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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K/A

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

Commission file number: 1-11376

The Allied Defense Group, Inc.

(Exact name of registrant as specified in its charter)


Delaware		04-2281015
(State of incorporation)		(I.R.S. Employer Identification No.)

8000 Towers Crescent Drive, Suite 260

Vienna, Virginia 22182

(Address of principal executive offices, including zip code)

(703) 847-5268

(Registrant’s telephone number, including area code)

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


Title of Class	Name of Exchange
Common Stock, $0.10 Par Value		American Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ

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 o No þ

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (Section 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/A. þ

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ

The aggregate market value of the voting stock of the registrant held by non-affiliates as of June 30, 2005 and June 30, 2006, the last days of the registrant’s two most recently completed second fiscal quarters, was $125,740,005 and $126,320,631 respectively. For purposes of this determination, only our directors and executive officers have been deemed affiliates.

The number of shares of registrant’s Common Stock outstanding as of September 29, 2006, was 6,032,465.

EXPLANATORY NOTE

This Form 10-K/A is being filed to amend The Allied Defense Group, Inc. (the “Company”) Annual Report on Form 10-K for the period ended December 31, 2005 to correct for a typing error on page F-6, Report of Independent Registered Public Accounting Firm. The original date of the report in the 10-K was September 28, 2005, but should have been September 28, 2006.

Generally, no attempt has been made in this Form 10-K/A to modify or update other disclosures presented in the original report on Form 10-K except as required to reflect the correction of the typing error and as set forth below. This Form 10-K/A does not reflect events occurring after the filing of the original Form 10-K or modify or update those disclosures. Information not affected by the foregoing is unchanged and reflects the disclosure made at the time of the original filing of the Form 10-K with the Securities and Exchange Commission on October 10, 2006.

The following item has been corrected as a result of the amended filing;


	•	Consolidated Financial Statements and Schedules — Report of Independent Registered Public Accounting Firm, page F-8

	•	Reference to the notes to the financial statements has been added to pages F-9 through F-13.

	•	The description of the totals on page F-10 have been corrected.

In addition to the above changes, the certification in exhibits 31.1, 31.2 and 32 have been updated to the most recent date.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Form 10-K/A to be signed on its behalf by the undersigned, thereunto duly authorized.

THE ALLIED DEFENSE GROUP, INC.


	By:	/s/ John J. Marcello

John J. Marcello,

President and Chief Executive Officer

Date: November 7, 2006

MANAGEMENT’S REPORT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING

To the Stockholders of The Allied Defense Group, Inc.:

The management of The Allied Defense Group, Inc. is responsible for establishing and maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. The Company’s internal control system was designed to provide reasonable assurance to the Company’s management and board of directors regarding the preparation and fair presentation of published financial statements.

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

The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control — Integrated Framework. Based on our assessment we believe that, as of December 31, 2005, the Company’s internal control over financial reporting was ineffective based on those criteria. We identified six material weaknesses in our internal control over financial reporting.

The first material weakness concerned the design of controls in place relating to estimates for warranty reserves at our Belgian subsidiary, VSK Electronics. We have strengthened the design and documentation supporting these accounts and believe that this material weakness was remediated in the first quarter of 2006. The amount in question was $819 as of December 31, 2005.

The second material weakness concerned the accounting for foreign currency exchange (FX) contracts of our foreign operations in that we did not comply with the guidelines of Financial Accounting Standard No. 133 “Accounting for Derivative Instruments and Hedging Activities” (FAS 133) and Financial Accounting Standard No. 52 “Foreign Currency Translation” (FAS 52) related to derivatives. We have retained an expert for contemporaneous review of our hedging activities and documentation to ensure compliance with FAS 133. We believe we are in the process of completing our remediation of the foreign currency weakness.

The third material weakness concerned accounting for contract costs at our Belgian subsidiary MECAR SA. The Company did not maintain an accurate contract accounting cost ledger. We have implemented improved processes and procedures for accounting and contract costs. Additionally, we are upgrading our accounting system at the subsidiary where the material weakness existed to improve the accuracy and timeliness of the information and transactions that are processed in the system. We are in the process of completing our remediation of this material weakness.

The fourth material weakness concerned accounting for inventory costs at certain U.S. Subsidiaries. The Company lacked sufficient key controls and was unable to accurately track and report inventory balances. In response, the Company undertook several remedial actions in 2006 to address the inventory related material weaknesses. The Company is in the process of implementing a new accounting system across all U.S. subsidiaries which will enable it to track its inventory on a real-time basis. Until this system is fully implemented management has implemented more manual processes and methods which are labor intensive to track inventory costs and movement. The Company expects that our new controls and processes will enable the Company to appropriately account for inventory going forward.

The fifth material weakness concerned the lack of documentation and testing of the Company’s IT general controls. The Company’s general controls were not appropriately designed and management testing was not performed on a timely basis. The Company is in the process of improving the documentation and processes in the IT department. Additionally, the Company has made staffing changes and improved the quality, focus and timing of the 404 IT testing.

F-3

The sixth material weakness concerns the Company’s inadequate financial reporting processes. The Company’s recent restatements as well as the Company’s general consolidation and reporting processes were not adequate to meet the needs of the public reporting requirements. As such, the Company has increased staffing and made resource changes at all levels throughout the organization. The Company will continue to address issues until management is satisfied that the matter is fully remediated.

The continued implementation of the initiatives described above is among our highest priorities. We have discussed our corrective actions and future plans with our Audit Committee and BDO Seidman, LLP. As of the date of this report, we believe the actions outlined above should correct the above-listed material weakness in our internal control. However, we cannot assure you that either we or our independent registered public accountants will not in the future identify additional material weaknesses or significant deficiencies in our internal control over financial reporting.

A material weakness is a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

The Company’s independent registered public accounting firm, BDO Seidman, LLP, has issued an attestation report on management’s assessment and the effectiveness of the Company’s internal control over financial reporting. The scope of BDO Seidman’s audit of management’s assessment and the effectiveness of internal control over financial reporting was limited as a result of management’s delay in the performance of and delivery to BDO Seidman of its completed assessment. Specifically, BDO Seidman was provided significant documentation related to management’s assessment subsequent to December 31, 2005 and, as a result, was unable to obtain sufficient evidence that the controls were designed and operating effectively at December 31, 2005. As a result of this limitation in scope, BDO Seidman is unable to render an opinion on either management’s assessment or the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. The disclaimer of opinion report of BDO Seidman appears below under the caption, “Report of Independent Registered Public Accounting Firm.”


/s/ Robert P. Dowski Robert P. Dowski Chief Financial Officer October 5, 2006		/s/ John J. Marcello John J. Marcello. Chief Executive Officer October 5, 2006

F-4

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We were engaged to audit management’s assessment included in the accompanying Management’s Report on Internal Control over Financial Reporting that The Allied Defense Group, Inc., and Subsidiaries (the “Company”) did not maintain effective internal control over financial reporting as of December 31, 2005, because of the effect of the material weaknesses described therein, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting.

The scope of our audit of management’s assessment and the effectiveness of internal control over financial reporting was limited as a result of management’s inability to complete its assessment prior to December 31, 2005. Specifically, we were provided a significant portion of the documentation related to management’s assessment subsequent to December 31, 2005 and, as a result, we were unable to obtain sufficient evidence that the controls were designed and operating effectively at December 31, 2005.

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim consolidated financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment as of December 31, 2005: 1) Ineffective controls and procedures to ensure that warranty reserves were properly estimated; 2) Ineffective controls and procedures to ensure that derivative contracts and foreign currency transactions were accounted for in accordance with generally accepted accounting principles; 3) Failure to maintain an appropriate contract cost accounting ledger; 4) Ineffective controls over inventory at certain subsidiaries; 5) Insufficient documentation and testing of the Company’s IT general controls; and 6) Inadequate financial reporting processes.

These material weaknesses were considered in determining the nature, timing, and extent of the audit tests we applied in our audit of the Company’s 2005 consolidated financial statements, and this report does not affect our report dated October 5, 2006 on those consolidated financial statements.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of consolidated financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Since management did not provide us with timely documentation of the Company’s internal controls over financial reporting and we were unable to apply other procedures to satisfy ourselves as to the effectiveness of the Company’s internal control over financial reporting, the scope of our work was not sufficient to enable us to express, and we do not express, an opinion either on management’s assessment of or on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005.

F-5

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

The Allied Defense Group, Inc.

Vienna, Virginia

We have audited the accompanying consolidated balance sheet of The Allied Defense Group, Inc. as of December 31, 2005 and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year ended December 31, 2005. We have also audited the schedules listed in the accompanying index. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audit.

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

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The Allied Defense Group, Inc. at December 31, 2005, and the results of its operations and its cash flows for the year ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.

Also, in our opinion, the schedules present fairly, in all material respects, the information set forth therein.

As discussed in Note A to the consolidated financial statements, the Company changed its methodology of applying the percentage of completion method for the recognition of revenue at one of its subsidiaries.

We were also engaged to audit, in accordance with the standards of the Public Company Accounting Oversight Board (United States), management’s assessment and the effectiveness of The Allied Defense Group, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Our report dated October 5, 2006, did not express an opinion on management’s assessment and the effectiveness of the Company’s internal control over financial reporting and the effectiveness of the Company’s internal control over financial reporting.

BDO Seidman, LLP

Bethesda, Maryland

October 5, 2006

F-7

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders of

The Allied Defense Group, Inc.

We have audited the accompanying consolidated balance sheets of The Allied Defense Group, Inc. and subsidiaries as of December 31, 2004 and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

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

As described in Note A, the Company restated its consolidated balance sheet as of December 31, 2004 and the related consolidated statements of earnings, stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2004.

Our audits were conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. The schedules listed in the index of financial statements are presented for purposes of additional analysis and are not a required part of the basic financial statements. These schedules have been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, are fairly stated in all material respects in relation to the basic financial statements taken as a whole.

/s/ Grant Thornton LLP

Baltimore, Maryland

September 28, 2006

F-8

THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED BALANCE SHEETS — (Continued)

December 31,

2005 2004

Restated

(In Thousands of Dollars)

Current Liabilities

Bank overdraft facility
$ 15,086 $ 5,553

Current maturities of long-term debt
4,342 2,788

Convertible subordinated debenture, current
— 2,231

Accounts payable
31,004 26,661

Accrued liabilities
15,097 10,760

Customer deposits
9,956 8,662

Foreign exchange contracts
1,161 —

Deferred compensation
— 1,612

Income taxes
1,288 811

Total current liabilities
77,934 59,078

Long-term Obligations

Short term debt to be refinanced
13,539 —

Long-term debt, less current maturities and unamortized discount
7,820 7,223

Deferred compensation
160 377

21,519 7,600

TOTAL LIABILITIES
99,453 66,678

Contingencies and Commitments

Stockholders’ Equity

Preferred stock, no par value; authorized, 1,000,000 shares; none issued
— —

Common stock, par value, $.10 per share; authorized 30,000,000 shares; issued and outstanding, 5,982,008 in 2005 and 5,601,101 in 2004
598 560

Capital in excess of par value
34,354 27,910

Retained earnings
34,466 73,386

Accumulated other comprehensive income
12,075 23,697

TOTAL STOCKHOLDERS’ EQUITY
81,493 125,553

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
$ 180,946 $ 192,231

The accompanying notes are an integral part of these consolidated financial statements.

F-10

THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS


	Years ended December 31,
	2005			2004			2003
				Restated			Restated
	(In Thousands of Dollars, except
	per share data)

Revenues	$	112,222		$	146,201		$	153,774
Cost and expenses
Cost of sales		94,154			105,819			114,904
Selling and administrative		36,471			29,605			24,449
Research and development		7,190			6,695			4,532
Goodwill impairment		3,060			—			—

Total cost and expenses		140,875			142,119			143,885

Operating income (loss)		(28,653	)		4,082			9,889
Other income (expense)
Interest income		580			549			460
Interest expense		(2,568	)		(2,441	)		(2,491	)
Other — net		(1,926	)		(511	)		(484	)

Total other income (expense)		(3,914	)		(2,403	)		(2,515	)

Earnings (loss) before income taxes and cumulative effect of change in the application of accounting principle		(32,567	)		1,679			7,374
Income tax expense (benefit)		1,060			309			4,656

Earnings (loss) before cumulative effect of accounting change		(33,627	)		1,370			2,718
Cumulative effect of accounting change, net of tax benefit of $2,726		(5,293	)		—			—

Net Earnings (Loss)	$	(38,920	)	$	1,370		$	2,718

Earnings (loss) per share:
Basic
Earnings (loss) before cumulative effect of accounting change	$	(5.84	)	$	0.25		$	0.49
Cumulative effect of accounting change, net of income taxes		(0.92	)		—			—

Net earnings (loss)	$	(6.76	)	$	0.25		$	0.49

Diluted
Earnings (loss) before cumulative effect of accounting change	$	(5.84	)	$	0.24		$	0.48
Cumulative effect of accounting change, net of income taxes		(0.92	)		—			—

Net earnings (loss)	$	(6.76	)	$	0.24		$	0.48

Weighted average number of common shares:
Basic		5,754,951			5,568,183			5,496,786

Diluted		5,754,951			5,745,282			5,670,119

The accompanying notes are an integral part of these consolidated financial statements.

