated financial data should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, “Financial Statements and Supplementary Data.” The table contains selected consolidated financial data for the years ended December 31, 1999, 2000, 2001 2002 and 2003, derived from our audited consolidated financial statements.

(In thousands, except
per share amounts and ratios)

	For the years ended December 31,
	2003			2002			2001			2000			1999
Net Sales	$	373,836		$	381,456		$	385,655		$	402,723		$	314,221
Cost of sales		176,763			186,983			211,161			243,685	(3)		159,463
Research and development		21,978			19,340			17,556			19,489			14,798
Selling, general and administrative		128,964			128,284			128,604			124,664			97,163
Amortization of goodwill		—			—			1,876			2,228			856
Amortization of purchased intangible assets		1,803			1,122			677			576			411
In-process research and development		—			—			—			5,433	(3)		—
Other charges		—			—			5,357	(2)		45,245	(3)		—
Operating (loss) income		44,328			45,727			20,424	(2)		(38,597	)(3)		41,530
Litigation settlement (net of costs except for taxes)		—			15,516	(1)		—			—			—
Write-down/recovery of investment in Inter-Tel.NET/Vianet		124			(1,200	)		—			—			—
Equity share of Cirilium Corp.’s net losses		—			—			—			(5,938	)(3)		—
Write-off of Cirilium Corp. investment		—			—			—			(2,045	)(3)		—
Interest and other income		1,683			1,936			1,081			1,474			2,391
Foreign currency transaction gains (losses)		18			330			(337	)		(421	)		(46	)
Interest expense		(155	)		(156	)		(468	)		(213	)		(110	)
Income (loss) before income taxes (benefit)		45,998			62,153	(1)		20,700	(2)		(45,740	)(3)		43,765
Income taxes (benefit)		17,480			23,516			7,659			(16,817	)		16,619
Net income (loss)	$	28,518		$	38,637	(1)	$	13,041	(2)	$	(28,923	)(3)	$	27,146
Net income (loss) per share
Basic	$	1.14		$	1.58	(1)	$	0.53	(2)	$	(1.10	)(3)	$	1.05
Diluted	$	1.08		$	1.49	(1)	$	0.52	(2)	$	(1.10	)(3)	$	1.01
Weighted average basic common shares		25,078			24,444			24,488			26,273			25,949
Weighted average diluted common shares		26,473			25,864			25,240			26,273			27,004
BALANCE SHEET DATA
Total assets	$	359,876		$	282,062		$	227,462		$	243,126		$	247,517
Working capital		200,561			131,624			93,156			86,008			60,799
Shareholders’ equity		207,305			173,903			126,837			136,436			168,121
KEY RATIOS
Current ratio		3.64			2.80			2.41			2.05			1.93
Dividends declared per share	$	0.18		$	0.10		$	0.05		$	0.04		$	0.04
Return on beginning equity		16.4	%		30.5	%		9.6	%		(17.2	)%		19.0	%
Return on beginning equity-excluding charges and litigation settlement		16.4	%		23.6	%(1)		12.0	%(2)		7.8	%(3)		19.0	%
Net cash provided by operating activities	$	54,890		$	77,195		$	75,006		$	17,339		$	33,380

(1) 2002 income before taxes includes $15.5 million of proceeds, net of related expenses from a binding arbitration settlement, which increased net income by $9.5 million, or $0.37 per share after tax. Without this settlement, we would have reported net income of $29.1 million ($1.13 per diluted share) for the year ended December 31, 2002.

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(2)

2001 operating income includes a pre-tax charge of $5.4 million, which reduced net income by $3.4 million, or $0.13 per share after tax. This pre-tax charge reflects the write-down of our investment in Inter-Tel.NET to net realizable value.

(3)

2000 operating income includes pre-tax charges of $66.8 million, which reduced net income by $42.0 million, or $1.60 per share after tax. These pre-tax charges reflect the write-off of the Executone acquisition of $50.9 million ($7.6 million of which is included in cost of sales) in the second quarter, the write-off of IPRD in connection with the Executone purchase of $5.4 million during the first quarter, the write-down to net realizable value of Inter-Tel.NET assets of $2.0 million during the second quarter, the equity share of the losses from an investment in a joint venture of $5.9 million for the year, and the write-off of our investment in such joint venture of $2.6 million (including reserve adjustments) during the third quarter. Without these charges, we would have reported net income of $13.1 million ($0.50 per diluted share) for the year ended December 31, 2000.

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

     This Management’s Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Annual Report on Form 10-K contain forward-looking statements that involve risks and uncertainties. The words “expects,” “anticipates,” “believes,” “intends,” “will” and similar expressions identify forward-looking statements, which are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in “Factors That May Affect Future Operating Results” and elsewhere in this Form 10-K.

Overview

     Inter-Tel (Nasdaq: INTL), incorporated in 1969, is a single point of contact, full service provider of converged voice and data business communications systems, voice mail systems and networking applications. Our customers include business enterprises, federal, state and local government agencies and non-profit organizations. We market and sell the following products and services:

• Axxess by Inter-Tel and EncoreCX by Inter-Tel converged voice and data business communication systems,

• integrated voice mail, voice processing and unified messaging systems,

• IP telephony voice and data routers, and e-commerce software,

• managed services, including voice and data network design and traffic provisioning, custom application development, and financial solutions packages (leasing),

• networking applications,

• local and long distance calling services and other communications services and peripheral products,

• call accounting software, computer-telephone integration (CTI) applications, and

• maintenance and support services for our products.

     We have developed a distribution network of direct sales offices, dealers and value added resellers (VARs), which sell our products to organizations throughout the United States and internationally, primarily targeting small-to-medium enterprises, service organizations and governmental agencies. As of March 5, 2004, we had fifty (50) direct sales offices in the United States, one (1) in Japan, and a network of hundreds of dealers and VARs primarily in the United States, that purchase directly from us. Included in our sales office in Phoenix is the primary location for our national and government accounts division, as well as our local, long distance and network services divisions. Our wholesale distribution center is located in Tempe, Arizona, which is the primary location from which we distribute products to our network of direct sales offices, dealers and VARs. In addition, we maintain a wholesale distribution office in the United Kingdom that supplies Inter-Tel’s dealers and distributors throughout the UK and other parts of Europe, and we have dealers in Japan and Mexico. We also maintain a research and development and software sales office in the United Kingdom.

     Key performance indicators that we use in order to manage our business and evaluate our financial and operating performance include: revenues, costs and gross margins, and cash flows.

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     Inter-Tel recognized revenue from the following significant sources of revenue:

• End-user sales through our direct sales offices and government and national accounts division. We recognize revenue from sales of systems and services to end-user customers upon installation of the systems and performance of the services, respectively, allowing for use by our customers of these systems. We defer pre-payments for communications services and recognize these pre-payments as revenue as the communications services are provided.

• Dealer and VAR sales. For shipments to dealers and other distributors, our revenue is recognized as products are shipped and services are rendered, because the sales process is complete. Title to these products passes when goods are shipped (free-on-board shipping point).

• Resale of long distance. We recognize revenue from long distance resale services as services are provided.

• Sales-leases. For our sales-type lease accounting, we record the discounted present values of minimum rental payments under sales-type leases as sales, net of provisions for continuing administration and other expenses over the lease period. We record the lease sales at the time of system sale and installation as discussed above for sales to end user customers, and upon receipt of the executed lease documents. The net rental streams are sold to funding sources on a regular basis with the income streams discounted by prevailing like-term rates at the time of sale. Gains or losses resulting from the sale of net rental payments from such leases are also recorded as net sales.

• Maintenance. Maintenance revenue is recognized ratably over the term of the maintenance agreement.

     Costs and gross margins. Our costs of products sold primarily consist of materials, labor and overhead. Our costs of services performed consist primarily of labor, parts and service overhead. Total costs of goods and services sold decreased 5.5%, or $10.2 million, to $176.8 million for the year ended December 31, 2003, compared to $187.0 million for the same period in 2002. Our consolidated gross margin percentage increased to 52.7% in 2003 compared to 51.0% in 2002, attributable to several factors, including a higher proportion of recurring revenues from existing customers in our direct sales offices and government and national accounts division, increased maintenance and services revenues as a percentage of total sales, higher software content in our products, cost containment efforts, product design improvements, and efficiencies achieved with our manufacturing vendors.

     Sales of systems through our direct sales organization typically generate higher gross margins than sales through our dealers and VARs, primarily because we recognize both the wholesale and retail margins on these sales. Conversely, sales of systems through our dealers and VARs typically generate lower gross margins than sales through our direct sales organization, although direct sales typically require higher levels of selling, general and administrative expenses. In addition, our long distance services and Datanet products typically generate lower gross margins than sales of software and system products. For revenues recognized under sales-leases, we record the costs of systems installed as costs of sales. Our margins may vary from period to period depending upon distribution channel, product and software mix. In the event that sales through our direct sales offices increase as a percentage of net sales, our overall gross margin could improve. Conversely, in the event net sales to dealers or sales of long distance services increase as a percentage of net sales, our overall gross margin could decline.

     Our operating results depend upon a variety of factors, including the volume and timing of orders received during a period, the mix of products sold and the mix of distribution channels, general economic conditions and world events impacting businesses, patterns of capital spending by customers, the timing of new product announcements and releases by us and our competitors, pricing pressures, the cost and effect of acquisitions and the availability and cost of products and components from our suppliers. Historically, a substantial portion of our net sales in a given quarter has been recorded in the third month of the quarter, with a concentration of such net sales in the last two weeks of the quarter. In addition, we are subject to seasonal variations in our operating results, as net sales for the first and third quarters are frequently less than those experienced during the fourth and second quarters, respectively. 2003 followed this historical pattern and we do not anticipate a significant change in this trend.

     Cash Flows. At December 31, 2003, Inter-Tel’s cash and short-term investments totaled $174.5 million. We also maintain a $10 million unsecured, revolving line of credit with BankOne, NA, which is available through June 1, 2004 and ordinarily used to support international letters of credit to suppliers, if

27

necessary. Historically, our primary source of cash has come from net income plus non-cash charges for depreciation and amortization expenses. We have generated cash from continuing operations in every year since 1986. In 1993, 1995 and 1997, the Company received net proceeds from stock offerings, offset in part by cash expended to repurchase the Company’s common stock. In addition, Inter-Tel historically has paid cash for capital expenditures of property and equipment or acquisitions. Inter-Tel has also received cash proceeds from the exercise of stock options and our Employee Stock Purchase Plan. We believe our working capital and credit facilities, together with cash generated from operations, will be sufficient to develop and expand our business operations, to finance acquisitions of additional resellers of telephony products and other strategic acquisitions or corporate alliances, and to provide adequate working capital for the foreseeable future.

     Our consolidated revenues from all sources have declined slightly during each of the past three years, but at a lower rate than the decline in revenues of some of our primary competitors in the business communications systems market. Net sales for the years ended December 31, 2001, 2002 and 2003 were $385.7 million, $381.5 million and $373.8 million, respectively. The slight decline in revenue in 2002 was primarily attributable to the sale of Inter-Tel.NET in July 2001. Excluding Inter-Tel.NET revenues in 2001, revenues increased by $9.8 million from 2001 to 2002. The 2.0% decline in net sales in 2003 resulted from the effect of general economic conditions and our customers appeared less willing to spend significantly on business communications systems. Although revenue declined slightly in 2003, revenue increased in the fourth quarter of 2003 compared to the fourth quarter of 2002. The fourth quarter increase in net sales can be attributed in part to new product releases and improved sales in our long distance resale division. However, we cannot provide assurance that the recent increase in revenue will continue in the future as we believe businesses may continue to be reluctant to significantly increase spending on enterprise communications systems in the near future.

     The decline in revenue from business communications systems may also be attributable in part to business investments in systems made in the late 1990s in anticipation of Year 2000 issues. We believe businesses may have been reluctant to make additional investments in these communications systems until their existing investments have been fully amortized over their useful life. In addition, we believe many customers are hesitant to invest in traditional voice communication systems as they may be anticipating broader adoption of next-generation communications systems.

     We believe that enterprises continue to be concerned about their ability to increase revenues and profitability, in part due to the uncertain economic environment and slowdown in the past few years. To maintain or improve profitability, we believe that businesses have attempted to reduce costs and capital spending. We expect continued pressure on our ability to generate or expand sales and it is not clear whether business communications spending will improve significantly in the near term. We cannot predict the nature, timing and extent of future business investments in communications systems and as a result, if and when our net sales will increase.

     The markets we serve have been characterized by rapid technological changes and increasing customer requirements. We have sought to address these requirements through the development of software enhancements and improvements to existing systems and the introduction of new systems, products, and applications. Inter-Tel’s research and development efforts over the last several years have been focused primarily on the development of, and enhancements to, our Axxess system, including adding new applications, enhancing our IP convergence applications and IP endpoints, developing Unified Communications applications, developing presence management applications, and developing speech-recognition and text-to-speech applications. More recently, Inter-Tel’s research and development efforts have been focused on the development of Session Initiation Protocol (SIP) interfaces and application as well as the development and a new line of multi-protocol SIP IP endpoints.

     We offer our customers a package of lease financing and other services under the name Total Solution (formerly, Totalease). Total Solution provides our customers lease financing, maintenance and support services, fixed price upgrades and other benefits. We finance this program through the periodic resale of lease rental streams to financial institutions. Refer to Note D of Notes to Consolidated Financial Statements for additional information regarding our program.

Results of Operations

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     The following table sets forth certain statement of income data expressed as a percentage of net sales for the periods indicated (amounts do not add due to rounding):

	Year Ended December 31
	2003			2002			2001
Net sales		100.0	%		100.0	%		100.0	%
Cost of sales		47.3			49.0			54.8
Gross profit		52.7			51.0			45.2
Research and development		5.9			5.1			4.6
Selling, general and administrative		34.5			33.6			33.3
Amortization of goodwill and intangibles		0.5			0.3			0.7
Other charges		—			—			1.4
Operating income		11.9			12.0			5.3
Litigation settlement		—			4.1			—
Write-down/recovery of investment in Inter-Tel.NET/Vianet		0.0			(0.3	)		—
Interest and other income		0.5			0.5			0.3
Foreign currency transaction gains (losses)		0.0			0.1			(0.1	)
Interest expense		(0.0	)		(0.0	)		(0.1	)
Income taxes		4.7			6.2			2.0
Net income		7.6	%		10.1	%		3.4	%

Year Ended December 31, 2003 Versus Year Ended December 31, 2002

     Net Sales. Net sales decreased 2.0% to $373.8 million in 2003 from $381.5 million in 2002, representing a decrease of $7.6 million. The decrease in net sales was primarily attributable to a reduction in sales through our direct sales offices and DataNet division, offset in part by sales increases from Inter-Tel NetSolutions, dealer and international sales. Sales from our direct sales offices decreased 6.9% in 2003 compared to 2002, due primarily to a revenue shortfall in the first quarter of 2003 relative to the comparable period in 2002. The first quarter of 2003 represented our worst quarter of the year, due primarily to relatively weak economic conditions, uncertainties associated with the war in Iraq and threatened terrorist attacks, and the impact of adverse weather conditions in the eastern United States and Colorado. Sales from our government and national accounts division decreased slightly by 2.0%, in 2003 compared to 2002. Sales from our DataNet division, which sells networking products through our direct sales offices, government and national accounts division and dealer channel, decreased $3.0 million, or 22.2% in 2003 compared to 2002 as a result of selling less third-party lower margin products. Sales to our dealer network increased slightly by 1.2% in 2003.

     The 2003 decrease in net sales from our direct sales offices, government and national accounts division and DataNet division was also attributable to delayed customer buying decisions related to a continued deterioration in industry and macroeconomic conditions, as well as increased competitive pressures, among other factors identified above and further noted above. Inter-Tel recognized lower revenues due to lower sales volumes of new system installations collectively through the direct sales offices and government and national accounts group, offset in part by sales increases in our NetSolutions division, and to a lesser extent, dealer sales and international operations. In some instances, prices of various telecommunications systems decreased, and discounts or other highly competitive promotions that were offered to customers to generate sales resulted in lower revenue through both our direct and indirect channels. Although sales to new customers declined during 2003, recurring revenues to existing customers increased in total dollars and as a percentage of total sales.

     Sales from NetSolutions, our long distance resale division, increased 27.4%, or $8.2 million in 2003 to $38.3 million compared to $30.0 million in 2002 and represented the division with our largest percentage sales increase. Sales increased in our long distance division despite downward price pressure and significant competition. Increased sales volume has allowed NetSolutions, our long distance resale division, to offer more competitive pricing, which improved sales to our existing customer base. Sales from Network Services Agency, a commission-based sales division acting as an agent to sell services for selected RBOC’s and CLEC’s, decreased 15.0% to $5.6 million, largely due to changes in our commission compensation structure from one of the RBOC’s. The change in the RBOC’s pricing structure resulted in a more deferred sales commission structure on local and network services such as T-1 access, frame relay and other voice and data circuit services. Net sales from lease financing were flat in 2003 compared to 2002, an increase of

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0.2%, and international revenues increased $0.9 million, or 9.1% in 2003 compared to 2002, primarily as a result of a full year of revenues from Swan, which was acquired in December 2002 and represented $0.6 million of the increase.

     Please refer to Note O of Notes to Consolidated Financial Statements for additional segment reporting information.

     Gross Profit. Gross profit increased 1.3% to $197.1 million, or 52.7% of net sales in 2003, from $194.5 million, or 51.0% of net sales, in 2002. Gross profit and gross margin increased in 2003 compared to 2002 as a result of several factors, including a higher proportion of recurring revenues from existing customers in our direct sales offices and government and national accounts division, increased maintenance and services revenues as a percentage of total sales, higher software content in our products, cost containment efforts, product design improvements, and efficiencies achieved with our manufacturing vendors.

     During 2003, recurring revenues from existing customers in our direct sales and national and government accounts channels increased as a percentage of total sales from these same channels from approximately 46% in 2002 to approximately 51% in 2003. Existing customers accounted for a significant portion of our 2003 net sales from maintenance and other services, software additions and/or upgrades, support, training and hardware products such as video conferencing, headsets (wired and wireless), networking products and speakerphones. Our business communications platforms allow for system migration without the complete change-out of hardware, which enables us to offer enhancements and new solutions through software-only upgrades to our existing customers. Our gross margin is generally higher with recurring revenues because we incur less materials costs compared to new installations. Accordingly, our gross profit and gross margins improved in 2003 as a result of this recurring revenue percentage increase.

     Sales from NetSolutions increased by 27.4%, or $8.2 million, in 2003 compared to 2002. Although gross margin is generally lower in this division than our consolidated gross margin, the gross margin improved to 32.2% in 2003 compared to 28.7% in 2002, based in part on our ability to negotiate more favorable pricing with vendors on higher resale volumes. In addition, sales from our Network Services Agency decreased 15.0%, or $1.0 million, in 2003 compared to 2002, which partially offset our overall increase in gross margin. This division generally receives commissions on network services we sell as an agent for RBOCs. These sales carry little to no equipment costs and generated margins of approximately 89% in 2003 compared to 91% in 2002. The decrease in sales from this division therefore partially offset our overall increase in consolidated gross profit and margins.

     The overall increases in gross margin noted above were also offset in part by continued competitive pricing pressures in our direct sales offices, government and national accounts and dealer channels in 2003, including pricing discounts or special competitor promotions on telephone system and software sales and related equipment. Our margins may vary from period to period depending upon distribution channel, product and software mix. In the event that sales through our direct sales offices increase as a percentage of net sales, our overall gross margin could improve. Conversely, in the event net sales to dealers or sales of long distance services increase as a percentage of net sales, our overall gross margin could decline.

     Research and Development. Research and development expenses increased 13.6% to $22.0 million, or 5.9% of net sales in 2003, compared to $19.3 million, or 5.1% of net sales in 2002. The increase is attributable in large part to the acquisition of Swan Solutions Limited (Swan) in December 2002. The increase is also attributable, to a lesser extent, to increased research and development spending related to convergence applications and new IP endpoint development. In 2003, research and development expenses were directed principally toward the continued development of the AXXESS software and systems, SIP applications, presence management applications, unified messaging and voice processing software, speech recognition and text-to-speech applications, call center applications, unified communications applications, IP endpoint development, and certain CTI and IVR applications. We expect that research and development expenses will increase in absolute dollars as we continue to develop and enhance existing and new technologies and products. These expenses may vary, however, as a percentage of net sales.

     Selling, General and Administrative. Selling, general and administrative expenses increased slightly in absolute dollars to $129.0 million in 2003, compared to $128.3 million in 2002. These expenses also increased as a percentage of net sales to 34.5% in 2003 compared to 33.6% in 2002. These increases in absolute dollars and as a percentage of net sales were primarily due to higher selling expenses relative to total sales.

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     Selling, general and administrative expenses increased as a percentage of net sales in part due to the decrease in consolidated net sales by $7.6 million in 2003 compared to 2002. We incurred higher relative selling expenses through our combined direct sales offices and government and national accounts divisions, as we had increased sales personnel and sales training and support in anticipation of higher sales volumes and activity than actually materialized, particularly in the early part of 2003. We also incurred higher relative sales expenses in our long distance calling services division in 2003 relative to 2002 as a result of an increased number of sales personnel working directly for this division. Selling, general and administrative expenses also increased as a percentage of net sales due to higher costs of benefits, including higher health insurance for our associates. Our consolidated bad debt costs decreased in 2003 compared to 2002 and also decreased as a percentage of total net sales, based on improved credit and collections on existing accounts receivable. Depreciation expense was relatively flat in 2003 compared to 2002. We expect for the foreseeable future selling, general and administrative expenses will increase sequentially in absolute dollars assuming we increase sales and continue to enhance existing and develop new technologies and products. These expenses may vary, however, as a percentage of net sales.

     Amortization of Goodwill and Purchased Intangible Assets. We adopted SFAS No. 142 effective the beginning of fiscal 2002. In accordance with SFAS 142, we ceased amortizing goodwill. We are required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances. As of December 31, 2003, no impairment of goodwill has been recognized. There can be no assurance that future goodwill impairment tests will not result in a charge to earnings. For additional information regarding SFAS 142, see “Goodwill and Other Intangible Assets” in Note A of Notes to Consolidated Financial Statements.

     Amortization of purchased intangible assets included in operating expenses was $1.8 million in 2003 compared to $1.1 million in 2002. The increases in the amortization of purchased intangible assets for 2003 compared to 2002 was primarily related to the additional amortization from recent acquisitions. For additional information regarding purchased intangible assets, see Note A—Significant Accounting Policies “Goodwill and Other Intangible Assets” and Note B “Acquisitions, Dispositions and Restructuring Charges “ to Consolidated Financial Statements.

     Litigation Settlement, Net of Costs Except for Taxes. In May 2001, Inter-Tel entered into an agreement to submit to binding arbitration a lawsuit we filed in 1996. The arbitration was completed in January 2002 and, as a result of the arbitration, Inter-Tel received a one-time gross cash award of $20 million in February 2002. Direct costs for attorney’s fees, expert witness costs, arbitration costs and additional payments and expenses, totaled approximately $4.5 million in 2002, excluding income taxes, for a net award of approximately $15.5 million. The net proceeds from this arbitration settlement were approximately $9.5 million after taxes, or $0.37 per diluted share for the year ended December 31, 2002.

