10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

þ	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the fiscal year ended September 30, 2007
or
o	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 0-27234

Photon Dynamics, Inc.

(Exact name of registrant as specified in its charter)

California
(State or other jurisdiction of
incorporation or organization) 94-3007502
(I.R.S. Employer
Identification No. )

5970 Optical Court

San Jose, CA 95138

(Address of principal executive offices, including zip code)

(408) 226-9900

(Registrant’s telephone number, including area code)

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

None

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

Common Stock, no par value per share

(Title of class)

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 Exchange 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 þ     No o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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 Exchange Act).  Yes o     No þ

As of March 31, 2007, the aggregate market value of the voting stock held by non-affiliates of the registrant, computed by reference to the last sale price of such stock as of such date on the NASDAQ National Market, was approximately $151,604,028. Excludes an aggregate of 4,570,000 shares of common stock held by officers and directors and by each person known by the registrant to own 5% or more of the outstanding common stock as of March 31, 2007. Exclusion of shares held by any of these persons should not be construed to indicate that such person possesses the power, direct or indirect, to direct or cause the direction of the management or policies of the registrant, or that such person is controlled by or under common control with the registrant.

As of January 2, 2008, there were 17,741,183 shares of the registrant’s Common Stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the end of the fiscal year covered by this Form 10-K, are incorporated by reference in Part III, Items 10-14 of this Form 10-K.

PHOTON DYNAMICS, INC.

ANNUAL REPORT ON FORM 10-K
For the fiscal year ended September 30, 2007

EXPLANATORY NOTE

Photon Dynamics, Inc. (“Photon Dynamics” or the “Company”) previously announced the need to restate: (1) the consolidated financial statements for the years ended September 30, 2004, 2005 and 2006 as contained in its Form 10-K for the year ended September 30, 2006; (2) the unaudited quarterly financial data for the first two quarters in the fiscal year ended September 30, 2007; and (3) the unaudited quarterly financial data for all quarters in the fiscal year ended September 30, 2006.

This Annual Report on Form 10-K for Photon Dynamics’ fiscal year ended September 30, 2007 includes restatements of the following previously filed financial statements and data (and related disclosures):

(a) the consolidated statements of operations, shareholders’ equity and cash flows for the fiscal years ended September 30, 2006 and 2005;

(b) the consolidated balance sheet as of September 30, 2006;

(c) the selected consolidated financial data as of and for the fiscal years ended September 30, 2003 through 2006; and

(d) the unaudited quarterly financial data for the first two quarters in the fiscal year ended September 30, 2007 and for all quarters in the fiscal year ended September 30, 2006.

In addition to the restated financial statements included in this document, this Annual Report on Form 10-K also includes the unaudited quarterly financial data for the third quarter in the fiscal year ended September 30, 2007, which had not been previously filed on a Quarterly Report on Form 10-Q.

Amendments of the Company’s previously filed Annual Reports on Form 10-K or Quarterly Reports on Form 10-Q for the periods affected by the restatements would, in large part, repeat the disclosure contained in this report. Accordingly, Photon Dynamics has not amended and does not plan to amend these or any other prior filings. Such previous filings should not be relied upon.

For a description of the current restatement, see Note 2, “Restatements of Consolidated Financial Statements and Company Findings” of “Notes to Consolidated Financial Statements” included under Part II, Item 8 of this Annual Report on Form 10-K and “Restatement of Financial Statements, Internal Review of Customs Practices, Remediation Plan and Related Proceedings” of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included under Part II, Item 7 of this Annual Report on Form 10-K.

Unless otherwise noted, all of the information in this Annual Report on Form 10-K is as of September 30, 2007.

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PHOTON DYNAMICS, INC.

ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 2007

TABLE OF CONTENTS

			Page
		Special Note Regarding Forward-Looking Statements		iii
PART I
	Item 1.	Business		1
	Item 1A.	Risk Factors		10
	Item 1B.	Unresolved Staff Comments		23
	Item 2.	Properties		23
	Item 3.	Legal Proceedings		23
	Item 4.	Submission of Matters to a Vote of Security Holders		24
PART II
	Item 5.	Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities		24
	Item 6.	Selected Financial Data		26
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		30
	Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		67
	Item 8.	Financial Statements and Supplementary Data		69
		Reports of Independent Registered Public Accounting Firm		70
		Consolidated Balance Sheets at September 30, 2007 and 2006		73
		Consolidated Statements of Operations for each of the three years in the period ended September 30, 2007		74
		Consolidated Statements of Shareholders Equity for each of the three years in the period ended September 30, 2007		75
		Consolidated Statements of Cash Flows for each of the three years in the period ended September 30, 2007		76
		Notes to Consolidated Financial Statements		77
	Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure		132
	Item 9A.	Controls and Procedures		132
	Item 9B.	Other Information		135
PART III
	Item 10.	Directors and Executive Officers of the Registrant		135
	Item 11.	Executive Compensation		135
	Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		136
	Item 13.	Certain Relationships and Related Transactions		136
	Item 14.	Principal Independent Registered Public Accounting Firm Fees and Services		136
PART IV
	Item 15.	Exhibits and Financial Statement Schedules		136
		Schedule II Valuation and Qualifying Accounts		137
		Signatures		138
		Exhibit Index		140
EXHIBIT 10.56
EXHIBIT 21.1
EXHIBIT 23.1
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act. All statements included or incorporated by reference in this Annual Report on Form 10-K other than statements of historical fact may be forward-looking statements. You can identify these and other forward-looking statements by the use of words such as “may,” “will,” “could,” “would,” “should,” “plans,” “anticipates,” “relies,” “expects,” “intends,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to any such statements. These forward-looking statements are based on current expectations as of the filing date of this Annual Report on Form 10-K and involve a number of uncertainties and risks. These uncertainties and risks include, but are not limited to: our ability to remediate material weaknesses in our internal controls; our ability to attract and retain qualified employees; possible further changes in our total customs duty liability; possible civil and criminal liability in connection with customs duty issues; the adoption of new technology by our existing and potential customers; our customers’ response to prevailing economic and market conditions; the changing customer investment climate, which could lead to the impairment of our assets; our ability to successfully migrate our manufacturing operations offshore; our ability to maintain competitive pricing; the introduction of competing products having technological and/or pricing advantages, which would reduce the demand for our products; our ability to operate and integrate our newly acquired subsidiary; and failure to comply with a variety of United States and foreign federal, state and local laws and regulations, which could lead to the Company incurring additional penalties, interest and other expenses. As a result, our actual results and end user demand may differ substantially from expectations.

Our actual results could differ materially from those projected in the forward-looking statements included herein as a result of a number of factors, risks and uncertainties, including the risk factors set forth in Part I Item 1A. “Risk Factors” in this Annual Report on Form 10-K and elsewhere in this Annual Report on Form 10-K. The information included in this Annual Report on Form 10-K is as of the filing date with the SEC and future events or circumstances could differ significantly from the forward-looking statements included herein. Accordingly, we caution readers not to place undue reliance on such statements and we expressly assume no obligation to update the forward-looking statements included in this report after the date hereof except as required by law.

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PART I

ITEM 1.   BUSINESS

Introduction

Photon Dynamics, Inc. (“Photon Dynamics” or the “Company”) is a California corporation incorporated in 1986. At Photon Dynamics, we utilize our advanced digital imaging technology to develop systems that enable flat panel display manufacturers to collect and analyze data from the production line, and quickly diagnose and repair process-related defects, thereby allowing manufacturers to decrease material costs and improve throughput. Flat panel display manufacturers use our portfolio of products, services and expertise to increase manufacturing yields of high-performance flat panel displays used in a number of products, including notebook and desktop computers, televisions and advanced mobile electronic devices such as cellular phones, personal digital assistants and portable video games.

On July 27, 2007 we acquired Salvador Imaging, Inc. (“Salvador Imaging”) an international supplier of high-performance digital cameras for the defense, industrial and scientific/medical industries. Salvador Imaging was previously one of our suppliers of camera equipment used in Photon Dynamics’ yield enhancing test equipment. In addition to acquiring their current product base of camera imaging systems, we intend to combine our digital imaging core competencies with Salvador Imaging’s technical strength, as well as our operational and manufacturing strengths, to develop highly sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for defense applications and unique inspection capabilities in industrial applications.