F-11

THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY


	Years ended December 31, 2005, 2004 and 2003
												Accumulated
	Preferred		Common Stock				Capital					other			Total
	Stock, no				$.10		in excess		Retained			comprehensive			stockholders’
	par value		Shares		par value		of par value		earnings			(loss) income			equity
	(In Thousands of Dollars, except per share data)

Balance at January 1, 2003 as previously reported	$	—		5,474,813	$	547	$	24,874	$	69,909		$	678		$	96,008
Adjustment related to restatement		—		—		—		378		(611	)		(39	)		(272	)
Balance at January 1, 2003, restated		—		5,474,813		547		25,252		69,298			639			95,736
Common stock awards		—		6,000		1		110		—			—			111
Employee stock purchase plan purchases		—		10,560		1		150		—			—			151
Exercise of stock options		—		60,000		6		759		—			—			765
Issue of stock options		—		—		—		429		—			—			429
Comprehensive income:		—		—		—		—		—			—			—
Net earnings for the year		—		—		—		—		2,718			—			—
Currency translation adjustment, net of tax		—		—		—		—		—			14,813			—
Total comprehensive income		—		—		—		—		—			—			17,531

Balance at December 31, 2003 restated	$	—		5,551,373	$	555	$	26,700	$	72,016		$	15,452		$	114,723
Common stock awards		—		5,753		1		105		—			—			106
Employee stock purchase plan purchases		—		16,241		1		259		—			—			260
Exercise of stock options		—		27,734		3		346		—			—			349
Warrants issued		—		—		—		68		—			—			68
Issue of stock options		—		—		—		432		—			—			432
Comprehensive income:		—		—		—		—		—			—			—
Net earnings for the year		—		—		—		—		1,370			—			—
Currency translation adjustment, net of tax		—		—		—		—		—			8,245			—
Total comprehensive income		—		—		—		—		—			—			9,615

Balance at December 31, 2004 restated	$	—		5,601,101	$	560	$	27,910	$	73,386		$	23,697		$	125,553
Common stock awards		—		54,729		5		399		—			—			404
Common stock issued with acquisition		—		118,072		11		2,489		—			—			2,500
Employee stock purchase plan purchases		—		5,507		1		107		—			—			108
Exercise of stock options		—		202,599		21		2,671		—			—			2,692
Warrants issued		—		—		—		488		—			—			488
Directors deferred stock						—		290		—			—			290
Comprehensive income:		—		—		—		—		—			—			—
Net loss for the year		—		—		—		—		(38,920	)		—			—
Currency translation adjustment, net of tax		—		—		—		—		—			(11,622	)		—
Total comprehensive income		—		—		—		—		—			—			(50,542	)

Balance at December 31, 2005	$	—		5,982,008	$	598	$	34,354	$	34,466		$	12,075		$	81,493

The accompanying notes are an integral part of these consolidated financial statements.

F-12

THE ALLIED DEFENSE GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS


	Years ended December 31,
	2005			2004			2003
				Restated			Restated
	(In Thousands of Dollars)

Cash flows from (used in) operating activities
Net earnings (loss) for the year	$	(38,920	)	$	1,370		$	2,718
Adjustments to reconcile net earnings (loss) to net cash from (used in) operating activities
Cumulative effect of accounting change		5,293			—			—
Goodwill impairment		3,060			—			—
In-process research & development		944			—			—
Unrealized (gains) losses on forward contracts		(4,798	)		4,758			(4,312	)
Depreciation and amortization		6,082			4,551			4,036
Gain on sale of fixed assets		(400	)		(44	)		(18	)
Deferred income taxes		(3,975	)		(2,405	)		1,712
Provision for estimated losses on contracts		39			662			255
Amortization of debt issue costs and conversion feature		220			179			243
Common stock and stock option awards		694			538			562
(Increase) Decrease in operating assets and increase (decrease) in liabilities
Restricted cash and restricted deposits		2,683			6,387			(4,786	)
Accounts receivable		16,325			(5,741	)		2,052
Cost and accrued earnings on uncompleted contracts		196			14,556			14,414
Inventories		(19,363	)		(4,208	)		(1,241	)
Prepaid expenses and assets		(3,909	)		1,275			(1,609	)
Accounts payable and accrued liabilities		12,905			(15,965	)		13,783
Customer deposits		2,334			3,340			(1,144	)
Deferred compensation		(1,829	)		521			671
Income taxes		190			(370	)		(2,569	)

Net cash provided by (used in) operating activities		(22,229	)		9,404			24,767
Cash flows from (used in) investing activities
Capital expenditures		(8,167	)		(5,036	)		(4,373	)
Acquisitions, net of cash acquired		(9,443	)		(525	)		—
Proceeds from sale of fixed assets		—			45			20

Net cash used in investing activities		(17,610	)		(5,516	)		(4,353	)
Cash flows from (used in) financing activities
Net (decrease) increase in short-term borrowings		594			(14,013	)		5,781
Repayment on capital lease obligations		(2,297	)		(2,357	)		(1,711	)
Borrowings on bank overdraft facility		9,534			1,293			(273	)
Principal payments on long-term debt and debenture		(2,478	)		(5,922	)		(632	)
Proceeds from issuance of long-term debt		12,000			2,300			—
Debt issue costs		—			(860	)		—
Proceeds from employee stock purchase plan		108			261			151
Proceeds from option exercises		2,692			348			765
Restricted cash and restricted deposits		—			(2,000	)		—

Net cash provided by (used in) financing activities		20,153			(20,950	)		4,081
Effects of exchange rates on cash		(451	)		1,625			4,006
Net (decrease) increase in cash		(20,137	)		(15,437	)		28,501
Cash at beginning of year		27,940			43,377			14,876

Cash at end of year	$	7,803		$	27,940		$	43,377

*Supplemental Disclosures of Cash Flow Information:*
Cash paid during the year for Interest	$	1,338		$	1,516		$	1,492
Income taxes		4,541			7,782			9,455
*Supplemental Non-Cash Investing and Financing Activities:*
Capital leases	$	850		$	2,481		$	1,989
Non-cash consideration in connection with business acquisition		8,672			—			—
Warrants issued in conjunction with long term debt		488			68			—

The accompanying notes are an integral part of these consolidated financial statements.

F-13

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars)

Note A — Summary of Significant Accounting Policies

Basis of Presentation. The consolidated financial statements of the Company include the accounts of Allied and its wholly-owned subsidiaries as follows:


	•	ARC Europe, S. A. (ARC Europe), a Belgian company,

	•	Allied Research Corporation Limited (Limited), an inactive United Kingdom company,

	•	News/Sports Microwave Rental, Inc. (NSM), a California corporation,

	•	Titan Systems, Inc., (Titan), a Texas corporation,

	•	SeaSpace Corporation (SeaSpace), a California corporation, and

	•	Mecar USA, a Delaware corporation,

	•	Allied Technology, LLC (“Allied Technology”), a Maryland limited liability company

	•	Global Microwave Systems, Inc. (“GMS”), a California corporation.

ARC Europe includes its wholly-owned subsidiaries MECAR S.A. (MECAR), Sedachim S.I., S.A. and VSK. VSK is comprised of VSK Electronics N.V. and its wholly-owned subsidiaries, Tele Technique Generale, S.A., Intelligent Data Capturing Systems, N.V., Belgian Automation Units, N.V., VIGITEC S.A., and CMS Security Systems.

Significant intercompany transactions have been eliminated in the consolidation.

Nature of Operations. The Allied Defense Group Inc. (Allied), a Delaware corporation, is a strategic portfolio of defense and security businesses, with presence in worldwide markets, offering both government and commercial customers leading edge products and services. These products and services are marketed to the ordinance, electronic security, environmental safety and software simulation markets.

Liquidity and Capital Resources. The Company incurred a net income (loss) of $38,920 and had net cash used from operations of $22,229 in 2005. ADG had a December 31, 2005 balance of cash and equivalents of $7,803 and restricted cash of $7,428. The Company closed a $30,000 convertible debt facility in March 2006. Net proceeds were $28,000. $15,200 was used to retire existing debt — including the Patriot facility. The remaining $12,800 was available to be used in 2006 to fund working capital needs. As of June 30, 2006 the Company had $13,700 of cash and equivalents and $9,300 of restricted cash.

The Company expects to expend nearly all of the net proceeds from the convertible note financing before December 31, 2006 and will likely explore other sources of additional liquidity pending the anticipated return of substantial business from MECAR’s traditional customer base.

At the headquarters level the Company believes that the professional costs related to the restatement incurred in the first three quarters of 2006 will not be recurring in 2007. The Company has invested in a financial and manufacturing ERP system for all of its US subsidiaries and enhanced its headquarters financial staff. These improvements should help the Company significantly reduce its compliance and audit costs starting in 2007. The Company has also invested in video conferencing facilities to link headquarters with all of the subsidiary locations, which should reduce travel costs from 2006 to 2007.

The Company is evaluating a variety of options to increase its liquidity in the fourth quarter of 2006 and into early 2007:


	•	The Company intends to have in place, and is in the process of negotiating, a domestic line of credit by year end that will provide $4,000 to $5,000 of immediate liquidity with a provision to accordion up to $20,000 based on financial performance in subsequent periods.

F-14

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)


	•	The Company is exploring possible asset backed financing from local banks at its US based AWE facilities that would be earmarked for capital improvement — buildings and/or equipment — at that site.

	•	The Company is evaluating the disposition of certain non strategic assets.

	•	The Company has the option of issuing dividends of excess cash from its Euro based ES operations at year end.

	•	The Company may further consolidate its California operations to further reduce operating expenses.

Restatements of Financial Results The consolidated balance sheet at December 31, 2004 and the related consolidated statements of operations, stockholders’ equity, and cash flows for the years ended December 31, 2004 and 2003 have been restated. The restatement provided in this Form 10-K corrects amounts previously reported in Allied’s consolidated balance sheet at December 31, 2004 and the related statements of operations, stockholders’ equity and cash flows for each of the two years in the period ended December 31, 2004 for certain errors related to incorrect currency rates used to translate MECAR, S.A.’s U.S. Dollar denominated assets and liabilities into its functional currency, and for the grant of stock options to certain officers and directors in 2002 for which the actual accounting measurement date was after the measurement dates used by the Company to record such awards.

The determination to restate the consolidated financial statements was approved by Allied’s Audit Committee of the Board of Directors upon the recommendation of Allied’s senior management.

In October 2005, the Company filed an amended 2004 Form 10-K and an amended Form 10-Q for the quarter ended March 31, 2005 related to the Company’s failure to comply with the guidelines of FAS 133 regarding accounting treatment of its foreign currency hedge contracts at its Belgian subsidiary, MECAR, and the subsequent valuation of that subsidiary’s assets and liabilities resulting from foreign currency transactions once the subsidiary failed to qualify for hedge accounting.

In the periods 2002 through 2005, as the volume of U.S. dollar sales contracts grew, MECAR entered into foreign currency hedge contracts to control the subsidiary’s exposure to currency risk from fluctuations in the U.S. dollar as compared to the Euro, its functional currency. Management and the audit committee determined that an additional restatement was necessary to correct foreign currency transaction and translation errors and correct certain reclassifications that were made in the previously reported amounts that were either incomplete or inaccurate.

In addition to the correction of previously reported amounts described above, this restatement also provides for the correction of compensation expense recorded in the years ended December 31, 2003 and 2004. In February 2002, the Compensation Committee of the Board of Directors of Allied granted stock option awards at the then market price, subject to subsequent approval by the stockholders of an amendment to the Company’s stock plan that would increase the number of shares available under that plan. The stockholders approved the amendment to the plan in June 2002. The Company incorrectly used the February 2002 award date as the measurement date for the options granted rather than the stockholder approval date in June 2002. The options granted were for 220,000 shares of common stock at an exercise price of $16.40 per share. The total compensation expense associated with this change in measurement date was $1,298 that should have been recognized over the vesting period of thirty-four months subsequent to the measurement date. Based on the vesting period of the options, an increase to compensation expense of $451 and $433 was recognized in 2003 and 2004, respectively.

The restatement also corrected the classification of MECAR’s bank overdraft facility from an operating activity for cash flow purposes to financing activity. Prior to the restatement, the balance of the bank overdraft facility was included in accounts payable. The balance of the bank overdraft facility at December 31, 2005 and December 31, 2004 was $15,086 and $5,553, respectively. The financing activity for the bank overdraft facility from a cash flow perspective was $9,534, $1,293 and $(273) of cash generated (used) in 2005, 2004 and 2003 respectively.

F-15

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

A summary of the impact of this restatement is provided below. The reader is referred to Note A to the Consolidated Financial Statements for additional information concerning these matters. The “As Previously Reported in 10-K/A” refers to previously reported in Allied’s Form 10-K/A filed in October 2005. The “Restated” information represents the correction of errors to MECAR’s foreign currency transactions and the correction of compensation expense recorded in the years 2002, 2003, and 2004 related to accounting for stock options granted in 2002

Selected Consolidated Statements of Operations Data:


			Impact from			Impact from			As Previously
			Foreign			Compensation			Reported
	Restated		Currency Translation (1)			Expense (2)			in 10-K/A

Year Ended December 31, 2004
Revenues	$	146,201	$	(3,930	)	$	—		$	150,131
Cost of Sales		105,819		117			—			105,936
Operating income		4,082		(3,812	)		(433	)		8,327
Earnings before income taxes		1,679		(3,511	)		(433	)		5,623
Income taxes		309		(1,234	)		(146	)		1,689

Net Earnings	$	1,370	$	(2,277	)		(287	)	$	3,934

Earnings per share
Basic	$	0.25	$	(0.40	)	$	(0.06	)	$	0.71

Diluted	$	0.24	$	(0.40	)	$	(0.06	)	$	0.70

Weighted average shares outstanding:
Basic		5,568,183								5,568,183

Diluted		5,745,282								5,991,101


						Impact from			As Previously
			Impact from Foreign			Compensation			Reported
	Restated		Currency Translation (1)			Expense (2)			in 10-K/A

Year Ended December 31, 2003
Revenues	$	153,774	$	(163	)	$	—		$	153,937
Cost of Sales		114,904		151			—			114,753
Operating income		9,889		(314	)		(451	)		10,654
Earnings before income taxes		7,374		(1,053	)		(451	)		8,878
Income taxes		4,656		(307	)		(153	)		5,116

Net Earnings	$	2,718	$	(747	)	$	(297	)	$	3,762

Earnings per share
Basic	$	0.49	$	(0.14	)	$	(0.05	)	$	0.68

Diluted	$	0.48	$	(0.13	)	$	(0.05	)	$	0.63

Weighted Average Shares Outstanding:
Basic		5,496,786								5,496,786

Diluted		5,670,119								5,970,119

F-16

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)


(1)		Impact of correcting for certain errors related to incorrect exchange rates to translate MECAR S.A.’s U.S. Dollar denominated assets and liabilities into its functional currency and other adjustments related to foreign currency transactions.

(2)		Impact of correcting compensation expense related to the grant of stock options to certain officers and directors in 2002 for which the measurement date was incorrectly determined. These options were granted in February 2002 by the Compensation Committee of the Board of Directors of the Company, but were subject to subsequent stockholder approval, which was not obtained until June 2002.

