Back to GetFilings.com

Table of Contents

U.S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

[X]

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

For the quarterly period ended September 30, 2002

[   ]

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

For the transition period from __________to__________

Commission File Number 0-22498

Acres Gaming Incorporated

7115 Amigo Street, Suite 150
Las Vegas, NV 89119
(Address of principal executive offices)

702-263-7588
(Registrant’s telephone number)

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

     The number of shares outstanding of the Registrant’s Common Stock, par value $.01 per share, as of October 31, 2002 was 9,574,556.

Table of Contents

ACRES GAMING INCORPORATED

Table of Contents

		Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets at September 30, 2002 (unaudited) and June 30, 2002			1
Consolidated Statements of Operations for the Three Months Ended September 30, 2002 and 2001 (unaudited)			2
Consolidated Statements of Cash Flows for the Three Months Ended September 30, 2002 and 2001 (unaudited)			3
Notes to Consolidated Financial Statements			4
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			9
Item 3. Quantitative and Qualitative Disclosures About Market Risk			14
Item 4. Controls and Procedures			14
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			16
Item 6. Exhibits and Reports on Form 8-K			16
SIGNATURES			17
302 CERTIFICATIONS			18
INDEX TO EXHIBITS			20

Table of Contents

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

ACRES GAMING INCORPORATED
CONSOLIDATED BALANCE SHEETS

				September 30, 2002				June 30, 2002
				(unaudited)
				(in thousands, except share data)
ASSETS
CURRENT ASSETS:
	Cash and equivalents			$	10,280			$	7,312
	Receivables, net of allowance of $951 and $932, respectively				8,116				7,582
	Inventories				4,019				3,985
	Prepaid expenses				423				439
		Total current assets			22,838				19,318
PROPERTY AND EQUIPMENT:
	Furniture and fixtures				1,952				1,944
	Equipment				3,716				3,618
	Leasehold improvements				486				486
	Accumulated depreciation				(5,483	)			(5,280	)
		Total property and equipment, net			671				768
OTHER ASSETS, Net					656				786
TOTAL ASSETS				$	24,165			$	20,872
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
	Accounts payable			$	2,529			$	2,277
	Accrued compensation				537				654
	Accrued other expenses				504				254
	Deferred revenue				6,993				4,375
	Convertible subordinated debentures, current				3,457				3,600
	Note payable, current				100				100
		Total current liabilities			14,120				11,260
	Convertible subordinated debentures, net of current portion and discount				—				677
	Note payable, net of current portion				344				369
		Total liabilities			14,464				12,306
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY:
	Common Stock, $.01 par value, 50 million shares authorized, 9.5 million and 9.4 million shares issued and outstanding, respectively				95				94
	Additional paid-in capital				22,636				22,003
	Deferred stock-based compensation, net				(471	)			(552	)
	Accumulated deficit				(12,559	)			(12,979	)
		Total stockholders’ equity			9,701				8,566
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY				$	24,165			$	20,872

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

1

Table of Contents

ACRES GAMING INCORPORATED
CONSOLIDATED STATEMENTS OF OPERATIONS

For the Three Months Ended September 30, 2002 and 2001
(unaudited)

				Three months ended
				September 30,
				2002				2001
				(in thousands except per share data)
NET REVENUES				$	5,945			$	6,092
COST OF REVENUES					1,878				3,079
GROSS PROFIT					4,067				3,013
OPERATING EXPENSES:
	Research and development				1,484				1,496
	Selling, general and administrative				1,933				1,163
		Total operating expenses			3,417				2,659
INCOME FROM OPERATIONS					650				354
INTEREST AND OTHER INCOME (EXPENSE), NET					(230	)			63
NET INCOME				$	420			$	417
NET INCOME PER SHARE — BASIC				$	.05			$	.05
NET INCOME PER SHARE — DILUTED				$	.04			$	.04

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

2

Table of Contents

ACRES GAMING INCORPORATED
CONSOLIDATED STATEMENTS OF CASH FLOWS

For the Three Months Ended September 30, 2002 and 2001
(unaudited)

