UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended September 30, 2004

OR

For the Transition Period from                     to.                   

Commission File Number: 000-27687

BSQUARE CORPORATION

(425) 519-5900
(Registrant’s telephone number, including area code)

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

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

As of October 31, 2004, there were 37,935,199 shares of the registrant’s common stock outstanding.

BSQUARE CORPORATION

FORM 10-Q

For the Quarterly Period Ended September 30, 2004

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

BSQUARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

See notes to condensed consolidated financial statements.

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BSQUARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2004
(unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by BSQUARE Corporation (the “Company” or “BSQUARE”) pursuant to the rules and regulations of the Securities and Exchange Commission for interim financial reporting and include the accounts of the Company and its subsidiaries. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. In the opinion of the Company, the unaudited financial statements reflect all adjustments necessary for a fair presentation, in conformity with U.S. generally accepted accounting principles, of the Company’s financial position at September 30, 2004 and its operating results and cash flows for the three and nine months ended September 30, 2004 and 2003. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Examples include provision for bad debts, estimates of progress on professional service arrangements, loss contract accruals and valuation of long-lived assets. Actual results may differ from these estimates. Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with the financial statements and notes thereto contained in the Company’s annual report on Form 10-K for the year ended December 31, 2003 and the quarterly reports on Form 10-Q for the three months ended March 31, 2004 and June 30, 2004 filed with the Securities and Exchange Commission. Certain reclassifications have been made for consistent presentation.

Stock-Based Compensation

The Company has elected to follow Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, in accounting for employee stock options rather than the alternative fair value accounting allowed by Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation.” Under APB No. 25, compensation expense related to the Company’s employee stock options is measured based on the intrinsic value of the stock option. SFAS No. 123, amended by SFAS No. 148 “Accounting for Stock-Based-Compensation — Transition and Disclosure,” requires companies that continue to follow APB No. 25 to provide pro forma disclosure of the impact of applying the fair value method of SFAS No. 123. The Company recognizes compensation expense for options granted to non-employees in accordance with the provisions of SFAS No. 123 and the Emerging Issues Task Force consensus Issue 96-18, “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling Goods or Services,” which require using the Black-Scholes option pricing model and re-measuring such stock options to the current fair market value as the underlying options vest.

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Pro forma information regarding net loss is required by SFAS No. 123 and SFAS No. 148 as if the Company had accounted for its employee stock options under the fair value method. The fair value of the Company’s options was estimated on the date of grant using the Black-Scholes method, with the following weighted average assumptions:

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options’ vesting period. The following table illustrates what net income or net loss would have been had the Company accounted for its stock options under the provisions of SFAS No. 123 and SFAS No. 148 (in thousands, except per share data):

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On October 13, 2004, the Financial Accounting Standards Board (FASB) concluded that Statement 123R, Share-Based Payment (FASB 123R), which would require all companies to measure compensation cost for all share-based payments (including employee stock options) at fair value, would be effective for public companies for interim or annual periods beginning after June 15, 2005 . Retroactive application of the requirements of Statement 123 (not Statement 123R) to the beginning of the fiscal year that includes the effective date would be permitted, but not required.

The Company would be required to apply Statement 123R beginning July 1, 2005 and could choose to apply Statement 123 retroactively from January 1, 2005 to June 30, 2005. The cumulative effect of adoption, if any, would be measured and recognized on July 1, 2005.

The FASB has tentatively concluded that companies could adopt the new standard in one of two ways:

•		Modified prospective transition method (the method proposed in the Exposure Draft). A company would recognize share-based employee compensation cost from the beginning of the fiscal period in which the recognition provisions are first applied as if the fair-value-based accounting method had been used to account for all employee awards granted, modified, or settled after the effective date and to any awards that were not fully vested as of the effective date.
		Measurement and attribution of compensation cost for awards that are nonvested as of the effective date of the proposed Statement would be based on the same estimate of the grant-date fair value and the same attribution method used previously under Statement 123 (either for recognition or pro forma purposes).

•

Modified retrospective transition method. A company would recognize employee compensation cost for periods presented prior to the adoption of Statement 123R in accordance with the original provisions of Statement 123; that is, an entity would recognize employee compensation cost in the amounts reported in the pro forma disclosures provided in accordance with Statement 123. A company would not be permitted to make any changes to those amounts upon adoption of the proposed Statement unless those changes represent a correction of an error (and are disclosed accordingly). For periods after the date of adoption of Statement 123R, the modified prospective transition method described above would be applied.

The FASB plans to issue a final statement on or around December 15, 2004. Management is currently evaluating the potential impact of this pronouncement.

Earnings Per Share

Basic earnings per share is computed using the weighted average number of common shares outstanding during the period, and excludes any dilutive effects of common stock equivalent shares. Diluted earnings per share is computed using the weighted average number of common and common stock equivalent shares outstanding during the period, such as stock options and warrants, using the treasury stock method. Common stock equivalent shares are excluded from the computation if their effect is antidilutive.

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The following table reconciles the denominator used for basic income (loss) per share to the denominator used for diluted income (loss) per share (in thousands):

As of September 30, 2004 and 2003, there were stock options and warrants outstanding to acquire 6,928,398 and 4,889,806 common shares, respectively, that were excluded from the computation of diluted income (loss) per share because their effect was antidilutive.

2. Discontinued Operations and Restructuring and Related Charges (Credit)

Restructuring and related charges (credits) included in income (loss) from continuing operations include the following (in thousands):

In the first quarter of 2004, $30,000 in assets related to the Company’s now closed Japan operation and $10,000 of related charges were charged to restructuring expense.

Restructuring and impairment charges (credits) included in income (loss) from discontinued operations include the following (in thousands):

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During the second quarter of 2004, the Company’s Board of Directors decided to discontinue the Company’s hardware business unit, resulting in a $3.3 million charge in that quarter, of which $1.8 million related to the impairment of inventory, $608,000 related to the impairment of tooling, $585,000 related to the impairment of prepaid software licenses used in the Company’s Power Handheld device, $120,000 related to severance for eight employees terminated, representing 7% of the Company’s then remaining workforce, and $162,000 related to other charges.

During the third quarter of 2004, the Company was able to sell some of the inventory written-off in the second quarter of 2004 for more than originally anticipated, resulting in an adjustment to the impairment of assets charge. Certain costs associated with disposition of the hardware tooling were ultimately determined to be less than anticipated in the second quarter of 2004 resulting in an adjustment to other charges in the third quarter of 2004. Remaining liabilities related to the discontinued hardware business unit, totaling $155,000 as of September 30, 2004.

During the first quarter of 2004, the Company eliminated ten positions in the hardware business, representing 7% of the Company’s then remaining workforce. The Company incurred severance of $79,000, paid in April 2004, and $10,000 of related charges.

The following table provides a rollforward of accrued restructuring costs (in thousands):

A reconciliation of income (loss) from discontinued operations for the three and nine months ended September 30, 2004 and 2003 is presented below (in thousands):

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Included in operating expenses of the discontinued operations was $263,000 for the three months ended September 30, 2003, and $74,000 and $678,000 for the nine months ended September 30, 2004 and 2003, respectively, related to corporate allocations, which will be allocated to continuing operations in future periods. There were no such allocations in the three months ended September 30, 2004.

3. Other Intangible Assets

The Company’s intangible assets subject to amortization consisted of the following (in thousands):