Selected Consolidated Balance Sheet Data:


						Impact from		As Previously
			Impact from Foreign			Compensation		Reported
	Restated		Currency Translation (1)			Expense (2)		in 10-K/A

Year Ended December 31, 2004
Restricted cash	$	9,239	$	(518	)	$	—		9,757
Accounts receivable		34,980		6,739			—	$	28,241
Costs and accrued earnings on uncompleted contracts		41,420		(13,457	)		—		54,877
Deferred tax asset		2,016		958			—		1,058
Total current assets		138,041		(6,579	)		—		144,352
Deferred tax asset — non current		2,461		1,033			408		1,020

Total assets		192,231		(4,495	)		408		196,318
Accounts payable		26,661		(8,272	)		—		34,933
Accrued liabilities		10,760		1,386			—		9,374
Customer deposits		8,662		(46	)		—		8,708
Total current liabilities		59,078		(1,378	)		—		60,456

Total liabilities		66,678		(595	)		—		67,273
Accumulated other comprehensive income (loss)		23,697		(514	)		—		24,211

Total liabilities and stockholders’ equity	$	192,231	$	(4,495	)	$	408	$	196,318


(1)		Impact of correcting for certain errors related to incorrect exchange rates to translate MECAR’s U.S. dollar denominated assets and liabilities into its functional currency and other adjustments related to foreign currency transactions.

(2)		Impact of correcting compensation expense related to stock options, noted above.

F-17

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Cash Flow Information

The cash flow statements for the years ended December 31, 2004 and 2003 have been restated to reflect a reclassification of a bank overdraft facility from operating cash flows to financing cash flows.


							As Previously
	Restated			Adjustment			Reported in 10K-A

Year ended December 31, 2004
Cash flows from operations
Accounts payable		(15,943	)		(1,293	)		(14,650	)*
Cash flows from financing
Borrowings on bank overdraft facility		1,293			1,293			—
Year ended December 31, 2003
Cash flows from operations
Accounts payable		13,782			273			13,509	*
Cash flows from financing
Borrowings on bank overdraft facility		(273	)		(273	)		—


*		— the as previously reported amount in the 10 K/A have been adjusted for the impact of the foreign currency translation described above of $7,772 and ($7,979) in 2004 and 2003 respectively

Foreign Currency Translation. The assets and liabilities of ARC Europe and subsidiaries including MECAR, VSK and ARC Limited are translated into U.S. dollars at year-end exchange rates. Resulting translation gains and losses are accumulated in a separate component of stockholders’ equity. Income and expense items are converted into U.S. dollars at average rates of exchange prevailing during the year. Foreign currency transaction gains and losses are credited or charged directly to operations.

Reclassifications. Certain items in the 2004 and 2003 financial statements have been reclassified to conform to the current presentation.

Use of Estimates. In preparing financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenue and expenses during the reporting period. Actual results could differ from those estimates.

Accounting Change. In 2005, MECAR changed its methodology of applying the percentage of completion method for the recognition of revenue. This change was made in an effort to better reflect the revenue recognized during the life of its sales contracts. Previously, MECAR used total direct costs as the basis for recognizing revenue, but in 2005, the Company elected to use direct labor as the basis of recognition. The impact of this change on the previously reported interim periods during 2005 is disclosed in Note W. The cumulative effect of this change, recorded January 1, 2005, reduced revenues by $5,293, net of tax benefit of $2,726. Pro forma amounts assuming change in application of accounting principle applied retroactively shown are in Note C.

Cash and cash equivalents. The Company considers all highly liquid investments purchased with a maturity of three months or less to be cash equivalents. At December 31, 2005 and 2004, the Company had no cash equivalents.

Accounts Receivable. Accounts receivable from foreign government agencies are supported by letters of credit or other guarantees. They are stated at the amount the Company expects to collect from balances outstanding at year end. Based on management’s assessment of the supported letters of credit and other guarantees, it has

F-18

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

concluded that no allowance for doubtful accounts is required. The Company maintains an allowance for uncollectible accounts receivable for commercial receivables which is determined based on historical experience and management’s expectations of future losses. Losses have historically been within management’s expectations. The Company charges the accounts receivable to the established provision when collection efforts have been exhausted and the receivables are deemed uncollectible. The balance of the allowance for doubtful accounts was $214 and $143 at 2005 and 2004, respectively.

Inventories. Inventories consist of raw materials, work in process, and finished goods, and are stated at the lower of cost or market. Cost is determined principally by the average cost method. The Company reviews its recorded inventory periodically and estimates a reserve for obsolete or slow-moving items to their net realizable value. The inventory reserve is based on current and forecasted demand and the age of the item, and therefore, if actual demand and market conditions are less favorable than those projected by management, additional reserves may be required.

Property, Plant and Equipment. Property, Plant and Equipment are stated at cost and depreciated using the straight-line method over their estimated service lives, as follows:


Buildings and improvements			20 — 30 years
Machinery and equipment			3 — 10 years
Demonstration Inventory			3 — 7 years

Leasehold improvements are amortized over the shorter of the lease term or their estimated useful lives. Accelerated depreciation methods are used for tax purposes on certain assets. Maintenance and repairs are charged to expense as incurred; additions and betterments are capitalized. Upon retirement or sale, the cost and related accumulated depreciation of the disposed assets are removed and any resulting gain or loss is credited or charged to operations.

Assets under capital lease obligations are recorded at the lesser of the present value of the minimum lease payments or the fair market value of the leased asset, at the inception of the lease. Amortization of assets acquired under capital lease obligations is recorded in depreciation expense.

Property, plant and equipment includes demonstration inventory, which is recorded at cost. Amortization of demonstration inventory is included in depreciation expense.

Intangibles/Goodwill. Intangibles and goodwill, acquired in connection with business acquisitions, are stated at cost. Approximately 85% of the value of intangible assets, other than goodwill, are amortized on a straight-line basis over their expected lives of three to ten years. Two intangibles, a customer list and a patent, in the Electronic Security segment are amortized over fifteen and sixteen and one-half years, respectively. Goodwill is not amortized, but is subject to an impairment test along with other indefinite lived intangibles, pursuant to the provision of SFAS No. 142, Goodwill and Other Intangible Assets.. Intangible assets with finite lives are evaluated for impairment in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. In addition, the Company evaluates the useful lives of finite life intangibles annually. The primary indicators in evaluating impairment are current and forecasted profitability and cash flow of the related businesses.

Based on the impairment tests performed in the fourth quarter of 2005, the Company took an impairment charge to the goodwill of its SeaSpace subsidiary of $3,060. The Company based this impairment on the historical and projected operating results of this business unit and had an independent firm prepare a valuation of the business based on this financial information. This impairment was due to SeaSpace’s increased competitive marketplace and its inability to yield its projected results in the four year period subsequent to the Company’s purchase of Seaspace.

Derivative Financial Instruments. The Company designates its derivatives based upon the criteria established by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in

F-19

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

other contracts, and for hedging activities. SFAS 133, as amended by SFAS 138 and SFAS 149, requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. The accounting for the changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation. For a derivative designated as a fair value hedge, the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item due to the risk being hedged. For a derivative designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of accumulated other comprehensive income (loss) and is subsequently reclassified to earnings when the hedge exposure effects earnings. The ineffective portion of the hedge is reported in earnings immediately. For a derivative that does not qualify as a fair value hedge or cash flow hedge, the change in fair value is recognized in net income in the current period. It is the Company’s policy to classify all of its derivative instruments for cash flow purposes as operating activities. The cash flows from (used in) forward contracts were ($2,987), $9,181 and $27,731 in 2005, 2004 and 2003, respectively.

Revenue and Cost Recognition.


	•	*Percentage of Completion Method* — Revenues under fixed price contracts are recognized on the percentage-of-completion method measured by direct labor incurred to total estimated direct labor. Revenues from indefinite delivery/indefinite quantity (IDIQ) are also recognized on a percentage of completion methodology, measured based upon units delivered. The actual costs on these contracts may differ from the Company’s estimate at completion. Provision for estimated losses and penalties on contracts are recorded when identified. Revenues under cost-plus-fixed-fee and time and material contracts are recognized on the basis of costs incurred during the period plus the fee earned. As contracts extend over one or more years, revisions in costs and earnings estimated during the course of the work are reflected in the accounting period in which the facts which require the revision become known. The revenue recognized on the contracts in progress for 2005, 2004 and 2003 were $81,301, $115,462 and $125,211, respectively. Costs and accrued profits on uncompleted direct and indirect fixed price contracts with foreign governments, direct and indirect U.S. government foreign military sales (FMS) contracts, and custom designed domestic security and weather systems, which are billable upon completion, are carried as costs and accrued earnings on uncompleted contracts.

	•	*Completed contract method* — Revenues from the sale of traditional fire & security systems, as well as battlefield effects simulators, are recognized when the installation is completed. Security system maintenance contract revenues are recognized over the term of the contract on a straight-line basis. Revenues from service work rendered are recorded when performed. The elements of fire and security systems are separable into units of accounting in accordance with EITF 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. The maintenance contracts are sold separately from the product and installation contracts and are priced at market value. There are no provisions related to performance, cancellation, termination or refunds.

In the normal course of the Company’s business, it does not bill shipping and handling costs to customers. Shipping and handling costs are included in cost of sales. Costs of sales also include inbound freight charges, purchasing and receiving costs, inspection costs and warehousing costs. No production costs are included in selling and administrative expense.

The Company records advances received from customers as a current liability.

Advertising. Advertising costs are expensed as incurred. These costs are not material to the Company’s operations.

Research and Development. Research and development costs are expensed as incurred. Such costs include salaries and benefits, rents, supplies, and other costs related to various products under development. Costs are also

F-20

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

included in research and development for the Company’s internally developed software, which was not required to be capitalized as described below.

Capitalization of Internally Developed Software. The Company capitalizes internally developed software systems in accordance with Statement of Position 98-1 (SOP 98-1), Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, which require that computer software meeting the characteristics of internal-use software be capitalized once the preliminary project stage has been completed. Once the capitalization criteria has been met, external direct costs of materials and services consumed in developing or obtaining internal-use computer software; payroll and payroll related costs for employees who are directly associated with and who devote time to the internal-use computer software project and interest costs incurred when developing computer software for internal use should be capitalized. During 2004, the Company capitalized $342 of costs related to internally developed software systems in accordance with SOP 98-1. During 2005 and 2003, no costs were capitalized.

Warranties. The Company grants warranties on certain products for periods varying from one to five years. Provision is made for estimated losses arising from warranty claims on ammunition products as incurred, based on a minimal level of claims historically for that segment. Provision is made for estimated warranty costs on the sale of security, weather and environmental satellite systems at the time of the sale. The reserves for warranty expense were not significant.

Income Taxes. Income taxes are provided based on the liability method for financial reporting purposes. Under this method, deferred and prepaid taxes are provided for on temporary differences in the basis of assets and liabilities which are recognized in different periods for financial and tax reporting purposes. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.

Earnings Per Common Share. Basic earnings per share amounts have been computed based on the weighted average number of common shares outstanding. Diluted earnings per share reflects the increase in weighted average common shares outstanding that would result from the assumed exercise of outstanding options, warrants, and convertible debt calculated using the treasury stock method, unless they are anti-dilutive.

Detachable Stock Purchase Warrants — In conjunction with debt financing, the Company has periodically committed to issue detachable stock purchase warrants to creditors. In accordance with EITF 00-19 the Company determines if warrants issued have the characteristics that would require treatment as equity or a liability. The fair value of the warrants is determined by the Black-Scholes option-pricing model at the date of issuance. Due to the terms of warrants the Company has recorded warrants as both equity and liabilities. Warrants meeting the classification of liabilities are recorded,at the fair value. Any gains or losses resulting from fluctuations in the fair value are recognized in the period of change in earnings. In those situations where warrants are classified as equity, the Company allocates proceeds received in a debt financing to the debt and any detachable warrants based on their relative fair values.

The Company analyzes its convertible debt financings in accordance with SFAS 133 to determine if any embedded features should be bifurcated. If the conversion feature is not required to be bifurcated the Company applies EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments and SFAS 133, as previously noted. EITF 98-5 clarifies the accounting for instruments with beneficial conversion features and adjustable conversion ratios. The beneficial conversion feature is calculated by allocating the proceeds received in the financing to the intrinsic value based on the effective conversion price as a result of the allocated proceeds. The value of the beneficial conversion feature is recognized as a discount and is amortized to interest expense from the date of issuance to the stated redemption date.

Stock-Based Compensation — The Company historically accounted for stock options using the intrinsic value method by applying APB Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly,

F-21

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

compensation costs for stock options are measured and recorded as the excess, if any, of the quoted market price of the Company’s stock at the date of grant over the amount an employee must pay to acquire the stock. Compensation cost for stock awards is recorded based on the quoted market value of the Company’s stock at the time of grant. Stock based compensation expense was $548, $538 and $562 for the years ended December 31, 2005, 2004 and 2003, respectively.

The following table presents the pro forma effect that would have been recorded had the fair values of options granted been recognized as compensation expense on a straight-line basis over the vesting period of the grant:


	2005			2004			2003
				Restated			Restated
	(In Thousands, except per share data)

Reported net earnings (loss)	$	(38,920	)	$	1,370		$	2,718
Elimination of compensation costs recognized for options		24			286			297
Stock-based compensation costs that would have been included in the determination of reported net earnings, if the fair value method was applied to all awards, net of tax		(457	)		(584	)		(471	)

Pro forma net earnings (loss)	$	(39,353	)	$	1,072		$	2,544

Basic earnings (loss) per share:
Reported earnings per share		(6.76	)		0.25			0.49
Compensation costs, net of tax		(0.08	)		(0.05	)		(0.03	)

Pro forma basic earnings (loss) per share	$	(6.84	)	$	0.20		$	0.46

Diluted earnings (loss) per share:
Reported earnings (loss) per share		(6.76	)		0.24			0.48
Compensation costs, net of tax		(0.08	)		(0.05	)		(0.03	)

Pro forma basic earnings (loss) per share	$	(6.84	)	$	0.19		$	0.45

Options granted during the years ended December 31, 2005, 2004 and 2003 were 120,000, 40,000, and 149,000 , respectively. The fair value of each option grant is estimated on the date of grant using the Black-Scholes options pricing model. The weighted-average fair values of each option at the date of grant for 2005, 2004 and 2003 were $8.42, $7.78 and $6.72, respectively. The weighted average assumptions used in the model were as follows.