						Three months ended
						September 30,
						2002				2001
						(in thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
	Net income					$	420			$	417
	Adjustments to reconcile net income to net cash provided by (used in) operating activities:
		Depreciation and amortization					259				358
		Amortization of debt issuance costs					88				—
		Amortization of debt discount					81				—
		Amortization of deferred stock-based compensation					81				81
		Provision for doubtful accounts					19				411
		Changes in assets and liabilities:
			Receivables				(553	)			245
			Inventories				(34	)			(681	)
			Prepaid expenses				16				(89	)
			Accounts payable and accrued expenses				385				(1,956	)
			Accrued litigation settlement obligation				—				(678	)
			Deferred revenue				2,618				(1,108	)
				Net cash provided by (used in) operating activities			3,380				(3,000	)
CASH FLOWS FROM INVESTING ACTIVITIES:
	Purchase of property and equipment						(106	)			(120	)
	Other, net						(14	)			(20	)
				Net cash used in investing activities			(120	)			(140	)
CASH FLOWS FROM FINANCING ACTIVITIES:
	Issuance of common stock, net						33				—
	Payments for subordinated convertible debentures						(300	)			—
	Payments on note payable						(25	)			8
				Net cash provided by (used in) financing activities			(292	)			8
NET INCREASE (DECREASE) IN CASH AND EQUIVALENTS							2,968				(3,132	)
CASH AND EQUIVALENTS AT BEGINNING OF PERIOD							7,312				11,958
CASH AND EQUIVALENTS AT END OF PERIOD						$	10,280			$	8,826

Supplemental Cash Flow Disclosures:

During the quarter ended September 30, 2002, the debenture holders elected to take stock rather than cash in satisfaction of $600,000 of principal redemptions.

The Company recorded interest paid in the amount of $5,585 and $3,014 for the quarter ended September 30, 2002 and 2001, respectively.

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

3

Table of Contents

ACRES GAMING INCORPORATED

Notes to Unaudited Consolidated Financial Statements

1. Unaudited Consolidated Financial Statements

     Certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted from these unaudited consolidated financial statements. These statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended June 30, 2002 filed with the Securities and Exchange Commission.

     In the opinion of management, the interim consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results of the interim period. The results of operations for the three-month period ended September 30, 2002 are not necessarily indicative of the expected operating results for the full year or future periods.

2. Revenue Recognition

     The Company sells certain of its products under contracts that generally provide for a deposit to be paid before commencement of the project and for a final payment to be made after completion of the project. Customer deposits received under sales agreements are reflected as deferred revenue until the related revenue is recognized.

     Revenue for hardware sales is recognized when hardware components and primary application software have been installed and are available for the customer’s use. For software license revenue, the Company applies the provisions of Statement of Position 97-2, Software Revenue Recognition (“SOP 97-2”), and Statement of Position 98-9 Modification of SOP 97-2 (“SOP 98-9”), Software Revenue Recognition with Respect to Certain Transactions, which amends SOP 97-2. The Company’s sales of software products generally include multiple elements such as installation of software, training, post contract customer support and maintenance services. SOP 97-2 and SOP 98-9, as amended, generally require revenue earned on software arrangements involving multiple elements to be allocated to each element based on the relative fair values of the elements. The fair value of an element must be based on the evidence that is specific to the vendor (vendor-specific objective evidence or “VSOE”). The Company follows the residual method under SOP 97-2 for software product sales with multiple elements. Software license revenue is recognized upon acceptance of the software. The only undelivered element at the time of revenue recognition for software is generally support and maintenance services. The Company uses renewal rates to establish VSOE for support and maintenance services. Revenue allocated to support and maintenance is recognized ratably over the maintenance term.

     The Company has entered into certain manufacturing royalty agreements where revenue is recognized as the licensed manufacturer sells the related hardware products.

     For certain contracts requiring significant product customization, revenue is recognized on the percentage-of-completion method. Labor costs incurred for customization and installation are the basis for determining percentage-of-completion, giving effect to the most recent estimates of such total labor costs. The effect of changes to total estimated customization and installation labor costs is recognized in the period in which such changes are determined. The Company defers revenue subject to penalty, forfeiture, refund or other concession until such factors have expired and the revenue meets the criteria for collectibility. Provisions for estimated losses are made in the period in which the loss first becomes apparent.

     Included in accounts receivable are unbilled receivables of $894,000 and $757,000 at September 30 and June 30, 2002, respectively. Unbilled receivables represent revenues recognized in excess of billings on certain contracts accounted for under the percentage of completion method. Unbilled receivables were not billable at the balance sheet date, but were recoverable as billings were made in accordance with the contract terms.

