United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the Quarterly Period Ended June 30, 2005.

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

For the transition period from              to             .

Commission File Number 0-10843

CSP Inc.

(Exact name of Registrant as specified in its Charter)

Massachusetts	04-2441294
(State of incorporation)	(I.R.S. Employer Identification No.)

43 Manning Road

Billerica, Massachusetts 01821-3901

(978) 663-7598

(Address and telephone number of principal executive offices)

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x.

As of August 12, 2005, the registrant had 3,682,065 shares of common stock issued and outstanding.

INDEX

		Page
PART I.	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Unaudited Consolidated Balance Sheets as of June 30, 2005 and September 30, 2004	3
	Unaudited Consolidated Statements of Operations for the three and nine months ended June 30, 2005 and 2004	4
	Unaudited Consolidated Statements of Cash Flows for the nine months ended June 30, 2005 and 2004	5
	Notes to Unaudited Consolidated Financial Statements	6-12
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13-22
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	23
Item 4.	Controls and Procedures	23
PART II.	OTHER INFORMATION
Item 4.	Submission of Matters to a vote of Security Holders	24
Item 5.	Other	24
Item 6.	Exhibits	24
	Exhibit 31.1
	Exhibit 31.2
	Exhibit 32.1

2

CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED BALANCE SHEETS

(Amounts in thousands, except par value)

	June 30, 2005			September 30, 2004
ASSETS
Current assets:
Cash and cash equivalents	$	7,768		$	2,880
Short-term investments		6,489			10,015
Accounts receivable, net of allowances of $122 and $180 as of June 30, 2005 and September 30, 2004		5,608			7,161
Inventories		4,166			3,599
Refundable income taxes		34			12
Other current assets		1,411			840
Current assets of discontinued operations		—			169
Total current assets		25,476			24,676
Property, equipment and improvements, net		1,152			1,201
Other assets:
Long-term investments		715			174
Goodwill		2,779			2,779
Deferred income taxes		158			264
Cash surrender value life insurance		1,911			1,704
Other assets		140			80
Non-current assets of discontinued operations		—			235
Total other assets		5,703			5,236
Total assets	$	32,331		$	31,113
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	7,270		$	8,103
Pension and retirement plans		404			368
Income taxes payable		1,035			700
Current liabilities of discontinued operations		—			82
Total current liabilities		8,709			9,253
Pension and retirement plans		7,793			7,717
Deferred income taxes		148			99
Other long-term liabilities		—			20
Total Liabilities		16,650			17,089
Commitments and contingencies
Shareholders’ equity:
Common stock, $.01 par; authorized, 7,500 shares; issued 4,242 and 4,140 shares as of June 30, 2005 and September 30, 2004		42			41
Additional paid-in capital		11,927			11,405
Retained earnings		11,063			9,865
Accumulated other comprehensive loss		(4,492	)		(4,428	)
		18,540			16,883
Less treasury stock, at cost, 570 shares		(2,859	)		(2,859	)
Total shareholders’ equity		15,681			14,024
Total liabilities and shareholders’ equity	$	32,331		$	31,113

See accompanying notes to unaudited consolidated financial statements.

3

CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(Amounts in thousands, except for per share data)

	For the three months ended					For the nine months ended
	June 30, 2005		June 30, 2004			June 30, 2005			June 30, 2004
Sales:
Product	$	7,612	$	11,196		$	33,926		$	28,325
Services		3,931		2,836			10,431			8,868
Total sales		11,543		14,032			44,357			37,193
Cost of sales:
Product		5,774		8,336			25,703			21,677
Services		2,202		1,805			6,664			5,791
Total cost of sales		7,976		10,141			32,367			27,468
Gross profit		3,567		3,891			11,990			9,725
Operating expenses:
Engineering and development		602		704			2,066			1,825
Selling, general and administrative		2,771		2,545			8,299			6,962
Total operating expenses		3,373		3,249			10,365			8,787
Operating income		194		642			1,625			938
Other income (loss):
Foreign exchange gain (loss)		3		(8	)		(25	)		(22	)
Other income (loss), net		65		(1	)		174			120
Total other income (loss), net		68		(9	)		149			98
Income from continuing operations before income taxes		262		633			1,774			1,036
Provision for income taxes		97		176			557			267
Income from continuing operations		165		457			1,217			769
Income (loss) from discontinued operations		46		(19	)		(19	)		(81	)
Net income	$	211	$	438		$	1,198		$	688
Income per share from continuing operations-basic	$	0.05	$	0.13		$	0.34		$	0.22
Income (loss) per share from discontinued operations - basic	$	0.01	$	(0.01	)	$	(0.01	)	$	(0.03	)
Net income per share-basic	$	0.06	$	0.12		$	0.33		$	0.19
Weighted average shares outstanding-basic		3,634		3,566			3,600			3,559
Income per share from continuing operations-diluted	$	0.05	$	0.12		$	0.32		$	0.21
Income (loss) per share from discontinued operations - diluted	$	0.01	$	0.00		$	(0.01	)	$	(0.03	)
Net income per share-diluted	$	0.06	$	0.12		$	0.31		$	0.18
Weighted average shares outstanding-diluted		3,828		3,746			3,806			3,741

See accompanying notes to unaudited consolidated financial statements

4

CSP INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Amounts in thousands)

	For the nine months ended
	June 30, 2005			June 30, 2004
Cash flows from operating activities:
Income	$	1,198		$	688
Loss from discontinued operations		(19	)		(81	)
Income from continuing operations		1,217			769
Adjustments to reconcile net income to net cash provided by continuing operations:
Depreciation and amortization		455			403
Loss on disposal of property, net		7			—
Loss on foreign currency transactions		25			22
Changes in the allowance for doubtful accounts		58			232
Deferred income taxes		(113	)		(109	)
Changes in operating assets and liabilities
(Increase) decrease in accounts receivable		1,507			(1,726	)
Increase in inventories		(583	)		(880	)
(Increase) decrease in refundable income taxes		(36	)		1,102
(Increase) decrease in other current assets		(206	)		121
(Increase) decrease in other assets		(180	)		34
Increase(decrease) in accounts payable and accrued expenses		(785	)		2,008
Increase in pension and retirement plans		218			36
Increase (decrease) in income taxes payable		974			(107	)
Decrease in other liabilities		(20	)		—
Net cash provided by operating activities of continuing operations		2,538			1,905
Cash flows from investing activities of continuing operations:
Purchases of available-for-sale securities		(117	)		(145	)
Purchases of held-to-maturity securities		(7,231	)		(1,839	)
Sales of available-for-sale securities		114			81
Maturities of held-to-maturity securities		10,047			1,378
Proceeds from sale of property, net of expenses		30			—
Purchases of property, equipment and improvements		(442	)		(509	)
Increase in cash surrender value life insurance		(207	)		(48	)
Net cash provided by (used in) investing activities of continuing operations		2,194			(1,082	)
Cash flows from financing activities of continuing operations:
Proceeds from stock issued from exercise of options		436			80
Proceeds from issuance of shares under employee stock purchase plan		87			22
Net cash provided by financing activities of continuing operations		523			102
Effects of exchange rate on cash		(224	)		(254	)
Net cash used for discontinued operations		(143	)		(46	)
Net increase in cash and cash equivalents		4,888			625
Cash and cash equivalents, beginning of period		2,880			3,129
Cash and cash equivalents, end of period	$	7,768		$	3,754
Supplementary cash flow information:
Cash paid for income taxes	$	56		$	169
Cash paid for interest	$	107		$	83

See accompanying notes to unaudited consolidated financial statements.