	2005			2004			2003

Risk free interest rate		3.93	%		3.63	%		2.86	%
Expected volatility rate		41.05	%		33.90	%		47.00	%
Expected lives — years		3			3			3
Divided yield		—			—			—

The pro forma amounts may not be representative of future amounts since the estimated fair value of stock options is amortized to expense over the vesting period, and additional options may be granted in future periods.

Beginning in 2006, FAS 123(R) Share-Based Payment (as amended), supersedes APB Opinion 25 and requires that companies granting stock options to employees record the economic impact of these options in the audited financial statements. Based on stock options granted to employees as of December 31, 2005, Allied’s stock compensation expense in relation to these would have been approximately $457 before tax. The Company intends to implement FAS 123(R) in the first quarter of 2006 using the “modified prospective” method and the Black-Scholes options pricing model. A “modified prospective” method is a method in which compensation cost is recognized beginning with the effective date a) based on the requirement of FAS 123(R) for all share-based payments granted

F-22

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

after the effective date and b) based on the requirement of FAS 123(R) for all awards granted to employees prior to the adoption of 123(R) that remain unvested at the adoption date.

Major Customers. The Company derives the majority of its revenues directly or indirectly from foreign governments (some of which are through the U.S. government via the Foreign Military Sales program), primarily on fixed price contracts. Direct and indirect sales to agencies of The Kingdom of Saudi Arabia accounted for approximately 44%, 56% and 58% of revenue in 2005, 2004, and 2003, respectively.

Concentrations of Credit Risk. Financial instruments and related items which potentially subject the Company to concentrations of credit risk consist principally of temporary cash investments, trade receivables and costs and accrued earnings on uncompleted contracts. The Company places its temporary cash investments with high credit quality financial institutions. Credit risk with respect to trade receivables and costs and accrued earnings on uncompleted contracts are concentrated due to the nature of the Company’s customer base. The Company generally receives guarantees and letters of credit from its foreign customers and performs ongoing credit evaluations of its other customers’ financial condition. The Company’s provision for doubtful accounts for 2005 and 2004 was not significant.

The majority of ammunition sales are to or for the benefit of agencies of The Kingdom of Saudi Arabia and other foreign governments. MECAR’s ammunition sales in any given period and its backlog at any particular time may be significantly influenced by one or a few large orders. In addition, the production period required to fill most orders ranges from several months to a year. Accordingly, MECAR’s business is dependent upon its ability to obtain such large orders and the required financing for these orders. As of December 31, 2005 and 2004, the Company’s backlog orders, believed to be firm, from operations, approximated $93,376 and $77,273, respectively. The December 31, 2005 and 2004 backlogs included an unfunded portion of $8,330 and $9,445, respectively, from an indefinite delivery, indefinite quantity (IDIQ) federal contract.

U.S. Government contracts and subcontracts are by their terms subject to termination by the Government or the prime contractor either for convenience or for default. U.S. Government sponsored foreign military sales contracts are subject to U.S. Government review. It is not anticipated that adjustments, if any, with respect to determination of costs under these direct contracts or subcontracts will have a material effect on the Company’s consolidated results of operations or financial position.

Amounts in foreign banks at December 31, 2005 and 2004 were approximately $10,704 and $34,529, respectively. Changes in the value of the U.S. dollar and other currencies affect the Company’s financial position and results of operations since the Company has assets and operations in Belgium and sells its products on a worldwide basis.

Recent Accounting Pronouncements

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” which amends SFAS 133 and SFAS 140. SFAS 155 permits hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation to irrevocably be accounted for at fair value, with changes in fair value recognized in the statement of income. The fair value election may be applied on an instrument-by-instrument basis. SFAS 155 also eliminates a restriction on the passive derivative instruments that a qualifying special purpose entity may hold. SFAS 155 is effective for those financial instruments acquired or issued after December 1, 2006. At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument will be recognized as a cumulative-effect adjustment to beginning retained earnings. The Company adopted SFAS No. 155 in March 2006 in conjunction with its debt refinancing. See Note Y — Subsequent Event.

In May 2005, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 154, “Accounting for Changes and Error Corrections — a replacement of Accounting

F-23

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Opinions Board (“APB”) Opinion No. 20 and FASB Statement No. 3.” SFAS No. 154 requires retrospective application to changes in accounting principles for prior periods’ financial statements, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005, and earlier adoption is permitted for accounting changes and corrections of errors made in fiscal years beginning after this statement was issued.

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes — an interpretation of SFAS No. 109”. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS 109 and prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, with early adoption permitted. The Company will adopt FIN 48 in fiscal 2007 and are currently evaluating whether the adoption of FIN 48 will have a material effect on the Company’s financial condition or results of operations.

In December 2004, the FASB issued revised SFAS No. 123R, Share-Based Payment. SFAS No. 123R sets accounting requirements for share-based compensation to employees and requires companies to recognize, in the income statement, the grant-date fair value of stock options and other equity-based compensation. The Company adopted SFAS No. 123R effective January 1, 2006.

In December 2004, the FASB issued FSP No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004,” which provides a practical exception to the SFAS No. 109 requirement to reflect the effect of a new tax law in the period of enactment by allowing additional time beyond the financial reporting period to evaluate the effects on plans for reinvestment or repatriation of unremitted foreign earnings. The American Jobs Creation Act of 2004 (the Jobs Act) creates a temporary incentive for U.S. corporations to repatriate accumulated income earned outside the United States by providing an 85% dividends-received deduction for certain dividends from controlled foreign corporations. The Company’s elected to utilize this deduction with respect to its 2005 dividend from its foreign subsidiaries.

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

Note B — Acquisitions

Global Microwave Systems, Inc.

On November 1, 2005, the Company acquired all of the common stock of Global Microwave Systems, Inc. (GMS) in a transaction accounted for as a purchase. The Company purchased GMS to enhance the Company’s competitiveness within the electronic security segment as well as to leverage a suite of technologies to deliver larger and more complex security solutions to its customers. The cost of the acquisition was $19,736 and consisted of cash of $11,011, a note payable of $6,700 with an unamortized discount of $528, common stock valued at $2,500 at the date of the acquisition, and $53 in direct and incremental acquisition costs. The Company issued 118,072 unregistered shares of its common stock valued at $21.17 per share, or $2,500 in total. Additional contingent payments of

F-24

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

up to $4,000 may be paid over a two-year period subject to the future profitability of GMS and if made, this additional amount will be recorded as additional goodwill. As of December 31, 2005, the Company has not accrued for any contingent payment amounts. The Company’s cash payment in this acquisition was financed through a corresponding borrowing on its senior debt facility as further described in Note L. The results of Global Microwave Systems, Inc. have been consolidated since November 1, 2005. The results of GMS would not have a material impact on the Company’s operations on a pro forma basis for the periods presented. The following table summarizes the fair value of the assets acquired and liabilities assumed in the acquisition of GMS:


				Intangible Weighted
	Allocation			Average Useful Life

Current assets	$	4,714
Property and equipment		500
Other Assets		21
Intangibles
Developed Technologies		5,272		10 years
Trade Name		2,915		Indefinite
Non-Competition Agreement		1,705		3 years
Purchased in-process research & development		944		Expensed in Research and Development in 2005
Goodwill		5,964		Indefinite

Total assets acquired	$	22,035
Current liabilities		(2,299	)

Net assets acquired	$	19,736

CMS Security Systems

On August 1, 2004, VSK acquired all the common stock of CMS Security Systems in a transaction accounted for as a purchase. This acquisition was undertaken to provide the Company with a position in a high-growth segment of the North American Electronic Security market. The cost of the acquisition was $400 of cash. VSK entered into a $300 loan to fund the acquisition. The loan is payable in equal installments on August 1, 2005, 2006, and 2007. The results of CMS Security Systems have been consolidated since its acquisition on August 1, 2004. The acquisition of CMS Security Systems did not have a material impact on the Company’s operations. The following table summarizes the fair value of the assets acquired and liabilities assumed in the acquisition of CMS Security Systems:


				Intangible Weighted
	Allocation			Average Useful Life

Current assets	$	69
Property and equipment		23
Intangibles (Customer list)		50		7 years
Goodwill		449		Indefinite

Total assets acquired	$	591
Current liabilities		(172	)
Deferred tax liability		(19	)

Net assets acquired	$	400

F-25

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Note C — Cumulative Effect of Change in Accounting Principle

In 2005, MECAR changed its methodology of applying the percentage of completion method for the recognition of revenue in an effort to better reflect the revenue recognized during the life of a sales contract. Although upon contract completion both methods would yield the same results, the Company felt that the direct labor method is preferable. Previously, MECAR used total direct costs as the basis for recognizing revenue. In 2005, MECAR changed the basis for recognition to direct labor rather than total direct costs. The Company has accounted for this as a change in accounting principle effective January 1, 2005 and the cumulative effect, based on a retroactive computation, of the accounting change of $5,293, net of a tax benefit of $2,726, was recognized in 2005. The cumulative effect of this change represents the difference between the amount of retained earnings at the beginning of the period of change and the amount of retained earnings that would have been reported at the date if the new accounting principle had been applied retroactively for all prior periods. The table below provides the pro forma impact of the change in this accounting principle as if the change had been in place throughout all years reported.


	2005			2004			2003

Pro forma amounts assuming change in application of accounting principle applied retroactively:
Net earnings (loss), as restated for 2003 and 2004	$	(38,920	)	$	1,370		$	2,718
Elimination of the cumulative effect of the change in accounting principle, net of taxes		5,293			—			—
Impact of change in MECAR revenue recognition based on total direct labor rather than total direct costs, net of taxes — unaudited		—			(1,691	)		1,650

Pro Forma net earnings (loss)	$	(33,627	)	$	(321	)	$	4,368

Pro Forma Earnings (loss) per share:
Basic	$	(5.84	)	$	(0.06	)	$	0.80
Diluted	$	(5.84	)	$	(0.06	)	$	0.77

Note D — Restricted Cash

Restricted Cash at December 31 is comprised as follows:


	2005			2004

Collateralized performance bonds and advance payment guarantees	$	5,393		$	9,227
Senior secured facility deposit		2,000			2,000
Other		35			12

	$	7,428		$	11,239
Portion included in current assets		(7,428	)		(9,239	)

Noncurrent portion	$	—		$	2,000

MECAR is generally required under the terms of its contracts with foreign governments and its distributor to provide performance bonds and advance payment guarantees. The credit facility agreements used to provide these financial guarantees place restrictions on certain cash deposits and other liens on MECAR’s assets. In addition, certain customers make advance deposits and require MECAR’s bank to restrict up to forty percent of the advance deposit as collateral. The majority of the restricted cash balance relates to requirements under our sales contracts to provide performance bonds and advance payment guarantees. These instruments typically expire within one year or operating cycle and the restriction on the cash is released. As such, the restricted cash is classified as current for the

F-26

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

periods presented. Restricted cash of $5,393 and $9,227 at December 31, 2005 and 2004, respectively, was restricted or pledged as collateral for these agreements.

Note E — Accounts Receivable and Costs & Accrued Earnings on Uncompleted Contracts

Accounts receivable at December 31 are comprised as follows:


	2005		2004
			Restated

Direct and indirect receivables from governments	$	1,777	$	22,324
Commercial and other receivables, less allowance for doubtful receivables of $214 in 2005 and $143 in 2004		16,770		12,656

	$	18,547	$	34,980

Receivables from foreign government and government agencies are generally due within 30 days of shipment, less a 10% hold back provision which is generally due within 90 days. Since these receivables are typically supported by letters of credit or other guarantees, no provision for doubtful accounts is deemed necessary. The Company maintains an allowance for doubtful accounts on commercial receivables, which is determined based on historical experience and management’s expectations of future losses. Losses have historically been within management’s expectations.

Costs and accrued earnings on uncompleted contracts totaled $35,178 and $41,420 at December 31, 2005 and 2004, respectively. The revenue recognized on the contracts in progress for the years ended December 31, 2005, 2004 and 2003 were $81,301 $115,463, and $125,211 respectively. The revenue recognized from the contracts in progress generally are not billed until products are completed and delivered.

Note F — Inventories

Inventories at December 31 are comprised as follows:


	2005		2004
			Restated

Raw materials	$	14,481	$	15,668
Work in process		19,265		686
Finished goods, less reserve for obsolescence of $882 in 2005 and $668 in 2004		554		774

	$	34,300	$	17,128

F-27

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Note G — Property, Plant & Equipment

Property, Plant & Equipment at December 31 are comprised as follows:


	2005			2004

Land	$	612		$	1,632
Buildings and improvements		22,309			23,621
Machinery and equipment		59,614			59,372
Demonstration Inventory		1,107			—

	$	83,642		$	84,625
Less accumulated depreciation		(53,816	)		(54,331	)

	$	29,826		$	30,294

Depreciation expense was $5,279, $4,093 and $3,592 for the years ended December 31, 2005, 2004, and 2003, respectively.

Capital Leases. The Company leases equipment under various capital leases, with lease terms through 2010. The economic substance of the leases is that the Company is financing the acquisition of the assets through the leases, and accordingly, they are recorded in the Company’s assets and liabilities.

The following is an analysis of the leased property under capital leases included in property plant and equipment:


	2005			2004

Leased equipment	$	10,823		$	13,721
Less: accumulated amortization		(4,135	)		(4,170	)

	$	6,688		$	9,551

The following is a schedule by years of future minimum lease payments under capital leases together with the present value of the net minimum lease payments as of December 31, 2005:


Year ending December 31,
2006	$	2,216
2007		1,635
2008		697
2009		302
2010		72

Total minimum lease payments		4,922
Less: Amount representing interest		(315	)

Present value of net minimum lease payments	$	4,607

F-28

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Note H — Intangible Assets

Intangible assets at December 31, 2005 and 2004 are comprised as follows:


	December 31, 2005						December 31, 2004
	Gross		Accumulated				Gross		Accumulated
	Amount		Amortization		Net		Amount		Amortization		Net

Intangible assets subject to amortization:
Capitalized Software	$	1,055	$	582	$	473	$	1,184	$	477	$	707
Developed Technologies		5,272		81		5,191		—		—		—
Customer Lists		2,297		727		1,570		2,297		540		1,757
Patents and Trade Name		1,225		392		833		1,189		235		954
Other		2,228		162		2,066		—		—		—

Sub Total	$	12,077	$	1,944	$	10,133	$	4,670	$	1,252	$	3,418

Intangible assets with indefinite lives:
Trade Names		3,220		—		3,220		305		—		305

Total	$	15,297	$	1,944	$	13,353	$	4,975	$	1,252	$	3,723

Consolidated amortization expense related to intangible assets, excluding goodwill, for 2005, 2004 and 2003 was $803, $467 and $445, respectively. Estimated future aggregate annual amortization for intangible assets is as follows:


Year	Amount

2006	$	1,387
2007		1,449
2008		1,354
2009		881
2010		803

Note I — Goodwill

As required by SFAS No. 142, the Company performs, at the component level of the segments, a review each year or earlier if an indicator of potential impairment of goodwill exists. The impairment review is based on a discounted cash flow approach that uses estimates of future cash flows discounted at the Company’s weighted average cost of capital. The estimates used are consistent with the plans and estimates that the Company uses to manage the underlying businesses.