4

Table of Contents

3. Recent Accounting Pronouncements

     In July 2001, the Financial Accounting Standards Board issued Statement No. 141 (“SFAS 141”), “Business Combinations” and Statement No. 142 (“SFAS 142”), “Goodwill and Other Intangible Assets”. SFAS 141 is effective as follows: (a) use of the pooling-of-interests method is prohibited for business combinations initiated after June 30, 2001; and (b) the provisions of SFAS 141 also apply to all business combinations accounted for by the purchase method that are completed after June 30, 2001. There are also transition provisions that apply to business combinations completed before July 1, 2001 which were accounted for by the purchase method.

     SFAS 142 is effective for fiscal years beginning after December 15, 2001 and applies to all goodwill and other intangible assets recognized in an entity’s statement of financial position at that date, regardless of when those assets were initially recognized.

     In August 2001, the Financial Accounting Standards Board issued Statement No. 143 (“SFAS 143”), “Accounting for Obligations Associated with the Retirement of Long-Lived Assets”. The objectives of SFAS 143 are to establish accounting standards for the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. SFAS 143 is effective for fiscal years beginning after June 15, 2002.

     In October 2001, the Financial Accounting Standards Board issued Statement No. 144 (“SFAS 144”), “Accounting for the Impairment or Disposal of Long-Lived Assets.” SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS 144 is effective for fiscal years beginning after December 15, 2001 and, generally, is to be applied prospectively.

     The Company has adopted SFAS 141, SFAS 142, SFAS 143 and SFAS 144 and such adoption had no effect on the Company’s financial position, results of operations or cash flows.

     In April 2002, the Financial Accounting Standards Board issued Statement No. 145 (“SFAS 145”), “Rescission of FASB Statements Nos. 4, 44, and 64 and Amendment of FASB Statement No. 13.” SFAS 145 addresses the presentation for losses on early retirements of debt in the statement of operations. The Company has adopted SFAS 145 and will not present losses on early retirements of debt as an extraordinary item. Adoption of SFAS 145 had no effect on the Company’s financial position, results of operations or cash flows.

     In June 2002, the Financial Accounting Standards Board issued Statement No. 146 (“SFAS 146”), “Accounting for Costs Associated with Exit or Disposal Activities.” The provisions of SFAS 146 become effective for exit or disposal activities commenced subsequent to December 31, 2002. The Company is currently evaluating the provisions of SFAS 146 and it does not anticipate that the adoption of those provisions will have a material effect on its financial position, results of operations or cash flows.

4. Inventories

     Inventories consist of electronic components and other hardware, which are recorded at the lower of cost (first-in, first-out) or market. Inventories consist of the following:

5

Table of Contents

5. Capitalized Software and Research and Development Costs

     Software development costs for certain projects are capitalized from the time technological feasibility is established to the time the resulting software product is commercially feasible. Technological feasibility is deemed to be established when the Company, using the detail program design method, completes the research necessary to determine that the software can be produced to function according to required specifications at an economically feasible cost. Capitalized software costs, net of accumulated amortization of $973,000 and $937,000, were $88,000 and $124,000 at September 30 and June 30, 2002, respectively, and are included in other assets. Capitalized costs are amortized on a straight-line basis over the estimated life of the product beginning when the product becomes commercially feasible. The Company recorded $36,000 and $88,000 of amortization expense for the three-month periods ended September 30, 2002 and 2001, respectively.

     All research and development costs are expensed as incurred.

6. Income Taxes

     At September 30, 2002, the Company had cumulative net operating losses of approximately $14.8 million, and research and development tax credits of $1.5 million available to offset future taxable income and future income tax liabilities through 2020. The full realizability of these net operating loss carryforwards and research and development tax credits is uncertain and the Company has provided a valuation allowance for the entire amount. Accordingly, no income tax benefit was recorded for the quarter ended September 30, 2002.