     Interest and Other Income. In 2003, interest and other income totaling $1.7 million consisted primarily of interest income and foreign currency transaction gains. Other income in 2002 totaling $1.9 million also consisted primarily of interest income and foreign currency transaction gains. Interest and other income decreased approximately $253,000 in 2003 compared to 2002 based on lower interest rates, despite a higher level of invested funds in part due to cash received from the litigation settlement noted above. During 2003, we recognized foreign currency transaction gains of $18,000, a decrease of $312,000 compared to gains of $330,000 in 2002.

     Interest expense. Interest expense was flat at $155,000 in 2003 compared to $156,000 in 2002.

     Other. Since July 24, 2001, the date of the sale of 83% of Inter-Tel.NET to Comm-Services/Vianet, we have used the cost method of accounting for our remaining investment in Inter-Tel.NET/Vianet. Accordingly, we have not recorded revenues or operating expenses of that entity since the date of sale. In 2002, the other component of this caption included an expense of approximately $1.2 million related to the write-down of Inter-Tel’s investment in Inter-Tel.NET/Vianet. In 2003, other income included $124,000 related to a recovery of our investment and adjustment of projected costs to actual costs associated with the 2002 write-down in the Vianet investment. At December 31, 2003, our net investment in Vianet was recorded at no value.

     Income Taxes. Our effective income tax rate for 2003 was relatively flat at 38.0% compared to 37.8% for 2002. The net deferred tax liabilities increased significantly in 2003 due primarily to accelerated depreciation of fixed assets, and temporary differences relating to leases in our Total Solution program. Most

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of the increase arose from deductions taken in the company’s 2002 federal income tax return wherein the company decided in 2003 to elect to take bonus depreciation and accelerated depreciation of fixed assets and certain leased equipment when filing its 2002 return in 2003. The company filed a change in accounting method with the Internal Revenue Service to utilize accelerated depreciation for the 2002 tax year. Effective May 6, 2003, the bonus depreciation increased from a 30% to a 50% depreciation deduction, which favorably impacted the 2003 tax deduction and increased the deferred liabilities for 2003.

     The depreciation deductions identified above generated a net operating loss that was not fully utilized in a carryback claim to 2001; accordingly, the loss was carried forward. This net operating loss created deferred assets for net operating loss carryforwards and certain tax credit carryforwards, each of which is separately identified in the components of deferred tax assets and liabilities schedule included in Note K to the Consolidated Financial Statements. We expect these carryforwards to be fully utilized by 2004. Our effective income tax rate for 2003 was not significantly impacted by these carryforwards. We expect the full-year 2004 tax rates to be comparable to the effective tax rate for 2003.

     Net Income. Net income for 2003 decreased to $28.5 million, or $1.08 per diluted share, compared to net income of $38.6 million, or $1.49 per diluted share, including the litigation settlement in 2002. The decrease was primarily attributable to income from net proceeds of an arbitration settlement in 2002. The net proceeds from this arbitration settlement were approximately $9.5 million after taxes, or $0.37 per diluted share for the year ended December 31, 2002.

     Excluding the 2002 litigation settlement, we would have reported net income of $29.1 million, or $1.13 per diluted share in 2002. The decrease in net income of 2.2% in 2003, excluding the settlement, was primarily the result of lower profits on a lower volume of sales, higher research and development expenses and higher amortization costs, offset by higher gross profit margins described in further detail above.

Year Ended December 31, 2002 Versus Year Ended December 31, 2001

     Net Sales. Net sales decreased 1.1% to $381.5 million in 2002 from $385.7 million in 2001, representing a decrease of $4.2 million. The decrease in net sales was primarily attributable to the fact that sales from Inter-Tel.NET (of which Inter-Tel sold 83% of its interest in July 2001) were not included in 2002. Inter-Tel.NET sales were $14.0 million in 2001. Sales from our direct sales offices were relatively flat in 2002 compared to 2001 including sales from McLeod offices acquired in 2002. Excluding the McLeod acquisition, sales in this division declined by approximately 5.4%. Sales from our government and national accounts division decreased $7.1 million, or 25.6%, in 2002 compared to 2001. The DataNet division, which sells networking products through our direct sales offices, government and national accounts division and dealer channel, was purchased in the 2002 McLeod acquisition, and accounted for $13.5 million in sales in 2002. Sales to our dealer network decreased by 4.1% in 2002, due primarily to the impact of the McLeod acquisition, since, prior to 2002, McLeod was a dealer that purchased $4.2 million from Inter-Tel in 2001. Excluding the McLeod acquisition, sales to the dealer network increased 1.5%.

     Sales from our long distance resale and network services divisions increased $7.1 million in 2002 compared to 2001. Net sales from lease financing increased 3.2% in 2002 compared to 2001 and international revenues increased by less than 1% in 2002 compared to 2001.

     Since July 24, 2001, the date of the sale of 83% of Inter-Tel.NET, we have used the cost method of accounting for our remaining investment in Inter-Tel.NET/Comm-Services. Accordingly, we have not recorded revenues or expenses of Inter-Tel.NET since the date of sale. The reduction in sales attributable to Inter-Tel.NET was due entirely to our sale of 83% of this subsidiary.

     The 2002 decrease in net sales from our direct sales offices, government and national accounts division and dealer channel was also attributable to delayed customer buying decisions related to a continued deterioration in industry and macroeconomic conditions, among other factors as follows. Inter-Tel recognized lower revenues due to lower sales volumes of systems collectively through the direct sales offices, government and national accounts group and dealer channel, offset in part by sales increases in our long distance and network services divisions, sales from acquired McLeod operations, and to a lesser extent, lease finance and international operations. In some instances, prices of various telecommunications systems decreased, and discounts or other highly competitive promotions that were offered to customers to generate sales resulted in lower revenues through both our direct and indirect channels. Sales of communications systems were heavily impacted by delayed buying decisions, in particular in our national accounts division

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and direct sales offices. Although sales to new customers declined during 2002, recurring revenues to existing customers increased as a percentage of total sales.

     Sales from long distance and network services increased in 2002 compared to 2001 and represented the divisions with our largest percentage sales increases. Sales increased in our long distance division by 17.5%, despite downward price pressure and significant competition. Increased sales volume has allowed NetSolutions, our long distance resale division, to offer more competitive pricing, which improved sales to our existing customer base. Network Services Agency revenues increased 66% in 2002 compared to 2001, on higher volume of sales and commissions on local and network services such as T-1 access, frame relay and other voice and data circuit services. Please refer to Note O of Notes to Consolidated Financial Statements for additional segment reporting information.

     Gross Profit. Gross profit increased 11.4% to $194.5 million, or 51.0% of net sales in 2002, from $174.5 million, or 45.2% of net sales, in 2001. The increases in gross profit and gross margins were the result of several different factors. Gross profit and gross margin in 2002 improved as a result of no longer including the results of Inter-Tel.NET, which experienced negative gross margins of $5.9 million during 2001. Gross profit and margins also increased in 2002 as compared to 2001 as a result of a higher proportion of recurring revenues from existing customers, including increased maintenance and services revenues as a percentage of total sales, higher software content in our products, cost containment efforts, product design improvements, efficiencies achieved with our manufacturing vendors and a more favorable sales channel mix.

     During 2002, recurring revenues from existing customers in our direct sales and national and government accounts channels increased as a percentage of total sales from these same channels from approximately 44% in 2001 to more than 46% in 2002. Existing customers accounted for a significant portion of our 2002 net sales from maintenance and other services, software additions and/or upgrades, support, training and hardware products such as video conferencing, headsets (wired and wireless), networking products and speakerphones. Our business communications platforms allow for system migration without the complete change-out of hardware, which enables us to offer enhancements and new solutions through software-only upgrades to our existing customers. Our gross margins are generally higher with recurring revenues because we incur less materials costs relative to new installations. Accordingly, our gross profit and margins improved in 2002 as a result of this recurring revenue percentage increase.

     Sales from NetSolutions increased by 17.5%, or $4.5 million, compared to 2001. Although gross margins are generally lower in this division than our consolidated margins, the margins improved slightly in 2002 relative to 2001, based in part on our ability to negotiate more favorable pricing with vendors on higher resale volumes. In addition, sales from our Network Services Agency increased 66%, or $2.6 million, in 2002 compared to 2001. This division generally receives commissions on network services we sell as an agent for RBOCs. These sales carry little to no equipment costs and generated margins of approximately 91% in 2002. The increase in sales from this division therefore improved our consolidated gross profit and margins.

     The increases in gross margin noted above were offset in part by continued competitive pricing pressures in our direct sales offices, government and national accounts and dealer channels in 2002, including pricing discounts or special competitor promotions on telephone system and software sales and related equipment.

     Research and Development. Research and development expenses increased 10.2% to $19.3 million, or 5.1% of net sales in 2002, from $17.6 million, or 4.6% of net sales in 2001. The increase is attributable in large part to the acquisitions of Mastermind in late October 2001 and Swan in early December 2002. The increase is also attributable, to a lesser extent, to increased research and development spending related to convergence applications and new IP endpoint development. In 2002, research and development expenses were directed principally toward the continued development of the AXXESS software and systems (including versions 6.0 and 7.0), unified messaging and voice processing software, speech recognition and text-to-speech applications, call center applications, unified communications applications, IP endpoint development, and certain CTI and IVR applications.

     Selling, General and Administrative. Selling, general and administrative expenses decreased slightly in absolute dollars to $128.3 million in 2002, compared to $128.6 million in 2001. However, these expenses increased as a percentage of net sales to 33.6% in 2002 compared to 33.3% in 2001. This decrease in

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absolute dollars was primarily due to the reduction in total net sales of $4.2 million in 2002 compared to 2001. The increase in these expenses as a percentage of net sales is in large part attributable to the sale of 83% of Inter-Tel.NET operations in July 2001. Selling, general and administrative expenses for Inter-Tel.NET were 16.8% of net sales when compared to the consolidated average. Accordingly, when these operations were no longer included in our consolidated results, our selling, general and administrative expenses increased as a percentage of net sales.

     Inter-Tel.NET incurred selling, general and administrative expenses, excluding amortization, of $2.3 million during 2001. Excluding the operations of Inter-Tel.NET for comparative purposes, selling, general and administrative expenses decreased as a percentage of net sales reflecting the lower percentage of total sales generated through our combined direct sales offices and government and national accounts divisions, including the acquired McLeod operations in January 2002. Selling, general and administrative expenses also decreased as a percentage of net sales due to lower depreciation and bad debt costs relative to total sales. In addition, the growth in sales from the resale of long distance calling services and Datanet products led to lower selling, general and administrative costs relative to total sales.

     Amortization of Goodwill and Purchased Intangible Assets. We adopted SFAS No. 142 effective the beginning of fiscal 2002. In accordance with SFAS 142, we ceased amortizing goodwill. We are required to perform goodwill impairment tests on an annual basis and between annual tests in certain circumstances. As of December 31, 2002, no impairment of goodwill has been recognized. Although amortization of goodwill ceased for 2002, goodwill amortization totaled $1.9 million in 2001, reflecting amortization from acquisitions completed prior to 2002. For additional information regarding SFAS 142, see “Goodwill and Other Intangible Assets” in Note A of Notes to Consolidated Financial Statements.

     Amortization of purchased intangible assets included in operating expenses was $1.1 million in 2002 compared to $677,000 for 2001. The increases in the amortization of purchased intangible assets for 2002 compared to 2001 was primarily related to the additional amortization from recent acquisitions. For additional information regarding purchased intangible assets, see Note A “Goodwill and Other Intangible Assets” and Note B “Acquisitions, Dispositions and Restructuring Charges “ to Consolidated Financial Statements.

     Other Charges. We recorded no charges in 2002. In connection with the sale of 83 percent of our interest in Inter-Tel.NET in July 2001, we recorded a pre-tax charge or $5.4 million during 2001, which reduced net income by $3.4 million, or $0.13 per share after-tax. This charge was associated with the impairment of our remaining investment in Inter-Tel.NET. The impairment was measured as the difference between the carrying value of Inter-Tel’s remaining 17% interest in Inter-Tel.NET and the estimated fair market value of the 17% interest.

     Litigation Settlement, Net of Costs Except Taxes. In May 2001, Inter-Tel entered into an agreement to submit to binding arbitration a lawsuit we filed in 1996. The arbitration was completed in January 2002 and, as a result of the arbitration, Inter-Tel received a one-time gross cash award of $20 million in February 2002. Direct costs for attorney’s fees, expert witness costs, arbitration costs and additional payments and expenses, totaled approximately $4.5 million in 2002, excluding income taxes, for a net award of approximately $15.5 million. The estimated net proceeds from this arbitration settlement were approximately $9.5 million after taxes, or $0.37 per diluted share for the year ended December 31, 2002.

     Interest and Other Income. Interest and other income increased approximately $855,000 in 2002 compared to 2001 based on a higher level of invested funds, due in part to cash received from the litigation settlement noted above, offset by expenditures relating to the McLeod and Swan acquisitions. During 2002, we recognized foreign currency transaction gains of $330,000, an improvement of $667,000 compared to losses of $337,000 in 2001.

     Interest expense. Interest expense was $156,000 in 2002, a decrease of $312,000 compared to $468,000 in 2001, due primarily to reduced interest on capital leases held by Inter-Tel.NET, 83% of which was sold in July 2001.

     Other. In 2002 included in other income was an expense of approximately $1.2 million related to the write-down of Inter-Tel’s investment in Inter-Tel.NET/Vianet. Other than the write-down, interest and other income in all periods consisted primarily of interest income and foreign currency transaction gains and losses.

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     Income Taxes. Our effective income tax rate for 2002 increased to 37.8% compared to 37.0% for 2001. The rate increased primarily as a result of higher marginal tax rates anticipated from higher net income.

     Net Income. Net income for 2002, including the litigation settlement in 2002, increased to $38.6 million, or $1.49 per diluted share, compared to 2001 net income of $13.0 million, or $0.52 per diluted share, including the charge for the impairment of the investment in Inter-Tel.NET.

     Excluding the 2002 litigation settlement, we would have reported net income of $29.1 million, or $1.13 per diluted share in 2002. Excluding both the 2001 charge and entire 2001 business operations of Inter-Tel.NET, we reported net income of $21.8 million, or $0.86 per diluted share, in 2001. The increase is the result of higher gross profit and increased operating efficiencies described in further detail above.

2001 and 2000 Other Charges.

     Set forth herein is a further description of the items reflected in other charges during the years ended December 31, 2001 and 2000, as well as subsequent events and activity occurring through 2003.

     Inter-Tel.NET/Comm-Services/Vianet. During the second quarter of 2000, Inter-Tel recorded a pre-tax charge associated with Inter-Tel.NET operations of $2.0 million ($1.2 million after-tax), related to the write-down to net realizable value of network equipment and lease termination costs of certain redundant facilities. The reserves established at the time of the write-down have been fully utilized as of December 31, 2001.

     On July 24, 2001, Inter-Tel sold 83% of the stock of Inter-Tel.NET, Inc. to Comm-Services Corporation for a note of $4.95 million, collateralized by Comm-Services stock, other marketable securities of the shareholders of Comm-Services and 100% of the net assets of Inter-Tel.NET. In connection with the sale of 83% of Inter-Tel.NET, we assessed the fair value of the remaining 17% investment in Inter-Tel.NET. Pursuant to SFAS 121, we recorded a charge as of the close of the second quarter of 2001 of $5.4 million ($3.4 million after tax) associated with the impairment of our investment in Inter-Tel.NET. After the impairment charge, the carrying value of our investment (the note receivable from Comm-Services plus the 17% ownership interest in Comm-Services) totaled $3.7 million as of December 31, 2001. The charge was primarily non-cash.

     Inter-Tel’s management has not participated in the management of Inter-Tel.NET since the sale in July 2001. As a result, since July 24, 2001, we have accounted for the remaining Inter-Tel.NET/Comm-Services investment using the cost method of accounting. On December 30, 2001, Comm-Services entered into a merger agreement with Vianet. Inter-Tel’s 17% investment in Comm-Services was converted to approximately 10% of Vianet stock and as a result, the loan for the purchase was assumed by Vianet and Inter-Tel continued to hold collateral from the former shareholders of Comm-Services until March 2003. During 2002, the net investment in the notes receivable and 10% interest in Vianet (formerly Comm-Services) was written down by $1.2 million and was recorded in other assets at a carrying value of approximately $2.5 million as of December 31, 2002, which approximated management’s estimate of the related collateral value at that time.

     During 1999, 2000 and 2001, Inter-Tel.NET entered into operating lease agreements totaling approximately $6.5 million from an equipment vendor for network equipment and software. The lease agreements required Inter-Tel.NET to purchase vendor maintenance on their products. Inter-Tel originally guaranteed the indebtedness. In February 2003, we executed an agreement with Vianet and this vendor releasing Inter-Tel from its guarantee of any and all of these obligations, and Inter-Tel and Vianet released the vendor from claims arising from the failure of the network equipment and software previously leased. As part of this agreement, Inter-Tel also received payment from the Vianet shareholders of $1.45 million, in exchange for the release of the remaining collateral and as payment of the loan. Inter-Tel had also retained a collateral interest in a Vianet shareholder’s variable forward option contract that matured in April and May of 2003, and for which we received no value for the collateral interest. After an adjustment of $124,000 in 2003 related to a recovery of our investment and adjustment of projected costs to actual costs associated with the 2002 write-down in the Vianet investment, the estimated value received in this transaction was equivalent to our remaining investment value, less accruals for potential obligations to the vendor discussed above.

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     Inter-Tel retains its ownership interest in Vianet and will account for the remaining investment interest of approximately 10% in Vianet using the cost method of accounting. At December 31, 2003, our net investment in Vianet was recorded at no value.

     Executone. On January 1, 2000 Inter-Tel purchased certain computer telephony assets and assumed certain liabilities of Executone Information Systems, Inc. (Executone). The Executone transaction was accounted for using the purchase method of accounting. The aggregate purchase price was allocated to the fair value of the assets and liabilities acquired, of which $5.4 million ($3.4 million after taxes) was written-off as purchased in-process research and development. In connection with the Executone acquisition, we sold Executone’s manufacturing assets and liabilities to Varian of Tempe, Arizona at a net book value of $6.6 million.

     During the second quarter of 2000, we decided to close the primary Executone facility in Milford, Connecticut and to recognize a restructuring charge related to our exit plan and closure of the Executone operations. We have accounted for the restructuring of the Executone operations, including severance and related costs, the shut down and consolidation of the Milford facility and the impairment of assets associated with the restructuring. We finalized our plan for the exiting of activities and the involuntary termination or relocation of the employees. Accrued costs associated with this plan were estimates, although the original estimates made for the second quarter of 2000 for reserve balances have not changed significantly as of December 31, 2003.

     Exit costs associated with the closure of the Milford facility also included liabilities for building, furniture and equipment lease, and other contractual obligations. We are liable for the lease on the Milford buildings through January 14, 2005. Various other furniture, computer and equipment leases terminated on varying dates through September 2002. To date, we have entered into sublease agreements with third parties to sublease portions of the facility. The reserve for lease and other contractual obligations is identified in the table below.

     The total restructuring charge from this event totaled $50.9 million. The following tables summarize details of the restructuring charge in connection with the Executone acquisition, including the description of the type and amount of liabilities assumed, and activity in the reserve balances from the date of the charge through December 31, 2003. Activity represents payments made or amounts written off.

(In thousands)

	Cash/												Reserve
	Non-	Restructuring			2000		2001		2002		2003		Balance
Description	Cash	Charge			Activity		Activity		Activity		Activity		At 12/31/03
Personnel Costs:
Severance and termination costs	Cash	$	(1,583	)	$	1,558	$	2	$	20	$	3	$	—
Other Plant closure costs	Cash		(230	)		30		200		—		—		—
Lease termination and other contractual obligations (net of anticipated recovery):
Building and equipment leases	Cash		(7,444	)		1,348		1,489		2,594		767		(1,246	)
Other contractual obligations	Cash		(1,700	)		—		1,700		—		—		—
Impairment of Assets:
Inventories	Non-Cash		(3,454	)		1,376		209		1,869		—		—
Prepaid inventory and other expenses	Non-Cash		(2,485	)		2,485		—		—		—		—
Accounts receivable	Non-Cash		(1,685	)		521		245		88		831		—
Fixed assets	Non-Cash		(3,151	)		2,942		—		53		14		(142	)
Net intangible assets	Non-Cash		(29,184	)		29,184		—		—
Total		$	(50,916	)	$	39,444	$	3,845	$	4,624	$	1,615	$	(1,388	)

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     Included in the total Executone restructuring costs of $50.9 million is a $43.3 million restructuring charge for exit costs and asset impairment included in other charges, and $7.6 million associated with the impairment of inventories, which has accordingly been recorded as additional costs of sales.

Inflation/Currency Fluctuation

     Inflation and currency fluctuations have not previously had a material impact on Inter-Tel’s operations. International procurement agreements have traditionally been denominated in U.S. currency. Moreover, a significant amount of contract manufacturing has been or is expected to be moved to alternative sources. The expansion of international operations in the United Kingdom and Europe and increased sales, if any, in Japan and other parts of Asia could result in higher international sales as a percentage of total revenues; however, international revenues do not currently represent a significant portion of our total revenues.

Liquidity and Capital Resources

(In thousands)	2003			2002			2001
Net cash provided by operating activities	$	54,890		$	77,195		$	75,006
Net cash used in investing activities		(27,040	)		(56,565	)		(17,604	)
Net cash provided by (used in) financing activities		2,424			5,498			(25,710	)
Increase in cash and equivalents		30,274			26,128			31,692
Cash and equivalents at beginning of year		84,923			58,795			27,103
Cash and equivalents at end of year	$	115,197		$	84,923		$	58,795

     At December 31, 2003, cash and equivalents and short-term investments totaled $174.5 million, which represented an increase of approximately $48.7 million from the $125.8 million total at December 31, 2002. We maintain a $10 million unsecured, revolving line of credit with BankOne, NA, which is available through June 1, 2004. Under the credit facility, we have the option to borrow at a prime rate or adjusted LIBOR interest rate. Historically, we have used the credit facility primarily to support international letters of credit to suppliers and we intend to renew this facility again in 2004. A portion of our cash balances may be used for, among other things, acquisitions, strategic alliances, working capital and general corporate purposes.

     Net cash provided by operating activities totaled $54.9 million for the year ended December 31, 2003, compared to $77.2 million for the same period in 2002. Cash provided by operating activities in 2003 primarily resulted from net income plus non-cash charges for depreciation and amortization expenses, provision for losses on receivables and leases, and increased deferred income taxes which was partially offset by cash used in the period by the change in operating assets and liabilities. Cash generated by the increase in deferred income taxes in 2003 totaled $30.3 million compared to $5.0 million in 2002. Cash used in 2003 by the change in operating assets and liabilities was $19.0 million, compared to cash generated by the change in operating assets and liabilities of $15.5 million in 2002. The primary factors for the use of cash for operating accounts in 2003 was an increase in inventories, increased income taxes receivable and increased net investment in sales-leases. We expect to expand sales through our direct sales office and dealer networks, which is expected to require the expenditure of working capital for increased accounts receivable and inventories.

     Net cash used in investing activities totaled $27.0 million for the year ended December 31, 2003, primarily in the form of $18.4 million used to purchase short-term investments net of sales and maturities, as well as capital expenditures, compared to net cash used in investing activities of $56.6 million in 2002, including $37.9 million used to purchase short-term investments. Cash used in acquisitions and other investments totaled approximately $3.1 million in 2003 compared to $11.4 million in 2002. Capital expenditures totaled approximately $7.0 million for 2003 compared to $7.6 million in 2002. We anticipate continued capital expenditures during 2004, principally relating to expenditures for equipment and management information systems used in operations, facilities expansion and acquisition activities.