5

CSP INC. AND SUBSIDIARIES

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

THREE AND NINE MONTH PERIODS ENDED JUNE 30, 2005 AND 2004

Organization and Business

CSP Inc. (“CSPI” or the “Company”) was founded in 1968 and is based in Billerica, Massachusetts. To meet the diverse requirements of its industrial, commercial, scientific and defense customers worldwide, CSPI and its subsidiaries develop and market IT integration solutions, messaging and image-processing software, and high-performance cluster computer systems. The Company’s wholly owned subsidiaries include MODCOMP, Inc. (“MODCOMP”), Scanalytics, Inc., and MultiComputer division. In June 2005, the Company sold the operating assets and liabilities of Scanalytics. Accordingly, the Company has classified the Scanalytics business as a “Discontinued Operation” in accordance with the guidance provided in Statement of Financial Accounting Standard (SFAS) No. 144 “Accounting for the Impairment of Disposal of Long-Lived Assets”.

1. Basis of Presentation

The accompanying financial statements have been prepared by the Company, without audit, and reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results of the interim periods presented. All adjustments were of a normal recurring nature. Certain information and footnote disclosures normally included in the annual financial statements, which are prepared in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted. Accordingly, the Company believes that although the disclosures are adequate to make the information presented not misleading, the financial statements should be read in conjunction with the footnotes contained in the Company’s Annual Report on Form 10-K for the fiscal year ended September 30, 2004.

In accordance with accounting principles generally accepted in the United States of America, all significant intercompany transactions and balances have been eliminated in consolidation. Accordingly, segment results reported by the Company exclude the effect of transactions between the Company’s subsidiaries.

2. Use of Estimates

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

3. Recent Accounting Pronouncements

In November 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 151, “Inventory Costs”, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS No. 151 will have a material impact on our consolidated financial statements or results of operations.

In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets”, which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not believe the adoption of SFAS No. 153 will have a material impact on our consolidated financial statements or results of operations.

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment”, which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This Statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The compensation expense will be recognized over the period during which an employee is required to provide service in exchange for the award. The Statement, as issued by the FASB, was to be effective as of the beginning of the first interim or annual reporting period that begins after June 15, 2005. However, on April 15, 2005, the Securities and Exchange Commission (SEC) adopted a new rule which amends the compliance dates for revised SFAS No. 123. The rule allows implementation of the Statement at the beginning of the next fiscal year that begins after June 15, 2005. We intend to adopt the revised Statement as of October 1, 2005.

6

In March 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107, which provides additional guidance to stock option expensing provisions under SFAS No. 123R. This additional guidance will be considered in establishing assumptions to value newly granted stock options under SFAS No. 123R. We are in the process of evaluating the impact of the adoption of SFAS No. 123R on our financial position and results of operations. See the pro forma disclosure in Note 6.

In March 2005, the FASB issued Interpretation (FIN) No. 47, “Accounting for Conditional Asset Retirement Obligations—an Interpretation of FASB Statement No. 143.” This Interpretation clarifies the timing of liability recognition for legal obligations associated with an asset retirement when the timing and (or) method of settling the obligation are conditional on a future event that may or may not be within the control of the entity. FIN No. 47 is effective no later than the end of fiscal years ending after December 15, 2005. We do not believe the adoption of FIN No. 47 will have a material impact on our consolidated financial statements or results of operations.

In June 2005, The FASB issued FSP FAS 143-1 titled “Accounting for Electronic Waste Obligations”. The obligations addressed in the FSP relate to those which might be created under the operation of Directive 2002/96/EC on Electrical and Electronic Equipment adopted by the European Union in February 2003. The FSP provides guidance on proper accounting for costs associated with retiring electronic equipment classified as “Historical” held by commercial users on or before August 13, 2005. Commercial users in EU countries that have adopted the law may be required to record an asset retirement obligation and to capitalize a related increase in the carrying value of the equipment subject to the directive utilizing concepts outlined under FASB Statement No. 143, Accounting for Asset Retirement Obligations, and the related FASB Interpretation No. 47, Accounting for Conditions Asset Retirement Obligations. The cumulative effect of the initial application of this FSP shall be recognized as a change in accounting principle as described in paragraph 20 of APB Opinion No. 20, Accounting Changes. The effective date of this FSP is the first reporting period after June 8, 2005 or the date of adoption of the law by the applicable EU-member country. The Company has evaluated whether the EU Directive is applicable to its two European subsidiaries. We will apply the prescribed accounting to those affected subsidiaries. Management has assessed the impact of the adoption of this accounting policy and there is no material affect on operating results.

4. Reclassifications

Certain amounts for prior periods in the accompanying unaudited consolidated financial statements have been reclassified to conform to current period presentations.

5. Earnings Per Share of Common Stock

Basic net income per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted net income per common share reflects the maximum dilution that would have resulted from the assumed exercise and share repurchase related to dilutive stock options and is computed by dividing net income by the assumed weighted average number of common shares outstanding.

7

The reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the Company’s reported net income is as follows:

	For the three months ended				For the nine months ended
(Amounts in thousands, except per share data)	June 30, 2005		June 30, 2004		June 30, 2005		June 30, 2004
Net income	$	211	$	438	$	1,198	$	688
Weighted average number of shares outstanding – basic		3,634		3,566		3,600		3,559
Incremental shares from the assumed exercise of stock options		194		180		206		182
Weighted average number of shares outstanding – dilutive		3,828		3,746		3,806		3,741
Net income per share – basic	$	0.06	$	0.12	$	0.33	$	0.19
Net income per share – diluted	$	0.06	$	0.12	$	0.31	$	0.18

SFAS No. 128 requires all anti-dilutive securities, including stock options, to be excluded from the diluted earnings per share computation. For the three and nine months ended June 30, 2005 and 2004, options of 434,739 and 507,456 were included in the diluted net income per share calculation and 84,500 and 3,000 options were excluded.

6. Stock-Based Compensation

The Company accounts for its stock compensation under the provisions of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure.” As permitted by SFAS No. 123, the Company measures compensation cost in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” and related interpretations. Accordingly, no accounting recognition is given to stock options granted at fair market value until they are exercised. Upon exercise, net proceeds, including tax benefits realized, are credited to shareholders’ equity.

The following table illustrates the pro forma effect on net income and net income per share if the Company had applied the fair value recognition provisions of SFAS No. 123.

