10-Q 1 scanoptics.txt UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 -------------------------------------------------- OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------------------ ------------------ Commission File No. 0-5265 ----------------------------------------------------- SCAN-OPTICS, INC. (Exact name of registrant as specified in its charter) Delaware 06-0851857 ------------------------------------ ------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 179 Allyn Street, Suite 508, Hartford, CT 06103 -------------------------------------------------------------------------------- (Address of principal executive offices) Zip Code (860) 547-1761 (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. ( X ) YES ( ) NO Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). ( ) YES ( X ) NO The number of shares of common stock, $.02 par value, outstanding as of November 1, 2005 was 41,451,577. 1

SCAN-OPTICS, INC. FORM 10-Q I N D E X PAGE NO. PART I - FINANCIAL INFORMATION Item 1. Consolidated Financial Statements.................................................... 3 Item 2. Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations.......................................................12. 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk ........................17.. 14 Item 4. Controls and Procedures............................................................. 1714 PART II - OTHER INFORMATION Item 46. ~~Submission of Matters to a Vote of Security Holders~~ Exhibits..............................~~18 Item 6~~. ~~Exhibits and Reports on Form 8-K~~............................................~~......18~~ 15

S PAPART I - FINANCIAL INFORMATION Item 1. Consolidated Financial Statements. SCAN-OPTICS, INC., AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED) (thousands, except share data) ~~June~~September 30, 2005 December 31, ~~Pro Forma June 2005~~ 2004 ~~30, 2005~~ -------------------------------------------------------------------------------------------------------------------- Assets Current Assets: Cash and cash equivalents $ ~~1,698~~0 $ 477 ~~$ 0~~ Accounts receivable less allowance of $~~131 at June 30, 2005 and $~~238 at December 31, 2004 ~~2,854~~0 4,314 0 Unbilled receivables - contracts in progress ~~289~~0 298 0 Inventories ~~7,714~~0 7,461 0 Prepaid expenses and other ~~880~~0 389 0 --------------------------------------------- Total current assets ~~13,435~~ 12,939 0 Equipment and Leasehold Improvements: Equipment ~~3,452~~0 3,386 0 Leasehold improvements ~~4,090~~0 4,089 0 Office furniture and fixtures ~~544~~0 557 0 --------------------------------------------- ~~8,086~~0 8,032 0 Less ~~allowances~~accumulated ~~for~~ depreciation and amortization ~~7,319~~0 7,095 0 --------------------------------------------- ~~767~~0 937 0 Goodwill 0 9,040 0 Other assets ~~951~~0 1,422 0 --------------------------------------------- Total Assets $~~15,153~~ 0 $ 24,338 ~~$ 0~~ =============================================

~~Pro Forma June~~ (thousands, except share data) ~~June~~September 30, 2005 December 31, 2004 ~~30, 2005~~ -----------------------------------------------------------------------------------------------------------~~-------------------------~~ Liabilities and Stockholders' Equity (Deficit) Current liabilities: ~~Notes~~Checks ~~payable~~outstanding toin ~~related~~excess ~~party~~of ~~including~~depository ~~long~~amounts ~~term~~$ ~~debt~~68 in$ ~~default~~0 ofNotes ~~$10,910~~payable $to ~~14,310~~related $party 0 1,000 ~~$ 0~~ Accounts payable ~~2,819~~262 2,822 ~~192~~ Salaries and wages ~~706~~0 702 0 Taxes other than income taxes ~~498~~446 641 ~~483~~ Income taxes 4456 68 59 Customer deposits ~~135~~0 143 0 Deferred revenues ~~3,787~~0 3,408 0 Other ~~1,119~~540 1,243 ~~689~~ ----------------------------------------~~-----------------------~~ Total current liabilities 231,~~418~~372 10,027 ~~1,423~~Note ~~Notes~~ payable to related party 0 10,605 0 Other liabilities ~~532~~0 537 ~~358~~ Mandatory redeemable preferred stock, at redemption ~~value~~Value: Series I, 420,857 shares issued and outstanding ~~872~~880 855 ~~872 --------------------------------------------------------------- Total Liabilities 24,822 22,024 2,653~~ Stockholders' Equity (Deficit) Preferred stock, par value $.02 per share,; ~~authorized~~ 5,000,000 ~~shares~~Shares authorized Common ~~stock~~Stock, par value $.02 per share:, authorized 65,000,000 shares; issued, - 41,865,077, ~~shares~~ including treasury shares 837 837 ~~837~~ Capital in excess of par value 4150,~~651~~960 41,651 ~~44,160~~ Accumulated retained- earnings deficit (4851,~~363~~403) (36,339) ~~(45,004)~~ Accumulated other comprehensive loss - currency ~~Translation~~0 (1,~~148) (1,~~189) 0translation adjustment ----------------------------------------~~-----------------------~~ ~~(7,023)~~394 4,960 ~~(7)~~Less ~~Cost~~cost of ~~common~~Common ~~stock~~Stock in treasury, 413,500 shares (2,646) (2,646) ~~(2,646)~~ ----------------------------------------~~-----------------------~~ Total stockholders' equity (deficit) (92,~~669~~252) 2,314 ~~(2,653)~~ ----------------------------------------~~-----------------------~~ Total Liabilities and Stockholders' Equity ~~(Deficit)~~ $ ~~15,153~~0 $ 24,338 ~~$ 0~~ ========================================~~=======================~~ See accompanying notes.