     Net cash provided by financing activities totaled $2.4 million during 2003 compared to net cash provided of $5.5 million in 2002. We expended approximately $207,000 and $13,000 for stock repurchases during 2003 and 2002, respectively, funded by existing cash balances during each period. Repayment of our long-term debt for the year 2003 was $102,000 compared to $481,000 in 2002. During 2003, we reissued treasury shares through stock option exercises and issuances, with the proceeds received totaling less than

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the cost basis of the treasury stock reissued. Accordingly, the difference was recorded as a reduction to retained earnings. Net cash used for cash dividends totaled $3.8 million in 2003 and $2.2 million during 2002. Cash provided by the exercise of stock options and stock issuances pursuant to our Employee Stock Purchase Plan totaled $6.5 million in 2003 and $8.2 million in 2002.

     We offer to our customers lease financing and other services, including our TotalSolution (formerly Totalease) program, through our Inter-Tel Leasing, Inc. subsidiary. We fund our Total Solution program in part through the sale to financial institutions of rental payment streams under the leases. Sold lease rentals totaling $210.1 and $205.8 million remained unbilled at December 31, 2003 and December 31, 2002, respectively. Such financial institutions have the option to require us to repurchase such income streams, subject to limitations, in the event of defaults by lease customers and, accordingly, we maintain reserves based on loss experience and past due accounts. Although we to date have been able to resell the rental streams from leases under the TotalSolution program profitably and on a substantially current basis, the timing and profitability of lease resales could impact our business and operating results, particularly in an environment of fluctuating interest rates and economic uncertainty. If we are required to repurchase rental streams and realize losses thereon in amounts exceeding our reserves, our operating results will be adversely affected.

     Divisions of the United States Department of Justice are investigating other companies’ and Inter-Tel’s participation in a federally funded “E-Rate program” to connect schools and libraries to the Internet. The Justice Department has provided Inter-Tel with only a limited description of the evidence on which the investigations are based. Inter-Tel is presently unable to predict or determine the final outcome of, or to estimate the potential range of loss with respect to, the investigations. Based upon the information known at this time, we do not know what, if any, impact the investigations may have on the Company’s business or financial condition. If Inter-Tel is convicted of any crime or subjected to sanctions, or debarred from certain government contracts or if penalties, damages or other monetary remedies are assessed against Inter-Tel in connection with or related to these and other investigations, our business and operating results could be materially and adversely affected. The existence and disclosure of the investigations may have already caused competitive harm to Inter-Tel, and any unfavorable resolution to these matters may further harm Inter-Tel’s business.

     We believe our working capital and credit facilities, together with cash generated from operations, will be sufficient to develop and expand our business operations, to finance acquisitions of additional resellers of telephony products and other strategic acquisitions or corporate alliances, and to provide adequate working capital for the foreseeable future. However, to the extent additional funds are required in the future to address working capital needs and to provide funding for capital expenditures, expansion of the business or additional acquisitions, we will seek additional financing. There can be no assurance additional financing will be available when required or on acceptable terms.

Contractual Obligations

     We had the following contractual obligations outstanding:

	Amount of Commitment Expiration Per Period
	(in thousands)
			Less Than						After 5
	Total		1 Year		1-3 Years		4-5 Years		Years
December 31, 2003
Operating lease obligations, primarily for building and equipment leases	$	22,740	$	9,896	$	9,609	$	3,235	$	—
Letters of credit		—		—		—		—		—
Totals at December 31, 2003	$	22,740	$	9,896	$	9,609	$	3,235	$	—
December 31, 2002
Operating lease obligations, primarily for building and equipment leases	$	28,819	$	9,390	$	13,939	$	5,142	$	348
Letters of credit		545		545		—		—		—
Totals at December 31, 2002	$	29,364	$	9,935	$	13,939	$	5,142	$	348

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     Noncancellable operating leases are primarily for buildings. Included in the operating lease obligation totals noted above are payments due on our building lease in Milford, Connecticut associated with the Executone acquisition in 2000. In connection with the Executone charge taken in 2000, we included in the charge anticipated lease costs through the lease termination date, offset by expected sublease receipts. The total costs included in operating lease obligations referred to above, which are associated with the Milford lease, total $2.9 million in 2004 and $121,000 in 2005. The Milford lease expires on January 14, 2005 and we will not renew that lease. Certain of the leases contain provisions for renewal options and scheduled rent increases. At December 31, 2003, future minimum commitments under noncancellable leases, including our headquarters facility and a 15 year lease for our research and development facility and 63 month lease for our distribution and support facility, are as follows: 2004 — $9,896,000; 2005 — $5,646,000; 2006 – $3,963,000; 2007 — $2,502,000; 2008 — $733,000.

     In connection with the acquisition of the rights to certain developed technology for a capitalized purchase price of $2.25 million (included in purchased intangible assets) during the year ended December 31, 2003, the Company entered into an arrangement with the selling entity under which the selling entity will perform additional development activities on a cost reimbursement basis through August 15, 2004. Under the terms of the arrangement, the selling entity can also earn bonus payments totaling up to $1,000,000 during 2004 for meeting certain development milestones. As of December 31, 2003, we did not consider the milestone bonuses to be probable or reasonably estimable, nor had technological feasibility of the underlying technology been achieved to provide for viable product sales; therefore, no bonus payments have been accrued, and the monthly cost of services performed totaling approximately $525,000 has been expensed in research and development costs for the year ended December 31, 2003.

Off-Balance Sheet Arrangements

     As part of our ongoing business, we do not participate in transactions that involve unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. However, we offer to our customers lease financing and other services through our Inter-Tel Leasing, Inc. subsidiary. We fund our Total Solution program in part through the sale to financial institutions of rental payment streams under the leases. Such financial institutions have the option to require us to repurchase such income streams, subject to limitations, in the event of defaults by lease customers and, accordingly, we maintain reserves based on loss experience and past due accounts. For more information regarding our lease portfolio and financing, please see “Liquidity and Capital Resources” above and Notes A and D of Notes to Consolidated Financial Statements.

Critical Accounting Policies and Estimates

     The methods, estimates and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our consolidated financial statements. We evaluate our estimates and judgments on an on-going basis. We base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate and different assumptions or estimates about the future could change our reported results. We believe the following accounting policies are the most critical to us, in that they are important to the portrayal of our financial statements and they require our most difficult, subjective or complex judgments in the preparation of our consolidated financial statements:

     Revenue Recognition. In December 2003, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 104 (SAB 104), “Revenue Recognition.” The Company applies the provisions of SAB 104 to all revenue transactions. SAB 104 supercedes SAB 101, “Revenue Recognition in Financial Statements.” The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the issuance of EITF 00-21. Additionally, SAB 104 rescinds the SEC’s Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (“the FAQ”) issued with SAB 101 that had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB 104. 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. The issuance of SAB 104 did not have a material impact on the Company’s financial position, results of operations or cash flows.

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     Accordingly, revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is both fixed and determinable and; (iv) collectibility is reasonably probable. Revenue derived from sales of systems and services to end-user customers is recognized upon primary installation of the systems and performance of the services, respectively, allowing for use by our customers of these systems. Pre-payments for communications services are deferred and recognized as revenue as the communications services are provided.

     For shipments to dealers and other distributors, our revenues are recorded as products are shipped and services are rendered, because the sales process is complete. These shipments are primarily to third-party dealers and distributors, and title passes when goods are shipped (free-on-board shipping point). Long distance services revenues are recognized as service is provided.

     Sales-Leases. For our sales-type lease accounting, we follow the guidance provided by FASB Statement No. 13, Accounting for Leases and FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – A Replacement of FASB Statement No. 125. We record the discounted present values of minimum rental payments under sales-type leases as sales, net of provisions for continuing administration and other expenses over the lease period. We record the lease sales at the time of system sale and installation pursuant to Staff Accounting Bulletin No. 104, as discussed above for sales to end user customers, and upon receipt of the executed lease documents. The costs of systems installed under these sales-leases are recorded as costs of sales. The net rental streams are sold to funding sources on a regular basis with the income streams discounted by prevailing like-term rates at the time of sale. Gains or losses resulting from the sale of net rental payments from such leases are recorded as net sales. We establish and maintain reserves against potential recourse following the resales based upon historical loss experience, past due accounts and specific account analysis. The allowance for uncollectible minimum lease payments and recourse liability at the end of the year represents reserves against the entire lease portfolio. Management reviews the adequacy of the allowance on a regular basis and adjusts the allowance as required. These reserves are either netted in the accounts receivable, current and long-term components of “Net investments in Sales-Leases” on the balance sheet, or included in long-term liabilities on our balance sheet for off-balance sheet leases.

     Historically, our reserves have been adequate to cover write-offs. During the year ended December 31, 2003, our total reserve for losses related to the lease portfolio declined from 6% to 5.7%, primarily as a result of improved write-off experience and accounts receivable agings. Should the financial condition of our customers deteriorate in the future, additional reserves in amounts that could be material to the financial statements could be required.

     Goodwill and Other Intangible Assets. We assess the impairment of goodwill and other identifiable intangibles whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors we consider important which could trigger an impairment review include the following:

• Significant under-performance relative to historical, expected or projected future operating results;

• Significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

• Our market capitalization relative to net book value, and

• Significant negative industry or economic trends.

     When we determine that the carrying value of goodwill and other identified intangibles may not be recoverable, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model. In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” on January 1, 2002, we ceased amortizing goodwill arising from acquisitions completed prior to July 1, 2001. Inter-Tel has tested goodwill for impairment using the two-step process prescribed in SFAS 142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. Inter-Tel has performed the first of the required impairment tests for goodwill as of December 31, 2003 and has determined that the carrying amount of goodwill is not impaired.

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     Inter-Tel has adopted SFAS 142 effective January 1, 2002. Application of the nonamortization provisions of SFAS 142 resulted in an increase in income from continuing operations before income taxes of approximately $1.8 million in 2003 and 2002.

     Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Additional reserves or allowances for doubtful accounts are recorded for our sales-type leases, discussed above in “Sales-Leases.” We establish and maintain reserves against estimated losses based upon historical loss experience, past due accounts and specific account analysis. Management reviews the level of the allowances for doubtful accounts on a regular basis and adjusts the level of the allowances as needed. In evaluating our allowance we consider accounts in excess of 60 days old as well as other risks in the more current portions of the accounts included. If the financial condition of our customers or channel partners were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

     Inventories. We value our inventories at the lower of cost (principally on a standard cost basis, which approximates the first-in, first-out (FIFO) method) or market. Significant management judgment is required to determine the reserve for obsolete or excess inventory and we make our assessment primarily on a significant product by product basis for the immediately preceding twelve-month period, adjusted for expected changes in projected sales or marketing demand. Inventory on hand may exceed future demand either because the product is outdated or obsolete, or because the amount on hand is more than can be used to meet estimated future needs. We consider criteria such as customer demand, product life-cycles, changing technologies, slow moving inventory and market conditions. We write down our excess and obsolete inventory equal to the difference between the cost of inventory and the estimated market value. If actual customer demand, product life cycles, changing technologies and market conditions are less favorable than those projected by management, additional inventory write-downs may be required in the future.

     Contingencies. We are a party to various claims and litigation in the normal course of business. Management’s current estimated range of liability related to various claims and pending litigation is based on claims for which our management can estimate the amount and range of loss, or can estimate a minimum amount of a loss. Because of the uncertainties related to both the amount and range of loss on the remaining pending claims and litigation, management is unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess the potential liability related to our claims and pending litigation, revise our estimates and accrue for any losses to the extent that they are probable and the amount is estimable. Such revisions in our estimates of the potential liability could materially impact our results of operations and financial position. However, at December 31, 2003, management did not believe that the ultimate impact of various claims and pending litigation would have a materially adverse impact on the Company.

Recent Accounting Pronouncements

     In June 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 supersedes Emerging Issues Task Force (“EITF”) No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring).” SFAS No. 146 eliminates the provisions of EITF No. 94-3 that required a liability to be recognized for certain exit or disposal activities at the date an entity committed to an exit plan. SFAS No. 146 requires a liability for costs associated with an exit or disposal activity to be recognized when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of this statement did not have a material impact on the Company’s results of operations or financial position.

     In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” SFAS No. 148 amends FASB Statement No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods of transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation. Statement 148 also amends the disclosure provisions of SFAS No. 123 and APB Opinion No. 28, “Interim Financial Reporting,” to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. While SFAS No. 148 does not amend SFAS No. 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of SFAS No. 148 are applicable to all companies with stock-based employee compensation, regardless of whether they account

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for that compensation using the fair value method of SFAS No. 123 or the intrinsic value method of APB Opinion No. 25. As allowed by SFAS No. 123, the Company has elected to continue to utilize the accounting method prescribed by APB Opinion No. 25 and has adopted the disclosure requirements of SFAS No. 123 as of December 31, 2002. The adoption of this statement did not have a material impact on the Company’s results of operations or financial position.

     In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45). This statement requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a rollforward of the entity’s product warranty liabilities. We will apply the recognition provisions of FIN 45 prospectively to guarantees issued after December 31, 2002. The disclosure provisions of FIN 45 were effective for financial statements of interim and annual periods ending December 15, 2002. The adoption of this statement did not have a material impact on the Company’s results of operations or financial position.

     In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (FIN 46). This statement requires specified variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003 and beginning July 1, 2003 for variable interest entities created or acquired prior to February 1, 2003. Our exposure to variable interest entities is limited and the adoption of FIN 46 did not have a material impact on the Company’s financial position or results of operations.

     In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material effect on the Company’s financial position, results of operations, or cash flows.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments.

     INVESTMENT PORTFOLIO. We do not use derivative financial instruments in our non-trading investment portfolio. Inter-Tel maintains a portfolio of highly liquid cash equivalents typically maturing in three months or less as of the date of purchase. Inter-Tel makes investments in instruments that meet high credit quality standards, as specified in our investment policy guidelines.

     The Company also maintains short-term investments, which are all classified as available for sale, and have been recorded at fair value, which approximates cost. Short-term investments include certificates of deposit, auction rate certificates, auction rate preferred securities, municipal preferred securities and mutual funds. The auction rate securities are adjustable-rate securities with dividend rates that are reset periodically by bidders through periodic “Dutch auctions” generally conducted every 7 to 49 days by a trust company or broker/dealer on behalf of the issuer. The Company believes these securities are highly liquid investments through the related auctions; however, the collateralizing securities have stated terms of up to thirty (30) years. These instruments are rated A or higher by Standard & Poor’s Ratings Group, or equivalent. The Company’s short-term investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to the Company’s investment guidelines and market conditions. Given the short-term nature of these investments, and that we have no borrowings outstanding other than short-term letters of credit, we are not subject to significant interest rate risk.

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     LEASE PORTFOLIO. We offer to our customers lease financing and other services, including our Total Solutions program, through our Inter-Tel Leasing subsidiary. We fund these programs in part through the sale to financial institutions of rental payment streams under the leases. Upon the sale of the rental payment streams, we continue to service the leases and maintain limited recourse on the leases. We maintain reserves for loan losses on all leases based on historical loss experience, past due accounts and specific account analysis. Although to date we have been able to resell the rental streams from leases under our lease programs profitably and on a substantially current basis, the timing and profitability of lease resales could impact our business and operating results, particularly in an environment of fluctuating interest rates and economic uncertainty. If we were required to repurchase rental streams and realize losses thereon in amounts exceeding our reserves, our operating results could be materially adversely affected. See “Liquidity and Capital Resources” in Management’s Discussion and Analysis and Notes A and D of Notes to Consolidated Financial Statements for more information regarding our lease portfolio and financing.

     IMPACT OF FOREIGN CURRENCY RATE CHANGES. We invoice the customers of our international subsidiaries primarily in the local currencies of our subsidiaries for product and service revenues. Inter-Tel is exposed to foreign exchange rate fluctuations as the financial results of foreign subsidiaries are translated into U.S. dollars in consolidation. The impact of foreign currency rate changes have historically been insignificant.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The information required by this Item is incorporated herein by reference to Exhibit 13.0.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report (the “Evaluation Date”). Based on this evaluation, our principal executive officer and principal financial officer concluded as of the Evaluation Date that our disclosure controls and procedures were effective such that the material information relating to Inter-Tel, including our consolidated subsidiaries, required to be disclosed in our Securities and Exchange Commission (“SEC”) reports is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and was made known to our principal executive officer and principal accounting officer during the period when this report was being prepared to allow timely decisions regarding required disclosure.

In addition, there were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the Evaluation Date. We have not identified any significant deficiencies or material weaknesses in our internal controls, and therefore there were no corrective actions taken.

PART III

     Certain information required by Part III is omitted from this report in that the Registrant will file a definitive proxy statement pursuant to Regulation 14A (the “Proxy Statement”) not later than 120 days after the end of the fiscal year covered by this report, and the information included therein is incorporated herein by reference to the extent the information required by Part III is not provided below.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

     The names of the executive officers of Inter-Tel and their ages, titles, and biographies as of the end of the period covered by this report are set forth below.

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     Steven G. Mihaylo; age 60; Chairman of the Board of Directors, Chief Executive Officer and President. Mr. Mihaylo, the founder of Inter-Tel, has served as Chairman of the Board of Directors of Inter-Tel from July 1969 to October 1982 and from September 1983 to the present. He served as President of Inter-Tel from 1969 to 1983, from 1984 to December 1994, and from May 1998 to present. Mr. Mihaylo has served as Inter-Tel’s Chief Executive Officer since the Company’s formation in July 1969.

     Craig W. Rauchle; age 48; Executive Vice President and Chief Operating Officer. Mr. Rauchle was elected Chief Operating Officer in August 2001 and has been our Executive Vice President since December 1994. As Chief Operating Officer, Mr. Rauchle is responsible for Inter-Tel’s sales and support functions, marketing, procurement, distribution and research and development activities. He had been our Senior Vice President and continues as President of Inter-Tel Technologies, Inc., our wholly owned sales subsidiary. Mr. Rauchle joined Inter-Tel in 1979 as Branch General Manager of the Denver Direct Sales Office and in 1983 was appointed the Central Region Vice President and subsequently the Western Regional Vice President. From 1990 to 1992, Mr. Rauchle served as President of Inter-Tel Communications, Inc. Mr. Rauchle holds a Bachelor of Arts degree in Communications from the University of Denver.

     Norman Stout; age 46; Executive Vice President and Chief Administrative Officer. Mr. Stout was elected Executive Vice President, Chief Administrative Officer and President of Inter-Tel Software and Services in June 1998. As Chief Administrative Officer, Mr. Stout is responsible for Inter-Tel’s strategic planning, mergers and acquisitions, leasing business and centralized corporate support functions including finance, treasury, accounting, human resources, legal, MIS and eCommerce. From October 1994 to June 1998, he served as one of our directors. Prior to joining Inter-Tel, Mr. Stout was Chief Operating Officer of Oldcastle Architectural Products and since 1996, Mr. Stout also had served as President of Oldcastle Architectural West. Mr. Stout was previously President of Superlite Block, a subsidiary of Oldcastle Architectural Products and a manufacturer of concrete products, since February 1993. Prior thereto he was employed by Boorhem-Fields, Inc. of Dallas, Texas, a manufacturer of crushed stone, as Chief Executive Officer from 1990 to 1993 and as Chief Financial Officer from 1986 to 1990. Prior to that, Mr. Stout was a Certified Public Accountant with Coopers & Lybrand. He currently serves on the board of Hypercom Corporation, a public company headquartered in Phoenix, Arizona. Mr. Stout holds a Bachelor of Science degree in Accounting from Texas A&M and an MBA from the University of Texas.

     Jeffrey T. Ford; age 42; Senior Vice President and Chief Technology Officer. Mr. Ford was elected Senior Vice President in May 1998 and has served as our Chief Technology Officer since 1997. He was elected President of Inter-Tel Integrated Systems, Inc. (IIS) in May 1998, after serving as Senior Vice President of IIS for one year and Vice President of Software Engineering of Inter-Tel Integrated Systems from 1993 to 1997. He joined Inter-Tel in 1983 as a software design engineer. Mr. Ford holds a Bachelor of Science degree in Computer Systems Engineering from Arizona State University and an SEP certificate from the Stanford Graduate School of Business.

     Kurt R. Kneip; age 41; Chief Financial Officer, Senior Vice President and Secretary. Mr. Kneip has served as our Chief Financial Officer since September 1993. He has served as Senior Vice President since February 2003 and as Vice President from September 1993 to February 2003. He was elected Secretary and Treasurer in October 1994. In May 1996 he was elected Assistant Treasurer, as John Abbott was elected Treasurer. He joined Inter-Tel in May 1992 as Director of Corporate Tax, after seven years with the accounting firms of Ernst & Young and KPMG Peat Marwick. Mr. Kneip is a Certified Public Accountant, and holds a Bachelor of Science degree in Commercial Economics from South Dakota State University and a Masters Degree in Professional Accountancy from the University of South Dakota.

Code of Business Conduct

     Inter-Tel has a Code of Business Conduct (“Code”) that applies to all of our employees, including our principal executive officer and principal financial and accounting officer. This code is posted on our Internet web site. The Internet address for our web site is http://www.inter-tel.com, and the code may be found as follows:

1.	From our main web page, first click on “About Inter-Tel.”
2.	Next, click on “Code of Business Conduct.”

     We will provide a copy of the Code upon request made by email to financialinfo@inter-tel.com or by writing to us at Inter-Tel, Incorporated, Attention: Investor Relations, 1615 S. 52nd Street, Tempe, Arizona 85281. We intend to satisfy the disclosure requirement under Item 10 of Form 8-K regarding an amendment to, or waiver from, a provision of this Code by posting such information on our web site, at the address and

44

location specified above, and to the extent required, by filing a Current Report on Form 8-K with the SEC disclosing such information.

     Additional information required by this Item is incorporated herein by reference to the Company’s Proxy Statement.

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item is included under the caption “Executive Compensation” in the Company’s Proxy Statement incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by this Item is included under the caption “Security Ownership of Management” in the Company’s Proxy Statement incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required by this Item is included under the caption “Certain Relationships and Related Party Transactions” in the Company’s Proxy Statement incorporated herein by reference.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this Item is included under the caption “Principal Accountant Fees and Services” in the Company’s Proxy Statement incorporated herein by reference.

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PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K

(a)  The following documents are filed as part of this Report:

1. Financial Statements

The following consolidated financial statements of Inter-Tel, Incorporated, and subsidiaries, are incorporated by reference to Exhibit 13.0:

Report of Ernst & Young LLP, Independent Auditors

Consolidated balance sheets—December 31, 2003 and 2002

Consolidated statements of income—years ended December 31, 2003, 2002 and 2001

Consolidated statements of shareholders’ equity—years ended December 31, 2003, 2002 and 2001

Consolidated statements of cash flows—years ended December 31, 2003, 2002 and 2001

Notes to consolidated financial statements

2. Financial Statement Schedules

The following consolidated financial statement schedule of Inter-Tel, Incorporated, and subsidiaries is filed as part of this Report and should be read in conjunction with the Consolidated Financial Statements of Inter-Tel, Incorporated and subsidiaries, and the notes thereto.

Schedule for the three years ended December 31, 2003:

Schedule II—Valuation and Qualifying Accounts Page No. 51

     Schedules not listed above have been omitted because they are not applicable or are not required or the information required to be set forth therein is included in the Consolidated Financial Statements or notes thereto.