	For the three months ended				For the nine months ended
(Amounts in thousands, except per share data)	June 30, 2005		June 30, 2004		June 30, 2005		June 30, 2004
Net income	$	211	$	438	$	1,198	$	688
Deduct: Stock based employee compensation expense determined under fair value based method for all awards		60		38		176		115
Pro forma net income	$	151	$	400	$	1,022	$	573
Income per share:
Basic, as reported	$	0.06	$	0.12	$	0.33	$	0.19
Diluted, as reported	$	0.06	$	0.12	$	0.31	$	0.18
Basic, pro forma	$	0.04	$	0.11	$	0.28	$	0.16
Diluted, pro forma	$	0.04	$	0.11	$	0.27	$	0.15
Weighted average shares outstanding – basic		3,634		3,566		3,600		3,559
Weighted average shares outstanding – diluted		3,828		3,746		3,806		3,741

8

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

	For the three months ended				For the nine months ended
	June 30, 2005		June 30, 2004		June 30, 2005		June 30, 2004
Risk-free interest rate	4.1	%	3.9	%	3.6	%	3.3	%
Expected dividend yield	—		—		—		—
Expected volatility	48.4	%	49.5	%	48.4	%	49.5	%
Expected life (years)	5		5		5		5
Weighted average fair value of options granted during the period	3.32		N/A		6.23		5.70

There were no stock options granted in the three months ended June 30, 2004.

7. Inventories

Inventories consist of the following:

	June 30, 2005		September 30, 2004
	(Amounts in thousands)
Raw materials	$	902	$	1,421
Work-in-process		854		737
Finished goods		2,410		1,441
Total	$	4,166	$	3,599

8. Comprehensive Income (Loss)

The components of comprehensive income (loss) are as follows:

	For the three months ended						For the nine months ended
(Amounts in thousands)	June 30, 2005			June 30, 2004			June 30, 2005			June 30, 2004
Net income	$	211		$	438		$	1,198		$	688
Unrealized gain (loss) on available-for-sale securities		(26	)		3			11			36
Effect of foreign currency translation		(191	)		(30	)		(75	)		(17	)
Comprehensive income (loss)	$	(6	)	$	411		$	1,134		$	707

The components of Accumulated Other Comprehensive Income (Loss) are as follows:

(Amounts in thousands)	June 30, 2005			September 30, 2004
Unrealized gain on available-for-sale securities	$	40		$	29
Cumulative Effect of Foreign currency translation		(1,663	)		(1,588	)
Additional minimum pension liability		(2,869	)		(2,869	)
Accumulated Comprehensive income (loss)	$	(4,492	)	$	(4,428	)

9. Pension and Retirement Plans

In the United Kingdom and Germany, the Company provides defined benefit pension plans and defined contribution plans for the majority of its employees. Domestically, the Company also provides benefits through supplemental retirement plans to certain current and former employees. These supplemental plans provide benefits

9

derived out of cash surrender values relating to current and former employee and officer life insurance policies, equal to the difference between the amounts that would have been payable under the defined benefit pension plans, in the absence of legislation limiting pension benefits and earnings that may be considered in calculating pension benefits, and the amounts actually payable under the defined benefit pension plans. Domestically, the Company provides for officer death benefits through the post-retirement plans to certain officers.

The Company funds its pension plans in amounts sufficient to meet the requirements set forth in applicable employee benefits laws and local tax laws. Liabilities for amounts in excess of these funding levels are accrued and reported in the consolidated balance sheet.

The plan assets comprise a diversified mix of assets including corporate equities, government securities and corporate debt securities.

The components of net periodic benefit costs related to the U.S. and foreign plans are as follows:

	For the Three Months Ended June 30
	2005								2004
	Foreign			U.S.		Total			Foreign			U.S.		Total
	(Amounts in thousands)
Pension:
Service cost	$	22		$	2	$	24		$	28		$	1	$	29
Interest cost		157			37		194			159			37		196
Expected return on plan assets		(92	)		—		(92	)		(59	)		—		(59	)
Amortization of:
Prior service costs/(gains)		40			15		55			43			—		43
Net transition asset		(31	)		—		(31	)		(30	)		—		(30	)
Net periodic benefit cost	$	96		$	54	$	150		$	141		$	38	$	179
Post Retirement:
Service cost	$	—		$	13	$	13		$	—		$	8	$	8
Interest cost		—			7		7			—			1		1
Expected return on plan assets		—			—		—			—			—		—
Amortization of:
Prior service costs/(gains)		—			—		—								—
Net transition asset		—			18		18			—			—		—
Net periodic benefit cost	$	—		$	38	$	38		$	—		$	9	$	9
	For the Nine Months Ended June 30
	2005								2004
	Foreign			U.S.		Total			Foreign			U.S.		Total
	(Amounts in thousands)
Pension:
Service cost	$	68		$	6	$	74		$	84		$	35	$	119
Interest cost		473			111		584			470			83		553
Expected return on plan assets		(276	)		—		(276	)		(232	)		—		(232	)
Amortization of:
Prior service costs/(gains)		120			45		165			128			—		128
Net transition asset		(93	)		—		(93	)		(89	)		—		(89	)
Net periodic benefit cost	$	292		$	162	$	454		$	361		$	118	$	479
Post Retirement:
Service cost	$	—		$	39	$	39		$	—		$	35	$	35
Interest cost		—			21		21			—			5		5
Expected return on plan assets		—			—		—			—			—		—
Amortization of:
Prior service costs/(gains)		—			—		—			—			—		—
Net transition asset		—			56		56			—			—		—
Net periodic benefit cost	$	—		$	116	$	116		$	—		$	40	$	40

There were no Company contributions for the three and nine months ended June 30, 2005 and 2004.

10

10. Segment and Geographical Information

Summarized financial information of the Company’s continuing operations by operating segment is as follows:

	Systems		Service and system integration			E-business Software			Continuing Operations Total
Quarter Ended June 30, 2005
Sales:
Product	$	1,376	$	6,179		$	57		$	7,612
Service		901		2,916			114			3,931
Total sales		2,277		9,095			171			11,543
Operating income (loss) from continuing operations		316		(89	)		(33	)		194
Assets		12,003		19,886			442			32,331
Capital expenditures		64		136			3			203
Depreciation and amortization		64		92			2			158
Quarter Ended June 30, 2004
Sales:
Product	$	2,692	$	8,473		$	31		$	11,196
Service		17		2,499			320			2,836
Total sales		2,709		10,972			351			14,032
Operating income (loss) from continuing operations		415		436			(209	)		642
Assets		10,537		18,570			609			29,716
Capital expenditures		41		74			2			117
Depreciation and amortization		49		92			4			145
Nine Months Ended June 30, 2005
Sales:
Product	$	6,907	$	26,918		$	101		$	33,926
Service		1,207		8,536			688			10,431
Total sales		8,114		35,454			789			44,357
Operating income (loss) from continuing operations		1,835		(50	)		(160	)		1,625
Assets		12,003		19,886			442			32,331
Capital expenditures		170		266			6			442
Depreciation and amortization		178		271			6			455
Nine Months Ended June 30, 2004
Sales:
Product	$	5,288	$	22,924		$	113		$	28,325
Service		604		7,384			880			8,868
Total sales		5,892		30,308			993			37,193
Operating income (loss) from continuing operations		795		678			(535	)		938
Assets		10,537		18,570			609			29,716
Capital expenditures		209		291			9			509
Depreciation and amortization		139		255			9			403

Operating income (loss) from continuing operations is sales less cost of sales, engineering and development, selling, general and administrative expenses but is not affected by either non-operating charges/income or by income taxes. Non-operating charges/ income consists principally of gain on sale of property, investment income and interest expense. In calculating operating income (loss) from continuing operations for the presentation of the individual operating segments above, sales and administrative expenses incurred at the corporate level that benefit the segments are allocated to each segment based upon their relative sales levels.