Additional information about Photon Dynamics, Inc. is available on our website at www.photondynamics.com. We make available free of charge, on or through our website, our Annual Report on Form 10-K, our Quarterly Reports on Form 10-Q, our Current Reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act, as soon as reasonably practicable after electronically filing such reports with, or furnishing such reports to, the SEC. Information contained on our website is not incorporated by reference in, or made part of this Annual Report on Form 10-K or our other filings with or reports furnished to the SEC.

Our Business Segments

We have two business segments: Flat Panel Display and High-Performance Digital Imaging. Flat Panel Display is our primary business segment, accounting for approximately 99% of our revenues during this fiscal year. We commenced operations in our High-Performance Digital Imaging segment with our acquisition of Salvador Imaging on July 27, 2007.

Flat Panel Display

Industry.  Flat panel displays have become the standard technology in both the mobile electronic devices market and the notebook and desktop computer market. In the television market, flat panel displays have become the standard in adoption rates; however, cathode ray tube displays continue to comprise the majority of the installed base. Competing technology in the television market, such as plasma technology, is limited to large-screen televisions.

Continuous innovations in microelectronics and materials science have enabled manufacturers, including our customers, to produce flat panel displays with sharper resolution, brighter pixels and faster imaging in varying sizes for differing applications. Growth in the mobile electronic devices market, the desktop computer market and the television market have driven the demand for flat panel displays, which offer reduced footprint, weight, power consumption and heat emission and better picture quality as compared to cathode ray tube displays.

Active matrix liquid crystal display (“AMLCD”), the most prevalent and one of the highest performance flat panel displays available today, produces full color images and operates at much faster refresh rates than earlier passive monochrome liquid crystal displays. The color capability, resolution, speed and picture quality of active matrix liquid crystal displays currently make these displays the preferred choice for high-performance mobile

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applications, such as portable computers, multimedia, televisions and other applications requiring the display of video and graphics.

Manufacturing these highly engineered flat panel display products requires complex, multi-stage production processes, increasing the potential for defects and errors associated with equipment failures, contamination of materials, drift in process parameters, human error and other related factors. These complexities are compounded by the flat panel display industry’s migration toward large-area glass substrates for economical, high-volume production of larger display panels. These manufacturing complexities increase investment in work-in-progress inventories and lengthen production cycles. Because of the high cost of materials used in the manufacture of liquid crystal display (“LCD”), defective LCDs can be quite costly for LCD manufacturers, and ultimately drive up both panel and end product costs. Reliable, repeatable methods of analyzing production-line data and repairing process-related defects are therefore essential to enabling the production of larger, higher-quality LCDs at affordable price points.

Enhancing yields through process control, defect detection and defect repair has become an essential component of optimizing costs and time-to-market in the Flat Panel Display sector. As production processes become more complex and reducing material and labor costs becomes increasingly important, we believe that yield enhancement solutions provide manufacturers with an important competitive advantage.

Manufacture of Active Matrix Liquid Crystal Displays.  The manufacture of active matrix liquid crystal displays is an extremely complex process, which has been developed and refined for different glass substrate sizes and resolutions through research and development, pre-production prototyping and commercial production.

An AMLCD uses liquid crystal to control the passage of light. Liquid crystals are organic molecules that have crystal-like properties but that are liquid at normal temperatures. Because the intermolecular forces are weak, the molecules can be oriented by weak electromagnetic fields. The liquid crystal molecules used in AMLCDs also have an optical anisotropy (different indices of refraction for different axes of the molecule) that is used to create visible images. Depending on the orientation of the molecules, the panel is either transparent or dark. The basic structure of an AMLCD panel may be thought of as two glass panels sandwiching a layer of liquid crystal. The front glass panel, referred to as the color filter plate, is fitted with a two dimensional matrix of color filters and the back glass panel, referred to as the array plate, has a matching two dimensional matrix of transistors fabricated on it. The individual element of the two dimensional matrix is referred to as a pixel. When voltage is applied to a transistor, the liquid crystal is bent, allowing light to pass through to form a pixel. A light source is located at the back of the panel and is called a backlight unit. The front glass panel is fitted with a color filter, which gives each pixel its own color. The combination of these pixels in different colors forms the image on the panel.