3. Exhibits

3.1(10)	Articles of Incorporation, as amended.
3.2(16)	By-Laws, as amended.
10.15(1)	Registrant’s form of standard Distributor Agreement.
10.16(1)	Registrant’s form of standard Service Agreement.
10.35(3)	Agreement between Registrant and Samsung Semiconductor and Telecommunications Company, Ltd. dated October 17, 1984.
10.37(3) *	Tax Deferred Savings Plan.
10.51(11) *	1990 Directors’ Stock Option Plan and form of Stock Option Agreement.
10.52(15) *	Inter-Tel, Incorporated Long-Term Incentive Plan and forms of Stock Option Agreements.
10.53(12)	Agreement between Registrant and Maxon Systems, Inc. dated February 27, 1990.
10.54(12)	Agreement between Registrant and Varian Tempe Electronics Center dated February 26, 1991.
10.55(12)	Agreement between Registrant and Jetcrown Industrial Ltd. dated February 18, 1993.
10.56(13) *	Employee Stock Ownership Plan.
10.57(14)	Loan and Security Agreement dated March 4, 1997 between Bank One, Arizona, N.A. and Registrant and Modification Agreement dated July 25, 1997.

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10.58 (16)	Development, Supply and License Agreement between Registrant and QUALCOMM dated January 17, 1996.
10.59(17) *	Inter-Tel, Incorporated 1997 Long-Term Incentive Plan.
10.60(18) *	Inter-Tel, Incorporated 1997 Employee Stock Purchase Plan.
10.61(19) *	Inter-Tel, Incorporated Acquisition Stock Option Plan and form of Stock Option Agreement.
10.62(20)	Computer Telephony Asset Purchase Agreement dated as of October 17, 1999 by and between Executone Information Systems, Inc., Inter-Tel, Incorporated and Executone Inter-Tel Business Information Systems, Inc.
10.63(21) *	Form of Key Employee Tier 1 Change of Control Severance Agreement.
10.64(21) *	Form of Key Employee Tier 2 Change of Control Severance Agreement.
13.0 (21)	Excerpts from Annual Report to Security Holders.

(1)	Incorporated by reference to Registrant’s Registration Statement on Form S-1 (File No. 2-70437).
(2)	Incorporated by reference to Registrant’s Registration Statement on Form S-8 (File No. 2-94805).
(3)	Incorporated by reference to Registrant’s Annual Report on Form 10-K for the year ended November 30, 1984 (File No. 0-10211), Registration Statement on Form S-8 (File No. 333-106868) and Registrant’s Annual Report on Form 11-K for the year ended December 31, 2002 (File No. 0-10211)
(10)	Incorporated by reference to Registrant’s Annual Report on Form 10-K for the year ended December 31, 1988 (File No. 0-10211).
(11)	Incorporated by reference to Registrant’s Registration Statement on Form S-8 (File No. 33-40353).
(12)	Incorporated by reference to Registrant’s Registration Statement on Form S-1 (File No. 33-70054).
(13)	Incorporated by reference to Registrant’s Registration Statement on Form S-8 (File No. 33-73620).
(14)	Incorporated by reference to Registrant’s Annual Report on Form 10-K for the year ended December 31, 1998 (File No. 0-10211).
(15)	Incorporated by reference to Registrant’s Proxy Statement dated March 23, 1994 and to Registrant’s Registration Statement on Form S-8 (File No. 33-83826).
(16)	Incorporated by reference to Registrant’s Annual Report on Form 10-K for the year ended December 31, 1995 (File No. 0-10211).
(17)	Incorporated by reference to Registrant’s Registration Statements on Forms S-8 (File Nos. 333-41197, 333-85098 and 333-104642).
(18)	Incorporated by reference to Registrant’s Registration Statements on Forms S-8 (File Nos. 333-41197 and 333-87474).
(19)	Incorporated by reference to Registrant’s Registration Statements on Forms S-8 (File Nos. 333-56872, 333-67261 and 333-85098).
(20)	Incorporated by reference to Registrant’s Report on Form 8-K (File No. 333-67261).
(21)	Filed herewith, except as noted.
*	Management contracts or compensatory plan or arrangement required to be filed as an exhibit to this report on Form 10-K.

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(b)  Reports on Form 8-K.

1.

On October 21, 2003, we filed a Current Report on Form 8-K under Item 7 (Financial Statements and Exhibits) and furnished disclosure under Item 12 (Results of Operations and Financial Condition) to report our press release dated October 20, 2003 announcing GAAP and non-GAAP results for the fiscal quarter ended September 30, 2003, and comparing such results with the results for the quarter ended September 30, 2002.

2.

On February 17, 2004, we filed a Current Report on Form 8-K under Item 7 (Financial Statements and Exhibits) and furnished disclosure under Item 12 (Results of Operations and Financial Condition) to report our press release dated February 17, 2004 announcing GAAP and non-GAAP results for the fiscal quarter and year ended December 31, 2003, and comparing such results with the results for the fiscal quarter and year ended December 31, 2002.

(c)  Exhibits.

10.63	Form of Key Employee Tier 1 Change of Control Severance Agreement
10.64	Form of Key Employee Tier 2 Change of Control Severance Agreement
13.0	Excerpts from Annual Report to Security Holders.
21	Subsidiaries of Inter-Tel, Incorporated
23.0	Consent of Ernst & Young LLP, Independent Auditors.
24.1	Power of Attorney (See signature page of this Annual Report on Form 10-K and incorporated herein by reference).
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

     See Item 15(a) 3 also.

(d)  Financial Statement Schedule. The response to this portion of Item 15 is submitted as a separate section of this report. See Item 8.

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SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Inter-Tel, Incorporated, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

INTER-TEL, INCORPORATED
BY:	/s/ Steven G. Mihaylo
	Steven G. Mihaylo
	Chairman and Chief Executive Officer

Dated: March 12, 2004

EXHIBIT 24.1—POWER OF ATTORNEY

     KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Steven G. Mihaylo and Kurt R. Kneip, jointly and severally, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendments to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.

     Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant in the capacities and on the dates indicated.

Signature	Title	Date
/s/ Steven G. Mihaylo Steven G. Mihaylo	Chairman and Chief Executive Officer	March 10, 2004
/s/ Kurt R. Kneip Kurt R. Kneip	Sr. Vice President and Chief Financial Officer	March 10, 2004
/s/ J. Robert Anderson J. Robert Anderson	Director	March 10, 2004
/s/ Jerry W. Chapman Jerry W. Chapman	Director	March 9, 2004
/s/ Gary D. Edens Gary D. Edens	Director	March 10, 2004
/s/ C. Roland Haden C. Roland Haden	Director	March 10, 2004

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SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS

(In thousands)

	COL. A		COL. B		COL. C			COL. D			COL. E
			ADDITIONS
					Charged
	Balance at		Charged		to Other			Charged to			Balance
	Beginning		to Costs		Accounts			Deductions			at End of
DESCRIPTION	of Period		& Expenses		Describe			Describe			Period
Year ended December 31, 2003
Deducted from asset accounts:
Allowance for doubtful accounts	$	12,159	$	3,164	$	(770	)(4)	$	3,543	(2)	$	11,010
Allowance for lease accounts		13,052		4,528		—			2,826	(2)		14,754
Inventory allowance		10,558		991		—			4,597	(3)		6,952
Year ended December 31, 2002
Deducted from asset accounts:
Allowance for doubtful accounts	$	11,858	$	4,177	$	517	(4)	$	4,393	(2)	$	12,159
Allowance for lease accounts		10,736		6,356		—			4,040	(2)		13,052
Inventory allowance		13,202		1,526		—			4,170	(3)		10,558
Year ended December 31, 2001
Deducted from asset accounts:
Allowance for doubtful accounts		17,187		6,260		207	(4)		11,796	(1, 2)		11,858
Allowance for lease accounts		9,200		5,840		—			4,304	(2)		10,736
Inventory allowance		11,897		1,614		2,000	(4)		2,309	(3)		13,202

(1)	Includes $4.6 million related to Executone acquisition adjustments and included in the balance at end of 2000. Additionally, this includes $1.9 million transferred to Comm-Services with the sale of Inter-Tel.NET that was also included in the balance at end of period.
(2)	Uncollectible accounts written off, net of recoveries.
(3)	Inventory written off or sold.
(4)	Acquisition related adjustments.

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Exhibit Index

10.63	Form of Key Employee Tier 1 Change of Control Severance Agreement
10.64	Form of Key Employee Tier 2 Change of Control Severance Agreement
13.0	Excerpts from Annual Report to Security Holders. Filed herewith.
21	Subsidiaries of Inter-Tel, Incorporated
23.0	Consent of Ernst & Young LLP, Independent Auditors.
24.1	Power of Attorney (See signature page of this Annual Report on Form 10-K and incorporated herein by reference).
31.1	Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

EX-10.63 3 p68909exv10w63.htm EX-10.63

Exhibit 10.63
Change of Control Severance Agreement

INTER-TEL, INCORPORATED

TIER 1
KEY EMPLOYEE
CHANGE OF CONTROL SEVERANCE AGREEMENT

     This Key Employee Change of Control Severance Agreement (the “Agreement”) is made and entered into by and between       (the “Executive”) and Inter-Tel, Incorporated, an Arizona Corporation (the “Company”), effective as of March        , 2004 (the “Effective Date”).

RECITALS

1. It is expected that the Company from time to time will consider the possibility of an acquisition by another company or other control change transaction. The Board of Directors of the Company (the “Board”) recognizes that such consideration can be a distraction to Executive and can cause Executive to consider alternative employment opportunities. The Board has determined that it is in the best interests of the Company and its stockholders to assure that the Company will have the continued dedication and objectivity of Executive, notwithstanding the possibility, threat or occurrence of a Change of Control of the Company.

2. The Board believes that it is in the best interests of the Company and its stockholders to provide Executive with an incentive to continue his or her employment and to motivate Executive to maximize the value of the Company upon a Change of Control for the benefit of its stockholders.

3. The Board believes that it is appropriate to provide Executive with certain severance benefits upon Executive’s termination of employment following a Change of Control. These benefits will provide Executive with enhanced financial security and incentive and encouragement to remain with the Company notwithstanding the possibility of a Change of Control.

4. Certain capitalized terms used in the Agreement are defined in Section 6 below.

AGREEMENT

NOW, THEREFORE, in consideration of the mutual covenants contained herein, the parties hereto agree as follows:

1. Term of Agreement. This Agreement shall terminate upon the date that all of the obligations of the parties hereto with respect to this Agreement have been satisfied.

2. At-Will Employment. The Company and Executive acknowledge that Executive’s employment is and shall continue to be at-will, as defined under applicable law, except as may otherwise be specifically provided under the terms of any written formal employment agreement between the Company and Executive (an “Employment Agreement”). If Executive’s employment terminates for any reason, including (without limitation) any termination prior to a Change of Control, Executive shall not be entitled to any payments, benefits, damages, awards or compensation other than as provided by this Agreement or under his or her Employment Agreement (if applicable) or under existing Company benefit plans and programs.

3. Acknowledgment Regarding Acceleration upon Change of Control. The Company and Executive hereby acknowledge that pursuant to the terms of the Company’s 1997 Long Term Incentive Plan and the related option agreement to which the Company and Executive are parties, upon a Change of Control, 100% of Executive’s then outstanding options to purchase shares of the Company’s Common Stock (the “Options”) shall immediately vest and become exercisable (that is, in addition to the shares subject to the Options which have vested and become exercisable as of the date of such Change of Control), but in no event shall the number of shares subject to such Options which so vest exceed the total number of shares subject to such Options. Additionally, 100% of the shares of the Company’s Common Stock then held by Executive subject to a Company repurchase right (the “Restricted Stock”) shall immediately vest and have such Company right of repurchase with respect to such shares of

1

Restricted Stock lapse (that is, in addition to the shares of Restricted Stock which have vested as of the date of such Change of Control), but in no event shall the number of shares which so vest exceed the number of shares of Restricted Stock outstanding immediately prior to the Change of Control.

4. Severance Benefits.

               (a) Involuntary Termination Following a Change of Control. If either (A) within ninety (90) days prior to a Change of Control or (B) within twenty-four (24) months following a Change of Control (i) Executive terminates his or her employment with the Company (or any parent or subsidiary of the Company) for Good Reason or (ii) the Company (or any parent or subsidiary of the Company) terminates Executive’s employment for other than Cause, and Executive signs and does not revoke a standard release of claims with the Company in a form acceptable to the Company (such acceptance not to be unreasonably withheld), then Executive shall receive the following severance from the Company:

                    (i) Severance Payment. Executive shall be entitled to receive a lump-sum severance payment equal to (A) twenty-four (24) months of Executive’s annual base salary (as in effect immediately prior to (1) the Change of Control, or (2) Executive’s termination, whichever is greater) and (B) 100% of Executive’s earned but unpaid bonus as of the date of such termination.

                    (ii) Continued Employee Benefits. Executive shall receive Company-paid coverage for a period of twelve (12) months for Executive and Executive’s eligible dependents under the Company’s Benefit Plans.

               (b) Timing of Severance Payments. The severance payment to which Executive is entitled shall be paid by the Company to Executive in cash and in full, not later than ten (10) calendar days after the date of the termination of Executive’s employment as provided in Section 4(a). If Executive should be entitled to a severance payment and should die before all amounts have been paid, such unpaid amounts shall be paid in a lump-sum payment to Executive’s designated beneficiary, if living, or otherwise to the personal representative of Executive’s estate.

               (c) Voluntary Resignation; Termination for Cause. If Executive’s employment with the Company terminates (i) voluntarily by Executive or (ii) for Cause by the Company, then Executive shall not be entitled to receive severance or other benefits except for those (if any) provided for in an Employment Agreement or as may then be established under the Company’s then existing severance and benefits plans and practices or pursuant to other written agreements with the Company.

               (d) Disability; Death. If the Company terminates Executive’s employment as a result of Executive’s Disability, or Executive’s employment terminates due to his or her death, then Executive shall not be entitled to receive severance or other benefits except for those (if any) provided for in an Employment Agreement or as may then be established under the Company’s then existing written severance and benefits plans and practices or pursuant to other written agreements with the Company.

               (e) Termination Apart from Change of Control. In the event Executive’s employment is terminated for any reason, either prior to the occurrence of a Change of Control or after the twenty-four (24) month period following a Change of Control, then Executive shall be entitled to receive severance and any other benefits only as provided for in an Employment Agreement, if any, or as may then be established under the Company’s existing written severance and benefits plans and practices, if any, or pursuant to any other written agreements with the Company.

               (f) Exclusive Remedy. In the event of a termination of Executive’s employment either (A) within ninety (90) days prior to a Change of Control or (B) within twenty-four (24) months following a Change of Control, the provisions of this Section 4 are intended to be and are exclusive and in lieu of any other rights or remedies to

2

which Executive or the Company may otherwise be entitled (including any provisions in an Employment Agreement), whether at law, tort or contract, in equity, or under this Agreement. Executive shall be entitled to no benefits, compensation or other payments or rights upon termination of employment following a Change in Control other than those benefits expressly set forth in this Section 4 or as otherwise set forth in existing Company benefit plans and programs.

5. Limitation on Payments. In the event that the severance and other benefits provided for in this Agreement or otherwise payable to Executive (i) constitute “parachute payments” within the meaning of Section 280G of the Internal Revenue Code of 1986, as amended (the “Code”) and (ii) but for this Section 5, would be subject to the excise tax imposed by Section 4999 of the Code, then Executive’s severance benefits under Section 4(a)(i) shall be either:

               (a) delivered in full, or

               (b) delivered as to such lesser extent which would result in no portion of such severance benefits being subject to excise tax under Section 4999 of the Code,

whichever of the foregoing amounts, taking into account the applicable federal, state and local income taxes and the excise tax imposed by Section 4999, results in the receipt by Executive on an after-tax basis, of the greatest amount of severance benefits, notwithstanding that all or some portion of such severance benefits may be taxable under Section 4999 of the Code. Unless the Company and Executive otherwise agree in writing, any determination required under this Section 5 shall be made in writing by the Company’s independent public accountants immediately prior to Change of Control (the “Accountants”), whose determination shall be conclusive and binding upon Executive and the Company for all purposes. For purposes of making the calculations required by this Section 5, the Accountants may make reasonable assumptions and approximations concerning applicable taxes and may rely on reasonable, good faith interpretations concerning the application of Sections 280G and 4999 of the Code. The Company and Executive shall furnish to the Accountants such information and documents as the Accountants may reasonably request in order to make a determination under this Section. The Company shall bear all costs the Accountants may reasonably incur in connection with any calculations contemplated by this Section 5.

6. Definition of Terms. The following terms referred to in this Agreement shall have the following meanings:

               (a) Benefit Plans. “Benefit Plans” means plans, policies or arrangements that the Company sponsors (or participates in) and that immediately prior to Executive’s termination of employment provide Executive and/or Executive’s eligible dependents with medical, dental, vision and/or financial counseling benefits. Benefit Plans do not include any other type of benefit (including, but not by way of limitation, disability, life insurance or retirement benefits). A requirement that the Company provide Executive and Executive’s eligible dependents with coverage under the Benefit Plans will not be satisfied unless the coverage is no less favorable than that provided to Executive and Executive’s eligible dependents immediately prior to Executive’s termination of employment. Notwithstanding any contrary provision of this Section 6, but subject to the immediately preceding sentence, the Company may, at its option, satisfy any requirement that the Company provide coverage under any Benefit Plan by instead providing coverage under a separate plan or plans providing coverage that is no less favorable or by paying Executive a lump-sum payment sufficient to provide Executive and Executive’s eligible dependents with equivalent coverage under a third party plan that is reasonably available to Executive and Executive’s eligible dependents.

               (b) Cause. “Cause” means (i) an act of dishonesty made by Executive in connection with such Executive’s responsibilities as an employee, (ii) Executive’s conviction of, or plea of nolo contendre to, a felony which the Board reasonably believes had or will have a material detrimental effect on the Company’s reputation or business, (iii) a willful act by Executive which constitutes gross misconduct and which is injurious to the Company, (iv) circumstances where Executive intentionally imparts material confidential information relating to the Company or its business to competitors or to other third parties other than in the course of carrying out Executive’s duties, or (v) Executive’s continued substantial violations of such Executive’s duties as an employee after Executive has received a written demand for performance from the Company which specifically sets forth the factual basis for the Company’s belief that Executive has not substantially performed such Executive’s duties and after such Executive has been given at least sixty (60) days to cure such performance issues.

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               (c) Change of Control. “Change of Control” means the occurrence of any of the following:

                    (i) Any action or event occurring within a two-year period, as a result of which fewer than a majority of the outside directors of the Company are Incumbent Directors. “Incumbent Directors” shall mean directors who either (A) are outside directors of the Company as of the date hereof, or (B) are elected, or nominated for election, as an outside director to the Board with the affirmative votes of at least a majority of the Incumbent Directors at the time of such election or nomination (but shall not include an individual whose election or nomination is in connection with an actual or threatened proxy contest relating to the election of directors to the Company); or

                    (ii) The consummation of a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least sixty percent (60%) of the total voting power represented by the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation; or

                    (iii) The consummation of the sale, lease or other disposition by the Company of seventy-five percent (75%) or more of the Company’s assets.

               (d) Disability. “Disability” shall mean that Executive has been unable to perform his Company duties as the result of his incapacity due to physical or mental illness, and such inability, at least twenty-six (26) weeks after its commencement, is determined to be total and permanent by a physician selected by the Company or its insurers and acceptable to Executive or Executive’s legal representative (such Agreement as to acceptability not to be unreasonably withheld). Termination resulting from Disability may only be effected after at least thirty (30) days’ written notice by the Company of its intention to terminate Executive’s employment. In the event that Executive resumes the performance of substantially all of his or her duties hereunder before the termination of his or her employment becomes effective, the notice of intent to terminate shall automatically be deemed to have been revoked.

               (e) Good Reason. “Good Reason” means without Executive’s express written consent (i) a significant reduction of Executive’s duties, position or responsibilities, or the removal of such Executive from such position and responsibilities, unless Executive is provided with a comparable position (i.e., a position of equal or greater organizational level, duties, authority, compensation and status); (ii) a reduction by the Company in the compensation of Executive as in effect immediately prior to such reduction; (iii) a material reduction by the Company in the kind or level of benefits or perquisites to which Executive was entitled immediately prior to such reduction with the result that such Executive ‘s overall benefits package is significantly reduced; (iv) the relocation of Executive to a facility or a location more than fifty (50) miles from Executive ‘s then present location.

7. Successors.

               (a) The Company’s Successors. Any successor to the Company (whether direct or indirect and whether by purchase, merger, consolidation, liquidation or otherwise) to all or substantially all of the Company’s business and/or assets shall assume the obligations under this Agreement and agree expressly to perform the obligations under this Agreement in the same manner and to the same extent as the Company would be required to perform such obligations in the absence of a succession. For all purposes under this Agreement, the term "Company” shall include any successor to the Company’s business and/or assets which executes and delivers the assumption agreement described in this Section 7(a) or which becomes bound by the terms of this Agreement by operation of law.

               (b) The Executive’s Successors. The terms of this Agreement and all rights of Executive hereunder shall inure to the benefit of, and be enforceable by, Executive’s personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees.

8. Notice.

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               (a) General. Notices and all other communications contemplated by this Agreement shall be in writing and shall be deemed to have been duly given when personally delivered or when mailed by U.S. registered or certified mail, return receipt requested and postage prepaid. In the case of Executive, mailed notices shall be addressed to him or her at the home address which he or she most recently communicated to the Company in writing. In the case of the Company, mailed notices shall be addressed to its corporate headquarters, and all notices shall be directed to the attention of its Chief Executive Office.

               (b) Notice of Termination. Any termination by the Company for Cause or by Executive for Good Reason or as a result of a voluntary resignation shall be communicated by a notice of termination to the other party hereto given in accordance with Section 8(a) of this Agreement. Such notice shall indicate the specific termination provision in this Agreement relied upon, shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination under the provision so indicated, and shall specify the termination date (which shall be not more than thirty (30) days after the giving of such notice). The failure by Executive to include in the notice any fact or circumstance which contributes to a showing of Good Reason shall not waive any right of Executive hereunder or preclude Executive from asserting such fact or circumstance in enforcing his or her rights hereunder.

9. Miscellaneous Provisions.

               (a) No Duty to Mitigate. Executive shall not be required to mitigate the amount of any payment contemplated by this Agreement, nor shall any such payment be reduced by any earnings that Executive may receive from any other source.

               (b) Waiver. No provision of this Agreement shall be modified, waived or discharged unless the modification, waiver or discharge is agreed to in writing and signed by Executive and by an authorized officer of the Company (other than Executive). No waiver by either party of any breach of, or of compliance with, any condition or provision of this Agreement by the other party shall be considered a waiver of any other condition or provision or of the same condition or provision at another time.

               (c) Headings. All captions and section headings used in this Agreement are for convenient reference only and do not form a part of this Agreement.

               (d) Entire Agreement. This Agreement constitutes the entire agreement of the parties hereto and supersedes in their entirety all prior representations, understandings, undertakings or agreements (whether oral or written and whether expressed or implied) of the parties with respect to the subject matter hereof, including (without limitation) an Employment Agreement). No future agreements between the Company and Executive may supersede this Agreement, unless they are in writing and specifically mention this Section 9(d).

               (e) Choice of Law. The laws of the State of Arizona (without reference to its choice of laws provisions) shall govern the validity, interpretation, construction and performance of this Agreement.