11

All intercompany transactions have been eliminated.

Assets, including deferred income tax assets and other financial instruments owned by the Company, common to more than one segment are allocated on a sales basis. Capital expenditures common to more than one segment are allocated on a sales basis.

For the nine months ended June 30, 2005 and 2004, the Company had sales to two customers Atos Origin GmbH (a Service and system integration customer, which effective in January 2005 became the primary system integrator for E-Plus) which accounted for approximately $4.8 million (11%) and $0.0 million of consolidated sales for the nine month periods ended June 30, 2005 and 2004 and E-Plus (a Service and system integration customer) which accounted for $3.1 million (7%) and $7.8 million (20%) of consolidated sales for the nine month periods ended June 30, 2005 and 2004, respectively. No other customers had sales in excess of 10% of consolidated sales for the nine months ended June 30, 2005 and 2004, respectively. As of June 30, 2005 and September 30, 2004 the accounts receivable balance for Atos Origin GmbH accounted for approximately $0.4 million (7%) and $0. million of the total net accounts receivable balance, respectively. As of June 30, 2005 and September 30, 2004, the accounts receivable balance for E-Plus accounted for approximately $0.0 million and $0.9 million (13%) of the total net Accounts receivable balance, respectively.

11. Discontinued Operations and Divestitures

In June 2005, the Company sold the operating assets and liabilities of Scanalytics which made up all of the previously reported “Other software” segment for net proceeds of approximately $446,000. Accordingly, the Company has classified the Scanalytics business as a “Discontinued Operation” in accordance with the guidance provided in FAS No.144. The assets, liabilities and operating results, including a gain of approximately $114,000 related to the sale of the net assets of this business, have been segregated from continuing operations and reported as discontinued operations in the accompanying consolidated balance sheets, statements of operations, and cash flows and related notes to the consolidated financial statements for all periods presented.

Certain amounts for prior periods in the accompanying consolidated financial statements, and in the discussion below, have been reclassified to conform to the current period discontinued operations presentation. In accordance with accounting principles generally accepted in the United States of America, all significant intercompany transactions and balances have been eliminated in consolidation. Also, segment results reported by the Company in Note 10 no longer include the other software segment.

Summarized financial information of the Company’s discontinued operations is as follows:

	For the three months ended					For the nine months ended
Discontinued Operations:	June 30, 2005		June 30, 2004			June 30, 2005			June 30, 2004
	(Amounts in thousands)
Sales:
Product	$	225	$	270		$	745		$	1,049
Service		7		—			8			25
Total sales		232		270			753			1,074
Income (loss) from discontinued operations		46		(19	)		(19	)		(81	)
Assets		—		403			—			403
Capital expenditures		—		—			13			5
Depreciation and amortization		3		3			8			10

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

Forward-Looking Statements

This quarterly report on form 10-Q contains forward-looking statements based on current expectations that involve a number of risks and uncertainties. Such statements are generally identified by the use of forward-looking words and phrases, such as “intended,” “expects,” “anticipates” and “is (or are) expected (or anticipated).” Actual results may differ materially from those discussed in such forward-looking statements, and our stockholders should carefully review the cautionary statements set forth in this form 10-Q, including those set forth under the caption “Risk Factors That May Affect Future Results”. Any forward-looking statement speaks only as of the date on which such statement is made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances after the date on which such statement is made. As it is not possible to predict every new factor that may emerge, forward-looking statements should not be relied upon as a prediction of actual future financial condition or results. In response to competitive pressures or new product introductions, we may take certain pricing or marketing actions that could adversely affect our operating results. In addition, changes in our products and services mix may cause fluctuations in our gross margin. Due to the potential quarterly fluctuations in our operating results, we believe that quarter-to-quarter comparisons of our results of operations are not necessarily an indicator of future performance.

Markets for our products and services are characterized by rapidly changing technology, new product introductions and short product life cycles. These changes can adversely affect our business and operating results. Our success will depend on our ability to enhance our existing products and services and to develop and introduce, on a timely and cost effective basis, new products that keep pace with technological developments and address increasing customer requirements. The inability to meet these demands could adversely affect our business and operating results.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an on-going basis, we evaluate our estimates, including those related to uncollectible receivables, inventory valuation, goodwill, income taxes, deferred compensation and retirement plans, restructuring costs and contingencies. We base our estimates on historical performance and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements: revenue recognition; valuation allowances, specifically the allowance for doubtful accounts and deferred tax assets valuation allowance; inventory valuation; and goodwill impairment.

Revenue recognition

Our revenues are primarily generated from the sale of IT solutions and image processing software, third-party products, network management and storage systems integration services and high-performance cluster computer systems. In accordance with generally accepted accounting principles in the United States and when all other revenue recognition criteria have been met, we recognize revenue as follows (organized by operating segment):

Systems Revenue

Revenue from the sale of hardware products is recognized at the time of shipment and when all revenue recognition criteria have been met.

In limited circumstances, we are engaged in long-term contracts to design, develop, manufacture or modify complex equipment. For these contracts, we may recognize revenue using the percentage-of-completion method of

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contract accounting, measuring progress toward completion based on contract cost incurred to date as compared with total estimated contract costs. The use of the percentage-of-completion method of accounting requires significant judgment relative to estimating total contract costs, including assumptions relative to the length of time to complete the contract, the nature and complexity of the work to be performed, anticipated increases in wages and prices for subcontractor services and materials, and the availability of subcontractor services and materials. Our estimates are based upon the professional knowledge and experience of our engineers, program managers and other personnel who review each long-term contract monthly to assess the contract’s schedule, performance, technical matters and estimated cost at completion. When adjustments in estimated contract costs are determined, such revisions may have the effect of adjusting in the current period the earnings applicable to performance in prior periods. Anticipated losses, if any, are recognized in the period in which determined.

We also offer training, maintenance agreements and support services. We have established fair value on our training, maintenance and support services based on separate sales of these elements at prices stated in our standard price lists. These prices are not discounted. Revenue from service obligations under maintenance contracts is deferred and recognized on a straight-line basis over the contractual period, which is typically three to twelve months, if all other revenue recognition criteria have been met. Support services provided on a time and material basis are recognized as provided if all of the revenue recognition criteria have been met for that element and the support services have been provided. Revenue on training is recognized when the training is completed.