Glass panels are initially manufactured on large glass substrates which are subsequently cut down to the panel size needed for the application. Each progressive increase in substrate size is referred to by its “generation.” Generation 5 substrate glass is approximately 1,200 × 1,300 mm in size, Generation 6 substrate glass is approximately 1,500 × 1,800 mm in size, Generation 7 substrate glass is approximately 1,870 × 2,200 mm in size, and Generation 7.5 and 8 substrate glass is approximately 2,160 x 2,460 mm in size. Next generation substrates glass (Generation 10) is currently estimated to be 2,850 x 3,050mm in size.

Manufacturing an active matrix liquid crystal display involves three principal phases:

•  Array Phase.  The first phase of the process involves the production of both the array plate and color filter plate. This phase of the process is the fabrication of an array of thin-film transistors (“TFT”), each of which is connected to a transparent sub-pixel, the smallest addressable unit in the display. Three or more sub-pixels are combined to produce a pixel, millions of which are fabricated, using semiconductor processes, on a large glass substrate. A similar process is used to fabricate an array of color filter sub-pixels on a large glass substrate. The array fabrication process is the most capital-intensive process and is housed in cleanrooms in order to minimize particles that can cause pixel defects.

•  Cell Assembly Phase.  The second phase, cell assembly, is the joining of the TFT array plate and the color filter plate with liquid crystal material.

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•  Module Assembly Phase.  The third phase, module assembly, involves packaging the display and attaching the electronics and illumination — or backlight — which will allow the device to display text, graphics and video images.

The AMLCD market is both price sensitive and cost competitive, making it critical for manufacturers to constantly strive for the highest possible yields to decrease costs. Unlike semiconductor fabrication facilities, where productivity can be increased by shrinking features and die size, AMLCD fabrication productivity is driven by yield and substrate size, the latter being because an increase in the plate area with each new generation results in a disproportionately lower increase in processing equipment costs, generating new production efficiencies.

At various points in the manufacturing process, the flat panel display manufacturer uses test and inspection equipment to identify defects to permit repair and to avoid wasting costly materials on continued manufacturing of a defective product. In addition, test and inspection systems can provide qualitative feedback to the flat panel display manufacturer and enable the manufacturer to address yield problems where they originate and to optimize the manufacturing process.

The manufacturing process for each new generation of glass substrate typically requires new fabrication facilities (“fabs”), modifications of the manufacturing process, development and installation of new manufacturing equipment, and, as a result, development and installment of new test and repair equipment. New fabrication facilities and upgrades to existing facilities represent significant investments by flat panel display manufacturers and take time to properly plan, implement, and bring to full capacity.

Challenges Faced by Flat Panel Display Manufacturers.  The ability of flat panel display manufacturers to improve yields of active matrix liquid crystal displays and other flat panel displays depends, in large part, on their ability to test, repair and inspect displays during the manufacturing process and to use the resulting data collection to refine the manufacturing process. The ability to test, repair and inspect helps manufacturers address a number of challenges, including:

•  Demand for Higher Quality.  Increased competition among flat panel display manufacturers, improvements in the manufacturing process and higher consumer expectations are moving the flat panel display industry towards a zero defect standard. The manufacturing challenges presented by the goal of zero-defect products have been compounded by the increasing demand for higher resolution and larger displays.

•  Increasing Display Resolutions.  Resolutions of advanced flat panel displays now involve several million pixels, presenting a challenge when test and inspection equipment must exercise each pixel. Traditional methods of physically contacting each row and column of pixels with probe cards have difficulty handling current advanced displays. Manufacturers require new techniques, such as non-contact pixel-addressing mechanisms, to more effectively handle these displays.

•  High Cost of Materials.  Materials costs comprise approximately 50% to 70% of flat panel display costs, in contrast to only approximately 10% for semiconductors, according to industry sources. Material costs are typically incurred at the start of the manufacturing process and expose the flat panel display manufacturer to higher overall costs due to yield losses incurred during the manufacturing process. High performance LCDs for television applications further increase the complexities associated with LCD manufacturing. Because of the high cost of materials used in the manufacture of LCDs, defective LCDs, especially larger displays, represent a substantial cost to LCD manufacturers, and can ultimately drive up both panel and end product costs. Therefore, it is important to test, repair and inspect early in the manufacturing process before expensive materials are added to the display in the latter assembly phases.

•  Need for Increased Yield and Greater Throughput.  Greater yields are realized in part through more effective test, repair and inspection. In order to maintain or improve profitability, flat panel display manufacturers need test, repair and inspection equipment that will allow them to increase process speed while using larger panels.