               (f) Severability. The invalidity or unenforceability of any provision or provisions of this Agreement shall not affect the validity or enforceability of any other provision hereof, which shall remain in full force and effect.

               (g) Withholding. All payments made pursuant to this Agreement will be subject to withholding of applicable income and employment taxes.

               (h) Counterparts. This Agreement may be executed in counterparts, each of which shall be deemed an original, but all of which together will constitute one and the same instrument.

IN WITNESS WHEREOF, each of the parties has executed this Agreement, in the case of the Company by its duly authorized officer, as of the day and year set forth below.

COMPANY INTER-TEL, INCORPORATED

5

	By:
	Title:
EXECUTIVE	By:
	Title:

6

EX-10.63

exv10w63

EX-10.64

Exhibit 10.64
Change of Control Severance Agreement

INTER-TEL, INCORPORATED

TIER 2
KEY EMPLOYEE
CHANGE OF CONTROL SEVERANCE AGREEMENT

This Key Employee Change of Control Severance Agreement (the “Agreement”) is made and entered into by and between        (the “Executive”) and Inter-Tel, Incorporated, an Arizona Corporation (the “Company”), effective as of March     , 2004 (the “Effective Date”).

RECITALS

1. It is expected that the Company from time to time will consider the possibility of an acquisition by another company or other control change transaction. The Board of Directors of the Company (the “Board”) recognizes that such consideration can be a distraction to Executive and can cause Executive to consider alternative employment opportunities. The Board has determined that it is in the best interests of the Company and its stockholders to assure that the Company will have the continued dedication and objectivity of Executive, notwithstanding the possibility, threat or occurrence of a Change of Control of the Company.

2. The Board believes that it is in the best interests of the Company and its stockholders to provide Executive with an incentive to continue his or her employment and to motivate Executive to maximize the value of the Company upon a Change of Control for the benefit of its stockholders.

3. The Board believes that it is appropriate to provide Executive with certain severance benefits upon Executive’s termination of employment following a Change of Control. These benefits will provide Executive with enhanced financial security and incentive and encouragement to remain with the Company notwithstanding the possibility of a Change of Control.

4. Certain capitalized terms used in the Agreement are defined in Section 6 below.

AGREEMENT

NOW, THEREFORE, in consideration of the mutual covenants contained herein, the parties hereto agree as follows:

1. Term of Agreement. This Agreement shall terminate upon the date that all of the obligations of the parties hereto with respect to this Agreement have been satisfied.

2. At-Will Employment. The Company and Executive acknowledge that Executive’s employment is and shall continue to be at-will, as defined under applicable law, except as may otherwise be specifically provided under the terms of any written formal employment agreement between the Company and Executive (an “Employment Agreement”). If Executive’s employment terminates for any reason, including (without limitation) any termination prior to a Change of Control, Executive shall not be entitled to any payments, benefits, damages, awards or compensation other than as provided by this Agreement or under his or her Employment Agreement (if applicable) or under existing Company benefit plans and programs.

3. Acknowledgment Regarding Acceleration upon Change of Control. The Company and Executive hereby acknowledge that pursuant to the terms of the Company’s 1997 Long Term Incentive Plan and the related option agreement to which the Company and Executive are parties, upon a Change of Control, 100% of Executive’s then outstanding options to purchase shares of the Company’s Common Stock (the “Options”) shall immediately vest and became exercisable (that is, in addition to the shares subject to the Options which have vested and become exercisable as of the date of such Change of Control), but in no event shall the number of shares subject to such Options which so vest exceed the total number of shares subject to such Options. Additionally, 100% of the shares

1

of the Company’s Common Stock then held by Executive subject to a Company repurchase right (the “Restricted Stock”) shall immediately vest and have such Company right of repurchase with respect to such shares of Restricted Stock lapse (that is, in addition to the shares of Restricted Stock which have vested as of the date of such Change of Control), but in no event shall the number of shares which so vest exceed the number of shares of Restricted Stock outstanding immediately prior to the Change of Control.

4. Severance Benefits.

               (a) Involuntary Termination Following a Change of Control. If either (A) within ninety (90) days prior to a Change of Control or (B) within twenty-four (24) months following a Change of Control (i) Executive terminates his or her employment with the Company (or any parent or subsidiary of the Company) for Good Reason or (ii) the Company (or any parent or subsidiary of the Company) terminates Executive’s employment for other than Cause, and Executive signs and does not revoke a standard release of claims with the Company in a form acceptable to the Company (such acceptance not to be unreasonably withheld), then Executive shall receive the following severance from the Company:

                    (i) Severance Payment. Executive shall be entitled to receive a lump-sum severance payment equal to (A) eighteen (18) months of Executive’s annual base salary (as in effect immediately prior to (1) the Change of Control, or (2) Executive’s termination, whichever is greater) and (B) 100% of Executive’s earned but unpaid bonus as of the date of such termination.

                    (ii) Continued Employee Benefits. Executive shall receive Company-paid coverage for a period of twelve (12) months for Executive and Executive’s eligible dependents under the Company’s Benefit Plans.

               (b) Timing of Severance Payments. The severance payment to which Executive is entitled shall be paid by the Company to Executive in cash and in full, not later than ten (10) calendar days after the date of the termination of Executive’s employment as provided in Section 4(a). If Executive should be entitled to a severance payment and should die before all amounts have been paid, such unpaid amounts shall be paid in a lump-sum payment to Executive’s designated beneficiary, if living, or otherwise to the personal representative of Executive’s estate.

               (c) Voluntary Resignation; Termination for Cause. If Executive’s employment with the Company terminates (i) voluntarily by Executive or (ii) for Cause by the Company, then Executive shall not be entitled to receive severance or other benefits except for those (if any) provided for in an Employment Agreement or as may then be established under the Company’s then existing severance and benefits plans and practices or pursuant to other written agreements with the Company.

               (d) Disability; Death. If the Company terminates Executive’s employment as a result of Executive’s Disability, or Executive’s employment terminates due to his or her death, then Executive shall not be entitled to receive severance or other benefits except for those (if any) provided for in an Employment Agreement or as may then be established under the Company’s then existing written severance and benefits plans and practices or pursuant to other written agreements with the Company.

               (e) Termination Apart from Change of Control. In the event Executive’s employment is terminated for any reason, either prior to the occurrence of a Change of Control or after the twenty-four (24) month period following a Change of Control, then Executive shall be entitled to receive severance and any other benefits only as provided for in an Employment Agreement, if any, or as may then be established under the Company’s existing written severance and benefits plans and practices, if any, or pursuant to any other written agreements with the Company.

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               (f) Exclusive Remedy. In the event of a termination of Executive’s employment either (A) within ninety (90) days prior to a Change of Control or (B) within twenty-four (24) months following a Change of Control, the provisions of this Section 4 are intended to be and are exclusive and in lieu of any other rights or remedies to which Executive or the Company may otherwise be entitled (including any provisions in an Employment Agreement), whether at law, tort or contract, in equity, or under this Agreement. Executive shall be entitled to no benefits, compensation or other payments or rights upon termination of employment following a Change in Control other than those benefits expressly set forth in this Section 4 or as otherwise set forth in existing Company benefit plans and programs.

5. Limitation on Payments. In the event that the severance and other benefits provided for in this Agreement or otherwise payable to Executive (i) constitute “parachute payments” within the meaning of Section 280G of the Internal Revenue Code of 1986, as amended (the “Code”) and (ii) but for this Section 5, would be subject to the excise tax imposed by Section 4999 of the Code, then Executive’s severance benefits under Section 4(a)(i) shall be either:

               (a) delivered in full, or

               (b) delivered as to such lesser extent which would result in no portion of such severance benefits being subject to excise tax under Section 4999 of the Code,

whichever of the foregoing amounts, taking into account the applicable federal, state and local income taxes and the excise tax imposed by Section 4999, results in the receipt by Executive on an after-tax basis, of the greatest amount of severance benefits, notwithstanding that all or some portion of such severance benefits may be taxable under Section 4999 of the Code. Unless the Company and Executive otherwise agree in writing, any determination required under this Section 5 shall be made in writing by the Company’s independent public accountants immediately prior to Change of Control (the “Accountants”), whose determination shall be conclusive and binding upon Executive and the Company for all purposes. For purposes of making the calculations required by this Section 5, the Accountants may make reasonable assumptions and approximations concerning applicable taxes and may rely on reasonable, good faith interpretations concerning the application of Sections 280G and 4999 of the Code. The Company and Executive shall furnish to the Accountants such information and documents as the Accountants may reasonably request in order to make a determination under this Section. The Company shall bear all costs the Accountants may reasonably incur in connection with any calculations contemplated by this Section 5.

6. Definition of Terms. The following terms referred to in this Agreement shall have the following meanings:

               (a) Benefit Plans. “Benefit Plans” means plans, policies or arrangements that the Company sponsors (or participates in) and that immediately prior to Executive’s termination of employment provide Executive and/or Executive’s eligible dependents with medical, dental, vision and/or financial counseling benefits. Benefit Plans do not include any other type of benefit (including, but not by way of limitation, disability, life insurance or retirement benefits). A requirement that the Company provide Executive and Executive’s eligible dependents with coverage under the Benefit Plans will not be satisfied unless the coverage is no less favorable than that provided to Executive and Executive’s eligible dependents immediately prior to Executive’s termination of employment. Notwithstanding any contrary provision of this Section 6, but subject to the immediately preceding sentence, the Company may, at its option, satisfy any requirement that the Company provide coverage under any Benefit Plan by instead providing coverage under a separate plan or plans providing coverage that is no less favorable or by paying Executive a lump-sum payment sufficient to provide Executive and Executive’s eligible dependents with equivalent coverage under a third party plan that is reasonably available to Executive and Executive’s eligible dependents.

               (b) Cause. “Cause” means (i) an act of dishonesty made by Executive in connection with such Executive’s responsibilities as an employee, (ii) Executive’s conviction of, or plea of nolo contendre to, a felony which the Board reasonably believes had or will have a material detrimental effect on the Company’s reputation or business, (iii) a willful act by Executive which constitutes gross misconduct and which is injurious to the Company, (iv) circumstances where Executive intentionally imparts material confidential information relating to the Company or its business to competitors or to other third parties other than in the course of carrying out Executive’s duties, or (v) Executive’s continued substantial violations of such Executive’s duties as an employee after Executive has received a written demand for performance from the Company which specifically sets forth the

3

factual basis for the Company’s belief that Executive has not substantially performed such Executive’s duties and after such Executive has been given at least sixty (60) days to cure such performance issues.

               (c) Change of Control. “Change of Control” means the occurrence of any of the following:

                    (i) Any action or event occurring within a two-year period, as a result of which fewer than a majority of the outside directors of the Company are Incumbent Directors. “Incumbent Directors” shall mean directors who either (A) are outside directors of the Company as of the date hereof, or (B) are elected, or nominated for election, as an outside director to the Board with the affirmative votes of at least a majority of the Incumbent Directors at the time of such election or nomination (but shall not include an individual whose election or nomination is in connection with an actual or threatened proxy contest relating to the election of directors to the Company); or

                    (ii) The consummation of a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least sixty percent (60%) of the total voting power represented by the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation; or

                    (iii) The consummation of the sale, lease or other disposition by the Company of seventy-five percent (75%) or more of the Company’s assets.

               (d) Disability. “Disability” shall mean that Executive has been unable to perform his Company duties as the result of his incapacity due to physical or mental illness, and such inability, at least twenty-six (26) weeks after its commencement, is determined to be total and permanent by a physician selected by the Company or its insurers and acceptable to Executive or Executive’s legal representative (such Agreement as to acceptability not to be unreasonably withheld). Termination resulting from Disability may only be effected after at least thirty (30) days’ written notice by the Company of its intention to terminate Executive’s employment. In the event that Executive resumes the performance of substantially all of his or her duties hereunder before the termination of his or her employment becomes effective, the notice of intent to terminate shall automatically be deemed to have been revoked.

               (e) Good Reason. “Good Reason” means without Executive’s express written consent (i) a significant reduction of Executive’s duties, position or responsibilities, or the removal of such Executive from such position and responsibilities, unless Executive is provided with a comparable position (i.e., a position of equal or greater organizational level, duties, authority, compensation and status); (ii) a reduction by the Company in the compensation of Executive as in effect immediately prior to such reduction; (iii) a material reduction by the Company in the kind or level of benefits or perquisites to which Executive was entitled immediately prior to such reduction with the result that such Executive ‘s overall benefits package is significantly reduced; (iv) the relocation of Executive to a facility or a location more than fifty (50) miles from Executive ‘s then present location.

7. Successors.

               (a) The Company’s Successors. Any successor to the Company (whether direct or indirect and whether by purchase, merger, consolidation, liquidation or otherwise) to all or substantially all of the Company’s business and/or assets shall assume the obligations under this Agreement and agree expressly to perform the obligations under this Agreement in the same manner and to the same extent as the Company would be required to perform such obligations in the absence of a succession. For all purposes under this Agreement, the term “Company” shall include any successor to the Company’s business and/or assets which executes and delivers the assumption agreement described in this Section 7(a) or which becomes bound by the terms of this Agreement by operation of law.

4

               (b) The Executive’s Successors. The terms of this Agreement and all rights of Executive hereunder shall inure to the benefit of, and be enforceable by, Executive’s personal or legal representatives, executors, administrators, successors, heirs, distributees, devisees and legatees.

8. Notice.

               (a) General. Notices and all other communications contemplated by this Agreement shall be in writing and shall be deemed to have been duly given when personally delivered or when mailed by U.S. registered or certified mail, return receipt requested and postage prepaid. In the case of Executive, mailed notices shall be addressed to him or her at the home address which he or she most recently communicated to the Company in writing. In the case of the Company, mailed notices shall be addressed to its corporate headquarters, and all notices shall be directed to the attention of its Chief Executive Office.

               (b) Notice of Termination. Any termination by the Company for Cause or by Executive for Good Reason or as a result of a voluntary resignation shall be communicated by a notice of termination to the other party hereto given in accordance with Section 8(a) of this Agreement. Such notice shall indicate the specific termination provision in this Agreement relied upon, shall set forth in reasonable detail the facts and circumstances claimed to provide a basis for termination under the provision so indicated, and shall specify the termination date (which shall be not more than thirty (30) days after the giving of such notice). The failure by Executive to include in the notice any fact or circumstance which contributes to a showing of Good Reason shall not waive any right of Executive hereunder or preclude Executive from asserting such fact or circumstance in enforcing his or her rights hereunder.

9. Miscellaneous Provisions.

               (a) No Duty to Mitigate. Executive shall not be required to mitigate the amount of any payment contemplated by this Agreement, nor shall any such payment be reduced by any earnings that Executive may receive from any other source.

               (b) Waiver. No provision of this Agreement shall be modified, waived or discharged unless the modification, waiver or discharge is agreed to in writing and signed by Executive and by an authorized officer of the Company (other than Executive). No waiver by either party of any breach of, or of compliance with, any condition or provision of this Agreement by the other party shall be considered a waiver of any other condition or provision or of the same condition or provision at another time.

               (c) Headings. All captions and section headings used in this Agreement are for convenient reference only and do not form a part of this Agreement.

               (d) Entire Agreement. This Agreement constitutes the entire agreement of the parties hereto and supersedes in their entirety all prior representations, understandings, undertakings or agreements (whether oral or written and whether expressed or implied) of the parties with respect to the subject matter hereof, including (without limitation) an Employment Agreement). No future agreements between the Company and Executive may supersede this Agreement, unless they are in writing and specifically mention this Section 9(d).

               (e) Choice of Law. The laws of the State of Arizona (without reference to its choice of laws provisions) shall govern the validity, interpretation, construction and performance of this Agreement.

               (f) Severability. The invalidity or unenforceability of any provision or provisions of this Agreement shall not affect the validity or enforceability of any other provision hereof, which shall remain in full force and effect.

               (g) Withholding. All payments made pursuant to this Agreement will be subject to withholding of applicable income and employment taxes.

               (h) Counterparts. This Agreement may be executed in counterparts, each of which shall be deemed an original, but all of which together will constitute one and the same instrument.

5

IN WITNESS WHEREOF, each of the parties has executed this Agreement, in the case of the Company by its duly authorized officer, as of the day and year set forth below.

COMPANY	INTER-TEL, INCORPORATED
	By:
	Title:
EXECUTIVE	By:
	Title	:

6

EX-13.0

EXHIBIT 13.0 ANNUAL REPORT TO SECURITY HOLDERS

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Report of Ernst & Young LLP, Independent Auditors

Shareholders and Board of Directors
Inter-Tel, Incorporated

We have audited the accompanying consolidated balance sheets of Inter-Tel, Incorporated and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedule listed in the Index to consolidated financial statements and schedule. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Inter-Tel, Incorporated and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Note A to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill.

/s/ Ernst & Young LLP

Phoenix, Arizona
February 17, 2004

INTER-TEL, INCORPORATED AND SUBSIDIARIES

     CONSOLIDATED BALANCE SHEETS

     December 31, 2003 and 2002

     (In thousands, except share amounts)

	2003			2002
ASSETS
CURRENT ASSETS
Cash and equivalents	$	115,197		$	84,923
Short-term investments		59,334			40,916
Total cash and short-term investments		174,531			125,839
Accounts receivable, net of allowances of $11,010 in 2003 and $12,159 in 2002		43,434			42,566
Inventories, net of allowances of $6,952 in 2003 and $10,558 in 2002		14,648			11,329
Net investment in sales-leases, net of allowances of $749 in 2003 and $516 in 2002		15,502			13,344
Income taxes receivable		8,196			2,604
Deferred income taxes		13,789			2,377
Prepaid expenses and other assets		6,432			6,705
TOTAL CURRENT ASSETS		276,532			204,764
PROPERTY, PLANT & EQUIPMENT		24,657			24,795
GOODWILL		17,967			17,646
PURCHASED INTANGIBLE ASSETS		8,191			7,416
NET INVESTMENT IN SALES-LEASES, net of allowances of $1,985 in 2003 and $1,411 in 2002		32,529			24,692
OTHER ASSETS		—			2,749
	$	359,876		$	282,062
LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES
Accounts payable	$	28,386		$	23,089
Other current liabilities		47,585			50,051
TOTAL CURRENT LIABILITIES		75,971			73,140
DEFERRED TAX LIABILITY		57,996			16,320
LEASE RECOURSE LIABILITY		12,020			11,125
RESTRUCTURING RESERVE		49			1,049
OTHER LIABILITIES		6,535			6,525
SHAREHOLDERS’ EQUITY
Common stock, no par value-authorized 100,000,000 shares; issued – 27,161,823 shares; outstanding – 25,429,642 shares at December 31, 2003 and 24,908,983 shares at December 31, 2002		113,960			111,639
Less: Shareholder loans		—			(338	)
Retained earnings		113,299			89,643
Accumulated other comprehensive income		1,025			195
		228,284			201,139
Less: Treasury stock at cost – 1,732,181 shares in 2003 and 2,252,840 shares in 2002		(20,979	)		(27,236	)
TOTAL SHAREHOLDERS’ EQUITY		207,305			173,903
	$	359,876		$	282,062

See accompanying notes.

52

INTER-TEL, INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

Years Ended December 31, 2003, 2002 and 2001

(In thousands, except per share data)

	2003			2002			2001
NET SALES
Telecommunications systems, software and related	$	335,570		$	351,414		$	346,094
Resale of long distance		38,266			30,042			25,575
Inter-Tel.NET/Vianet		—			—			13,986
Total net sales		373,836			381,456			385,655
Cost of sales
Telecommunications systems, software and related		150,833			165,567			172,271
Resale of long distance		25,930			21,416			19,012
Inter-Tel.NET/Vianet		—			—			19,878
Total cost of sales		176,763			186,983			211,161
GROSS PROFIT		197,073			194,473			174,494
Research and development		21,978			19,340			17,556
Selling, general and administrative		128,964			128,284			128,604
Amortization of goodwill		—			—			1,876
Amortization of purchased intangible assets		1,803			1,122			677
Other charges		—			—			5,357
		152,745			148,746			154,070
OPERATING INCOME		44,328			45,727			20,424
Litigation settlement (net of costs except for taxes)		—			15,516			—
Write-down/recovery of investment in Inter-Tel.NET/Vianet		124			(1,200	)		—
Interest and other income		1,683			1,936			1,081
Foreign currency transaction gains (losses)		18			330			(337	)
Interest expense		(155	)		(156	)		(468	)
INCOME BEFORE INCOME TAXES		45,998			62,153			20,700
INCOME TAXES (BENEFIT)
Current		(12,784	)		18,495			(3,647	)
Deferred		30,264			5,021			11,306
		17,480			23,516			7,659
NET INCOME	$	28,518		$	38,637		$	13,041
NET INCOME PER SHARE
Basic	$	1.14		$	1.58		$	0.53
Diluted	$	1.08		$	1.49		$	0.52
Weighted average basic common shares		25,078			24,444			24,488
Weighted average diluted common shares		26,473			25,864			25,240

See accompanying notes.

53

INTER-TEL, INCORPORATED AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
Years Ended December 31, 2003, 2002 and 2001

(in thousands)

										Accumulated
				Share-						Other
	Common			holder			Retained			Comprehensive			Treasury
	Stock			Loans			Earnings			Income (loss)			Stock			Total
Balance at December 31, 2000	$	109,132		$	(1,018	)	$	44,099		$	(280	)	$	(15,497	)	$	136,436
Net income								13,041									13,041
Gain on currency translation											431						431
Comprehensive income																	13,472
Stock repurchase														(28,905	)		(28,905	)
Exercise of stock options								(509	)					1,806			1,297
Tax benefit from stock options		263															263
Shareholder loan repayments					76												76
Stock issued under ESPP								(91	)					1,057			966
Issuance of treasury shares in conversion of subsidiary stock		(427	)					(471	)					5,322			4,424
Dividends								(1,192	)								(1,192	)
Balance at December 31, 2001		108,968			(942	)		54,877			151			(36,217	)		126,837
Net income								38,637									38,637
Gain on currency translation											44						44
Comprehensive income																	38,681
Stock repurchase								(16	)					3			(13	)
Exercise of stock options								(1,626	)					8,234			6,608
Tax benefit from stock options		2,671															2,671
Shareholder loan repayments					604												604
Stock issued under ESPP								228						744			972
Dividends								(2,457	)								(2,457	)
Balance at December 31, 2002		111,639			(338	)		89,643			195			(27,236	)		173,903
Net income								28,518									28,518
Gain on currency translation											830						830
Comprehensive income																	29,348
Stock repurchase								(58	)					(149	)		(207	)
Exercise of stock options								(465	)					5,701			5,236
Tax benefit from stock options		2,321															2,321
Shareholder loan repayments					338												338
Stock issued under ESPP								210						705			915
Dividends								(4,549	)								(4,549	)
Balance at December 31, 2003	$	113,960		$	—		$	113,299		$	1,025		$	(20,979	)	$	207,305

See accompanying notes.