Service and System Integration Revenue

Our Service and Systems Integration segment includes third-party hardware and third-party software sales, which may be bundled with extended third party warranty, installation, training and support services. The third-party warranty is solely serviced by our vendors and we do not have any service obligations under these warranties. Under the support services agreements, we provide services to identify which component in the system is causing a malfunction; however, once the malfunctioning component is isolated, the customer must deal directly with the third party vendor for remediation.

The support services are always priced using a standard calculation based on estimated calls and are based on our price lists. This price is not discounted and renewals are only adjusted for standard price index increases. As a result, we believe that we have established fair market value for this element.

As a result, we recognize revenue on all elements, except for the support services, when all the products and services included in these elements have been delivered, customer acceptance has been ascertained, if and when applicable, and all other revenue recognition criteria have been meet. Revenue for the support services is recognized over the term of the contract, typically three to twelve months.

Service and systems integration also has some customized integration revenue, which may include revenue from the sale of third-party hardware, licensed software (either proprietary or third-party), consulting integration services, maintenance support, and service support. Maintenance support agreements represent fixed-fee support agreements on our delivered integration systems, while the service agreements represent time and material billings for services on an as-needed basis. These services do not provide for upgrades unless the upgrade is required to fix a functionality issue (i.e. bug fix).

We have established vendor-specific evidence of fair value on our maintenance support and service support elements.

Service support is available to customers who have not entered into a maintenance support agreement, and this service is billed on a time and material basis at our standard prices. These rates are not discounted and are provided on an as-needed basis.

As a result, revenue for all items, except for maintenance support and service support, are recognized when all the products and services included in these elements have been delivered, customer acceptance has been ascertained and all other revenue recognition criteria have been met. Maintenance support revenue is recognized over the term of the contract. Service support revenue is recognized upon performance of the services.

For software licenses sold separately without modification and training, revenue is recognized upon delivery.

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Revenue derived from consulting services rendered in connection with the integration of third-party hardware and third-party software is generally recognized when the services have been completed.

E-business Software Revenue

Our E-business Software segment includes customized integration revenue which may include revenue from the sale of third party hardware, licensed software (either proprietary or third-party), consulting integration services, maintenance support, and service support. Maintenance support agreements represent fixed fee support agreements on our delivered integration systems while the service agreements represent time and material billings for services on an as needed basis. These services do not provide for upgrades unless the upgrade is required to fix a functionality issue (i.e. bug fix).

We have not established vendor specific evidence of fair value on our third party hardware, licensed software and consulting integration services and they are recognized on a combined basis pursuant to accounting literature noted above. We have established vendor specific evidence of fair value on our maintenance support and service support elements.

Maintenance support is priced based on prices charged in separate sales to customers at prices established and published in our standard price list depending on the size of the project and the type of support requested. Renewal rates are specified in the contracts and are consistent with the initial rates. These rates will only change as a result of (i) a standard price index increase, and/or (ii) additional customization services provided (this adjustment is based on the price list renewal rate on the additional services provided). In addition, maintenance support is never discounted.

Service support is available to customers who have not entered into a maintenance support agreement and this service is billed on a time and material basis at our standard prices. These rates are never discounted and are provided on an as needed basis.

As a result, revenue for all items, except for maintenance support and service support, are recognized when all the products and services included in these elements have been delivered, customer acceptance, if any, has been ascertained and all other revenue recognition criteria have been met. Maintenance support revenue is recognized over the term of the contract. Service support revenue is recognized upon performance of the services.

Valuation Allowances

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in impairment of their ability to make payments, additional allowances may be required.

We record a valuation allowance for the entire balance of deferred tax assets in the U.S. and U.K. as it is more likely than not they will not be realized due to our being in a cumulative loss position. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which the associated temporary differences become deductible. We consider the scheduled reversals of deferred tax liabilities and projected taxable income in making this assessment. Based on our lack of income in the U.S. and U.K. over several years and lack of significant orders, we established a valuation allowance for the entire deferred tax asset. Based upon the level of historical taxable income and projections for the future taxable income over the period in which the deferred taxes will reverse or NOLs expire, management believes it is more likely than not, that we will not realize the benefits of these deductible differences.

In assessing the realizability of our deferred tax assets, we consider and rely upon projections of future income. The key assumptions in our projections include sales growth rates, including potential contract wins, and expected levels of operating expenditures in addition to factors discussed in the section “Risk Factors That May Affect Future Results”. These assumptions are subject to variation based upon both internal and external factors, many of which are beyond our control. To the extent that actual experience deviates from our assumptions, our projections would be affected and hence our assessment of realizability of our deferred tax asset may change. If we are awarded a significant contract our projections will be impacted and we may reverse the valuation allowance against the deferred tax asset.

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Inventory Valuation

The recoverability of inventories is based upon the types and levels of inventories held, forecasted demand, pricing, competition and changes in technology. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-down may be required.

Goodwill Impairment

We adopted SFAS No. 142, “Goodwill and Other Intangible Assets” on October 1, 2002. This standard requires that goodwill no longer be amortized, and instead, be tested for impairment at least annually and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could indicate impairment include significant under performance relative to prior operating results, change in projections, significant changes in the manner of our use of assets or the strategy for our overall business, and significant negative industry or economic trends. At June 30, 2005 and 2004, we had $2,779,000 in Goodwill. We had no impairment charge during the year ended September 30, 2004. In evaluating the impairment of goodwill, we consider a number of analyses such as discounted cash flow projections and market capitalization value. The process of evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. In estimating fair value of the businesses with goodwill for the purposes of our annual or periodic analyses, we make estimates and judgments about the future cash flows of these businesses. Our cash flow forecasts are based on assumptions that are consistent with the plans and estimates we are using to manage the underlying businesses. In addition, we make certain judgments about assets such as accounts receivable and inventory to the estimated balance sheet for those businesses. We also consider our market capitalization (adjusted for unallocated monetary assets such as cash, marketable debt securities and debt) on the date we perform the analysis. Our key assumptions include sales growth and expected levels of operating expenditures, which are subject to variation based on both internal and external factors. To the extent that actual experience deviates from the projections, our assessment regarding impairment may change. Such a change could have a material adverse affect on the statement of operations.

Pension and Retirement Plans

In the United Kingdom and Germany, we provide defined benefit pension plans and defined contribution plans for the majority of the employees. In the U.S., we also provide benefits through supplementary retirement plans to employees. These supplemental plans are funded from cash surrender values from life insurance policies. The plan assumptions in the U.S. include a discount rate of 6.0% and the plan assumptions in the U.K. and Germany include a discount rate of 5.0%. In addition, in the U.S., we provide for officer death benefits through the post-retirement plans to certain officers. In calculation of the deferred compensation and retirement plans net liabilities, we make assumptions regarding expected discount rates, rates of return on assets and compensation increase rates. If activities differ from the assumptions, deferred compensation and retirement plans net liabilities may require significant adjustments. We fund the pension plans in amounts sufficient to meet the requirements set forth in applicable employee benefits laws and local tax laws. Liabilities for amounts in excess of these funding levels are accrued and reported in the consolidated balance sheet.