7. Commitments and Contingencies

     Litigation

     Two lawsuits have been filed regarding ownership of the Wheel of Gold™ (“WOG”) technology that is the subject of two patents that were assigned to Anchor Gaming (“Anchor”). In the first suit, now pending in U.S. District Court for the District of Nevada, the WOG plaintiffs brought patent infringement, breach of warranty and breach of contract actions against the Company based on the WOG patents and the Company’s supply agreement with Anchor. Plaintiffs seek to enjoin the Company from infringing the WOG patents and from competing with it in the sale of wheel styled bonus gaming devices. The plaintiffs also seek unspecified compensatory damages for patent infringement and breach of contract, compensatory damages substantially in excess of $1.0 million for breach of warranty, treble damages, costs of suit, and attorney’s fees. The Company has denied the allegations and is pursuing a counterclaim in that proceeding for a declaration that the Company is the joint owner of the WOG patents. Discovery is closed. Currently pending before the Court are four summary judgment motions and one discovery-related motion filed by Anchor, as well as one summary judgment motion filed by the Company. No trial date has been set. The Company cannot predict the outcome, nor estimate the range of possible loss, if any, related to this suit but believes that an unfavorable outcome could have a material adverse effect on the Company’s financial condition, results of operations and cash flows. The second action regarding the WOG patents was filed by the Company against Anchor and Spin for Cash Wide Area Progressive Joint Venture (collectively, “Anchor”) in U.S. District Court for the District of Oregon. The Company alleges in the suit that Anchor wrongfully used the Company’s intellectual property to obtain the WOG patents, that the filing of the patent applications was fraudulently concealed from the Company, that Anchor was unjustly enriched by retaining the benefits of the Company’s technology without compensating the Company and that Anchor breached fiduciary duties owed to the Company. The Company seeks $40 million in compensatory damages, treble damages, costs of suit and attorneys’ fees. The Company has participated in court-mandated settlement conferences concerning the litigation, and the Oregon lawsuit has been stayed pending resolution of the first Anchor lawsuit.

     The defense of the first suit with Anchor was accepted by the Company’s former professional errors and omissions insurance carrier. However, in April 2000, the carrier denied coverage. The Company is involved in litigation, now pending in the U.S. District Court of Nevada, with its former insurance carrier regarding such coverage. On motions for summary judgment, the court found on February 28, 2002 that the insurance carrier has a duty to defend the Company against the lawsuit. A motion to have the court reconsider its decision filed by the insurance carrier is pending. The Company cannot predict the outcome of this suit.

     In a separate but related action, the Company sued its former general liability insurance carrier for breach of insurance contract related to the cost of defense of the claims alleged by the CDS defendant. That suit is now pending in U.S. District Court

6

Table of Contents

for the District of Nevada. The insurance carrier seeks a declaration that no coverage is provided for the claim; if coverage is provided it should be provided by the prior insurance carrier; and the Company must reimburse the insurance carrier for nominal amounts paid under its insurance policy to defend the Company. On motions for summary judgment, the court found on February 28, 2002 that the insurance carrier did not have a duty to defend the Company against the lawsuit and that the Company must repay the insurance carrier approximately $70,000 in defense costs previously paid by the insurance carrier. A motion seeking to have the court reconsider its decision filed by the Company is pending. At June 30, 2002, the Company recorded a liability in the amount of $70,000 to provide for the contingency. The Company cannot predict the outcome of this suit but believes that an unfavorable outcome would not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

     Wild Game NG, LLC, a Nevada limited liability company, which owns and operates Siena Hotel Spa Casino in Reno, Nevada, filed a lawsuit against the Company in November 2001 in the Second Judicial District Court of the State of Nevada in the County of Washoe. Siena alleges that the Company failed to perform its obligations under a $1.8 million Equipment Sale Agreement to install and maintain a networked slot accounting, cage and credit and player tracking system in Siena’s casino. Siena seeks unspecified damages in excess of $10,000. The Company believes that Siena’s claims are unfounded and has filed counterclaims seeking, among other things, payments Siena owes the Company for installation of the Company’s hardware in Siena’s casino. The Company cannot predict the outcome of this suit but believes that an unfavorable outcome would not have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

     The Company from time to time is involved in other various legal proceedings arising in the normal course of business.

     Purchase Commitments

     At September 30, 2002, the Company had $2.4 million outstanding under non-cancelable purchase commitments and safety-stock agreements with suppliers. These commitments generally require that the Company take physical delivery of and pay for the items within 180 days.

7

Table of Contents

8. Per Share Computation

     The Company reports basic and diluted earnings per share. Only the weighted average number of common shares issued and outstanding is used to compute basic earnings per share. The computation of diluted earnings per share includes the effect of stock options, warrants, convertible subordinated debentures and redeemable convertible preferred stock, if such effect is dilutive.