54

INTER-TEL, INCORPORATED AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

Years ended December 31, 2003, 2002 and 2001

(In thousands)

	2003			2002			2001
OPERATING ACTIVITIES:
Net income	$	28,518		$	38,637		$	13,041
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation of fixed assets		7,109			7,310			8,742
Amortization of goodwill and purchased intangibles		1,803			1,122			2,553
Amortization of patents included in R&D expenses		222			222			222
Non-cash portion of other charges (recoveries)		(124	)		1,200			5,357
Provision for losses on receivables		3,164			4,177			6,260
Provision for losses on leases		4,528			6,356			5,840
Provision for inventory valuation		991			1,526			1,614
Decrease in other liabilities		(3,563	)		(3,937	)		(1,289	)
(Gain) loss on sale of property and equipment:		118			37			(39	)
Deferred income tax expense		30,263			5,021			11,306
Effect of exchange rate changes		830			44			431
Changes in operating assets and liabilities		(18,969	)		15,480			20,968
NET CASH PROVIDED BY OPERATING ACTIVITIES		54,890			77,195			75,006
INVESTING ACTIVITIES:
Purchases of short-term investments		(170,464	)		(67,682	)		(3,000	)
Maturities and sales of short-term investments		152,046			29,766			—
Additions to property and equipment and equipment held under lease		(7,048	)		(7,600	)		(7,988	)
Proceeds from sale of property and equipment and equipment held under lease		76			328			173
Proceeds from investment in Inter-Tel.NET/Vianet		1,450			—			—
Cash used in acquisitions and other investments		(3,100	)		(11,377	)		(6,789	)
NET CASH USED IN INVESTING ACTIVITIES		(27,040	)		(56,565	)		(17,604	)
FINANCING ACTIVITIES:
Cash dividends paid		(3,756	)		(2,192	)		(983	)
Payments on term debt		(102	)		(481	)		(1,548	)
Treasury stock purchases		(207	)		(13	)		(28,905	)
Proceeds from term debt		—			—			3,387
Proceeds from stock issued under the Employee Stock Purchase Plan		915			972			966
Proceeds from exercise of stock options, including shareholder loan repayments		5,574			7,212			1,373
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES		2,424			5,498			(25,710	)
INCREASE IN CASH AND EQUIVALENTS		30,274			26,128			31,692
CASH AND EQUIVALENTS AT BEGINNING OF YEAR		84,923			58,795			27,103
CASH AND EQUIVALENTS AT END OF YEAR	$	115,197		$	84,923		$	58,795

See accompanying notes.

55

INTER-TEL, INCORPORATED AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2003, 2002 and 2001

NOTE A – SIGNIFICANT ACCOUNTING POLICIES

     Description of Business. Inter-Tel, incorporated in 1969, is a single point of contact, full service provider of converged voice and data business communications systems, voice mail systems and networking applications. We market and sell voice processing and unified messaging software, call accounting software, Internet Protocol (IP) telephony software, computer-telephone integration (CTI) applications, local and long distance calling services, and other communications services. Our products and services include the Axxess by Inter-Tel and EncoreCX by Inter-Tel business communication systems, with integrated voice processing and unified messaging systems, IP telephony voice and data routers, and e-commerce software. We also provide maintenance, leasing and support services for our products. Our customers include business enterprises, government agencies and non-profit organizations. Our common stock is quoted on the Nasdaq National Market System under the symbol “INTL.”

     Principles of Consolidation. The consolidated financial statements include the accounts of Inter-Tel, Incorporated and all significant subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.

     Cash and Equivalents and Short-Term Investments. Cash and equivalents include all highly liquid investments with a remaining maturity of three months or less at date of acquisition. Cash and equivalents are primarily invested in mutual funds comprised of foreign and domestic high quality dollar denominated money market instruments rated A-1 by Standard & Poor’s Ratings Group, or equivalent.

     The Company accounts for short-term investments in accordance with Financial Accounting Standard No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The Company’s short-term investments are classified as available for sale, and have been recorded at fair value, which approximates cost.

     Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Additional reserves or allowances for doubtful accounts are recorded for our sales-type leases, discussed below in “Sales-Leases.” We establish and maintain reserves against estimated losses based upon historical loss experience, past due accounts and specific account analysis. Management reviews the level of the allowances for doubtful accounts on a regular basis and adjusts the level of the allowances as needed. In evaluating our allowance we consider accounts in excess of 60 days old as well as other risks in the more current portions of the accounts included. At December 31, 2003, our allowance for doubtful accounts for accounts receivable was $11.0 million of our $54.4 million in gross accounts receivable. If the financial condition of our customers or channel partners were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.

     Inventories. We value our inventories at the lower of cost (principally on a standard cost basis, which approximates the first-in, first-out (FIFO) method) or market. Significant management judgment is required to determine the reserve for obsolete or excess inventory and we make our assessment primarily on a significant product by product basis for the immediately preceding twelve-month period, adjusted for expected changes in projected sales or marketing demand. Inventory on hand may exceed future demand either because the product is outdated or obsolete, or because the amount on hand is more than can be used to meet estimated future needs. We consider criteria such as customer demand, product life-cycles, changing technologies, slow moving inventory and market conditions. We write down our excess and obsolete inventory equal to the difference between the cost of inventory and the estimated market value. At December 31, 2003, our inventory reserves were $7.0 million of our $21.6 million gross inventories. If actual customer demand, product life cycles, changing technologies and market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

     Property, Plant and Equipment. Property, plant and equipment is stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related real and personal property, which range from 3 years to 30 years. Leasehold improvements are depreciated over the shorter of the related lease terms or the estimated useful lives of the improvements. Within the category “computer

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systems and equipment,” including database and enterprise software, WAN and LAN equipment and software, personal computers, servers and related software, the range for estimated useful lives is 3 years to 7 years.

     Goodwill and Other Intangible Assets. On January 1, 2002, Inter-Tel adopted SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. Purchase prices of acquired businesses that are accounted for as purchases have been allocated to the assets and liabilities acquired based on the estimated fair values on the respective acquisition dates. Based on these values, the excess purchase prices over the fair value of the net assets acquired were allocated to goodwill.

     Prior to January 1, 2002, Inter-Tel amortized goodwill over the useful life of the underlying asset, not to exceed 40 years. On January 1, 2002, Inter-Tel began accounting for goodwill under the provisions of SFAS Nos. 141 and 142 and discontinued the amortization of goodwill. As at December 31, 2003, Inter-Tel had gross goodwill of $23.0 million and accumulated amortization of $5.0 million. For the year ended December 31, 2003, Inter-Tel did not recognize amortization expense related to goodwill. Inter-Tel completed two acquisitions in 2002 and one in 2003 and has not recorded any amortization for these acquisitions on amounts allocated to goodwill in accordance with SFAS No. 141.

     In assessing the recoverability of Inter-Tel’s goodwill and other intangibles, Inter-Tel must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, Inter-Tel may be required to record impairment charges for these assets not previously recorded. Some factors considered important which could trigger an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, Inter-Tel’s market capitalization relative to net book value, and significant negative industry or economic trends.

     The Company has tested goodwill for impairment using the two-step process prescribed in SFAS No. 142. The first step is a screen for potential impairment, while the second step measures the amount of the impairment, if any. Inter-Tel performed the first of the required impairment tests for goodwill as of December 31, 2003 and determined that goodwill is not impaired and it is not necessary to record any impairment losses related to goodwill and other intangible assets.

     Net income, basic earnings per share and diluted earnings per share for the years ended December 31, 2003, 2002 and 2001, respectively, adjusted to exclude amortization expense for goodwill, are as follows (net of tax, in thousands, except per share data):

	Years Ended December 31,
	2003		2002		2001
Reported net income	$	28,518	$	38,637	$	13,041
Add back: goodwill amortization		—		—		694
Adjusted net income	$	28,518	$	38,637	$	13,735
Reported earnings per share – basic	$	1.14	$	1.58	$	0.53
Add back: goodwill amortization		—		—		0.03
Adjusted earnings per share – basic	$	1.14	$	1.58	$	0.56
Reported earnings per share – diluted	$	1.08	$	1.49	$	0.52
Add back: goodwill amortization		—		—		0.03
Adjusted earnings per share – diluted	$	1.08	$	1.49	$	0.54

     At December 31, 2003, goodwill, net of accumulated amortization, totaled $18.0 million. Other acquisition-related intangibles, net of accumulated amortization, totaled $8.2 million at December 31, 2003. Accumulated amortization through December 31, 2003 was $11.0 million. This amount includes $5.0 million of amortization of goodwill and $6.0 million of amortization of other acquisition-related intangibles. Other acquisition-related intangibles, comprised primarily of developed technology, customer lists and non-competition agreements, are amortized on a straight-line basis over periods ranging from 5-17 years. See Note F to Consolidated Financial Statements for additional information.

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     Sales-Leases. For our sales-type lease accounting, we follow the guidance provided by FASB Statement No. 13, Accounting for Leases and FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – A Replacement of FASB Statement No. 125. We record the discounted present values of minimum rental payments under sales-type leases as sales, net of provisions for continuing administration and other expenses over the lease period. We record the lease sales at the time of system sale and installation pursuant to Staff Accounting Bulletin No. 104, as discussed above for sales to end user customers, and upon receipt of the executed lease documents. The costs of systems installed under these sales-leases are recorded as costs of sales. The net rental streams are sold to funding sources on a regular basis with the income streams discounted by prevailing like-term rates at the time of sale. Gains or losses resulting from the sale of net rental payments from such leases are recorded as net sales. We establish and maintain reserves against potential recourse following the resales based upon historical loss experience, past due accounts and specific account analysis. The allowance for uncollectible minimum lease payments and recourse liability at the end of the year represents reserves against the entire lease portfolio. Management reviews the adequacy of the allowance on a regular basis and adjusts the allowance as required. These reserves are either netted in the accounts receivable, current and long-term components of “Net investments in Sales-Leases” on the balance sheet, or included in long-term liabilities on our balance sheet for off-balance sheet leases.

     Income Taxes. Deferred income taxes result from temporary differences in the recognition of revenues and expenses for financial reporting and income tax purposes.

     Advertising. The cost of advertising is expensed as incurred. We incurred $331,000; $443,000; and $596,000 in advertising costs during 2003, 2002, and 2001, respectively.

     Revenue Recognition. In December 2003, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 104 (SAB 104), “Revenue Recognition.” The Company applies the provisions of SAB 104 to all revenue transactions. SAB 104 supercedes SAB 101, “Revenue Recognition in Financial Statements.” The primary purpose of SAB 104 is to rescind accounting guidance contained in SAB 101 related to multiple element revenue arrangements, superceded as a result of the issuance of EITF 00-21. Additionally, SAB 104 rescinds the SEC’s Revenue Recognition in Financial Statements Frequently Asked Questions and Answers (“the FAQ”) issued with SAB 101 that had been codified in SEC Topic 13, Revenue Recognition. Selected portions of the FAQ have been incorporated into SAB 104. 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. The issuance of SAB 104 did not have a material impact on the Company’s financial position, results of operations or cash flows.

     Accordingly, revenue is recognized when all four of the following criteria are met: (i) persuasive evidence that arrangement exists; (ii) delivery of the products and/or services has occurred; (iii) the selling price is both fixed and determinable and; (iv) collectibility is reasonably probable. Revenue derived from sales of systems and services to end-user customers is recognized upon installation of the systems and performance of the services, respectively, allowing for use by our customers of these systems. Pre-payments for communications services are deferred and recognized as revenue as the communications services are provided.

     For shipments to dealers and other distributors, our revenues are recorded as products are shipped and services are rendered, because the sales process is complete. These shipments are primarily to third-party dealers and distributors and title passes when goods are shipped (free-on-board shipping point). Long distance services revenues are recognized as service is provided.

     Shipping and Handling Costs. EITF 00-10 “Accounting for Shipping and Handling Fees and Costs,” addresses the accounting for shipping and handling fees and costs. Our policy is primarily not to bill customers for shipping costs, unless the customer requests priority shipping. Any amounts billed are recorded net in cost of goods sold. Billed shipping and handling costs in 2003, 2002 and 2001 were approximately $1.3 million, $1.1 million, and $1.2 million, respectively, and are not a significant component of our operations.

     Stock Based Compensation. We grant stock options for a fixed number of shares to employees and directors with an exercise price equal to the fair market value of the shares at the date of grant. We account for such stock option grants using the intrinsic-value method of accounting in accordance with Accounting

58

Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and related Interpretations. Under APB 25, we generally recognize no compensation expense with respect to such awards. Also, we do not record any compensation expense in connection with our Employee Stock Purchase Plan as long as the purchase price is not less than 85% of the fair market value at the beginning or end of each offering period, whichever is lower.

     The pro forma impact on net income and net income per share as if the fair value of stock-based compensation plans had been recorded as a component of compensation expense in the consolidated financial statements as of the date of grant of awards related to such plans, pursuant to the provisions of the Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based Compensation” and Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure an amendment of FASB Statement No. 123,” is disclosed as follows and in Note L.

	Years Ended December 31,
(in thousands, except per share data)	2003			2002			2001
Net income, as reported	$	28,518		$	38,637		$	13,041
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(3,007	)		(3,062	)		(2,446	)
Pro forma net income	$	25,511		$	35,575		$	10,595
Earnings per share:
Basic – as reported	$	1.14		$	1.58		$	0.53
Basic – pro forma	$	1.02		$	1.46		$	0.43
Diluted – as reported	$	1.08		$	1.49		$	0.52
Diluted – pro forma	$	0.96		$	1.38		$	0.42

     Pro forma results disclosed are based on the provisions of SFAS 123 using the Black-Scholes option valuation model and are not likely to be representative of the effects on pro forma net income for future years. In addition, the Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in our opinion, the estimating models do not necessarily provide a reliable single measure of the fair value of our stock options. See Note L for further discussion of the Company’s stock-based employee compensation.

     Foreign Currency Translation and Transactions. For our foreign operations, the local currency is the functional currency. All assets and liabilities are translated at period-end exchange rates and all income statement amounts are translated at an average of month-end rates. Adjustments resulting from this translation are recorded in accumulated other comprehensive income. Foreign currency transaction gains and losses also result from transactions denominated in a currency other than U.S. dollars; gains and losses resulting from remeasuring monetary assets and liability accounts that are denominated in currencies other than a subsidiary’s functional currency are included in other income under the caption “Foreign currency transaction gains (losses).”

     Contingencies. We are a party to various claims and litigation in the normal course of business. Management’s current estimated range of liability related to various claims and pending litigation is based on claims for which our management can estimate the amount and range of loss, or can estimate a minimum amount of a loss. Because of the uncertainties related to both the amount and range of loss on the remaining pending claims and litigation, management is unable to make a reasonable estimate of the liability that could result from an unfavorable outcome. As additional information becomes available, we will assess the potential liability related to our claims and pending litigation, revise our estimates and accrue for any losses to the extent that they are probable and the amount is estimable. Such revisions in our estimates of the potential liability could materially impact our results of operations and financial position. However, at December 31, 2003, management did not believe that the ultimate impact of various claims and pending litigation would have a materially adverse impact on the Company.

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      Divisions of the United States Department of Justice are investigating other companies’ and Inter-Tel’s participation in a federally funded “E-Rate program” to connect schools and libraries to the Internet. The Justice Department has provided Inter-Tel with only a limited description of the evidence on which the investigations are based. Inter-Tel is presently unable to predict or determine the final outcome of, or to estimate the potential range of loss with respect to, the investigations. Based upon the information known at this time, we do not know what, if any, impact the investigations may have on the Company’s business or financial condition. If Inter-Tel is convicted of any crime or subjected to sanctions, or debarred from certain government contracts or if penalties, damages or other monetary remedies are assessed against Inter-Tel in connection with or related to these and other investigations, our business and operating results could be materially and adversely affected. The existence and disclosure of the investigations may have already caused competitive harm to Inter-Tel, and any unfavorable resolution to these matters may further harm Inter-Tel’s business.

     Use of Estimates. The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

     Reclassifications. Certain reclassifications have been made to the 2002 and 2001 financial statements to conform to the 2003 presentation.

Recent Accounting Pronouncements

     In June 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS No. 146 supersedes Emerging Issues Task Force (“EITF”) No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring).” SFAS No. 146 eliminates the provisions of EITF No. 94-3 that required a liability to be recognized for certain exit or disposal activities at the date an entity committed to an exit plan. SFAS No. 146 requires a liability for costs associated with an exit or disposal activity to be recognized when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The adoption of this statement did not have a material impact on the Company’s results of operations or financial position.

     In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure.” SFAS No. 148 amends FASB Statement No. 123, “Accounting for Stock-Based Compensation”, to provide alternative methods of transition to SFAS No. 123’s fair value method of accounting for stock-based employee compensation. Statement 148 also amends the disclosure provisions of SFAS No. 123 and APB Opinion No. 28, “Interim Financial Reporting,” to require disclosure in the summary of significant accounting policies of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share in annual and interim financial statements. While SFAS No. 148 does not amend SFAS No. 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of SFAS No. 148 are applicable to all companies with stock-based employee compensation, regardless of whether they account for that compensation using the fair value method of SFAS No. 123 or the intrinsic value method of APB Opinion No. 25. As allowed by SFAS No. 123, the Company has elected to continue to utilize the accounting method prescribed by APB Opinion No. 25 and has adopted the disclosure requirements of SFAS No. 123 as of December 31, 2002. The adoption of this statement did not have a material impact on the Company’s results of operations or financial position.

     In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45). This statement requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a rollforward of the entity’s product warranty liabilities. We will apply the recognition provisions of FIN 45 prospectively to guarantees issued after December 31, 2002. The disclosure provisions of FIN 45 were effective for financial statements of interim and annual periods ending December 15, 2002. The adoption of this statement did not have a material impact on the Company’s results of operations or financial position.

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     In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51” (FIN 46). This statement requires specified variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after January 31, 2003 and beginning July 1, 2003 for variable interest entities created or acquired prior to February 1, 2003. Our exposure to variable interest entities is limited and the adoption of FIN 46 did not have a material impact on the Company’s financial position or results of operations.

     In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150). SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material effect on the Company’s financial position, results of operations, or cash flows.

NOTE B – ACQUISITIONS, TECHNOLOGY INVESTMENTS, DISPOSITIONS AND RESTRUCTURING CHARGES

     New Sales Office in Philadelphia. In connection with opening a new sales office in Pennsylvania during December 2003, we acquired certain assets and assumed certain liabilities relating to a customer base of a former dealer. The total assets acquired and liabilities assumed were approximately $0.5 million and $0.9 million, respectively. Total goodwill and purchased intangibles recorded as a result of the transaction were $0.3 million and $0.1 million, respectively. The goodwill balance will be accounted for in accordance with SFAS 141 and 142. The balance included in the $0.1 million in other purchased intangible assets will be amortized over a period of five years.

     Technology Investment. In connection with the acquisition of the rights to certain developed technology for a capitalized purchase price of $2.25 million (included in purchased intangible assets) during the year ended December 31, 2003, the Company entered into an arrangement with the selling entity under which the selling entity will perform additional development activities on a cost reimbursement basis through August 15, 2004. Under the terms of the arrangement, the selling entity can also earn bonus payments totaling up to $1.0 million during 2004 for meeting certain development milestones. As of December 31, 2003, we did not consider the milestone bonuses to be probable or reasonably estimable, nor had technological feasibility of the underlying technology been achieved to provide for viable product sales; therefore, no bonus payments have been accrued, and the monthly cost of services performed totaling approximately $0.5 million has been expensed in research and development costs for the year ended December 31, 2003.

     McLeod. On January 24, 2002, we acquired certain assets of McLeodUSA Integrated Business Systems, Inc. (“McLeod”) for cash plus the assumption of various specific liabilities and related acquisition costs. Inter-Tel acquired McLeod’s voice customer base in Minnesota, Iowa and Colorado and DataNet operations in South Dakota, which also included the related accounts receivable, inventory and fixed assets along with assumption of scheduled specific liabilities for warranty and maintenance obligations. The aggregate purchase price of $7.9 million was allocated to the fair value of the assets and liabilities acquired.

     We recorded goodwill of approximately $4.0 million and other purchased intangible assets of $0.5 million, for a total of $4.5 million, in connection with the McLeod acquisition. The goodwill balance will be accounted for in accordance with SFAS 141 and 142. The balances included in the $0.5 million in other purchased intangible assets will be amortized over periods ranging from two to five years from the date of the acquisition. During each of the years ended December 31, 2003 and 2002, the amortization of purchased intangible assets from McLeod was approximately $138,000.

     Swan. On December 3, 2002, Inter-Tel Integrated Systems, Inc., our wholly-owned subsidiary, acquired 100% of the capital stock of Swan Solutions Limited (Swan) in England and Wales, for $4.0 million in cash. $3.0 million was paid at closing, $250,000 is payable in six months and $250,000 is payable one year from closing date. The remaining $500,000 is subject to the achievement of five performance milestones at $100,000 each. As of March 5, 2004, portions of four of the five $100,000 milestones were

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achieved for which $350,436 was paid to the Swan shareholders. The final milestone is due on June 3, 2004. Payments relating to the achievement of performance milestones were capitalized and are being amortized as purchased intangible assets over five years. In total, the Company recorded amortizable intangible technology assets totaling $3.9 million in connection with this acquisition. These technology assets are being amortized over five years. During the years ended December 31, 2003 and 2002, the amortization of purchased intangible assets from Swan was approximately $796,000 and $57,000 respectively.

     Convergent. On January 26, 2001, Inter-Tel Technologies, Inc., our wholly-owned subsidiary, acquired certain assets of Convergent Communications Services, Inc. (Convergent) for cash plus the assumption of various specific liabilities and related acquisition costs. The Company acquired segments of the voice customer base, accounts receivable, specified inventory and fixed assets, and assumed liabilities for warranty, maintenance and specified leased premises costs.

     The adjusted purchase price paid by us in the Convergent transaction included cash of $3.9 million plus assumption of specific liabilities totaling $6.3 million. The final purchase price was adjusted pursuant to a settlement agreement with Convergent representatives which specified the return of $6.7 million to Inter-Tel, representing funds from escrow and other amounts owed to Inter-Tel by Convergent that were previously set aside by the bankruptcy court, as well as adjustments for assets to be acquired and liabilities to be assumed. The settlement payments only required adjustments or reallocations based on the specified assets acquired and liabilities assumed in connection with the purchase, and differences have been represented as adjustments to the net assets acquired. The Company recorded goodwill of $880,000 and other intangible assets of $120,000 in connection with this acquisition. Goodwill and intangibles were amortized through December 31, 2001. The net goodwill balance of $810,000 as of December 31, 2001 will no longer be amortized, but accounted for in accordance with SFAS 141 and 142. The net balance of $98,000 in other intangible assets will continue to be amortized for five years from the date of the acquisition.

     MasterMind. On October 19, 2001, Inter-Tel Integrated Systems, Inc., our wholly-owned subsidiary, acquired certain of the assets and assumed certain stated liabilities from MasterMind Technologies, Inc. (MasterMind), for $2.0 million. $1.79 million was paid at or before closing with the balance placed into a bonus pool with earn-out provisions for MasterMind shareholders and employees based on performance parameters. The portion relating to employees who have joined Inter-Tel will be charged to expenses. The Company recorded amortizable intangible technology assets totaling $1.4 million in connection with this acquisition. These technology assets are being amortized over 5 years.

     Each of the acquisitions discussed above were not material business acquisitions either individually or collectively and have been accounted for using the purchase method of accounting. The results of operations of each of these acquisitions have been included in our accompanying consolidated statements of operations from the date of acquisitions.

     Inter-Tel.NET/Comm-Services/Vianet. During the second quarter of 2000, Inter-Tel recorded a pre-tax charge associated with Inter-Tel.NET operations of $2.0 million ($1.2 million after-tax), related to the write-down to net realizable value of network equipment and lease termination costs of certain redundant facilities. The reserves established at the time of the write-down have been fully utilized as of December 31, 2001.