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Results of Operations

The following table details our results of operations in dollars and as a percentage of sales for the three and nine months ended June 30, 2005 and 2004:

	Three months ended									Nine months ended
	June 30, 2005		% of sales		June 30, 2004			% of sales		June 30, 2005			% of sales		June 30, 2004			% of sales
Sales	$	11,543	100	%	$	14,032		100	%	$	44,357		100	%	$	37,193		100	%
Costs and expenses:
Cost of sales		7,976	69	%		10,141		72	%		32,367		73	%		27,468		74	%
Engineering and development		602	5	%		704		5	%		2,066		5	%		1,825		5	%
Selling, general and administrative		2,771	24	%		2,545		18	%		8,299		18	%		6,962		19	%
Total costs and expenses		11,349	98	%		13,390		95	%		42,732		96	%		36,255		98	%
Operating income		194	2	%		642		5	%		1,625		4	%		938		2	%
Other income		68	—	%		(9	)	—			149		—			98		1	%
Income from continuing operations before income taxes		262	2	%		633		5	%		1,774		4	%		1,036		3	%
Provision for income taxes		97	1	%		176		1	%		557		1	%		267		1	%
Income from continuing operations		165	1	%		457		4	%		1,217		3	%		769		2	%
Income (loss) from discontinued operations		46	1	%		(19	)	(1	)%		(19	)	—			(81	)	—
Net income	$	211	2	%	$	438		3	%	$	1,198		3	%	$	688		2	%

Sales

The following table details our sales by operating segment, excluding discontinued operations, for the three and nine month periods ended June 30, 2005 and 2004:

By Operating Segment:	June 30, 2005		% of Total		June 30, 2004		% of Total		$ Increase (decrease)			% Increase (decrease)
			(Amounts in thousands)
For the Three Months Ended:
Systems	$	2,277	20	%	$	2,709	19	%	$	(432	)	(16	)%
Service and system integration		9,095	79	%		10,972	78	%		(1,877	)	(17	)%
E-business software		171	1	%		351	3	%		(180	)	(51	)%
Total	$	11,543	100	%	$	14,032	100	%	$	(2,489	)	(18	)%
For the Nine Months Ended:
Systems	$	8,114	18	%	$	5,892	16	%	$	2,222		38	%
Service and system integration		35,454	80	%		30,308	81	%		5,146		17	%
E-business software		789	2	%		993	3	%		(204	)	(21	)%
Total	$	44,357	100	%	$	37,193	100	%	$	7,164		19	%

The Systems segment revenue decreased by $.4 million (16%) and increased by $2.2 million (38%) for the three and nine months ended June 30, 2005, respectively. The nine month period increase was primarily due to sales to defense contractors for two programs in Q2, one in the U.S., which represented 60% and 33% of the segment sales for the three and nine months ended June 30, 2005, and one in Japan which represented 5% and 32% of segment sales for the three and nine month periods ended June 30, 2005. Included in the revenues for the third quarter of 2005 was $576,000 of royalty revenue related to our contract with Lockheed Martin for the Hawkeye E-2D program. The Company expects a continued stream of royalty revenue from this contract though fiscal 2006. The Service and system integration segment sales decreased by $1.9 million (17%) and increased by $5.1 million (17%) for the three and nine months ended June 30, 2005, respectively. The decrease in the third quarter of 2005 was due primarily to lower demand for third party product in Germany relative to the same quarter of 2004, partially offset by approximately $.2 million of foreign currency effects due to the increase in value of the euro with respect to the US dollar. The increase for the nine month period ended June 30, 2005 compared to the same period of fiscal 2004 was primarily due to an increase of $5.0 million (36%) in sales by our German subsidiary for a number of large systems integration projects which included the sale of equipment and services primarily in the first six months of fiscal year 2005. Included in the increase for the nine month period was approximately $.8 million of foreign currency effects related to the increase in value of the euro relative to the US dollar.

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Our sales by geographic area excluding discontinued operations, based on the location of where the products were shipped or services rendered, are as follows:

	2005		%		2004		%		$ Increase (decrease)			% Increase (decrease)
	(Amounts in thousands)
For the Three Months Ended June 30:
Europe	$	3,844	33	%	$	5,747	41	%	$	(1,903	)	(33	)%
North America		7,603	66	%		7,458	53	%		145		2	%
Asia and the rest of the world		96	1	%		827	6	%		(731	)	(88	)%
Totals	$	11,543	100	%	$	14,032	100	%	$	(2,489	)	(18	)%
For the Nine Months Ended June 30:
Europe	$	20,972	47	%	$	15,881	43	%	$	5,091		32	%
North America		20,842	47	%		20,295	54	%		547		3	%
Asia and the rest of the world		2,543	6	%		1,017	3	%		1,526		150	%
Totals	$	44,357	100	%	$	37,193	100	%	$	7,164		19	%

The European sales increase over the nine month period ended June 30, 2005 over the comparable period of 2004 was due to the increase in Service and systems integration revenue primarily in Germany. Recent softness in the market for integration services in Germany noted in the third quarter of 2005 is reflected in the lower revenue levels in Europe in the three months ended June 30, 2005 compared to the same period of 2004. Sales in Asia were primarily from the Systems segment to a defense related program in Japan.

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Cost of Sales

The following table details our sales, cost of sales and gross margin by operating segment, excluding discontinued operations, for the three and nine months ended June 30, 2005 and 2004:

	Systems			Service and system integration			E-business Software			Total
	(Amounts in thousands)
For the Three Months Ended June 30:
2005
Sales	$	2,277		$	9,095		$	171		$	11,543
Cost of sales		762			7,089			125			7,976
Gross margin $		1,515			2,006			46			3,567
Gross margin %		67	%		22	%		27	%		31	%
2004
Sales	$	2,709		$	10,972		$	351		$	14,032
Cost of sales		1,073			8,925			143			10,141
Gross margin $		1,636			2,047			208			3,891
Gross margin %		60	%		19	%		59	%		28	%
Increase (decrease)
Sales - $ Increase (decrease)	$	(432	)	$	(1,877	)	$	(180	)	$	(2,489	)
% Increase (decrease)		(16	)%		(17	)%		(51	)%		(18	)%
Cost of sales - $ Increase (decrease)	$	(311	)	$	(1,836	)	$	(18	)	$	(2,165	)
% Increase (decrease)		(29	)%		(21	)%		(13	)%		(21	)%
Gross margin - $ Increase (decrease)	$	(121	)	$	(41	)	$	(162	)	$	(324	)
Gross margin% - Increase (decrease)		7	%		3	%		(32	)%		3	%
For the Nine Months Ended June 30:
2005
Sales	$	8,114		$	35,454		$	789		$	44,357
Cost of sales		2,946			29,030			391			32,367
Gross margin $		5,168			6,424			398			11,990
Gross margin %		64	%		18	%		50	%		27	%
2004
Sales	$	5,892		$	30,308		$	993		$	37,193
Cost of sales		2,378			24,674			416			27,468
Gross margin $		3,514			5,634			577			9,725
Gross margin %		60	%		19	%		58	%		26	%
Increase (decrease)
Sales-$ Increase (decrease)	$	2,222		$	5,146		$	(204	)	$	7,164
% Increase (decrease)		38	%		17	%		(21	)%		19	%
Cost of sales - $ Increase (decrease)	$	568		$	4,356		$	(25	)	$	4,899
% Increase (decrease)		24	%		18	%		(6	)%		18	%
Gross margin - $ Increase (decrease)	$	1,654		$	790		$	(179	)	$	2,265
Gross margin % - Increase (decrease)		4	%		(1	)%		(8	)%		1	%