•  Need for Flexibility.  The flat panel display industry is producing a larger number of different panel sizes as the variety of applications incorporating flat panel displays has increased. Manufacturers are seeking test,

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repair and inspection equipment that can be reconfigured quickly and accurately for different panel sizes, with minimal production downtime.

Products.  Today’s market dynamics demand that flat panel display manufacturers leverage the latest yield enhancement and process tools. We focus specifically on delivering yield enhancement solutions that enable manufacturers to collect data from the production line, analyze the data, and quickly diagnose and repair process-related defects. We focus specifically on delivering solutions that help manufacturers decrease material costs and improve throughput to gain that incremental yield edge so critical to success. Our offerings can be broadly classified into two categories: Yield Enhancement Products and Customer Support.

Yield Enhancement Products.  Our flat panel display yield enhancement products include test and repair equipment that are used primarily in the Array phase of production. Our test equipment can identify and characterize defects at early stages of the manufacturing process so that the panels may be repaired before the next stage or, if necessary, discarded, minimizing the loss of time and materials. Our test and repair systems use similar software-based controls, processing and graphical user interfaces. Our products can be networked together with one another as well as with complementary vendor products so that defect data can be stored, analyzed and used throughout the manufacturing process. Our systems are also compatible with a variety of material handling automation systems.

•  Flat Panel Display Array Test Systems.  Our ArrayChecker^tm test systems detect, locate, quantify and characterize electrical, contamination and other defects in active matrix liquid crystal displays after array fabrication. These systems use our proprietary non-contact voltage imaging technology to provide a high-resolution voltage map of the entire display and our proprietary image analysis software converts this voltage map into complete pixel defect data. The ArrayChecker^tm test systems determine whether individual pixels or lines of pixels are functional and also find more subtle defects such as variations in individual pixel voltage. These defect data files are then used for repair and statistical process control.

•  Flat Panel Display Array Repair Systems.  Our ArraySaver^tm repair systems utilize multiple wavelength laser technology to repair defects in flat panel displays during and after array fabrication. Our systems can use defect data files downloaded from our ArrayChecker^tm test systems or other test and inspection systems to automatically position the panel for repair, thereby eliminating the time spent by operators locating defects. The ArraySaver^tm system includes a high-precision materials handling platform and a user-friendly graphical interface allowing for high throughput. Our high-precision materials handling platform fully automates the precise positioning of the plate for each successive repair, thereby substantially increasing throughput. Our graphical user interface and software supports semi-automated setup of repair programs for common types of defects so that repairs can be executed rapidly and accurately. These programs provide a series of actions that the system automatically executes to repair the particular defect type.

Customer Support.  We enhance the value of our products through our customer support programs, which provide comprehensive worldwide service and support across all of our product lines. With years of experience helping our customers increase yields across a myriad of production environments, our global yield enhancement support organization is equipped to provide customers with a range of preventative and corrective services. These include design, development, and integration services associated with yield enhancement, as well as comprehensive training, project management, process and applications consulting, product maintenance, and life cycle optimization.

Customers.  We sell our flat panel display yield enhancement products to manufacturers in the flat panel display industry. Nearly all of our flat panel display customers are located in South Korea, Taiwan, Japan and China, where flat panel display production is concentrated. We derive most of our revenue from a small number of customers, and we expect this to continue for the foreseeable future. Sales to our top four customers accounted for 77% of revenue in fiscal 2007, while sales to our top three customers accounted for 76% and 46% of revenue in fiscal 2006 and 2005, respectively. During fiscal 2007, sales to LG.Phillips LCD, Samsung Electronics, AU Optronics Corporation and Sharp Corporation each accounted for more than 10% of our total revenues. See Note 14 of our “Notes to Consolidated Financial Statements” in Part II, Item 8. “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for further information, which is incorporated here by reference, regarding sales to our major customers.