SCAN-OPTICS, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) Three Months Ended ~~Six~~Nine Months Ended ~~June~~September 30 ~~June~~September 30 (thousands, except share data) 2005 2004 2005 2004 -----------------------------------------------------------------------------------------------------------------~~------------------~~ Revenues Hardware and software $ ~~1,240~~410 $ 21,~~549~~935 $ 34,~~981~~391 $ 57,~~976~~911 Professional services ~~1,565~~303 1,~~497~~440 23,~~900~~203 34,~~007~~447 Access services ~~2,999~~807 2,~~832~~812 56,~~699~~506 58,~~228~~040 -----------------------------~~---------~~ -----------------------------~~-------~~ Total revenues 51,~~804~~520 6,~~878~~187 1214,~~580~~100 1420,~~211~~398 Costs of Revenue Hardware and software 1,~~631~~548 1,~~914~~527 35,~~957~~505 46,~~519~~046 Professional services ~~989~~441 ~~759~~626 12,~~783~~224 12,~~638~~264 Access services ~~2,315~~999 2,~~505~~174 45,~~566~~565 47,~~837~~011 -----------------------------~~---------~~ -----------------------------~~-------~~ Total costs of revenue 42,~~935~~988 54,~~178~~327 1013,~~306~~294 1015,~~994~~321 ----------------------------- -----------------------------~~-------------------~~ Gross Profit ~~869~~(Loss) (1,~~700~~468) 21,~~274~~860 3806 5,~~217~~077 Operating Expenses Sales and marketing ~~628~~461 ~~802~~871 1,~~333~~794 12,~~492~~363 Research and development ~~489~~176 ~~629~~381 ~~886~~1,062 1,~~180~~561 General and administrative ~~1,355~~863 1,~~665~~060 23,~~172~~035 23,~~498~~558 Goodwill impairment ~~9,040~~0 0 9,040 0 Interest Related party ~~615~~75 0 ~~871~~946 0 Other ~~191~~0 ~~358~~187 0 545 -----------------------------~~---------~~ -----------------------------~~-------~~ Total operating expenses 121,~~127~~575 32,~~287~~499 1415,~~302~~877 58,~~528~~027 -----------------------------~~---------~~ -----------------------------~~-------~~ Operating loss (113,~~258~~043) (~~1,587~~639) (1215,~~028~~071) (2,~~311~~950) Other income (loss), net 43 (214) 1013 3016 -----------------------------~~---------~~ -----------------------------~~-------~~ Loss before income taxes (113,~~254~~040) (~~1,589~~653) (1215,~~018~~058) (2,~~281~~934) Income taxes 0 3010 6 5060 -----------------------------~~---------~~ -----------------------------~~-------~~ Net Loss $ (113,~~254~~040) $ (~~1,619~~663) $ (1215,~~024~~064) $ (2,~~331~~994) =============================~~=========~~ =============================~~=======~~ Basic and diluted loss per share $ (0.2707) $ (0.2302) $ (0.2936) $ (0.3321) =============================~~=========~~ =============================~~=======~~ Basic and diluted weighted-average common shares 41,451,577 727,~~026~~606,~~232~~601 41,451,577 713,~~026~~961,~~232~~741 =============================~~=========~~ =============================~~=======~~ See accompanying notes.