F-29

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Goodwill for each segment at December 31 is as follows:


	Ammunition &			Electronic
	Weapons Effects			Security			Other			Total

Balance as of January 1, 2003	$	1,345		$	5,936		$	3,323		$	10,604
Goodwill acquired during the year					—			125			125
Deferred tax asset adjustment		311			426			874			1,611
Foreign exchange fluctuation					1,378			—			1,378

Balance as of December 31, 2003	$	1,656		$	7,740		$	4,322		$	13,718
Goodwill acquired during the year		—			449			125			574
Deferred tax asset adjustment		(261	)		—			—			(261	)
Foreign exchange fluctuation		—			370			—			370

Balance as of December 31, 2004	$	1,395		$	8,559		$	4,447		$	14,401
Goodwill acquired during the year		—			5,964			—			5,964
Impairment loss					—			(3,060	)		(3,060	)
Foreign exchange fluctuation		—			(607	)		—			(607	)

Balance as of December 31, 2005	$	1,395		$	13,916		$	1,387		$	16,698

The Electronic Security segment goodwill experienced a net increase in 2005 resulting from a $5,964 increase related to the acquisition of Global Microwave Systems. The Other segment reflects the $3,060 impairment write-down of SeaSpace. During 2005, the Company determined that the carrying amount of goodwill attributed to SeaSpace exceeded its fair value, which was estimated based on (1) present value of expected future cash inflows and (2) market capitalization. Accordingly, a goodwill impairment expense was recognized at SeaSpace.

The Other segment goodwill acquired in 2004 is associated with final adjustments of the 2002 SeaSpace acquisition. The Electronic Security segment increase in goodwill of $449 related to the acquisition of CMS Security Systems in 2004. The 2004 deferred tax asset adjustment for the Ammunition & Weapons Effects segment is related to the removal of Titan’ valuation allowance.

Note J — Bank Overdraft Credit Facility

Credit Facility — MECAR is obligated under an agreement (the Agreement), executed March 2002, with its foreign banking syndicate that provides credit facilities of up to 49,400 Euros (approximately $58,500 USD) primarily for bank guarantees including performance bonds, letters of credit and similar instruments required for specific sales contracts, as well as a line of credit for tax prepayments and working capital. The Agreement was modified in 2006 with the result that the available credit facility has been reduced to 42,850 Euros (approximately $50,750 USD). The Agreement provides for certain bank charges and fees as the facility is used, plus fees of 2% of guarantees issued and quarterly fees at an annual rate of 1.25% of guarantees outstanding. These fees are charged to interest expense. The interest rate as of December 31, 2005 was Libor +2.75% or approximately 6.02%. As of December 31, 2005 and 2004, guarantees and performance bonds of approximately $27,538 and $25,779, respectively, were outstanding. Advances for working capital and tax pre-payments provided for under the bank overdraft facility, amounted to $15,086 and $5,553 as of December 31, 2005 and 2004, respectively. Advances under the Agreement are secured by restricted cash of approximately $5,393 and $9,228 at December 31, 2005 and 2004, respectively. MECAR is generally required under the terms of its contracts with foreign governments and its distributor to provide performance bonds and advance payment guarantees. The credit facility agreement is used to provide these financial guarantees and in turn places restrictions on certain cash deposits and other liens on MECAR’s assets. In addition, certain customers make advance deposits and require MECAR’s bank to restrict up to forty percent of the advance deposit as collateral. The majority of the restricted cash balance relates to requirements

F-30

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

under our sales contracts to provide performance bonds and advance payment guarantees. Amounts outstanding are also collateralized by the letters of credit received under the contracts financed, and a pledge on MECAR’s assets of approximately $41,000 of MECARs assets. The Agreement has an annual term but is cancellable by either party on 90 days notice. The Agreement requires that MECAR maintains certain net worth and working capital covenants. As of December 31, 2005 MECAR was not in compliance with the facility covenants, The Company is in the process of renegotiating the terms and covenants of the agreement. The banks continue to lend cash and extend guarantees while the renegotiation is taking place. New terms are expected to be in the place by December, 2006.

Note K — Accrued Losses on Contracts, Deferred Compensation and Warranty Reserves

Accrued losses on contracts. At December 31, 2005, the provision for accrued losses on contracts calculated to $0. The Company provided for accrued losses of $726 at December 31, 2004 in connection with the completion of certain contracts in progress as of year end that were to be completed in 2005. These amounts are included in accrued liabilities.

Deferred compensation. The December 31, 2005 deferred compensation balance represents cash compensation deferred by the non-employee directors. The December 31, 2004 balance represents cash and stock compensation deferred by non-employee directors in addition to a post-employment obligation to a Company employee, which was paid in early 2005.

Accrued Warranty Costs. At December 31, 2005 the Company provided $819 for accrued costs related to warranties. The balance at December 31, 2004 was $912. These amounts are included in accrued liabilities.

Note L — Long-Term Debt

Long-term obligations as of December 31 consist of the following:


	2005		2004

Notes payable, less unamortized discount	$	13,539	$	1,959
Note related to GMS acquisition, less unamortized discount		6,173		—
Mortgage loan agreements		193		284
Loan for CMS Security Systems acquisition		200		300
Notes payable		618		54
Capital leases and other		4,978		7,414

Total Long-Term Debt obligations	$	25,701	$	10,011
Less current maturities		4,342		2,788

Long-Term Debt obligations, less current maturities and unamortized discount (including short-term debt to be refinanced)	$	21,359	$	7,223

Notes payable. On May 28, 2004 the Company obtained a senior loan facility from an accredited lender under which the Company could borrow up to $18,000 for acquisitions and working capital. At closing, the Company borrowed $2,000 and deposited $2,000 in a restricted account to secure the repayment. An additional draw of $12,000 was made against this facility in November 2005, which was used for the acquisition of GMS. All loans under the facility bear interest at the rate of 11.5% per year payable quarterly. Principal was payable in sixty equal monthly payments that commenced in late December 2005. The Company paid a fee on the unused portion of the facility. Warrants exercisable at $0.01 per share to purchase 4,000 shares of the Company’s common stock were issued at closing and were valued at $68. In November 2005, warrants exercisable at $0.01 per share to purchase 24,000 shares were issued pursuant to the senior loan facility and were valued at $487. All warrants issued in conjunction with this facility have an expiration date of May 28, 2012. The facility was secured by first priority

F-31

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

security interest, subject only to permitted liens, in substantially all of the Company’s domestic tangible and intangible assets. The Company also incurred $860 of closing costs related to this note payable. The note draw down period extended to November 28, 2005 and the five year amortization period began at that time. The final payment on the note was scheduled for October 2010. At December 31, 2005, the Company was not compliant with the covenants of this facility. The facility was paid in full and refinanced in March 2006, this note has been classified, in accordance with SFAS No. 6, as long term debt as of December 31, 2005.

Note payable refinancing — In March 2006, the Company refinanced the notes payable that were outstanding at December 31, 2005 and the senior loan facility was repaid in full. As described more completely in Note Y as a subsequent event, the purchasers of the new notes payable received subordinated convertible notes in the principal amount of $30,000 and 226,800 warrants to purchase common stock of the Company. The Note will initially accrue interest at a rate of 7.5% per annum with accrued interest payable quarterly in arrears in cash. The Note has a provision for the interest rate to step down to 5% per annum once certain financial and registration milestones are achieved. The Note will mature in March 2011 and are convertible into shares of common stock at a conversion price of $26.46 per share, subject to various terms and restrictions. The warrants issued in conjunction with the refinancing will expire on March 9, 2011.

Note payable for GMS acquisition. On November 1, 2005, the Company entered into a $6,700 unsecured note payable to fund the acquisition of GMS. This note was taken back by the seller. There are no significant covenants. The note is payable in equal annual installments over three years bearing interest at the rate of 7.5% per year payable quarterly. The discount of the note was $527.

Mortgage loan Agreements. The Company is also obligated on several mortgages on VSK’s buildings which have a total balance due of $193 at December 31, 2005 and $284 at December 31, 2004. The note is secured by the asset that has been financed. There are no significant covenants. The mortgages mature at various dates through 2009, plus interest at rates ranging from 3.9% to 4.5% per year.

Loan for CMS Security Systems acquisition. VSK entered into a $300 unsecured loan to fund the acquisition of CMS Security Systems in August 2004. There are no significant covenants. The loan is payable in equal installments on August 1, 2005, 2006, and 2007 and had outstanding balances of $200 and $300 at December 31, 2005 and 2004, respectively.

Notes Payable. Notes Payable — At December 31, 2005, MECAR borrowed $592 related to a carve out of the overdraft facility with one of the banks in their banking facility to pay capital lease obligations. In addition, NSM had a note for machinery and vehicles of $26 and $54 at December 31, 2005 and 2004, respectively. The weighted average interest rate for Notes Payable as of December 31, 2005 and 2004 was 3%. The terms and security are consistent with the MECAR credit facility.

Capital Leases and Other. The Company is also obligated on various vehicle, equipment, capital lease obligations and other loans. The notes and leases are generally collateralized by the assets acquired, bear interest at rates ranging from 3.50% to 8.00% and mature at various dates through 2010.

The annual maturities of long-term obligations as of December 31, 2005 are as follows:


Year	Amount

2006	$	4,342
2007		3,337
2008		3,978
2009		309
2010		13,735

F-32

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

See subsequent events Note Y for a description of the Notes Payable Refinancing that was completed in March 2006.

Note M — Convertible Subordinated Debenture

Convertible Subordinated Debenture. On June 28, 2002 the Company sold to an accredited investor for $7,500 (i), an 8% subordinated debenture convertible into shares of the Company’s common stock at $25.00 per share and (ii) warrants to purchase 15,000 shares of the Company’s common stock at an exercise price of $28.75 per share in cash. The warrants to purchase 15,000 shares of the Company’s common stock were valued at $140 and expired on June 28, 2006. The Company registered the shares of common stock that could be issued in the event the holder elected to convert the debenture and exercise the warrants. The final payment on the debenture was made in March 2005.

Note N — Benefit Plans

In 2003, the Company adopted a 401(k) plan. Employer contributions to the plans in 2005, 2004 and 2003 were approximately $135, $96, and $108, respectively. Employee contributions to the plan in 2005 were $102. Under the terms of labor agreements at its Belgian subsidiaries, the Company contributes to certain governmental and labor organization employee benefit and retirement programs.

Note O — Contingencies and Commitments

A suit has been filed against one of the VSK subsidiaries in the Belgian courts for failure to honor a contracted agreement. The suit demands damages of approximately $130. Management intends to vigorously defend this suit and believes that it has meritorious defense to the claim, and therefore no loss provision has been established. The Belgian Court will hold its first hearing on the matter in October 2006.

The Company has entered into consulting and employment agreements with certain management personnel at the Company’s subsidiaries and with certain domestic management personnel. Certain of these agreements provide for severance payments in the event of termination under certain conditions.

The Company leases domestic office space and equipment under operating leases which expire at various dates through 2013. Certain leases also include escalation provisions for taxes and operating costs. The following is a schedule by year of base expense due on operating leases that have initial or remaining lease terms in excess of one year as of December 31, 2005:


Year	Amount

2006	$	998
2007		1,013
2008		636
2009		402
2010		278
2011 and after		885

Total rental expense charged to operations approximated $860, $387 and $356, for the years ended December 31, 2005, 2004 and 2003, respectively.

The Company’s domestic operations do not provide post employment benefits to its employees. Under Belgian labor provisions, the Company may be obligated for future severance costs for its employees. After giving effect to prior workforce reductions, current workloads, expected levels of future operations, severance policies and future severance costs, post employment benefits are not expected to be material to the Company’s financial position.

F-33

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Note P — Fair Value of Financial Instruments

At December 31, 2005 and 2004, the Company’s financial instruments include cash, receivables, payables, borrowings, forward exchange contracts, guarantees and performance bonds. The face value of cash, receivables and payables approximate their carrying values because of the short-term nature of the instruments. The estimated fair value of the other financial instruments and off-balance-sheet credit obligations are as follows:


	2005				2004
	Carrying		Estimated		Carrying		Estimated
	Amount		Fair Value		Amount		Fair Value

Notes payable and long-term obligations, including current maturities	$	25,701	$	25,701	$	10,011	$	10,011
Foreign exchange contracts		1,156		1,156		1,223		1,223
Off-balance-sheet instruments Guarantees and performance bonds		—		28,123		—		26,781

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value.


	•	The fair value of notes payable and long-term obligations is estimated based on approximate market prices for the same or similar issues or the current rates offered to the Company for debt of the same remaining maturities. The Company believes the aggregate carrying value approximates fair value.

	•	The fair value of foreign exchange contracts is based on the mark to market calculations performed at the end of each period. The balance sheet at December 31, 2005 and 2004 includes the fair value of MECAR’s forward contracts of $1,161 liability and $1,195 asset, respectively. The fair value of VSK’s forward contracts was $5 and $28 at December 31, 2005 and 2004, respectively.

	•	Estimated fair values for off-balance-sheet instruments, which include performance bonds and advance payment guarantees are reflected at the face value of these obligations, since management does not expect to have any claims against these obligations based on its past experience.