     (*) The Company’s earnings release issued on October 30, 2002 reported earnings per share that was rounded up from $.0463 to $.05 per diluted share for the quarter ended September 30, 2002. However, the Company’s calculation of earnings per share included a rounding error and an incorrect calculation of the number of fully diluted shares. After recalculating, the fully diluted earnings per share for the quarter has been rounded down from $.0434 to $.04 per diluted share.

     The following common stock equivalents were excluded from the earnings per share computations because their effect would have been anti-dilutive:

     ⁽¹⁾  The computation of earnings per share excludes (i) the effect of interest on convertible subordinated debentures and (ii) the effect of convertible subordinated debentures after application of the if-converted method because the combined effect would be anti-dilutive.

8

Table of Contents

9. Deferred Compensation

     The Company entered into an employment agreement with Floyd W. Glisson effective as of January 1, 2001 (the “Glisson Employment Agreement”), pursuant to which Mr. Glisson was granted a restricted stock award for 300,000 shares of the company’s common stock and received a base salary of $275,000 for the period from July 1, 2001 to June 30, 2002. No bonus was accrued or paid to Mr. Glisson for the fiscal year ended June 30, 2002. Half, or 150,000 shares, of the restricted stock become unrestricted on June 30, 2003, and the remaining 150,000 shares become unrestricted on June 30, 2005, subject to acceleration of a ratable portion of the remaining restricted shares in the applicable period if Mr. Glisson’s employment is terminated by the Company without cause. Pursuant to the Glisson Employment Agreement, Mr. Glisson will receive severance payments equal to 1.6 times his annual base salary under certain circumstances. Currently, Mr. Glisson’s annual compensation under the Glisson Employment Agreement consists of a base salary of $300,000 and a bonus of up to ninety percent of his annual base salary depending on the Company’s performance as measured against targets set by the Board of Directors.

     The 300,000 restricted shares of the Company’s Common Stock issued to Mr. Glisson have been included in the Common Stock issued and outstanding presented in the Company’s balance sheet. As of September 30 and June 30, 2002, approximately 112,500 and 100,000 shares, respectively would become unrestricted if Mr. Glisson’s employment were terminated by the Company. The Company recorded approximately $81,000 of compensation expense for the three-month periods ended September 30, 2002 and September 30, 2001, respectively. Approximately $471,000 and $552,000 of deferred compensation has been recorded to reflect the remaining restricted balance of the stock as of September 30 and June 30, 2002, respectively.

10. Convertible Subordinated Debentures

     On December 21, 2001, the Company sold to three institutional investors $5,000,000 principal amount of 6% convertible subordinated debentures that are convertible into shares of the Company’s common stock at $4.6433 per share. The investors also acquired warrants to purchase 177,674 shares of the Company’s common stock at an exercise price of $4.6433 per share. Interest on the debentures at the rate of 6% is payable semi-annually starting in April 2002. Principal payments of $300,000 are due monthly from June 2002 to August 2003 and principal payments of $500,000 are due monthly from September 2003 until the principal is repaid no later than December 21, 2003. During the quarter ended September 30, 2002, the debenture holders elected to receive cash for one of the three scheduled, monthly principal payments and elected to convert the other two scheduled, monthly principal payments into common stock of the Company. The Company may elect to pay the principal of and interest on the debentures in shares of its common stock at a discounted price rather than cash, in the case of principal payments, or market price, in the case of interest payments, as more fully described below. The Company also issued a warrant to purchase 75,317 shares of its common stock at an exercise price of $4.6433 per share to the placement agent in connection with the sale of the debentures and warrants.

     The Company may elect to repay the outstanding principal amount of the debentures in shares of its common stock, rather than in cash, at a conversion price equal to the lesser of $4.6433 or 90% of an average market price per share (the average of the five lowest daily volume-weighted average prices of the Company’s common stock on the Nasdaq Small Cap Market for the 22 consecutive trading days immediately preceding the conversion date). The Company may also elect to make interest payments due under the debentures in shares of its common stock, rather than in cash, at an interest conversion price, which will be calculated as the average of the daily volume-weighted average prices of the Company’s common stock on the Nasdaq SmallCap Market for the five consecutive trading days immediately preceding the interest payment date.