SCAN-OPTICS, INC., AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) ~~Six~~Nine Months Ended ~~June~~September 30 (thousands) 2005 2004 ------------------------------------------------------------------------------------------------~~----------------------------~~ Operating Activities Net loss $ (1215,~~024~~064) $ (2,~~331~~994) Adjustments to reconcile net loss to net cash used by operating activities: Depreciation and amortization of equipment and leasehold ~~Improvements~~improvements ~~224~~270 ~~150~~270 Amortization of customer service inventory and development costs ~~835~~1,801 1,~~092~~548 Amortization of deferred debt costs 357 0143 Accretion of interest on related party debt 408 0 Accretion of interest on preferred stock 1725 0 Goodwill impairment 9,040 0 Provision for losses on accounts receivable 25 0543 Provision for inventory obsolescence 50113 0 Changes in operating assets and liabilities: Accounts receivable 1,~~444~~102 ~~636~~1,971 Inventories (1,~~026~~001) (12,~~096~~638) Prepaid expenses and other (~~491~~325) ~~(534)~~9 Checks outstanding in excess of depository amounts 68 0 Accounts payable ~~(3)~~350 ~~520~~643 Accrued salaries and wages 4125 (~~832~~835) Taxes other than income taxes (~~143~~160) (8129) Income taxes ~~(24)~~52 (8893) Deferred revenues ~~379~~586 ~~900~~1,164 Customer deposits ~~(8)~~219 (~~309~~315) Other (86436) (~~106~~360) ----------------------------------~~-------------~~ Net cash used by operating activities (12,~~022~~445) (~~2,079~~973) Investing Activities Purchases of equipment (5458) (~~101~~198) ----------------------------------~~--------------~~ Net cash used by investing activities (5458) (~~101~~198) Financing Activities Debt and equity transaction fees 0 (936) Cash transferred to lender with foreclosure agreement (758) 0 Proceeds from Wind down borrowings -from ~~all~~related party 487 0 Proceeds from aborrowings - related party in 2005 3,337 4,711 Principal payments on borrowings - ~~all from a~~ related party in 2005 (1,040) (2,200) ----------------------------------~~--------------~~ Net cash provided by financing activities 2,~~297~~026 21,~~511~~575 Change in cash and cash equivalents ~~1,221~~(477) ~~331~~404 Cash and Cash Equivalents at Beginning of Period 477 585 ----------------------------------~~-------------~~ Cash and Cash Equivalents at End of Period $ ~~1,698~~0 $ ~~916~~989 ==================================~~=============~~ See accompanying notes.

6 NOTE 1 - Basis of Presentation The accompanying unaudited interim condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for interim periods are not necessarily indicative of the results that may be expected for the year. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2004. The condensed consolidated balance sheet as of December 31, 2004 was derived from the audited financial statements for the year then ended. NOTE 2 - Foreclosure and Cessation of Business During the quarter ended June 30, 2005, the Company violated certain covenants of its credit agreement (the Credit Agreement) with lenders affiliated with Patriarch Partners, LLC (collectively, the Lenders). The Lenders own approximately 80% of the Company's common stock and all of its redeemable preferred stock. As a result of the covenant violations, on August 5, 2005, the Company entered into a Foreclosure Agreement with the Lenders. Under the Foreclosure Agreement the Company transferred substantially all of its assets to the Lenders to extinguish its obligations under the Credit Agreement (the outstanding principal under the Credit Agreement at the time of closing of the Foreclosure Agreement was $14,310,000). The Lenders also assumed certain liabilities of the Company, including but not limited to, certain accrued obligations with respect to current employees and certain trade payables and accrued expenses. None of the assets retained by the Company can be liquidated for cash. The Lenders also assumed certain employee benefit plans of the Company and certain of its insurance policies. In connection with the Foreclosure Agreement, the net carrying value of the liabilities extinguished exceeded the net carrying value of the assets transferred and liabilities assumed by $8.8 million. This amount has been reflected in additional paid-in-capital. Under the Foreclosure Agreement, the Company was permitted to obtain extended directors and officers insurance, and the Lenders agreed to assume or fund the defense of actions brought against the Company after the closing. At the closing the Company terminated all of its employees as of that time. Under the Foreclosure Agreement the Lenders agreed to fund certain expenses of the Company in its winding-down of its business, but the Company has no cash or other sources of liquidity. If the funds provided for in the wind-down budget are not used for the purposes specified in the budget, the Company is not entitled to receive any differential cash such funds provided are reflected in additional paid-in-capital. Following the closing of the Foreclosure Agreement, the Company ceased doing business and is expected to be dissolved in accordance with the applicable provisions of the Delaware 7 General Corporation Law. Following the closing of the Foreclosure Agreement, the Company's sole remaining executive officer is Scott Schooley who serves as President and Secretary of the Company. Following the closing of the Foreclosure Agreement, board of directors also voted to dissolve the Company, subject to requisite stockholder approval and compliance with the related SEC regulations. Because none of the assets retained by the Company can be liquidated for cash, there will be no residual value left to the holders of common stock of the Company following the closing of the Foreclosure Agreement and any winding-down of the Company's affairs. After the foreclosure of August 5, 2005, the Company was engaged in activities related to the wind down of its business affairs, including tax and legal filings, employee related matters, payment of vendors and Securities and Exchange Commission filings. Through September 30, 2005, the Company spent $487,000 on wind down activities. NOTE 3 - Stock Based Compensation The Company granted stock options to key employees and members of the Board of Directors with an exercise price equal to the fair value of the shares on the date of grant. The Company accounted for stock option grants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and, accordingly, recognized no compensation expense for the stock option grants. The Company has elected the disclosure provisions only of FASB Statement No. 123, "Accounting for Stock-Based Compensation". For the purpose of pro forma disclosures, the estimated fair value of the stock options is expensed ratably over the vesting period, which is generally 36 months for key employees and 6 months for the Board of Directors. 8 The following table illustrates the effect on net loss and loss per share as if the Company had applied the fair value recognition provisions of SFAS No. 123:

For the three months ended For the ~~six~~nine months ended ~~June~~September 30 ~~June~~September 30 (thousands, except per share amounts) 2005 2004 2005 2004 --------------------------------------------------------------------------------------------------------------------------- Net loss, as reported $ (113,~~303~~040) $ (~~1,619~~663) $(1215,~~073~~064) $(2,~~331~~994) Stock option expense ~~(8)~~3 (17732) ~~(17)~~15 (32764) ----------------------------------------------------------- Pro forma net loss $ (113,~~311~~037) $ (1,~~636~~395) $(1215,~~090~~049) $(23,~~363~~758) =============================================================== Basic and diluted loss per share, as reported $ (.2707) $ (.2302) $ (.2936) $ (.3321) Stock option expense .00 (.0005) .00 (.0006) ----------------------------------------------------------- Pro forma basic and diluted loss per share $ (.2707) $ (.2307) $ (.2936) $ (.3327) ===============================================================

NOTE 4 - Inventories The components of inventories as of December 31, 2004 were as follows: December 31 (thousands) 2004 ---------------------------------------------------- Finished goods $ 57 Work-in-process 644 Service parts 2,713 Materials and component parts 4,047 ------------------- $7,461 =================== 9

NOTE 5 - Comprehensive Loss The components of comprehensive loss follow: Three Months Ended ~~Six~~Nine Months Ended ~~June~~September 30 ~~June~~September 30 (thousands) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------~~-------~~ Net loss $ (113,~~303~~040) $ (~~1,619~~663) $ (1215,~~073~~064) $ (2,~~331~~994) Foreign currency translation adjustments 341,148 (~~113~~96) 411,189 (~~100~~196) --------------------------------------------------------------- Comprehensive loss $ (111,~~269~~892) $ (~~1,732~~759) $ (1213,~~032~~875) $ (23,~~431~~190) =============================================================== NOTE 6 - Segment Information The Company viewed its business in three distinct revenue categories: Solution and products sales, Access Services, and contract manufacturing services. Additional segment information follows: Three Months Ended Nine Months Ended September 30 September 30 (thousands) 2005 2004 2005 2004 ---------------------------------------------------------------------------------- Revenues Solutions and products $ 640 $ 2,881 $ 5,833 $ 11,411 Access services 807 2,812 6,506 8,040 Contract manufacturing services 73 494 1,761 947 --------------------------------------------- Total revenues 1,520 6,187 14,100 20,398 Cost of solutions and products 1,989 2,153 7,729 8,310 Service expenses 999 2,174 5,565 7,011 --------------------------------------------- Gross margin (1,468) 1,860 806 5,077 Operating expenses and other expenses, net 1,572 2,513 15,864 8,011 --------------------------------------------- Loss before income taxes $ (3,040) $ (653) $(15,058) $ (2,934) =============================================