     On July 24, 2001, Inter-Tel sold 83% of the stock of Inter-Tel.NET, Inc. to Comm-Services Corporation for a note of $4.95 million, collateralized by Comm-Services stock, other marketable securities of the shareholders of Comm-Services and 100% of the net assets of Inter-Tel.NET. In connection with the sale of 83% of Inter-Tel.NET, we assessed the fair value of the remaining 17% investment in Inter-Tel.NET. Pursuant to SFAS 121, we recorded a charge as of the close of the second quarter of 2001 of $5.4 million ($3.4 million after tax) associated with the impairment of our investment in Inter-Tel.NET. After the impairment charge, the carrying value of our investment (the note receivable from Vianet plus the 17% ownership interest in Vianet) totaled $3.7 million as of December 31, 2001. The charge was primarily non-cash.

     Inter-Tel’s management has not participated in the management of Inter-Tel.NET since the sale in July 2001. As a result, since July 24, 2001, we have accounted for the remaining Inter-Tel.NET/Comm-Services investment using the cost method of accounting. On December 30, 2001, Comm-Services entered into a merger agreement with Vianet. Inter-Tel’s 17% investment in Comm-Services was converted to

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approximately 10% of Vianet stock and as a result, the loan for the purchase was assumed by Vianet and Inter-Tel continued to hold collateral from the former shareholders of Comm-Services until March 2003. During 2002, the net investment in the notes receivable and 10% interest in Vianet (formerly Comm-Services) was written down by $1.2 million and was recorded in other assets at a carrying value of approximately $2.5 million as of December 31, 2002, which approximated management’s estimate of the related collateral value at that time.

     During 1999, 2000 and 2001, Inter-Tel.NET entered into operating lease agreements totaling approximately $6.5 million from an equipment vendor for network equipment and software. The lease agreements required Inter-Tel.NET to purchase vendor maintenance on their products. Inter-Tel originally guaranteed the indebtedness. In February 2003, we executed an agreement with Vianet and this vendor releasing Inter-Tel from its guarantee of any and all of these obligations, and Inter-Tel and Vianet released the vendor from claims arising from the failure of the network equipment and software previously leased. As part of this agreement, Inter-Tel also received payment from the Vianet shareholders of $1.45 million, in exchange for the release of the remaining collateral and as payment of the loan. Inter-Tel had also retained a collateral interest in a Vianet shareholder’s variable forward option contract that matured in April and May of 2003, and for which we received no value for the collateral interest. After an adjustment of $124,000 in 2003 related to a recovery of our investment and adjustment of projected costs to actual costs associated with the 2002 write-down in the Vianet investment, the estimated value received in this transaction was equivalent to our remaining investment value, less accruals for potential obligations to the vendor discussed above.

     Inter-Tel retains its ownership interest in Vianet and will account for the remaining investment interest of approximately 10% in Vianet using the cost method of accounting. At December 31, 2003, our net investment in Vianet was recorded at no value.

     Executone. On January 1, 2000 Inter-Tel purchased certain computer telephony assets and assumed certain liabilities of Executone Information Systems, Inc. (Executone). The Executone transaction was accounted for using the purchase method of accounting. The aggregate purchase price was allocated to the fair value of the assets and liabilities acquired, of which $5.4 million ($3.4 million after taxes) was written-off as purchased in-process research and development. In connection with the Executone acquisition, we sold Executone’s manufacturing assets and liabilities to Varian of Tempe, Arizona at a net book value of $6.6 million.

     During the second quarter of 2000, we decided to close the primary Executone facility in Milford, Connecticut and to recognize a restructuring charge related to our exit plan and closure of the Executone operations. We have accounted for the restructuring of the Executone operations, including severance and related costs, the shut down and consolidation of the Milford facility and the impairment of assets associated with the restructuring. We finalized our plan for the exiting of activities and the involuntary termination or relocation of the employees. Accrued costs associated with this plan were estimates, although the original estimates made for the second quarter of 2000 for reserve balances have not changed significantly as of December 31, 2003.

     Exit costs associated with the closure of the Milford facility also included liabilities for building, furniture and equipment lease, and other contractual obligations. We are liable for the lease on the Milford buildings through January 2005. Various other furniture, computer and equipment leases terminated on varying dates through September 2002. To date, we have entered into sublease agreements with third parties to sublease portions of the facility. The reserve for lease and other contractual obligations is identified in the table below.

     The total restructuring charge from this event totaled $50.9 million. The following tables summarize details of the restructuring charge in connection with the Executone acquisition, including the description of the type and amount of liabilities assumed, and activity in the reserve balances from the date of the charge through December 31, 2003. Activity represents payments made or amounts written off.

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						(In thousands)
		Cash/												Reserve
		Non-	Restructuring			2000		2001		2002		2003		Balance
Description		Cash	Charge			Activity		Activity		Activity		Activity		At 12/31/03
Personnel Costs:
	Severance and termination costs	Cash	$	(1,583	)	$	1,558	$	2	$	20	$	3	$	—
	Other Plant closure costs	Cash		(230	)		30		200		—		—		—
Lease termination and other contractual obligations (net of anticipated recovery):
	Building and equipment leases	Cash		(7,444	)		1,348		1,489		2,594		767		(1,246	)
	Other contractual obligations	Cash		(1,700	)		—		1,700		—		—		—
Impairment of Assets:
	Inventories	Non-Cash		(3,454	)		1,376		209		1,869		—		—
	Prepaid inventory and other expenses	Non-Cash		(2,485	)		2,485		—		—		—		—
	Accounts receivable	Non-Cash		(1,685	)		521		245		88		831		—
	Fixed assets	Non-Cash		(3,151	)		2,942		—		53		14		(142	)
	Net intangible assets	Non-Cash		(29,184	)		29,184		—		—
Total			$	(50,916	)	$	39,444	$	3,845	$	4,624	$	1,615	$	(1,388	)

Included in the total Executone restructuring costs of $50.9 million is a $43.3 million restructuring charge for exit costs and asset impairment, and $7.6 million associated with the impairment of inventories, which has accordingly been recorded as additional costs of sales.

NOTE C — SHORT-TERM INVESTMENTS

     The Company accounts for short-term investments in accordance with Financial Accounting Standard No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The Company’s short-term investments are all classified as available for sale, and have been recorded at fair value, which approximates cost. At December 31, 2003 and December 31, 2002, $59.3 million and $40.9 million, respectively, were recorded as short-term investments. Short-term investments include certificates of deposit, auction rate certificates, auction rate preferred securities, municipal preferred securities and mutual funds. The auction rate securities are adjustable-rate securities with dividend rates that are reset periodically by bidders through periodic “Dutch auctions” generally conducted every 7 to 49 days by a trust company or broker/dealer on behalf of the issuer. The Company believes these securities are highly liquid investments through the related auctions; however, the collateralizing securities have stated terms of up to thirty (30) years. These instruments are rated A or higher by Standard & Poor’s Ratings Group, or equivalent.

     The Company’s short-term investments are intended to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to the Company’s investment guidelines and market conditions.

     The following is a summary of available-for-sale securities:

December 31, 2003			Gross Unrealized		Gross Unrealized
(in thousands)	Cost		Gains		Losses		Gross Fair Value
Equity securities	$	57,855	$	—	$	—	$	57,855
Mutual funds		1,479		—		—		1,479
December 31, 2003	$	59,334	$	—	$	—	$	59,334

NOTE D — NET INVESTMENT IN SALES-LEASES

     Net investment in sales-leases represents the value of sales-leases presently held under our Total Solution program. We currently sell the rental payments due to us from some of the sales-leases. We maintain reserves against our estimate of potential recourse for the balance of sales-leases and for the balance of sold rental payments remaining unbilled. The following table provides detail on the total net balances in sales-leases (In thousands):

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		December 31
		2003		2002		2001
Lease balances included in consolidated accounts		$	7,240	$	6,470	$	7,924
receivable, net of allowances of $1,774 in 2003; $2,562 in 2002; and $3,112 in 2001
Net investment in Sales-Leases:
	Current portion, net of allowances of $749 in 2003; $516 in 2002; and $640 in 2001		15,502		13,344		13,799
	Long-term portion, includes residual amounts of $652 in 2003; $518 in 2002; and $907 in 2001, net of allowances of $1,985 in 2003; $1,411 in 2002; and $1,206 in 2001		32,529		24,692		21,735
Total investment in Sales-Leases, net of allowances of $4,508 in 2003; $4,489 in 2002; and $4,958 in 2001			55,271		44,506		43,458
Sold rental payments remaining unbilled (subject to limited recourse provisions), net of allowances of $12,020 in 2003; $11,125 in 2002; and $8,890 in 2001			198,091		194,684		193,825
Total balance of sales-leases and sold rental payments remaining unbilled, net of allowances		$	253,362	$	239,190	$	237,283
Total allowances for entire lease portfolio (including limited recourse liabilities)		$	16,528	$	15,614	$	13,848

     Reserve levels are established based on portfolio size, loss experience, levels of past due accounts and periodic, detailed reviews of the portfolio. Recourse on the sold rental payments is contractually limited to a percentage of the net credit losses in a given annual period as compared to the beginning portfolio balance for a specific portfolio of sold leases. While our recourse is limited, we maintain reserves at a level sufficient to cover all anticipated credit losses. The aggregate reserve for uncollectible lease payments and recourse liability represents the reserve for the entire lease portfolio. These reserves are either netted from consolidated accounts receivable, netted against current or long-term “investment in sales-leases” or included in long-term liabilities for sold rental payments remaining unbilled. Sales of rental payments per period:

	Years Ended December 31
(In thousands)	2003		2002		2001
Sales of rental payments	$	88,352	$	83,141	$	86,788
Sold payments remaining unbilled at end of year	$	210,111	$	205,809	$	202,715

     Sales of rental payments represents the gross selling price or total present value of the payment stream on the sale of the rental payments to third parties. Sold payments remaining unbilled at the end of the year represents the total balance of leases that are not included in our balance sheet. We do not expect to incur any significant losses in excess of reserves from the recourse provisions related to the sale of rental payments. Inter-Tel is compensated for administration and servicing of rental payments sold.

     At December 31, 2003, future minimum lease payments related to the sold rental streams remaining unbilled are: 2004 — $67.5 million, 2005 — $57.6 million, 2006 — $44.2 million, 2007 — $27.8, 2008 — $12.9 million, thereafter — $177,000.

     At December 31, 2003, future minimum lease receipts due from customers related to the lease portfolio included in our December 31, 2003 balance sheet are: 2004 — $16.9 million, 2005 — $19.9 million, 2006 — $5.9 million, 2007 — $3.9 million, 2008 — $2.8, thereafter — $2.2 million.

NOTE E — PROPERTY, PLANT & EQUIPMENT

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	December 31
(In thousands)	2003		2002
Computer systems, data processing and other office equipment	$	38,906	$	40,089
Transportation equipment		3,761		2,328
Furniture and fixtures		3,899		4,942
Leasehold improvements		4,501		4,215
Building		7,297		7,297
Land		2,499		2,499
		60,863		61,370
Less: Accumulated depreciation and amortization		36,206		36,575
Net property, plant & equipment	$	24,657	$	24,795

NOTE F — GOODWILL AND PURCHASED INTANGIBLE ASSETS

		December 31
(In thousands)		2003		2002
Goodwill		$	22,992	$	22,671
Less: Accumulated amortization			5,025		5,025
Net Goodwill			17,967		17,646
Purchased intangible assets:
	Acquired developed technology		11,765		9,065
	Customer lists and non-competition agreements		2,418		2,319
			14,183		11,384
Less: Accumulated amortization			5,992		3,968
Net purchased intangible assets			8,191		7,416
Net goodwill and purchased intangible assets		$	26,158	$	25,062

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NOTE G — OTHER ASSETS

	December 31
(In thousands)	2003		2002
Note receivable and investment in Vianet (formerly Inter-Tel.Net)	$	—	$	2,500
Other assets		—		249
	$	—	$	2,749

     Refer to Note B to Consolidated Financial Statements for additional information regarding our investment in Vianet.

NOTE H — OTHER CURRENT LIABILITIES

	December 31
(In thousands)	2003		2002
Compensation and employee benefits	$	18,118	$	18,325
Customer deposits		4,451		5,331
Restructuring charge		1,194		955
Deferred revenues		7,641		7,324
Miscellaneous taxes payable		3,331		2,569
Other accrued expenses		12,850		15,547
	$	47,585	$	50,051

NOTE I — CREDIT LINE

     We maintain a $10 million unsecured bank credit line at prime rate to cover international letters of credit and for other purposes. The credit agreement matures June 1, 2004 and contains certain restrictions and financial covenants. At December 31, 2003, none of the credit line was committed under letter of credit arrangements.

NOTE J — LEASES

     Rental expense amounted to $9,591,000; $9,800,000; and $9,679,000 in 2003, 2002, and 2001, respectively. Noncancellable operating leases are primarily for buildings. Including in the preceding rental expense totals are payments on our building lease in Milford, Connecticut associated with the Executone acquisition in 2000. In connection with the Executone charge taken in 2000, we included in the charge anticipated lease costs through the lease termination date, offset by expected sublease receipts. The total costs included in gross rental expense above associated with the Milford lease totaled $2.8 million in each of the years ended 2003, 2002, and 2001. The Milford lease expires on January 14, 2005 and we will not renew that lease. Certain of the leases contain provisions for renewal options and scheduled rent increases. At December 31, 2003, future minimum commitments under noncancellable leases are as follows: 2004 — $9,896,000; 2005 — $5,646,000; 2006 — $3,963,000; 2007 — $2,502,000; 2008 — $733,000.

NOTE K — INCOME TAXES

     We account for income taxes under Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”). Under SFAS 109, the liability method is used in accounting for income taxes. Under this method, deferred tax assets and liabilities are determined (and classified as current or long-term) based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.

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Significant components of our deferred tax liabilities and assets as of December 31 are as follows:

		December 31
(in thousands)		2003		2002
Deferred tax liabilities:
	Lease — sales and capitalized costs	$	73,823	$	36,739
	Other		5,841		4,929
Total deferred tax liabilities			79,664		41,668
Deferred tax assets:
	Net operating loss carryforward		7916		—
	Tax credit carryforward		3,421		—
	Inventory basis differences		—		1,224
	Accounts receivable reserves		3,758		4,244
	Accrued vacation pay		1,652		1,524
	Book over tax depreciation		—		277
	Foreign loss carryforwards		880		537
	In-process R&D write-off		5,428		5,949
	Restructuring reserves		1,968		2,227
	Lease receivable reserves		5,169		4,766
	Other — net		6,145		7,514
Deferred tax assets			36,337		28,262
	Less valuation reserve		880		537
Net deferred tax assets			35,457		27,725
Net deferred tax liabilities		$	44,207	$	13,943

     The net deferred tax liabilities increased significantly in 2003 due primarily to accelerated depreciation of fixed assets, and temporary differences relating to leases in our Total Solution program. Most of the increase arose from deductions taken in the company’s 2002 federal income tax return wherein the company decided in 2003 to elect to take bonus depreciation and accelerated depreciation of fixed assets and certain leases when filing its 2002 return in 2003. The company filed a change in accounting method with the Internal Revenue Service to utilize accelerated depreciation for the 2002 tax year. Effective May 6, 2003, the bonus depreciation increased from a 30% to 50% depreciation deduction, which favorably impacted the 2003 tax deduction and increased the deferred liabilities for 2003.

     The depreciation deductions identified above generated a net operating loss that was not fully utilized in a carryback claim to 2001; accordingly, the loss was carried forward. This net operating loss created deferred assets for net operating loss carryforwards and certain tax credit carryforwards, each of which is separately identified in the components of deferred tax assets and liabilities schedule above. We expect these carryforwards to be fully utilized by 2004. Our effective income tax rate for 2003 was not impacted by these carryforwards.

     During 2003, 2002 and 2001, we recorded income of $1,037,000, $295,000, and a loss of $437,000, respectively, from foreign operations. At December 31, 2003, we had foreign loss carryforwards of approximately $2,200,000, a portion of which began to expire in 2002. The valuation allowance in 2003 increased by $343,000 and decreased by $277,000 in 2002 due to expiration of foreign loss carryforwards and greater losses in the most current year.

     Federal and state income taxes consisted of the following:

(In thousands)	2003		2002		2001
Federal	$	15,126	$	20,206	$	5,076
State		1,620		2,584		2,583
Foreign		734		726		—
	$	17,480	$	23,516	$	7,659

     The principal reasons for the difference between total income tax expense (benefit) and the amount computed by applying the statutory federal income tax rate to income before taxes are as follows:

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	2003			2002			2001
Federal tax at statutory rates Applied to pre-tax income		35	%		35	%		35	%
State tax net of federal benefit		2			2			5
Credit for research activities		(1	)		(1	)		(5	)
Other — net		2			2			2
		38	%		38	%		37	%

NOTE L — EQUITY TRANSACTIONS

     Treasury Stock. During the first quarter of 2001, we initiated a stock repurchase program under which the Board of Directors authorized the repurchase of up to 4,000,000 shares of Inter-Tel Common Stock. Under this and prior authorizations, we repurchased 8,271 and 662 shares during 2003 and 2002, respectively, expending $207,000 and $13,000 to repurchase shares for cash pay-outs to former employees in place of ESOP share distributions during 2003 and 2002, respectively. During 2001, we expended approximately $28.9 million for stock repurchases, which was funded primarily through existing cash balances. We reissued approximately 529,000, 743,000 and 740,000 shares in 2003, 2002 and 2001, respectively, through stock option and employee stock purchase plan exercises and issuances, and stock issued in conversion of subsidiary stock through an acquisition. The proceeds received for the stock reissued were less than our total cost basis. Accordingly, the difference was recorded as a reduction to retained earnings. Attached below is a summary of treasury share activity for the past three years.

Treasury shares	2003		2002		2001
Balance on January 1		2,252,840		2,995,393		1,210,854
Stock repurchases, including ESOP		8,271		662		2,524,582
Shares reissued		528,930		743,215		740,043
Balance on December 31		1,732,181		2,252,840		2,995,393

     Dividend Policy. From December 31, 1997 through the third quarter of 2001, we paid quarterly cash dividends (the “cash dividend”) of $0.01 for every share of Common Stock, to shareholders of record. On October 23, 2001, our Board of Directors increased the cash dividend from $0.01 to $0.02 for every share of Common Stock, payable quarterly to shareholders of record beginning December 31, 2001. On July 16, 2002, our Board of Directors increased the cash dividend from $0.02 to $0.03 for every share of Common Stock, payable quarterly to shareholders of record beginning September 30, 2002. On July 21, 2003, our Board of Directors increased the cash dividend from $0.03 to $0.06 for every share of Common Stock, payable quarterly to shareholders of record beginning September 30, 2003. Dividend payments commence on or about 15 days after the end of each fiscal quarter. Attached below is a summary of our dividends accrued and paid since December 31, 1997, the date we first declared cash dividends on our Common Stock.

Period	Q1		Q2		Q3		Q4		Totals
1997		—		—		—	$	0.01	$	0.01
1998	$	0.01	$	0.01	$	0.01	$	0.01	$	0.04
1999	$	0.01	$	0.01	$	0.01	$	0.01	$	0.04
2000	$	0.01	$	0.01	$	0.01	$	0.01	$	0.04
2001	$	0.01	$	0.01	$	0.01	$	0.02	$	0.05
2002	$	0.02	$	0.02	$	0.03	$	0.03	$	0.10
2003	$	0.03	$	0.03	$	0.06	$	0.06	$	0.18

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     Stock Option Plans. In July 1990, we adopted the Director Stock Option Plan (“the Director Plan”) and reserved a total of 500,000 shares of Common Stock for issuance thereunder. Commencing with the adoption of the Plan through 2001, each Eligible Director received a one-time automatic grant of an option to purchase 5,000 shares of our Common Stock. In addition, through 2001 each Eligible Director was granted an option to purchase 5,000 shares upon the date five (5) days after such person became Director, and an additional option to purchase 5,000 shares five (5) days after the date of the regularly scheduled board meeting following the close of our third quarter. All options granted through 2001 had a five-year term and fully vested at the end of six months from the grant date.

     In July 2001, as approved by shareholders at the annual shareholders’ meeting in April 2002, the board of directors extended the term of the Director Plan to 2010. Our shareholders also approved amendments to change the date of the annual grant to directors under the Director Plan to five (5) business days after the re-election of directors at the annual meeting of shareholders, increased the initial automatic option grant and each annual option grant from 5,000 to 7,500 shares. The term of options granted under the Director Plan was also increased from five (5) years to ten (10) years. These amendments did not increase the number of shares authorized for the Director Plan. In each instance, Director Plan options must be granted at not less than 100% of the fair market value of our stock at the dates of grant.

     In November 1993, the Board of Directors authorized the Inter-Tel, Incorporated Long-Term Incentive Plan (“the 1994 Long Term Plan”). 2,000,000 shares of Common Stock have been reserved for issuance under the 1994 Long Term Plan to selected officers and key employees. Options must be granted at not less than 100% of the fair market value of our stock at the dates of grant. Options generally vest over four or five years and expire five to ten years from the date of grant. The 1994 Long Term Plan does not allow incentive stock options to be granted after November 19, 2003, but other forms of awards, as defined in the plan, may be continue to be granted to participants.

     In February 1997, the Board of Directors authorized the Inter-Tel, Incorporated 1997 Long-Term Incentive Plan (“the 1997 Long Term Plan”). Option must be granted at not less than 100% of the fair market value of our stock at the dates of grant. Options generally vest over four or five years and expire ten years from the date of grant. In March 2000, the Board of Directors authorized an amendment to the 1997 Long Term Plan to limit our ability to reprice options under the 1997 Long Term Plan. Prior to January 1, 2002, a total of 3,650,000 shares of Common Stock had been reserved for issuance under the 1997 Long Term Plan to selected officers and key employees.

     On February 27, 2001 our Board of Directors authorized an amendment to the 1997 Long Term Plan, approved by the stockholders, that provides for an automatic increase in the number of shares of Common Stock reserved thereunder on the first day of each fiscal year equal to the lesser of (a) 2.5% of the outstanding shares on that date, (b) 750,000 shares (subject to appropriate adjustment for all stock splits, dividends, subdivisions, combinations, recapitalizations and like transactions) or (c) a lesser amount as determined by the Board of Directors (the “Renewal Feature”). For 2002, based on shares outstanding at January 1, 2002 and as approved by the Board of Directors in February 2002, this renewal feature provided for an increase of 604,161 shares for issuance under the 1997 Long Term Plan. For 2003, based on shares outstanding at January 1, 2003 and as approved by the Board of Directors in February 2003, this renewal feature provided for an increase of 622,725 shares for issuance under the 1997 Long Term Plan. For 2004, based on shares outstanding at January 1, 2004 and as approved by the Board of Directors in February 2004, this renewal feature provided for an increase of 635,741 shares for issuance under the 1997 Long Term Plan.

     Under the 1994 and 1997 Long Term Plans, in some instances, predetermined share market value increases must be met to allow acceleration of option vesting provisions before the end of the option term.

     In April 1998, the Board of Directors authorized the Inter-Tel, Incorporated Acquisition Stock Option Plan (the Acquisition Plan). A total of 82,428 shares of Common Stock was reserved for issuance under the Acquisition Plan to selected key employees hired as a result of the acquisition of TMSI. New options must be granted at not less than 100% of the fair market value of our stock at the dates of grant. Options generally vest over four or five years and expire ten years from the date of grant. A portion of the options granted were replacements for options held to purchase shares of stock of the selling company; such replacement grants retained the original terms, including grant dates for vesting purposes and the original grant prices, adjusted

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using the applicable conversion ratio of the fair value of Inter-Tel’s stock compared to that of the selling company.