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

Overview

     The Company develops, manufactures and markets electronic equipment and software for the casino gaming industry. Many of the Company’s products are based on its proprietary Acres Bonusing Technology™ and are designed to enhance casino profitability by providing entertainment and incentives to players of gaming machines. The bonusing technology improves the efficiency of bonus and incentive programs currently offered by many casinos, and makes possible some bonus and incentive programs that have not previously been offered.

9

Table of Contents

     The Company’s financial position, operating results or cash flows may be materially affected by a number of factors, including the timing of receipt, installation and regulatory approval of any one order, availability of additional capital, competition and technological change.

Critical Accounting Policies and Estimates

     The Company’s financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Management of the Company has discussed the development and selection of these critical accounting estimates with the audit committee of our board of directors and the audit committee has reviewed the Company’s disclosure relating to them in this MD&A. Critical accounting policies for the Company include revenue recognition, accounting for research and development costs, and accounting for legal contingencies.

     Revenue Recognition

     Revenue for hardware sales is recognized when hardware components and the primary application software have been installed and are available for the customers’ use. The Company accounts for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. Revenue earned on software arrangements involving multiple elements is required to be allocated to each element based on the relative fair values of the elements. The Company’s sales of software products generally include multiple elements such as installation of software, training, post contract customer support and maintenance services. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and the specific terms of the agreement with the customer, could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products. Software license revenue is recognized upon acceptance of the software and the criteria for customer acceptance are generally defined by agreement. The only undelivered element at the time of revenue recognition for software is generally support and maintenance services. The Company uses renewal rates to establish VSOE for support and maintenance services. Revenue allocated to support and maintenance is recognized ratably over the maintenance term.

     The Company has entered into certain manufacturing royalty agreements where revenue is recognized as the licensed manufacturer sells the related hardware products.

     For certain contracts requiring significant product customization, revenue is recognized on the percentage-of-completion method. Labor costs incurred for customization and installation are the basis for determining percentage-of-completion, giving effect to the most recent estimates of such total labor costs. The effect of changes to total estimated customization and installation labor costs is recognized in the period in which such changes are determined. The Company defers revenue subject to penalty, forfeiture, refund or other concession until such factors have expired and the revenue meets the criteria for collectibility. Provisions for estimated losses are made in the period in which the loss first becomes apparent.

     Research and Development Costs

     The Company accounts for research and development costs in accordance with several accounting pronouncements, including SFAS 2, Accounting for Research and Development Costs, and SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. SFAS 86 specifies that costs incurred internally in creating a computer software product should be charged to expense when incurred as research and development until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when the technological feasibility of a product is established. The Company has determined that technological feasibility for its products is reached shortly before the products are released to customers. Costs incurred after technological feasibility is established are not material, and accordingly, the Company expenses all research and development costs when incurred.

10

Table of Contents

     Legal Contingencies

     The Company is subject to various legal proceedings and claims, the outcomes of which are subject to significant uncertainty. SFAS 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency should be accrued by a charge to income if it is probable that an asset has been impaired or a liability has been incurred and the amount of the loss can be reasonably estimated. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. The Company evaluates, among other factors, the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. Changes in these factors could materially impact the Company’s financial condition, results of operations and cash flow.

Results of Operations

     The Company’s net revenues during the quarter ended September 30, 2002 were $5.9 million compared to $6.1 million in the same quarter of fiscal 2002. The decrease in revenues is primarily attributable to the timing of hardware revenue for the quarter ended September 30, 2002, compared to the same quarter of fiscal 2002. The Company’s revenues fluctuate significantly based on the timing of the delivery of any large order. Revenues for the quarter ended September 30, 2002 consisted of $2.3 million for hardware components and $3.6 million for royalties and software and services sold to a number of customers. Software and services revenue for the quarter included $1.9 million in revenue for the first bonus installed at 5 of the 6 Station Casinos properties and for which the Company satisfied the customer’s acceptance criteria during the quarter ended September 30, 2002. Revenues in the quarter ended September 30, 2001 consisted of $3.5 million in hardware sales and $2.6 million of software and service sales.

     Gross profit margin was 68 percent in the current quarter compared to 49 percent in the same quarter of fiscal 2001. The higher gross profit margin was primarily attributable to the fact that the mix of software sales to hardware sales was greater during the quarter ended Septem