10 NOTE 7 - Contingencies On March 9, 2005, the Company received from attorneys representing James C. Mavel, the Company's former Chief Executive Officer and President, a "notice of termination" pursuant to his Employment Agreement and asserting entitlement to severance compensation under the agreement. On or about August 3, 2005 the Company was notified that Mr. Mavel had filed a demand for arbitration with the American Arbitration Association, but the Company did not receive a copy of the demand until on or about August 9, 2005. The demand, among other things claims that Mr. Mavel is entitled to $2.5 million from the Company. Although the Company does not believe that Mr. Mavel's claim to severance compensation or the amount claimed is supported by the Employment Agreement or the facts, should Mr. Mavel's claim be supported, any material award of severance compensation to Mr. Mavel would have a material adverse effect on the financial condition of the Company following the closing of the Foreclosure Agreement with its secured lender on August 5, 2005. Item 2. Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations. Forward Looking Information Certain statements contained in this Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities and Exchange Act of 1934 and as such may involve known or unknown risks, uncertainties and other factors which may cause the Company's actual results, performance or achievements to be materially different from future results, performance or achievements expressed or implied by such forward-looking statements. Forward-looking statements, which are based on certain assumptions and describe the Company's future plans, strategies and expectations are generally identifiable by use of the words "may," "will," "should," "expect," thereon or comparable terminology. Foreclosure and Cessation of Business The Company entered into a foreclosure agreement on August 5, 2005 pursuant to which it transferred substantially all of its assets to its secured lender and ceased operations (see "-Liquidity and Capital Resources" below and Note 2 to the Company's Consolidated Financial Statements for further details). On November 10, 2005, the Company filed a preliminary proxy statement with the SEC with respect to holding a stockholder meeting to approve the dissolution of the Company and an amendment to its certificate of incorporation to allow a board of directors consisting of one director. ARK-CLO 2000-1 Limited, holder of approximately 80% of the Company's outstanding common stock and an affiliate of the Company's secured lender under the foreclosure agreement, has sufficient votes to approve both the dissolution and the amendment and has indicated its intent to vote in favor of the Company's dissolution and amendment of its certificate of incorporation. Total revenues decreased $6.3 million or 31% from the first nine months of 2004 to the first nine months of 2005 and decreased $4.7 million or 75% from the third quarter of 2004 to the third quarter of 2005. 11 Costs of revenues decreased $2.0 million or 13% from the first nine months of 2004 to the first nine months of 2005 and decreased $1.3 million or 31% from the third quarter of 2004 to the third quarter of 2005. Gross profit decreased $4.3 million or 84% from the first nine months of 2004 to the first nine months of 2005 and decreased $3.3 million or 177% from the third quarter of 2004 to the third quarter of 2005. Operating expenses increased $7.8 million or 97% from the first nine months of 2004 to the first nine months of 2005, including goodwill impairment of $9.0 million, and decreased $1.0 million or 40% from the third quarter of 2004 to the third quarter of 2005. Net loss increased $ 12.1 million or 410% from the first nine months of 2004 to the first nine months of 2005 and increased $2.4 million or 359% from the third quarter of 2004 to the third quarter of 2005. After the foreclosure of August 5, 2005, the Company was engaged in activities related to the wind down of its business affairs, including tax and legal filings, employee related matters, payment of vendors and Securities and Exchange Commission filings. Through September 30, 2005, the Company spent $487,000 on wind down activities. Liquidity and Capital Resources Please refer to Note 2 Foreclosure and Cessation of Business as part of the Liquidity and Capital Resources. As a means of attempting to alleviate the Company's liquidity problems previously disclosed in the Company's Form 10-Q for the fiscal quarter ended March 30, 2005, on June 29, 2005 the Company entered into a First Amendment to the Credit Agreement (described below) pursuant to which, among other things, an additional $900,000 was made available to the Company through July 1, 2005 as part of the Credit Agreement's revolving credit facility. Subsequently, the Company failed to repay such amounts by July 1, 2005, which was a default under Section 2.9 of the Credit Agreement. The Company was also in default of certain financial covenants under Section 6.2(c) of the Credit Agreement regarding Consolidated Earnings Before Interest, Taxes, Depreciation and Amortization. On July 8, 2005 Patriarch Partners Agency Services, LLC as agent to the Lenders under the Credit Agreement, submitted to the Company a draft foreclosure agreement. On August 3, 2005, Patriarch Partners Agency Services, LLC on behalf of the secured Lenders, delivered a notice of default to the Company, accelerating all of the outstanding debt under the Credit Agreement. As a result of the covenant violations, on August 5, 2005, the Company entered into a Foreclosure Agreement with the Lenders. Under the Foreclosure Agreement the Company transferred substantially all of its