Note Q — Derivative Financial Instruments

Derivatives and hedging

The Company uses derivative financial instruments to manage foreign currency exposure. As a matter of policy, the Company does not enter into speculative hedge contracts or use other derivative financial instruments. To qualify for hedge accounting, the details of the hedging relationship must be formally documented at inception of the arrangement, including the risk management objective, hedging strategy, hedged item, specific risks that are being hedged, the derivative instrument and how effectiveness will be measured. The derivative must be highly effective in offsetting either changes in fair value or cash flows, as appropriate, for the risk being hedged. Effectiveness is evaluated on a retrospective and prospective basis. If a hedge relationship becomes ineffective, it no longer qualifies as a hedge. Any excess gains or losses attributable to such ineffectiveness, as well as subsequent changes in the fair value of the derivative, are recognized in net earnings.

Fair value hedges

Fair value hedges are hedges that eliminate the risk of changes in the fair values of assets, liabilities and certain types of firm commitments. The Company uses foreign currency forward contracts to minimize the foreign currency exposures with debt, which is payable in U.S. dollars rather than the Euro. At December 31, 2005, VSK designated a forward contract as a fair value hedge with a notional amount of $200 and the fair value of the contracts was $5. The derivative was entered into on August 1, 2005 and expires July 31, 2006. Realized and unrealized gains

F-34

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

and losses from derivative contracts are reported in earnings. There were no net gains or losses realized during the year ended December 31, 2005 from hedge ineffectiveness or from firm commitments that no longer qualify as fair value hedges.

Cash flow hedges

Cash flow hedges are hedges that offset the changes of expected future cash flows. The Company has not designated any hedging relationships as cash flow hedges.

Derivatives not designated as hedges

The Company uses foreign currency futures contracts to minimize the foreign currency exposures that arise from sales contracts with certain foreign customers. Under the terms of these sales contracts, the selling price and certain costs are payable in U.S. dollars rather than the Euro, which is MECAR’s functional currency. As discussed in Note A, the Company’s accounting for foreign currency exchange contracts at MECAR did not comply with the guidelines of FAS 133. As such, realized and unrealized gains from derivative contracts are reported as a component of revenues and amounted to ($7,785), $3,698 and $13,625 for the years ended December 31, 2005, 2004, and 2003, respectively.

Counterparty credit risk

The Company’s foreign exchange forward contracts expose the Company to credit risks to the extent that the counterparties may be unable to meet the terms of the agreement. The Company minimizes such risk by using major financial institutions as its counterparties. Management does not expect any material loss as result of default by counterparties.

Note R — Stockholders’ Equity

The Company has various equity compensation plans for employees as well as non-employee members of the board of directors. The Company may grant stock options, stock appreciation rights, incentive and non-statutory options, performance shares and other awards to key executives, management, directors and employees under various plans at prices equal to or in excess of the market price at the date of the grant. The options for common shares generally are exercisable over a five to ten year period and expire up to ten years from the date of grant. The equity compensation plans consist of the following:

2001 Equity Incentive Plan. During 2001, the Board of Directors and stockholders approved and reserved 240,000 shares of common stock for awards to key employees of the Company and its subsidiaries. In each of 2002, 2003 and 2005, the Board of Directors and the stockholders authorized the plan to be increased by 250,000 shares. The plan authorizes the Compensation Committee of the Board of Directors to grant stock options, stock appreciation rights, restricted stock, performance shares and cash awards. Each type of grant places certain requirements and restrictions upon the Company and grantee. Total stock awards in 2005 were 54,729 shares of which 50,046 shares were grants to certain key employees and 4,683 shares were issued to non-employee directors. For 2004, stock awards totaled 5,753 shares of which 1,747 shares were grants to certain key employees and 4,006 shares were issued to non-employee directors. Restricted shares generally vest over periods of one to five years from the date of award. As of December 31, 2005, total restricted shares of 51,793 shares were reserved for certain employees, which will vest with continued service to the Company per the vesting schedule.

1997 Incentive Stock Plan. During 1997, the Board of Directors and stockholders approved and reserved 225,000 shares of common stock for awards to key employees of the Company and its subsidiaries in the form of stock options and stock awards. The Plan is administered by the Compensation Committee of the

F-35

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Board of Directors. Employees of the Company and its subsidiaries who are deemed to be key employees by the Committee are eligible for awards under the Plan.

1992 Employee Stock Purchase Plan. During 1992, the Board of Directors and stockholders approved and reserved 525,000 shares for the plan. The plan is voluntary and substantially all full-time employees are eligible to participate through payroll deductions. The purchase price of each share is equal to 85% of the closing price of the common stock at the end of each calendar quarter. The Plan is subject to certain restrictions and the Board may amend or terminate it at any time. With the adoption of SFAS 123R, Share Based Payment, at January 1, 2006, the Company will begin to recognize the compensation cost related to the plan. The Company does not believe the compensation cost of this plan will be significant.

Rights Agreement. The Board of Directors adopted a Rights Agreement in 2001 and amended the agreement in June, 2006. The Agreement provides each stockholder of record a dividend distribution of one “right” for each outstanding share of common stock. Rights become exercisable the earlier of ten days following: (1) a public announcement that an acquiring person has purchased or has the right to acquire 20% or more of the Company’s common stock, or (2) the commencement of a tender offer which would result in an offeror beneficially owning 20% or more of the outstanding common stock. All rights held by an acquiring person or offeror expire on the announced acquisition date and all rights expire at the close of business on May 31, 2011.

Each right under the Rights Agreement entitles a stockholder to acquire at a purchase price of $50, one-hundredth of a share of preferred stock which carries voting and dividend rights similar to one share of common stock. Alternatively, a right holder may elect to purchase for $50 an equivalent number of common shares (or in certain circumstances, cash, property or other securities of the Company) at a price per share equal to one-half of the average market price for a specified period. In lieu of the purchase price, a right holder may elect to acquire one-half of the common shares available under the second option. The purchase price and the preferred share fractional amount are subject to adjustment for certain events as described in the Agreement.

Rights also entitle the holder to receive a specified number of shares of an acquiring company’s common stock in the event that the Company is not the surviving corporation in a merger or if 50% or more of the Company’s assets are sold or transferred.

At the discretion of a majority of the Board and within a specified time period, the Company may redeem all of the rights at a price of $.01 per right. The Board may also amend any provision of the Agreement prior to exercise of the rights.

F-36

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

The following table summarizes option activity:


	2005					2004					2003
				Weighted					Weighted					Weighted
				Average					Average					Average
				Exercise					Exercise					Exercise
	Shares			Price		Shares			Price		Shares			Price

Options outstanding at beginning of year		632,266		$	14.69		620,000		$	14.08		531,000		$	12.81
Options granted		120,000			22.68		40,000			20.43		149,000			16.92
Options exercised		(202,599	)		13.28		(27,734	)		9.21		(60,000	)		9.87
Options forfeited		—			—		—			—		—			—
Options expired		(42,000	)		17.19		—			—		—			—

Options outstanding at end of year		507,667		$	16.94		632,266		$	14.69		620,000		$	14.08

Options exercisable at end of year		375,667					416,930					305,333
Weighted-average fair value of options, granted during the year	$	8.42				$	7.59				$	7.73

The following table summarizes options outstanding at December 31, 2005:


					Weighted
					Average		Exercisable
Number		Range of	Weighted Average		Remaining		Number of		Weighted Average
Outstanding		Exercise Prices	Exercise Prices		Contractual Life		Options		Exercise Prices

	119,500	$ 7.88 to $ 8.63	$	8.53		4.27 Years		119,500	$	8.53
	40,000	$ 9.01 to $14.90	$	14.90		2.33 Years		24,000	$	14.90
	348,167	$16.40 to $25.00	$	20.07		4.46 Years		232,167	$	18.98

	507,667	$ 7.88 to $25.00	$	16.94		—		375,667		—

Note S — Other — Net

Other income (expense) included in the Company’s consolidated statements of earnings is comprised of the following:


	2005			2004			2003
				Restated			Restated

Net currency transaction gains (losses)	$	(721	)	$	(1,530	)	$	(1,404	)
Miscellaneous — net		(1,205	)		1,019			920

	$	(1,926	)	$	(511	)	$	(484	)

Miscellaneous — net includes bank charges related to MECAR’s performance bonds and advance payment guarantees, which are generally required under the terms of MECAR’s contracts with foreign governments and its distributor.

Note T — Income Taxes

The Company recognizes deferred tax liabilities and assets for the expected future tax consequences of events that have been included in the consolidated financial statements or tax returns. Under this method, deferred tax

F-37

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

liabilities and assets are determined based on the difference between the consolidated financial statement and tax basis of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to reverse.

Earnings (loss) before income taxes is comprised as follows:


	2005			2004			2003
				Restated			Restated

Domestic	$	(21,594	)	$	(6,066	)	$	(5,896	)
Foreign		(10,973	)		7,745			13,270

	$	(32,567	)	$	1,679		$	7,374

The Company’s provision for income taxes is comprised of:


	2005			2004			2003
				Restated			Restated

Current (Benefit) Provision
Domestic	$	(61	)	$	417		$	309
Foreign		2,800			6,364			8,301

Total Current Provision		2,739			6,781			8,610
Deferred (Benefit) Provision
Domestic		3,501			(2,995	)		(848	)
Foreign		(5,180	)		(3,477	)		(3,106	)

Total Deferred (Benefit)		(1,679	)		(6,472	)		(3,954	)
Total tax provision	$	1,060		$	309		$	4,656

The Company’s provision for income taxes differs from the anticipated United States federal statutory rate. Differences between the statutory rate and the Company’s provision are as follows:


	2005			2004			2003
				Restated			Restated

Taxes at statutory rate		(34.0	)%		34.0	%		34.0	%
State taxes, net of federal benefit		(2.9	)		(4.9	)		(2.7	)
Impact of international operations		0.4			127.6			(14.6	)
Goodwill and other permanent differences		3.8			—			—
Other permanent differences		2.2			10.8			9.4
Valuation allowance		33.8			(149.1	)		37.0

Income taxes		3.3	%		18.4	%		63.1	%

F-38

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

The components of the deferred taxes at December 31, 2005 and 2004 are comprised as follows:


	2005			2004
				Restated

Deferred tax assets
Inventory	$	386		$	769
Compensation accruals		152			113
Valuation adjustments		598			198
Accrued expenses		471			225
Business tax credits		458			394
Deferred compensation		476			536
Capitalized R&D		2,013			1,309
Derivatives		253			958
Revenue recognition		2,223			—
Foreign tax credit carryforwards		2,368			1,295
Net operating loss carryforwards		12,325			1,469

Gross deferred tax asset		21,723			7,266
Valuation allowance		(12,784	)		(1,466	)

Total deferred tax assets	$	8,939		$	5,800
Deferred tax liabilities
Depreciation and amortization	$	(498	)	$	(1,250	)
Deferred income		(73	)		(73	)

Total deferred tax liabilities	$	(571	)	$	(1,323	)

Net Deferred Tax Assets (Liabilities)	$	8,368		$	4,477

At December 31, 2005, the Company had U.S. net operating loss carryforwards of approximately $16,133 which will begin to expire in 2010 and foreign NOLs of approximately $15,493 which may be carried forward indefinitely. A portion of the U.S. net operating loss carryforwards are subject to limitations on the amount that can be utilized each year. As of December 31, 2005, the Company also had foreign tax credits and alternative minimum tax credits of approximately $2,368 and $458, respectively. The foreign tax credits will begin to expire in 2010 and the alternative minimum tax credits do not expire.

The Company regularly reviews the recoverability of its deferred tax assets and establishes a valuation allowance as deemed appropriate. Realization of deferred tax assets is dependent upon generation of sufficient income by the Company in the jurisdictions in which it has operations and, in some cases, by specific office locations. Because the Company experienced losses in the U.S. in previous years and continued U.S. losses in the current year, management recorded a valuation allowance of approximately $12,784 against its U.S. net deferred tax asset as of as of December 31, 2005. The change in the valuation allowance from December 31, 2004 to December 31, 2005 was an increase of $11,318, which is due primarily to the valuation allowance recorded against the U.S. net deferred tax assets during 2005. As of December 31, 2005, the portion of the valuation allowance for which subsequently recognized tax benefits will increase stockholders’ equity was $342.

As of December 31, 2005, the Company has not recorded U.S. income tax expense for $32,730 of unremitted earnings of its foreign subsidiaries for which it has designated as indefinitely reinvested. The amount of earnings designated as indefinitely reinvested offshore is based upon the actual deployment of such earnings in our offshore assets and our expectations of the future cash needs of our U.S. and foreign entities. In the event that actual cash needs of our U.S. entities exceed our current expectations, we may need to repatriate foreign earnings which have

F-39

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

been designated as indefinitely reinvested offshore. This could result in additional income tax expense being recorded.

The American Jobs Creation Act of 2004 (the Jobs Act) created a temporary incentive for U.S. corporations to repatriate accumulated income earned outside the United States by providing an 85% dividends-received deduction for certain dividends from controlled foreign corporations. The Company elected to utilize this deduction in 2005.

The Jobs Act also included a qualified manufacturing deduction that applies to domestic manufacturers. The deduction, when fully phased in, will provide a deduction of up to 9% of qualified manufacturing income. The deduction cannot be claimed by companies in a net operating loss carryforward position. Therefore, the Company did not claim a 2005 benefit related to the qualified manufacturing deduction. The Company has not quantified the impact of the qualified manufacturing deduction that it can use once the net operating loss carryforward has been fully used.