     In March 2000, the Board of Directors authorized an additional 216,000 shares of Common Stock for issuance under the Acquisition Plan to selected employees hired as a result of the acquisition of selected assets of Executone. In February 2001, the Board of Directors authorized an additional 300,000 shares of Common Stock for issuance under the Acquisition Plan to selected employees hired as a result of the acquisition of selected assets of Convergent. In addition, in October 2001, the Board of Directors authorized an additional 150,000 shares of Common Stock for issuance under the Acquisition Plan to selected employees hired as a result of the acquisition of Mastermind Technologies. Options in each instance must be granted at not less than 100% of the fair market value of our stock at the dates of grant. Options vest over five years and expire ten years from the date of grant.

     Option activity for the past three years under all plans is as follows:

	Years Ended December 31,
(Number of shares)	2003			2002			2001
Outstanding at beginning of year		4,188,641			4,567,945			3,143,292
Granted		879,950			608,000			2,007,500
Exercised		(476,410	)		(710,304	)		(210,633	)
Expired or canceled		(176,050	)		(277,000	)		(372,214	)
Outstanding at end of year		4,416,131			4,188,641			4,567,945
Exercisable at end of year		1,877,151			1,628,533			1,458,388
Weighted-average grant price of options granted	$	13.66		$	13.40		$	12.26
Weighted-average fair value (FAS 123) of options granted during the year	$	7.04		$	9.32		$	6.42

     At December 31, 2003, we have reserved 4,961,607 shares of Common Stock for issuance in connection with the stock option plans.

     As permitted under Statement of Financial Accounting Standards No. 123 (FAS 123) “Accounting for Stock-Based Compensation,” we have elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations, in accounting for stock based awards to employees. Under APB 25, we generally recognize no compensation expense with respect to such awards.

     The following table summarizes information about stock options outstanding at December 31, 2003:

	Number		Weighted-Average	Weighted
Range of	Outstanding		Remaining	Average
Exercise Price	at 12-31-03		Contractual Life	Exercise Price
$2.24 - $5.24		81,979	1 years	$	3.00
$5.25 - $7.68		92,900	3 years	$	6.07
$7.69 - $15.12		2,908,230	7 years	$	11.09
$15.13 - $43.44		1,333,022	7 years	$	20.45

71

The following table summarizes information about stock options exercisable at December 31, 2003:

	Number		Weighted-Average	Weighted
Range of	Exercisable		Remaining	Average
Exercise Price	at 12-31-03		Contractual Life	Exercise Price
$2.24 - $5.24		81,979	1 years	$	3.00
$5.25 - $7.68		92,900	3 years	$	6.07
$7.69 - $15.12		1,009,570	7 years	$	10.04
$15.13 - $43.44		692,702	7 years	$	21.14

     During 2003, the weighted average exercise price of options granted, exercised, and expired or canceled was $14.50, $11.30 and $17.99, respectively.

     Pro forma information regarding net income and net income per share, as disclosed in Note A, has been determined as if the Company had accounted for its employee stock-based compensation plans under the fair value method of SFAS No. 123.

     The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model using the low end of reasonable assumptions for input variables rather than attempting to identify a best-point estimate. The option pricing model utilized the following weighted average assumptions for 2003, 2002 and 2001, respectively: risk free interest rates of 3.05% for 2003, 2.73% for 2002 and 4.5% for 2001; dividend yields of 1.2% for 2003, .75% for 2002 and .50% for 2001; volatility factors of the expected market price of our stock averaged .770 for 2003, .576 for 2002 and .766 for 2001; and a weighted average expected life of the option of 4 to 5 years for employee stock options which vest over four to five year periods with a weighted average life of 2.5 years and 1.5 years for director options which vest at the end of six months from the grant date.

     1997 Employee Stock Purchase Plan. In April 1997, the Board of Directors and stockholders adopted the Employee Stock Purchase Plan (the Purchase Plan) and reserved 500,000 shares for issuance to eligible employees. In April 2002, the Board of Directors and stockholders approved an amendment to the Plan to increase the number of authorized shares by 500,000 shares for a total of 1,000,000 authorized thereunder. Under the Purchase Plan, employees are granted the right to purchase shares of Common Stock at a price per share that is 85% of the lesser of the fair market value of the shares at: (i) the participant’s entry date into each six-month offering period, or (ii) the end of each six-month offering period. Employees may designate up to 10% of their compensation for the purchase of stock. Under the Plan, we sold 58,242 shares for approximately $915,000 ($15.71 per share) to employees in 2003, 61,562 shares for approximately $972,000 ($15.80 per share) to employees in 2002, and 108,742 shares for approximately $966,000 ($8.89 per share) to employees in 2001. At December 31, 2003, 516,342 shares remained authorized under the Plan.

     Stock Option Loans. During 1999, selected officers and employees of Inter-Tel were offered loans to acquire Inter-Tel common stock. Promissory Notes were established to cover the cost of exercise of stock options, including applicable taxes, or the cost of Inter-Tel common stock purchased in the open market during May and June of 1999. The loans were interest-only notes with balloon payments due on or before March 15, 2004. Interest was charged on the loans at the mid-term applicable federal interest rate, compounded annually. Interest payments were due on or before March 15 of each anniversary beginning on March 15, 2000. The loans were recorded in our balance sheet as reductions to shareholders’ equity. The notes were full recourse loans and we retained the common stock certificates as collateral. All of the loans have been paid in full prior to the end of 2003.

72

NOTE M - EARNINGS PER SHARE

     The following table sets forth the computation of basic and diluted earnings per share:

		Years Ended December 31,
(In thousands, except per share amounts)		2003		2002		2001
Numerator:
	Net income	$	28,518	$	38,637	$	13,041
Denominator:
	Denominator for basic earnings per share - weighted average shares		25,078		24,444		24,488
Effect of dilutive securities:
	Employee and director stock options		1,395		1,420		752
Denominator for diluted earnings per share - adjusted weighted average shares and assumed conversions			26,473		25,864		25,240
Basic income per share		$	1.14	$	1.58	$	0.53
Diluted income per share		$	1.08	$	1.49	$	0.52

     In 2003, 2002 and 2001, options to purchase 227,150; 280,580 and 577,800 shares, respectively, of Inter-Tel stock were excluded from the calculation of diluted net earnings per share because the exercise price of these options was greater than the average market price of the common shares for the respective fiscal years, and therefore the effect would have been antidilutive.

NOTE N — RETIREMENT PLANS

     We have two retirement plans for the benefit of our employees. Under our 401(k) Retirement Plan, participants may contribute on an annual basis up to the maximum amount allowed by the Internal Revenue Service. We make voluntary annual contributions to the Plan of 50% of contributions made by Plan participants of up to 6 percent of each participant’s compensation. Our matching contributions to the Plan totaled $1,627,000; $1,567,000; and $1,476,000; in 2003, 2002 and 2001, respectively.

     In 1992, we initiated an Employee Stock Ownership Plan (ESOP), advancing $500,000 to the ESOP Trust for the purpose of purchasing Common Stock of the Company. The Trust purchased 307,000 shares of Inter-Tel Common Stock in July 1992. The loan was paid in full during 1997. As the principal amount of the loan was repaid to Inter-Tel through Company annual contributions, the equivalent number of shares released were allocated to employees’ accounts to be held until retirement. Total shares so allocated were 32,380 in 1997. Contributions to the ESOP totaled $62,500 in 1997, and were based upon the historic cost of the shares purchased by the ESOP. After the final allocation of shares in 1997, the ESOP plan was “frozen,” so that all eligible participants as of July 1, 1997 became 100% vested in their accounts, regardless of length of service. No further purchases are anticipated through the ESOP, and we do not anticipate making future allocations of shares from this plan. In October 2002, our Board of Directors authorized the termination of this plan, allowing one-time rollover contributions to be made to participants in our 401(k) Retirement Plan, other qualified plans or as early taxable distributions. With the exception of a few of our former employees whom we could not locate, the Plan assets were distributed in their entirety during 2003, as allowed pursuant to a favorable determination letter that was issued by the Internal Revenue Service on January 16, 2003.

NOTE O — SEGMENT INFORMATION

     Inter-Tel adopted Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS 131”) in the fiscal year ended December 31, 1998. SFAS 131 establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information for those segments to be presented in interim financial reports issued to stockholders. SFAS 131 also establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker,

73

or decision making group, in making decisions as to how to allocate resources and assess performance. The Company’s chief decision maker, as defined under SFAS 131, is the Chief Executive Officer.

     Prior to 2000, we had viewed our operations as principally one segment: telephone systems, telecommunications software and hardware, and related long distance calling services. These services are provided through the Company’s direct sales offices and dealer network to business customers throughout the United States, Europe, Asia, Mexico and South America. As a result, financial information disclosed previously represented substantially all of the financial information related to the Company’s principal operating segment.

     During 2000, we determined that the operations of Inter-Tel.NET, Inter-Tel’s former IP long distance subsidiary, would be separately disclosed as a business segment. The operations represented a more significant component of the consolidated operations in 2000 compared to prior years and had a significant impact on the revenues and net losses. On July 24, 2001, Inter-Tel agreed to sell 83% of Inter-Tel.NET to Comm-Services Corporation. As a result, since July 24, 2001, we have accounted for the remaining 17% Inter-Tel.NET/Comm-Services investment using the cost method of accounting. On December 30, 2001, Comm-Services entered into a merger agreement with Vianet. Inter-Tel’s 17% investment in Inter-Tel.NET/Comm-Services was converted to approximately 10% of Vianet stock. Inter-Tel will account for the remaining 10% investment in Vianet using the cost method of accounting.

     Commencing the third quarter of 2001, we began disclosing as a separate business segment operating results relating to local and long distance resale services. Inter-Tel offers these services to its customers as part of a total telephony solution approach. Results of operations for this segment, if the operations were not included as part of the consolidated group, could differ materially, as the operations are integral to the total telephony solution offered by us to our customers.

     For the years ended December 31, we generated income from business segments, including charges, as follows:

											Resale of
											Local and
						Subtotal					Long
(In thousands, except per	Principal			Litigation		Principal			Inter-Tel.NET		Distance
share amounts)	Segment			Settlement		Segment			/Vianet		Services			Total
2003
Net sales	$	335,570		$	—	$	335,570		$	—	$	38,266		$	373,836
Gross profit		184,737			—		184,737			—		12,336			197,073
Operating income		38,697			—		38,697			—		5,631			44,328
Interest and other income		1,526			—		1,526			124		157			1,807
Gain on foreign currency transactions		18			—		18			—		—			18
Interest expense		(153	)		—		(153	)		—		(2	)		(155	)
Net income	$	24,831		$	—	$	24,831		$	77	$	3,610		$	28,518
Net income per diluted share (1)	$	0.94		$	—	$	0.94		$	—	$	0.14		$	1.08
Weighted average diluted shares (1)		26,473			26,473		26,473			26,473		26,473			26,473
Total assets	$	341,550		$	—	$	341,550		$	—	$	18,326		$	359,876
Depreciation and amortization		9,083			—		9,083			—		51			9,134

74

												Resale of
												Local and
						Subtotal						Long
(In thousands, except per	Principal			Litigation		Principal			Inter-Tel.NET			Distance
share amounts)	Segment			Settlement		Segment			/Vianet			Services			Total
2002
Net sales	$	351,414		$	—	$	351,414		$	—		$	30,042		$	381,456
Gross profit		185,847			—		185,847			—			8,626			194,473
Operating income		41,837			—		41,837			—			3,890			45,727
Interest and other income		1,772			15,516		17,288			(1,200	)		164			16,252
Gain on foreign currency transactions		330			—		330			—			—			330
Interest expense		(155	)		—		(155	)		—			(1	)		(156	)
Net income (loss)	$	27,371		$	9,492	$	36,863		$	(746	)	$	2,520		$	38,637
Net income (loss) per diluted share (1)	$	1.06		$	0.37	$	1.43		$	(0.03	)	$	0.10		$	1.49
Weighted average diluted shares (1)		25,864			25,864		25,864			24,444			25,864			25,864
Total assets	$	266,015		$	—	$	266,015		$	—		$	16,047		$	282,062
Depreciation and amortization		8,574			—		8,574			—			80			8,654

							Resale of
							Local and
							Long
	Principal			Inter-Tel.NET			Distance
(In thousands, except per share amounts)	Segment			/Vianet			Services			Total
2001
Net sales	$	346,094		$	13,986		$	25,575		$	385,655
Gross profit (loss)		173,823			(5,892	)		6,563			174,494
Charge (see Note B)		—			(5,357	)		—			(5,357	)
Operating income (loss)		30,911			(13,718	)		3,231			20,424
Interest and other income		970			(1	)		112			1,081
Loss on foreign currency transactions		(337	)		—			—			(337	)
Interest expense		(293	)		(173	)		(2	)		(468	)
Net income (loss)	$	19,688		$	(8,752	)	$	2,105		$	13,041
Net income (loss) per diluted share (1)	$	0.78		$	(0.36	)	$	0.08		$	0.52
Weighted average diluted shares (1)		25,240			24,488			25,240			25,240
Total assets	$	215,340		$	—		$	12,122		$	227,462
Depreciation and amortization		9,367			1,994			156			11,517

(1) Options that are antidilutive because the exercise price was greater than the average market price of the common shares are not included in the computation of diluted earnings per share when a net loss is recorded. See Note M for additional information.

     Our revenues are generated predominantly in the United States. Total revenues generated from U.S. customers totaled $362.8 million, $371.3 million, and $375.6 million, of total revenues for the years ended December 31, 2003, 2002 and 2001, respectively. Revenues from international sources were primarily generated from customers located in the United Kingdom, Europe, Asia, and Mexico. In 2003, 2002 and 2001, revenues from customers located internationally accounted for 3.0%, 2.7% and 2.6% of total revenues, respectively.

NOTE P — FINANCIAL INSTRUMENTS

     Concentration of Credit Risk. Financial instruments that potentially subject Inter-Tel to significant concentrations of credit risk consist principally of cash investments, trade accounts receivable, and net investment in sales-leases. We maintain cash and equivalents not invested in money market funds with a major bank in our marketplace. We perform periodic evaluations of the relative credit standing of the financial institution. Concentrations of credit risk with respect to trade accounts receivable and net investment in sales-leases are limited due to the large number of entities comprising our customer base.

75

Fair Value of Financial Instruments. The carrying amount of cash and equivalents, accounts receivable, net investment in sales-leases, and accounts payable reported in the consolidated balance sheets approximate their fair value.

NOTE Q — SUPPLEMENTAL CASH FLOW

		Years Ended December 31,
(In thousands)		2003			2002			2001
Cash paid for:
	Interest	$	156		$	156		$	468
	Income taxes paid (received)	$	(9,384	)	$	15,424		$	(11,398	)
Additional disclosure of cash flow information:
	Tax benefit from stock options	$	(2,321	)	$	(2,671	)	$	(263	)
Changes in operating assets and liabilities:
	(Increase) decrease in receivables and current net investment in sales-leases	$	(6,096	)	$	1,907		$	7,556
	(Increase) decrease in inventories		(4,069	)		9,759			14,647
	(Increase) decrease in prepaid expenses and other assets		(2,935	)		4,248			15,883
	(Increase) decrease in long-term net investment in sales-leases and other assets		(6,962	)		(3,448	)		927
	Increase (decrease) in accounts payable and other current liabilities		1,093			3,014			(18,045	)
		$	(18,969	)	$	15,480		$	20,968

NOTE R — QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)

     A summary of the quarterly results of operations for the years ended December 31, 2003 and 2002 follows:

(In thousands, except per share amounts)
2003	1st Qtr		2nd Qtr		3rd Qtr		4th Qtr
Net sales	$	84,169	$	95,102	$	94,545	$	100,020
Gross profit	$	44,074	$	50,250	$	49,244	$	53,505
Net income	$	4,672	$	7,269	$	7,218	$	9,359
Net income per share — Basic	$	0.19	$	0.29	$	0.29	$	0.37
Net income per share — Diluted	$	0.18	$	0.28	$	0.27	$	0.35
Weighted average basic common shares		24,920		24,947		25,107		25,338
Weighted average diluted common shares		26,039		25,970		26,865		27,020

2002	1st Qtr		2nd Qtr		3rd Qtr		4th Qtr
Net sales	$	90,070	$	95,948	$	96,665	$	98,774
Gross profit		45,054		48,475		49,050		51,895
Litigation settlement (net of costs except for taxes)		15,302		214		—		—
Net income		15,395		7,035		7,543		8,664
Net income per share — Basic	$	0.64	$	0.29	$	0.31	$	0.35
Net income per share — Diluted	$	0.60	$	0.28	$	0.29	$	0.33
Weighted average basic common shares		24,179		24,270		24,544		24,783
Weighted average diluted common shares		25,550		25,562		26,033		26,307

76 EX-21 6 p68909exv21.htm EX-21

EXHIBIT 21

SUBSIDIARIES OF INTER-TEL, INCORPORATED

     Listed below are all the subsidiaries of Inter-Tel, Incorporated, as well as the jurisdiction under the laws of which each was organized, and the percentage of the outstanding voting stock of each owned by Inter-Tel, Incorporated.

	Percentage			State or
	of Voting			Jurisdiction
Name	Stock Owned			of Organization
Inter-Tel Integrated Systems, Inc.		100	%	Arizona
Inter-Tel Technologies, Inc.		100	%	Arizona
Inter-Tel Leasing, Inc.		100	%	Arizona
Inter-Tel Software and Services, Inc.		100	%	Arizona
Inter-Tel Midwest, Inc.		100	%	Delaware
Inter-Tel Incorporated-New Jersey		100	%	Delaware
Inter-Tel NetSolutions, Inc.		100	%	Texas
Inter-Tel DataCom, Inc.		100	%	California
Southwest Telephone Systems, Inc.		100	%	New Mexico
American Telcom Corp. of Georgia, Inc.		100	%	Georgia
Access West, Inc.		100	%	Delaware
Inter-Tel Integrated Systems (UK), Ltd.		100	%	United Kingdom
Swan Solutions Limited		100	%	United Kingdom
Inter-Tel Japan, Inc.		100	%	Japan
Tri-Com Communications, Inc.		100	%	North Carolina
Florida Telephone Systems, Inc.		100	%	Florida
NTL Corporation dba ComNet of Ohio		100	%	Ohio
Integrated Telecom Services Corporation		100	%	Kentucky
Telephone Corporation of America, Inc. (Telcoa)		100	%	Maryland
TDI Services Corporation, Technology Dynamics for the 21st Century		100	%	Virginia
Inter-Tel Business Information Systems, Inc.		100	%	Arizona

EX-23 7 p68909exv23.htm EX-23

EXHIBIT 23.0—CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS

     We consent to the incorporation by reference in Registration Statement (Form S-8 No. 33-40353) pertaining to the 1990 Directors Stock Option Plan, Registration Statement (Form S-8 No. 33-83826) pertaining to the Inter-Tel, Incorporated 1994 Long Term Incentive Plan, Registration Statement (Form S-8 No. 33-73620) pertaining to the Inter-Tel, Incorporated Employee Stock Ownership Plan, Registration Statement (Form S-8 No. 333-41197) pertaining to the Inter-Tel, Incorporated 1997 Long Term Incentive Plan and Inter-Tel, Incorporated 1997 Employee Stock Purchase Plan, Registration Statement (Form S-8 No. 333-56872) pertaining to the Acquisition Stock Option Plan, Registration Statement (Form S-8 No. 333-67261) pertaining to the Acquisition Stock Option Plan, Registration Statement (Form S-8 No. 333-85098) pertaining to the Inter-Tel, Incorporated 1997 Long Term Incentive Plan and Acquisition Stock Option Plan, Registration Statement (Form S-8 No. 333-87474) pertaining to the Inter-Tel, Incorporated 1997 Employee Stock Purchase Plan, Registration Statement (Form S-8 No. 333-104642) pertaining to the Inter-Tel, Incorporated 1997 Long Term Incentive Plan, Registration Statement (Form S-8 No. 333-106868) pertaining to the Inter-Tel, Incorporated Tax Deferred Savings Plan and Retirement Trust, and Registration Statement (Form S-3 No. 33-58161), Registration Statement (Form S-3 No. 33-61437), Registration Statement (Form S-3 No. 333-01735), Registration Statement (Form S-3 No. 333-12433), Registration Statement (Form S-3 No. 333-39221), of our report dated February 17, 2004, with respect to the consolidated financial statements and schedule of Inter-Tel, Incorporated included in this Annual Report (Form 10-K) of Inter-Tel, Incorporated for the year ended December 31, 2003.

Phoenix, Arizona
March 10, 2004 /s/ ERNST & YOUNG LLP

EX-31.1 8 p68909exv31w1.htm EX-31.1

EXHIBIT 31.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER
AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Steven G. Mihaylo, certify that:

1.	I have reviewed this annual report on Form 10-K of Inter-Tel, Incorporated.
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 officer 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)) 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.	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
c.	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 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 officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and audit committee of the registrant’s board of directors:

a.	All significant deficiencies and material weaknesses in the design or operation of internal controls 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.

Date: March 12, 2004

By:	/s/ Steven G. Mihaylo
Name:	Steven G. Mihaylo
Title:	Chief Executive Officer

EX-31.2 9 p68909exv31w2.htm EX-31.2

EXHIBIT 31.2

CERTIFICATION OF CHIEF FINANCIAL OFFICER
AS ADOPTED PURSUANT TO
SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Kurt R. Kneip, certify that:

1.	I have reviewed this annual report on Form 10-K of Inter-Tel, Incorporated.
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 officer 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)) 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.	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
c.	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 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 officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and audit committee of the registrant’s board of directors:

a.	All significant deficiencies and material weaknesses in the design or operation of internal controls 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.

Date: March 12, 2004

By:	/s/ Kurt R. Kneip
Name:	Kurt R. Kneip
Title:	Chief Financial Officer

EX-32.1 10 p68909exv32w1.htm EX-32.1

EXHIBIT 32.1

CERTIFICATION OF CHIEF EXECUTIVE OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

As of the date hereof, I, Steven G. Mihaylo, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report of Inter-Tel, Incorporated on Form 10-K for the fiscal year ended December 31, 2003 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Annual Report on Form 10-K fairly presents in all material respects the financial condition and results of operations of Inter-Tel, Incorporated. This written statement is being furnished to the Securities and Exchange Commission as an exhibit accompanying this report and shall not be deemed filed pursuant to the Securities Exchange Act of 1934.

By:	/s/ Steven G. Mihaylo
Name:	Steven G. Mihaylo
Title:	Chief Executive Officer
Dated:	March 12, 2004

EX-32.2 11 p68909exv32w2.htm EX-32.2

EXHIBIT 32.2

CERTIFICATION OF CHIEF FINANCIAL OFFICER
PURSUANT TO 18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

As of the date hereof, I, Kurt R. Kneip, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that the Annual Report of Inter-Tel, Incorporated on Form 10-K for the fiscal year ended December 31, 2003 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that information contained in such Annual Report on Form 10-K fairly presents in all material respects the financial condition and results of operations of Inter-Tel, Incorporated. This written statement is being furnished to the Securities and Exchange Commission as an exhibit accompanying this report and shall not be deemed filed pursuant to the Securities Exchange Act of 1934.

By:	/s/ Kurt R. Kneip
Name:	Kurt R. Kneip
Title:	Chief Financial Officer
Dated:	March 12, 2004

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