assets to the Lenders to extinguish its obligations under the 12 Credit Agreement. (The outstanding principal under the Credit Agreement at the time of closing of the Foreclosure Agreement was $14,310,000). The Lenders also assumed certain liabilities of the Company, including but not limited to, certain accrued obligations with respect to current employees and certain trade payables and accrued expenses. None of the assets retained by the Company can be liquidated for cash. The Lenders also assumed certain employee benefit plans of the Company and certain of its insurance policies. Under the Foreclosure Agreement, the Company was permitted to obtain extended directors and officers insurance, and the Lenders agreed to assume or fund the defense of actions brought against the Company after the closing. At the closing the Company terminated all of its employees as of that time. Under the Foreclosure Agreement the Lenders agreed to fund certain expenses of the Company winding-down its business. However, the Company has no cash or other sources of liquidity and if the funds provided for in the wind-down budget are not used for the purposes specified in the budget, the Company is not entitled to receive any differential cash. Following the closing of the Foreclosure Agreement, the Company ceased doing business and is expected to be dissolved in accordance with the applicable provisions of the Delaware General Corporation Law. Following the closing of the Foreclosure Agreement, the Company's sole remaining executive officer is Scott Schooley who serves as President and Secretary of the Company. Following the closing of the Foreclosure Agreement, board of directors also voted to dissolve the Company, subject to requisite stockholder approval and compliance with the related SEC regulations. Because none of the assets retained by the Company can be liquidated for cash, there will be no residual value left to the holders of common stock of the Company following the closing of the Foreclosure Agreement and any winding-down of the Company's affairs. Critical Accounting Policies Our critical accounting policies are discussed in Management's Discussion and Analysis of Consolidated Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2004. There have been no significant changes in our critical accounting policies since then through September 30, 2005. The preparation of our financial statements requires us to make estimates that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures of contingent assets and liabilities. We base our accounting estimates on historical experience and other factors that are believed to be reasonable under the circumstances. However, actual results may vary from these estimates under different assumptions or conditions. 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk. As disclosed elsewhere, the Company's board of directors voted to dissolve the Company in conjunction with the Foreclosure Agreement. Item 4. Controls and Procedures. The Company evaluated the design and operation of its disclosure controls and procedures to determine whether they are effective in ensuring that the disclosure of required information is timely made in accordance with the Securities Exchange Act of 1934 (the "Exchange Act") and the rules and forms of the Securities and Exchange Commission. This evaluation was made under the supervision and with the participation of management, including the Company's principal executive and financial officer as of the end of the period covered by this Quarterly Report on Form 10-Q. The principal executive officer and principal financial officer has concluded, based on his review, that the Company's disclosure controls and procedures, as defined at Exchange Act Rules 13a-14(c) and 15d-14(c), are effective to provide reasonable assurance that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There were no changes in the Company's internal control over financial reporting that occurred during the Company's most recent fiscal quarter that materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 14 PART II - OTHER INFORMATION Item 6. Exhibits (a) Exhibits. Exhibit Number Description Exhibit 31.1* Chief Executive and Chief Financial Officer Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. Exhibit 32.1* Chief Executive and Chief Financial Officer Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. * Filed herewith. 15 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SCAN-OPTICS, INC. Date November 21, 2005 /s/ Scott Schooley --------------------------- ----------------------- Scott Schooley President 16

NOTE 7 - Segment Information The Company views its business in three distinct revenue categories: Solution and products sales, Access services, and Contract manufacturing services. Additional segment information follows: Three Months Ended Six Months Ended June 30 June 30 (thousands) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------- Revenues Solutions and products $ 1,978 $ 3,703 $ 5,193 $ 8,530 Access services 2,999 2,832 5,699 5,228 Contract manufacturing services 827 343 1,688 453 --------------------------------------------------------------- Total revenues 5,804 6,878 12,580 14,211 Cost of solutions and products 2,620 2,673 5,740 6,157 Service expenses 2,315 2,505 4,566 4,837 --------------------------------------------------------------- Gross margin 869 1,700 2,274 3,217 Operating expenses and other expenses, net 12,123 3,289 14,292 5,498 --------------------------------------------------------------- Loss before income taxes $ (11,254) $ (1,589) $ (12,018) $ (2,281) ================================================================

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