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Cost of sales as a percentage of sales was 73% for the nine months ended June 30, 2005, compared to 74% for the prior fiscal year. The cost of sales for the three month period decreased by 3% to 69% due primarily to the inclusion of $576,000 of royalty revenues in the Systems segment in the third quarter of 2005 for which no related costs were incurred.

Engineering and Development Expenses

The following table details our engineering and development expenses by operating segment, excluding discontinued operations, for the three and nine months ended June 30, 2005 and 2004:

By Operating Segment:	2005		% of Total		2004		% of Total		$ Increase (Decrease)			% Increase (Decrease)
	(Amounts in thousands)
For the Three Months Ended June 30:
Systems	$	521	87	%	$	449	64	%	$	72		16	%
Service and system integration		19	3	%		89	13	%		(70	)	(79	)%
E-business software		62	10	%		166	23	%		(104	)	(63	)%
Total	$	602	100	%	$	704	100	%	$	(102	)	(15	)%
For the Nine Months Ended June 30:
Systems	$	1,518	73	%	$	1,100	60	%	$	418		38	%
Service and system integration		266	13	%		231	13	%		35		15	%
E-business software		282	14	%		494	27	%		(212	)	(43	)%
Total	$	2,066	100	%	$	1,825	100	%	$	241		13	%

The increase in engineering and development expense was primarily due to the hiring of four new employees in the Systems segment needed to meet the requirements of our product development schedule. The decrease in expenses in the Service and systems integration segment for the quarter and E-business software segment was due primarily to a reduction in the engineering and labor expense for the redeployment of resources to activities and customers projects which are either classified as cost of sales or inventory for uncompleted projects where we have not recognized the revenue.

Selling, General and Administrative

The following table details our selling, general and administrative expense by operating segment, excluding discontinued operations, for the three and nine months ended June 30, 2005 and 2004:

By Operating Segment:	2005		% of Total		2004		% of Total		$ Increase (Decrease)			% Increase (Decrease)
	(Amounts in thousands)
For the Three Months Ended June 30:
Systems	$	678	24	%	$	774	30	%	$	(96	)	(12	)%
Service and system integration		2,076	75	%		1,521	60	%		555		36	%
E-business software		17	1	%		250	10	%		(233	)	(93	)%
Total	$	2,771	100	%	$	2,545	100	%	$	226		9	%
For the Nine Months Ended June 30:
Systems	$	1,815	22	%	$	1,619	23	%	$	196		12	%
Service and system integration		6,208	75	%		4,725	68	%		1,483		31	%
E-business software		276	3	%		618	9	%		(342	)	(55	)%
Total	$	8,299	100	%	$	6,962	100	%	$	1,337		19	%

Selling, general and administrative expense increased by $.2 million and $1.3 million for the three and nine months ended June 30, 2005 compared to the same periods of the prior fiscal year. This increase was primarily due to increased audit and outside consultant expenses related to new regulatory requirements created by the Sarbanes-Oxley Act of 2002 and related increased staffing in finance functions representing approximately $.2 million and $.5 million of the increase in the quarter and the nine month period, respectively. Increased staffing and marketing programs in the Service and systems segment contributed an additional $.1 million and $.3 million of the increase in the quarter and the

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year-to-date. Offsetting these increases were increases in the cash surrender value of life insurance contracts and reductions of management bonus accruals, reducing costs by approximately $.2 million in the quarter and in the nine months ended June 30, 2005 compared to the same periods in the previous year.

Other Income/Expenses

The following table details our other income/expenses, excluding discontinued operations, for three and nine months ended June 30, 2005 and 2004:

	2005			2004			$ Increase (Decrease)
	(Amounts in thousands)
For the Three Months Ended June 30:
Interest expense	$	(26	)	$	(25	)	$	(1	)
Interest income		99			39			60
Dividend income		2			1			1
Foreign exchange gain (loss)		3			(8	)		11
Other income (expense), net		(10	)		(16	)		6
Total other income (expense), net	$	68		$	(9	)	$	77
For the Nine Months Ended June 30:
Interest expense	$	(88	)	$	(78	)	$	(10	)
Interest income		234			157			77
Dividend income		5			3			2
Foreign exchange gain (loss)		(25	)		(22	)		(3	)
Other income (expense), net		23			38			(15	)
Total other income (expense), net	$	149		$	98		$	51

Interest income increased $60,000 and $77,000 in the quarter and the nine months ended June 30, 2005 compared the same periods in the prior year due to higher average interest rates during the periods and to higher levels of invested cash and marketable securities.

Income Taxes

We recorded a provision for income tax expense of $557,000 for the nine months ended June 30, 2005 compared to $267,000 for the nine months ended June 30, 2004. The tax expense recorded in the nine month periods is primarily due to the income generated by our foreign subsidiaries in Germany and the U.K. which accounted for approximately 65% of the expense. The balance is for US Alternative Minimum Tax (AMT) and tax related to goodwill, not amortizable for financial statement purposes, and state tax expense. We record a valuation allowance for our deferred tax assets. This valuation allowance was determined in accordance with the provisions of SFAS No. 109 (SFAS 109), “Accounting for Income Taxes” which requires an assessment of both positive and negative evidence when determining whether it is more likely than not that deferred tax assets are realizable. Such assessment is required on a jurisdiction-by-jurisdiction basis. Cumulative losses incurred in recent years represented sufficient negative evidence under SFAS 109 to record a valuation allowance against the deferred tax assets in the U.S. and the U.K. Our U.S. tax expense for fiscal year 2005 and 2004 has been reduced by decreasing our valuation allowance.

We have maintained the valuation allowances for the deferred tax assets for our U.S. and U.K. operations due to the losses sustained over the last three years. Management believes that it is more likely than not the deferred tax assets will not be realized.

We reinvest our foreign earnings indefinitely. Accordingly, no U.S. income taxes have been provided for the unremitted earnings of our international subsidiaries. Due to various methods by which such earnings could be repatriated in the future, it is not currently practicable to determine the amount of applicable taxes that would result from such repatriation, if any.

On October 22, 2004, the American Jobs Creation Act of 2004 (“the Act”) was enacted into law. We are not yet in a position to decide on whether, and to what extent, we might repatriate foreign earnings. We cannot reasonably estimate the tax liability if we elect to repatriate any accumulated foreign earnings. We expect to finalize our assessment after further guidance is published.