Note U — Earnings Per Common Share

Basic earnings per share exclude dilution and are computed by dividing net earnings by the weighted average number of common shares outstanding for the period. The computation of diluted earnings per share includes the effects of convertible debentures, stock options, warrants and restricted stock (unvested stock awards), if such effect is dilutive. The table below shows the calculation of basic and diluted earnings per share for the years ended December 31, 2005, 2004 and 2003, respectively:


	2005			2004		2003
				Restated		Restated

Earnings (loss) before cumulative effect of accounting change	$	(32,567	)	$	1,370	$	2,718
Cumulative effect of accounting change, net of taxes		(5,293	)		—		—

Net earnings after cumulative effect of accounting change	$	(38,920	)	$	1,370	$	2,718
Weighted average number of basic shares		5,754,951			5,568,183		5,496,786
Warrants		—			2,381		—

Stock Options		—			174,718		173,333

Weighted average number of diluted shares		5,754,951			5,745,282		5,670,119

Basic earnings (loss) per share before cumulative effect of accounting change	$	(5.84	)	$	0.25	$	0.49
Cumulative effect of accounting change, net of taxes		(0.92	)		—		—

Basic earnings (loss) per share	$	(6.76	)	$	0.25	$	0.49

Diluted earnings (loss) per share before cumulative effect of accounting change	$	(5.84	)	$	0.24	$	0.48
Cumulative effect of accounting change, net of taxes		(0.92	)		—		—

Diluted earnings (loss) per share	$	(6.76	)	$	0.24	$	0.48

For the year ended December 31, 2005, warrants, stock options and restricted stock shares of 6,956, 181,740 and 390, respectively, were excluded from the calculation of earnings per share since their effect would be anti-dilutive. During 2004 and 2003, common stock equivalents related to convertible debentures of 245,819 and 300,000 were excluded since their impact would be anti-dilutive. In addition, 15,000 warrants associated with the Riverview convertible debenture financing were excluded from the earnings per share calculation in each of 2005,

F-40

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

2004 and 2003 since the strike price of $28.05 exceeded the average share prices for each of those years respectively.

In accordance with SFAS No. 128, Earnings Per Share, the Company calculates the dilutive effect, if any, of restricted stock awards using the treasury stock method to calculate equivalent weighted average shares outstanding. As of December 31, 2005, 51,793 shares of Restricted Stock had been awarded to employees in 2004 and 2005.

Note V — Geographic Areas and Industry Segments

In late 2005, Allied changed the composition of its business structure from the four segments used for management and reporting purposes in prior years into two primary operating segments in order to more accurately reflect the strategic focus of the Company. In conformity with SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information” the Company’s segment information is presented on the basis that management uses in evaluating segment performance. As required under SFAS 131, the Company has restated all prior period segment information to be consistent with the 2005 segment reporting.

The new operating segments are Ammunition & Weapons Effects and Electronic Security:

Ammunition & Weapons Effects segment consists of MECAR, MECAR USA and Titan. MECAR develops and produces medium caliber tank, mortar and other ammunition. MECAR USA will initially pursue contracts from the U.S. government and others for ammunition and pyrotechnics devices. MECAR USA became operational in the third quarter of 2005. Titan designs, manufactures and sells battlefield effects simulators, minor pyrotechnics, and other training devices.

Electronic Security segment consists of VSK, NSM, and GMS. VSK Electronics N.V. manufactures access control, intrusion protection, fire detection and video systems; Télé Technique Générale S.A. installs security systems; Intelligent Data Capturing Systems N.V. manufactures integrated video systems; VIGITEC S.A. installs networked video surveillance systems; and CMS Security Systems manufactures access control systems. NSM designs, manufactures, distributes and services industrial and law enforcement security products and systems. Global Microwave Systems designs and manufactures miniature and sub-miniature FM and digital transmitters, receivers, and related equipment for investigative, surveillance, and security applications, and live TV news/sports/entertainment coverage.

The Other segment consists of SeaSpace, which designs, manufactures, distributes and services weather and environmental satellite ground reception systems, as well as a line of antennas is reported as Other. It was formerly 100% of the Environmental Safety and Security segment.

Allied, the parent Company, provides management and other services to its subsidiaries and has no operating activities. Significant intercompany transactions have been eliminated in consolidation.

F-41

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

The Company’s foreign operations are conducted by MECAR and VSK.


	2005		2004		2003
			Restated		Restated

Revenues from external customers
Ammunition & Weapons Effects	$	67,396	$	93,793	$	113,406
Electronic Security		38,802		45,973		33,303
Other		6,024		6,435		7,065

	$	112,222	$	146,201	$	153,774

Interest expense
Ammunition & Weapons Effects	$	1,406	$	1,483	$	1,603
Electronic Security		79		48		49
Other		4		1		1
Corporate		1,079		909		838

	$	2,568	$	2,441	$	2,491


	2005			2004			2003
				Restated			Restated

Interest income
Ammunition & Weapons Effects	$	258		$	203		$	221
Electronic Security		222			275			167
Other		23			21			36
Corporate		77			50			36

	$	580		$	549		$	460

Income tax expense (benefit)
Ammunition & Weapons Effects	$	(4,481	)	$	614		$	3,274
Electronic Security		2,707			2,694			654
Other		1,094			(1,411	)		(200	)
Corporate		1,740			(1,588	)		928

	$	1,060		$	309		$	4,656

F-42

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

2005 2004 2003

Restated Restated

Depreciation and amortization

Ammunition & Weapons Effects
$ 3,498 $ 2,764 $ 2,410

Electronic Security
1,939 1,216 1,093

Other
595 524 488

Corporate
50 47 46

$ 6,082 $ 4,551 $ 4,037

Segment profit (loss) before taxes

Ammunition & Weapons Effects
$ (18,119 ) $ 1,671 $ 7,562

Electronic Security
(2,041 ) 6,987 2,618

Other
(6,238 ) (3,283 ) (528 )

Corporate
(6,169 ) (3,696 ) (2,278 )

$ (32,567 ) $ 1,679 $ 7,374

Segment assets(1)

Ammunition & Weapons Effects
$ 118,669 $ 127,880

Electronic Security
49,528 45,231

Other
8,270 12,808

Corporate
4,479 6,312

$ 180,946 $ 192,231

Capital Expenditure for Segment assets

Ammunition & Weapons Effects
$ 6,706 $ 2,271 $ 2,941

Electronic Security
1,041 1,525 747

Other
411 1,230 682

Corporate
9 10 3

$ 8,167 $ 5,036 $ 4,373


(1)		Amounts net of intersegment receivables.

F-43

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

The following geographic area data includes trade revenues based on customer location and assets based on physical location.


	Geographic Segment Data
	2005		2004		2003
			Restated		Restated

Revenues from external customers
United States(1)	$	45,216	$	56,932	$	78,330
Belgium		19,229		25,694		24,378
Saudi Arabia		24,010		33,657		13,051
France		3,254		6,676		6,385
Venezuela		8,348		8,900		18,042
Cyprus		909		—		—
Germany		1,331		1,345		1,233
Indonesia		—		—		549
Brunei		598		—		378
Kuwait		869		—		3,545
Taiwan		1,570		—		338
Japan		1,278		353		899
Qatar		1,196		2,844		—
Other foreign countries		4,414		9,800		6,646

	$	112,222	$	146,201	$	153,774


(1)		Includes foreign military sales for the benefit of Saudi Arabia.


	Geographic Segment Data
	2005		2004
			Restated

Segment assets
Belgium	$	131,801	$	152,934
United Kingdom		171		199
United States(1)		48,974		39,098

	$	180,946	$	192,231


(1)		Net of inter-segment receivables and investments.


	2005		2004

Property and equipment
Belgium	$	24,813	$	27,956
United States		5,013		2,338

	$	29,826	$	30,294

F-44

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Note W — Quarterly Financial Data (Unaudited)


	First			Second			Third			Fourth
2005 Restated	Quarter			Quarter			Quarter			Quarter			Total
	(Amounts in thousands, except per share data)

Revenues	$	24,018		$	26,158		$	26,819		$	35,227		$	112,222
Gross profit		4,101			7,904			(175	)		6,238			18,068
Net earnings (loss)- before cumulative effect of change in the application of accounting principle		(3,656	)		(811	)		(6,761	)		(22,399	)		(33,627	)
Net Earnings (Loss)		(9,233	)		(701	)		(6,666	)		(22,320	)		(38,920	)
Per share Net Earnings (Loss):
Basic	$	(1.64	)	$	(0.12	)	$	(1.15	)	$	(3.75	)	$	(6.76	)

Diluted	$	(1.64	)	$	(0.12	)	$	(1.15	)	$	(3.75	)	$	(6.76	)

The following significant pre-tax adjustments were made in the fourth quarter of 2005:


Impairment to SeaSpace Goodwill	$	3,060
NSM physical inventory adjustment		1.157
Write off of in process R&D expenses related to November 2005 acquisition		944
Increase to corporate audit accrual		870
SeaSpace physical inventory adjustment		422

Total fourth quarter significant adjustments — pretax	$	6,453

In addition, the Company booked, also in the fourth quarter of 2005, a tax valuation allowance for the U.S. operations of $9,359 and an accrual for a tax audit at MECAR for $560.

The tables below reconcile the 2005 quarterly data as previously reported to the restated quarterly data above.

F-45

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Impact from

Foreign
Impact from
Impact of
As Previously

Currency
Compensation
Revenue
Reported in

March 31, 2005
Restated Translation(1) Expense(2) Recognition(3) 10-Q/A

Revenues
$ 24,018 $ 755 $ 0 $ 2,207 $ 21,056

Cost of Sales
$ 19,917 (33 ) $ 0 4,952 14,998

Operating Income (loss)
(4,935 ) 788 (36 ) (2,746 ) (2,941 )

Earnings before income taxes and the cumulative effect of change in application of accounting principle
(5,800 ) 81 (36 ) (2,745 ) (3,100 )

Income tax expense (benefit)
(2,144 ) (5 ) (12 ) (934 ) (1,193 )

Cumulative effect of change in the application of accounting principle
(5,577 ) — — (5,577 ) —

Net earnings (loss)
(9,233 ) 76 (24 ) (7,388 ) (1,907 )

Earnings (loss) per share — Basic & Diluted:

Loss before cumulative effect of change in the application of accounting principle
$ (0.65 ) $ 0.01 $ (0.00 ) $ (0.32 ) $ (0.34 )

Cumulative effect of change in the application of accounting principle:
$ (0.99 ) — — $ (0.99 ) —

Net income (loss)
$ (1.64 ) $ 0.01 $ (0.00 ) $ (1.31 ) $ (0.34 )

Weighted Average number of common shares (4):

Basic
5,620,634 5,609,351

Diluted
5,620,634 5,609,351


(1)		Impact of correcting for the failure to comply with the documentation requirements of FAS 133, hedge accounting, for changing the exchange rates to period end spot rates at the Company’s MECAR subsidiary for its foreign currency transactions and other adjustments related to sales contracts.

(2)		Impact of correcting the measurement date for options granted in February 2002 by the Compensation Committee of the Board of Directors of the Company that were subject to subsequent stockholder approval that was obtained in June 2002.

(3)		Impact of change in accounting principle on revenue recognition at the Company’s MECAR subsidiary.

(4)		Shares Outstanding for the period were restated to correct for deferred compensation for the outside directors that was stock based that had been incorrectly excluded from the earnings per share calculation in the period.

F-46

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Impact from

Foreign
Impact from
Impact of
As Previously

Currency
Compensation
Revenue
Reported in

June 30, 2005
Restated Translation(1) Expense(2) Recognition(3) 10-Q/A

Revenues
$ 26,158 $ (1,733 ) $ — $ 6,790 $ 21,101

Cost of Sales
$ 18,254 (1 ) — 2,577 15,678

Operating Income (loss)
(2,098 ) (1,731 ) — 4,213 (4,580 )

Earnings before income taxes and the cumulative effect of change in application of accounting principle
(1,851 ) (1,317 ) — 4,214 (4,748 )

Income tax expense (benefit)
(1,040 ) (583 ) — 1,433 (1,890 )

Cumulative effect of change in the application of accounting principle
110 — — 110 —

Net earnings (loss)
(701 ) (734 ) — 2,891 (2,858 )

Earnings (loss) per share — Basic & Diluted:

Loss before cumulative effect of change in the application of accounting principle
$ (0.14 ) $ (0.12 ) $ — $ .49 $ (0.51 )

Cumulative effect of change in the application of accounting principle:
$ 0.02 — $ — $ 0.02 —

Net income (loss)
$ (0.12 ) $ (0.12 ) $ — $ 0.51 $ (0.51 )

Weighted Average number of common shares (4):

Basic
5,655,369 5,632,071

Diluted
5,655,369 5,632,071


(1)		Impact of correcting for the failure to comply with the documentation requirements of FAS 133, hedge accounting, for changing the exchange rates to period end spot rates at the Company’s MECAR subsidiary for its foreign currency transactions and other adjustments related to sales contracts.

(2)		Impact of correcting the measurement date for options granted in February 2002 by the Compensation Committee of the Board of Directors of the Company that were subject to subsequent stockholder approval that was obtained in June 2002.

(3)		Impact of change in accounting principle on revenue recognition at the Company’s MECAR subsidiary.

(4)		Shares Outstanding for the period were restated to correct for deferred compensation for the outside directors that was stock based that had been incorrectly excluded from the earnings per share calculation in the period.

F-47

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Impact from

Foreign
Impact from
Impact of
As Previously

Currency
Compensation
Revenue
Reported in

September 30, 2005
Restated Translation(1) Expense(2) Recognition(3) 10-Q/A

Revenues
$ 26,819 $ (78 ) $ — $ 3,421 $ 23,476

Cost of Sales
$ 26,994 — — 6,717 20,277

Operating Income (loss)
(8,734 ) (79 ) — (3,295 ) (5,360 )

Earnings before income taxes and the cumulative effect of change in application of accounting principle
(9,124 ) (353 ) — (3,295 ) (5,476 )

Income tax expense (benefit)
(2,363 ) (59 ) — (1,120 ) (1,184 )

Cumulative effect of change in the application of accounting principle
95 — — 95 —

Net earnings (loss)
(6,666 ) (294 ) — (2,080 ) (4,292 )

Earnings (loss) per share — Basic & Diluted:

Loss before cumulative effect of change in the application of accounting principle
$ (1.17 ) $ (0.05 ) $ — $ (.39 ) $ (0.74 )

Cumulative effect of change in the application of accounting principle:
$ 0.02 — $ — $ 0.02 —

Net income (loss)
$ (1.15 ) $ (0.05 ) $ — $ (0.36 ) $ (0.74 )

Weighted Average number of common shares (4):

Basic
5,798,619 5,780,911

Diluted
5,798,619 5,780,911


(1)		Impact of correcting for the failure to comply with the documentation requirements of FAS 133, hedge accounting, for changing the exchange rates to period end spot rates at the Company’s MECAR subsidiary for its foreign currency transactions and other adjustments related to sales contracts.

(2)		Impact of correcting the measurement date for options granted in February 2002 by the Compensation Committee of the Board of Directors of the Company that were subject to subsequent stockholder approval that was obtained in June 2002.

(3)		Impact of change in accounting principle on revenue recognition at the Company’s MECAR subsidiary.