Discontinued Operations

In June 2005, the Company sold the operating assets and liabilities of Scanalytics for net proceeds of approximately $446,000. Accordingly, the Company has classified the Scanalytics business as a “Discontinued Operation” in accordance with the guidance provided in FAS 144. The sale of the Company’s net investment of approximately $332,000 in Scanalytics created a gain of $114,000, which is included in the operating results of discontinued operations. The assets, liabilities and operating results of this business have been segregated from continuing operations and reported as discontinued operations in the accompanying consolidated balance sheets, statements of operations, and cash flows and related notes to the consolidated financial statements for all periods presented. This business made up 100% of what we previously reported as the Other software segment.

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Revenues generated by Scanalytics for the three months ended June 30, 2005 and 2004 were $232,000 and $270,000, respectively. Revenues generated for the nine months ended June 30, 2005 and 2004 were $753,000 and $1,074,000, respectively.

Income (loss) generated by Scanalytics for the three months ended June 30, 2005 and 2004 was $46,000 and $(19,000), respectively. Income (loss) for the nine months ended June 30, 2005 and 2004 was ($19,000) and ($81,000), respectively.

Liquidity and Capital Resources

Our primary source of liquidity is our cash and cash equivalents and short-term investments, which increased by $1.4 million to $14.3 million as of June 30, 2005, as compared to $12.9 million as of September 30, 2004. In the nine month period ended June 30, 2005, we generated approximately $2.5 million of cash in operating activities, compared to $1.9 million generated by operating activities in the same period of the prior fiscal year. The significant change in net cash provided by operating activities was primarily due to income from continuing operations of $1.2 million versus $0.8 million for the prior comparable period and to the decrease in accounts receivable and an increase in pension related liabilities and an increase in income taxes payable. Offsetting these factors were a decrease in accounts payable and accrued expenses, and increase in inventories, and increases in several other assets.

Approximately $2.2 million of net cash was provided by investing activities for the nine months ended June 30, 2005 compared to a use of $1.0 million during the prior comparable period. During the nine month period ended June 30, 2005, our investing activities consisted of purchases, sales and maturities of marketable securities providing net cash of $2.8 million from the net sales of investments and the use of $0.4 million for the purchases of property equipment and improvements.

Financing activities generated approximately $0.5 million of cash during the nine month period ended June 30, 2005. This cash was provided from the proceeds of stock issued from the exercise of stock options and from the issuance of shares under our employee stock purchase plan.

If cash generated from operations is insufficient to satisfy working capital requirements, we may need to access funds through bank loans, sale of securities or other means. There is no assurance that we will be able to raise any such capital on terms acceptable to us, on a timely basis or at all. If we are unable to secure additional financing, we may not be able to complete development or enhancement of products, take advantage of future opportunities, respond to competition or continue to effectively operate our business.

The following is a schedule of our contractual obligations at June 30, 2005:

	Total		One year or less		2-3 Years		4-5 Years		Thereafter
	(Amounts in thousands)
Operating leases	$	2,341	$	1,042	$	944	$	237	$	118
Retirement Obligations		8,197		404		1,100		1,227		5,466
	$	10,538	$	1,446	$	2,044	$	1,464	$	5,584

Based on our current plans and business conditions management believes that our available cash and cash generated from operations and investments will be sufficient to provide for our working capital and capital expenditure requirements for the foreseeable future.

Inflation and Changing Prices

Management does not believe that inflation and changing prices had significant impact on sales, revenues or net income during the three and nine month periods ended June 30, 2005 and 2004. There is no assurance that our business will not be materially and adversely affected by inflation and changing prices in the future.

The Company’s German operations conduct its business in Euros, while the U.K. operations conduct its business in Pounds Sterling. Due to movements of the Euro, and to a lesser extend, the U.K. Pound relative to the U.S. Dollar, the Company has realized losses of $58 thousand for the nine months ended June 30, 2005. The Company has unrealized gains of $75 thousand for the nine months ended June 30, 2005.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

There was no material change in our exposure to market risk during the three and nine months ended June 30, 2005.

Item 4. Controls and Procedures

Our chief executive officer, chief financial officer, and other members of our senior management team believe that the procedures followed by the Company provide reasonable assurance that the identified weaknesses noted by our independent auditors KPMG, LLP in the course of auditing the Company’s fiscal 2004 financial statements, the need for additional staff in its financial group, did not lead to material misstatements in the Company’s consolidated financial statements. We recognize the need to improve and enhance our internal control and financial reporting system. To address the weaknesses noted by the auditors, we have hired a Director of Accounting and Financial Reporting and he started in late April 2005 and we hired a senior accountant at our MODCOMP subsidiary in Florida who started in July 2005. If greater or additional resources are needed to meet the requirements necessary to handle the complexities of our operations, management will authorize the hiring of additional personnel as needed.

The effectiveness of a system of disclosure controls and procedures is subject to various inherent limitations, including cost limitations, judgments used in decision making, assumptions about the likelihood of future events, the soundness of internal controls, and fraud. Due to such inherent limitations, there can be no assurance that any system of disclosure controls and procedures will be successful in preventing all errors or fraud, or in making all material information known in a timely manner to the appropriate levels of management.

During the first three quarters of fiscal 2005, there were no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting with the exception of our hiring a Director of Accounting and Financial Reporting and a senior accountant at our MODCOMP subsidiary in Florida as described above.

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PART II. OTHER INFORMATION

Item 4. Submissions of Matters to a vote of Security Holders

None

Item 5. Other Information

None

Item 6. Exhibits

(a) Exhibits

Number	Description
3.1	Articles of Organization and amendments thereto (incorporated by reference to Exhibit 3.1 to our Form 10-K for the year ended August 31, 1990)
3.2	By-Laws, as amended (incorporated by reference to Exhibit 3.2 to our Form 10-K for the year ended August 25, 1995)
31.1	Certification of Chief Executive Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant Section 906 of the Sarbanes-Oxley Act of 2002

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SIGNATURES

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

	CSP INC.
Date: August 15, 2005	By:	/s/ ALEXANDER R. LUPINETTI
		Alexander R. Lupinetti
		Chief Executive Officer,
		President and Chairman
Date: August 15, 2005	By:	/s/ GARY W. LEVINE
		Gary W. Levine
		V.P. of Finance and
		Chief Financial Officer

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Exhibit Index

Number	Description
3.1	Articles of Organization and amendments thereto (incorporated by reference to Exhibit 3.1 to our Form 10-K for the year ended August 31, 1990)
3.2	By-Laws, as amended (incorporated by reference to Exhibit 3.2 to our Form 10-K for the year ended August 25, 1995)
31.1	Certification of Chief Executive Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
31.2	Certification of Chief Financial Officer Pursuant Section 302 of the Sarbanes-Oxley Act of 2002
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant Section 906 of the Sarbanes-Oxley Act of 2002

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