(4)		Shares Outstanding for the period were restated to correct for deferred compensation for the outside directors that was stock based that had been incorrectly excluded from the earnings per share calculation in the period.

F-48

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

Impact from

Foreign
Impact from
Impact of
Results

Currency
Compensation
Revenue
Excluding

December 31, 2005
Restated Translation(1) Expense(2) Recognition(3) Impact

Revenues
$ 35,227 $ 1,227 $ — $ (12,091 ) $ 46,091

Cost of Sales
$ 28,989 — — (15,061 ) 44,050

Operating Income (loss)
(12,886 ) 1,227 — 2,970 (17,083 )

Earnings before income taxes and the cumulative effect of change in application of accounting principle
(15,792 ) 1,072 — 2,970 (19,834 )

Income tax expense (benefit)
6,607 122 — 384 6,101

Cumulative effect of change in the application of accounting principle
79 — — 79 —

Net earnings (loss)
(22,320 ) 950 — 2,665 (25,935 )

Earnings (loss) per share — Basic & Diluted:

Loss before cumulative effect of change in the application of accounting principle
$ (3.73 ) $ 0.16 $ — $ .43 $ (4.32 )

Cumulative effect of change in the application of accounting principle:
$ 0.01 — $ — $ 0.01 —

Net income (loss)
$ (3.72 ) $ 0.16 $ — $ 0.44 $ (4.32 )

Weighted Average number of common shares (4):

Basic
6,001,941 6,001,941

Diluted
6,001,941 6,001,941


(1)		Impact of correcting for the failure to comply with the documentation requirements of FAS 133, hedge accounting, for changing the exchange rates to period end spot rates at the Company’s MECAR subsidiary for its foreign currency transactions and other adjustments related to sales contracts.

(2)		Impact of correcting the measurement date for options granted in February 2002 by the Compensation Committee of the Board of Directors of the Company that were subject to subsequent stockholder approval that was obtained in June 2002. (3) Impact of change in accounting principle on revenue recognition at the Company’s MECAR subsidiary. (4) Shares Outstanding for the period were restated to correct for deferred compensation for the outside directors that was stock based that had been incorrectly excluded from the earnings per share calculation in the period.


	First		Second			Third		Fourth
2004, restated	Quarter		Quarter			Quarter		Quarter			Total
	(Amounts in Thousands, except per share data)

Revenues	$	37,420	$	19,348		$	61,276	$	28,157		$	146,201
Gross profit		13,352		(8,997	)		34,294		1,733			40,382
Net earnings (loss)		3,363		(11,657	)		16,726		(7,062	)		1,370
Per share Net Earnings (Loss):
Basic	$	.61	$	(2.10	)	$	3.01	$	(1.27	)	$	0.25

Diluted	$	.56	$	(2.10	)	$	2.81	$	(1.27	)	$	0.24

F-49

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

First
Second
Third
Fourth

2004 (As previously reported in 10-K/A)
Quarter Quarter Quarter Quarter Total

(Amounts in Thousands, except per share data)

Revenues
$ 33,090 $ 39,069 $ 34,927 $ 43,045 $ 150,131

Gross profit
9,023 10,723 7,945 16,504 44,195

Net earnings (loss)
(6 ) 1,608 (567 ) 2,899 3,934

Per share Net Earnings (Loss):

Basic
$ (0.01 ) $ 0.29 $ (0.10 ) $ 0.52 $ 0.71

Diluted
$ (0.01 ) $ 0.27 $ (0.10 ) $ 0.49 $ 0.70

Note X — Off-Balance Sheet Transaction

In 2005 the Company and the Marshall Economic Development Corporation (MEDCO)entered into an agreement under which MEDCO agreed to provide funds for the build out of the initial MECAR USA facilities. MEDCO is a state funded organization chartered to assist in the creation of manufacturing jobs in the Marshall, Texas areas by facilitating the construction of roads and buildings for companies willing to locate manufacturing facilities in the local area.. As part of the incentive package, MEDCO contributed $500 to MECAR USA toward the construction of facilities (used predominately for the installation of roads and utilities) and $1,650 worth of land to house these facilities. The Company provided $640 towards the construction of the initial buildings which was capitalized and is being amortized as an asset over the term of the lease, The agreement between the Company and MEDCO calls for a ten year lease, commencing October 1, 2004 at a total lease cost of $1 (one dollar) with a buyout option for the building and land at the end of the lease provided certain hiring targets are achieved. If at the end of the lease term the Company has created at least 175 full time jobs at the Marshall facility (at MECAR USA and Titon), MEDCO will convey title to the land and the facilities for which they provided funding, to the Company without any additional payment by the Company. If at the end of the lease term the Company has continuously occupied and used the facilities but has not fully met the 175 job goal, the Company will have the option to purchase the land and facilities at a price to be computed based on the actual number of full time jobs created. The purchase price will be equal to 175 minus the actual number of full time jobs created as of October 2014 times $9,750 dollars.

Note Y — Subsequent Event

In March 2006, the Company entered into a Securities Purchase Agreement (the “Agreement”) with several purchasers for the private placement of Senior Subordinated Convertible Notes (the “Notes”) in the principal amount of $30,000 and related warrants to purchase common stock. In connection with the Agreement the Company entered into a Registration Rights Agreement with the purchasers.

The Notes will accrue interest at a rate of 7.5% per annum, subject to adjustment, with accrued interest payable quarterly in arrears in cash. The Notes mature on March 9, 2011, and the Notes are convertible into shares of common stock of Allied at a conversion price of $26.46, subject to anti-dilution provisions, as well as for adjustment for stock splits. Upon a change of control as defined in the Notes, the holders of the Notes will have certain redemption rights.

In connection with the issuance of the Notes, the Company issued detachable warrants (the “warrants”) to the Purchasers exercisable for an aggregate of 226,800 shares of Allied common stock. The Warrants are exercisable for a term of five years at an exercise price of $27.68 per share, subject to anti-dilution provisions similar to the provisions set forth in the Notes and expire on March 9, 2011.

Pursuant to the Registration Rights Agreement, Allied will file a registration statement to cover the resale of the Conversion Shares and the Warrant Shares. In connection with the Transactions, Allied has also agreed to pay

F-50

THE ALLIED DEFENSE GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(Thousands of Dollars)

certain fees and expenses (including warrants) to the placement agent, Cowen & Co., LLC for its activity engaged on behalf of Allied.

The Company determined that the Notes are hybrid instruments and the warrants are derivatives that should be carried at fair value, with any changes in fair value reported as gains or losses in subsequent periods. The notes were deemed to have embedded derivatives with the terms of the agreement and such derivatives were bifurcated from the notes. In March, 2006, the Company adopted SFAS 155, “Accounting for Certain Hybrid Instruments”, which allows the Company to make irrevocable election to initially and subsequently measure a hybrid financial instrument in its entirety at fair value after having identified all embedded derivative features, contained in a hybrid instrument. The Company identified and documented the embedded derivative features, and the irrevocably elected to measure and carry the notes at fair value. At March 9, 2006, the fair value of the notes was calculated to be $29,120.

The Warrants did not meet the requirement for equity classification in accordance with SFAS 133, “Accounting for Derivatives and Hedging Activities”, mainly because the Warrants are required to settle in registered shares of the Company’s common stock.

The Warrants were recorded as a derivative instrument and will be recorded and carried at the fair value of the instrument. At March 9, 2006, the fair value of the Warrants was $2,014.

F-51

SCHEDULE I — CONDENSED FINANCIAL INFORMATION OF REGISTRANT

THE ALLIED DEFENSE GROUP, INC.
(Parent Company)

BALANCE SHEETS


	December 31,
	2005		2004
			Restated
	(Thousands of Dollars)

ASSETS
Cash and equivalents	$	1,267	$	1,017
Restricted cash		2,000		2,012
Investment in subsidiaries		99,451		125,837
Due from subsidiaries		322		1,202
Deferred taxes		—		1,485
Other		1,411		1,125

Total assets	$	104,451	$	132,678


LIABILITIES AND STOCKHOLDERS’ EQUITY

Liabilities
Accounts payable and accrued liabilities	$	2,811	$	1,995
Income tax		102		4
Deferred Compensation		160		376
Long term debt, less unamortized discount		19,712		1,959
Convertible Debenture, less unamortized discount		—		2,231

Total liabilities		22,785		6,565
Stockholders’ Equity
Common stock		598		560
Capital in excess of par value		34,354		27,910
Retained earnings		34,466		73,386
Accumulated other comprehensive loss		12,248		24,257

		81,666		126,113

	$	104,451	$	132,678

F-52

SCHEDULE I — CONDENSED FINANCIAL INFORMATION OF REGISTRANT — (Continued)

THE ALLIED DEFENSE GROUP, INC.
(Parent Company)

STATEMENTS OF CASH FLOWS


	Year ended December 31,
	2005			2004			2003
				(Restated)			(Restated)

Cash flows from operating activities
Net earnings (loss) for the year	$	(38,920	)	$	1,370		$	2,718
Adjustments to reconcile net earnings (loss) to net cash from (used in) operating activities
Equity in operations of subsidiaries		29,972			(3,411	)		(5,506	)
Dividend from subsidiary		10,430			—			14,186
Depreciation and amortization		50			47			46
Deferred taxes		1,485			(804	)		(528	)
Amortization of debenture issue costs and conversion feature		220			179			243
Common stock and stock option awards		404			539			561
Changes in assets and liabilities
Restricted Cash		—			—			—
Other assets		(497	)		(477	)		(546	)
Due to subsidiaries		880			(1,605	)		(3,492	)
Accounts payable and accrued liabilities		816			1,270			(30	)
Deferred compensation		(216	)		(27	)		191
Income taxes		98			4			—

		43,642			(4,285	)		5,125

Net cash provided by (used in) operating activities		4,722			(2,915	)		7,843
Cash flows used in investing activities
Capital expenditures		(9	)		(10	)		(3	)
Equity infusions in subsidiaries		(7,353	)		(6,367	)		—
Acquisitions		(9,443	)		(125	)		—

Net cash used in investing activities		(17,266	)		(6,502	)		(3	)
Cash flows from financing activities
Proceeds from issuance of long-term debt		12,000			2,000			—
Debt issue costs		—			(77	)		—
Principal payments on debenture		(2,478	)		(5,250	)		—
Proceeds from employee stock purchase plan		108			261			152
Proceeds from option exercises		2,691			348			765
Restricted cash		12			(1,887	)		—

Net cash provided by (used in) financing activities		12,333			(4,605	)		1,042

Net increase (decrease) in cash and equivalents		250			(14,022	)		8,882
Cash and equivalents at beginning of year		1,017			15,039			6,157

Cash and equivalents at end of year	$	1,267		$	1,017		$	15,039

Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for:
Income taxes	$	—		$	45		$	—
Interest		496			641			590
Supplemental of Non-Cash Investing and Financing Activities:
Non-cash consideration in connection with business acquisition		8,672			—			—
Warrants issued in conjunction with long term debt		488			68			—

F-54

SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS

THE ALLIED DEFENSE GROUP, INC.

Valuation and Qualifying Accounts

Years ended December 31, 2005, 2004 and 2003


			Additions
	Balance at		Charged to		Charged					Balance
	beginning		costs and		to other					at end of
Description	of period		expenses		accounts		Deductions			period
	(In Thousands)

*Year ended December 31, 2005*
Estimated losses on contracts	$	726	$	39	$	—	$	765	(1)	$	—

Allowance for doubtful receivables	$	143	$	334	$	—	$	263	(2)	$	214

Valuation allowance on inventory	$	668	$	1,584	$	—	$	1,473		$	779

Valuation allowances on deferred tax assets	$	1,466	$	11,318	$	—	$	—	(3)	$	12,784

Warranty reserve	$	912	$	98	$	—	$	191		$	819

*Year ended December 31, 2004*
Estimated losses on contracts	$	283	$	726	$	—	$	283	(1)	$	726

Allowance for doubtful receivables	$	115	$	143	$	—	$	115	(2)	$	143

Valuation allowance on inventory	$	214	$	454	$	—	$	—		$	668

Valuation allowances on deferred tax assets	$	4,117	$	1,466	$	—	$	4,117	(3)	$	1,466

Warranty reserve	$	944	$	61	$	—	$	93		$	912

*Year ended December 31, 2003*
Estimated losses on contracts	$	313	$	283	$	—	$	313	(1)	$	283

Allowance for doubtful receivables	$	233	$	115	$	—	$	233	(2)	$	115

Valuation allowance on inventory	$	200	$	14	$	—	$	—		$	214

Valuation allowances on deferred tax assets	$	1,244	$	2,873	$	—	$	—		$	4,117

Warranty reserve	$	826	$	262	$	—	$	144		$	944


(1)		Represents amount of reserve relieved through completion of contracts.

(2)		Represents write-off of receivables.

(3)		Represents amounts of valuation allowance relieved through use of deferred tax assets.

F-55


	Page

Management’s Report on Internal Controls Over Financial Reporting		F-3
Report of Independent Registered Public Accounting Firm		F-5
Report of Independent Registered Public Accounting Firm		F-7
Report on Independent Registered Public Accounting Firm		F-8
Consolidated Balance Sheets at December 31, 2005 and 2004		F-9
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2005		F-11
Consolidated Statements of Stockholders’ Equity for each of the three years in the period ended December 31, 2005		F-12
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2005		F-13
Notes to Consolidated Financial Statements		F-14
Schedules as of and for the three years ended December 31, 2005
Schedule I — Condensed Financial Information of Registrant		F-52
Schedule II — Valuation and Qualifying Accounts		F-55
Exhibit 18.1
Exhibit 21
Exhibit 23
Exhibit 23.1
Exhibit 31.1
Exhibit 31.2
Exhibit 32


Number			Description of Exhibit	Page

	18	.1	Letter from independent public accountant related to change in application of accounting principle	E-2
	21		List of Subsidiaries	E-3
	23		Consent of Independent Registered Public Accounting Firm	E-4
	23	.1	Consent of Independent Registered Public Accounting Firm	E-5
	31	.1	Certification of Chief Executive Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002, dated October 6, 2006	E-6
	31	.2	Certification of Chief Financial Officer pursuant to Section 302 of Sarbanes-Oxley Act of 2002, dated October 6, 2006	E-7
	32		Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of Sarbanes-Oxley Act of 2002, dated October 6, 2006	E-8