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Our business depends significantly upon the capital expenditures of flat panel display manufacturers, which in turn depend on the current and anticipated market demand for products utilizing flat panel displays. We do not consider our business to be seasonal in nature, but it is cyclical with respect to the capital equipment procurement practices of flat panel display manufacturers and is impacted by the investment patterns of these manufacturers. We do consider consumer demand for flat panel display products to be seasonal, with peak demand occurring in the latter half of each calendar year. This end-user seasonality has an influence on capacity decisions by flat panel display manufacturers and has a limited influence on the flat panel display manufacturers’ overall investment patterns. However, because new fabrication facilities and upgrades to existing facilities represent significant investments and require long lead times to implement, we consider flat panel display manufacturers to have cyclical investment patterns. Downturns in the flat panel industry or slowdowns in the worldwide economy have in the past had and could in the future have a material adverse effect on our future business and financial results.

Sales, Service and Marketing.  Our sales, service and marketing strategy is to provide our flat panel display customers with increased manufacturing yields and throughput, improved quality and greater overall efficiency in their manufacturing process. Our sales, service and marketing efforts are focused on building long-term relationships with our customers. We sell our products for the flat panel display industry directly to our customers in South Korea, Taiwan, Japan and China. We service our products worldwide directly at the customer site.

Revenue from our flat panel display products represented 99% of our revenue in fiscal 2007, and 100% of our revenue in fiscal 2006 and 2005, and all of this revenue was derived from sales to companies located outside of the United States. We believe that sales outside the United States will continue to comprise substantially all of our flat panel display revenues. Our future performance will depend, in part, on our ability to compete successfully in Asia. Our ability to compete in this area of the world is dependent upon the continuation of favorable trade laws between countries in the region and the United States, our continuing ability to maintain satisfactory relationships with flat panel display manufacturers in the region and our ability to price our products competitively as compared to our competitors.

Our sales terms range from 60% to 90% of the sales price due upon shipment with the remaining amount due after installation and upon final customer acceptance. We typically provide a limited warranty on our products for a period of 12 months from final acceptance or 14 months from shipment, whichever is shorter. Our field service employees and third-party field service personnel provide customers with repair and maintenance services, primarily warranty related. As of September 30, 2007, we employed 105 sales and service personnel, 20 of whom were located in North America and 85 of whom were located in the Asia-Pacific region, and contracted with a third party to provide an additional field service personnel in Asia. We outsourced a portion of our field service operation in Asia with the objective of lowering overall costs of service without compromising quality.

International sales expose us to risks that are not experienced with domestic sales, such as export license restrictions, political instability, customs compliance, trade restrictions and currency fluctuations. These and other risks relating to our business are detailed Part I, Item 1A. “Risk Factors” in this Annual Report on Form 10-K. See Note 14 of our “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K for additional geographic information, which is incorporated here by reference, including long-lived assets by geographic area as well as revenue from external customers attributable to geographic areas during the last three years.

Manufacturing.  While our products have been historically manufactured in San Jose, California, during the second quarter of our fiscal 2007, we began manufacture of certain of our ArraySaver^tm products in Daejon, Korea and have begun to outsource both our ArraySaver^tm and ArrayTester products to third party manufacturers. We perform design, assembly and testing in-house and utilize an outsourcing strategy for the manufacture of a majority of our components and subassemblies. Our in-house manufacturing activities consist primarily of final assembly and test of components and subassemblies that are acquired through third-party vendors and integrating those subassemblies into our finished products. As of September 30, 2007, we employed 61 manufacturing personnel, 52 of whom were located in North America and 9 of whom were located in the Asia-Pacific region. Our strategy to outsource the assembly of our ArraySaver^tm product line and certain generations of our ArrayChecker^tm product line entirely to third-party contractors in Asia is designed to allow us to manufacture our products closer to our customers, transform fixed costs into variable costs and reduce overall costs. We expect to outsource all of our

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manufacturing in the future with the exception of key core components such as modulators and payloads, which we will continue to source in the United States.

We schedule our flat panel display production based upon customer purchase orders and anticipated orders during the planning cycle. We generally expect to be able to accept a customer order, build the required systems and ship to the customer within approximately 20 to 36 weeks. We maintain quality control through inspection of components, in-process inspection during equipment assembly and final inspection and operation of all manufactured equipment prior to shipment. Although we assemble some components and final test our systems under limited clean room conditions, most of our manufacturing occurs in standard manufacturing space.

Because of the long lead time required to acquire the materials and manufacture a customer order and the cyclical nature of the business, a significant increase in orders could necessitate a build-up in inventory and therefore initially have a negative impact on cash flow. In addition, all orders are subject to postponement or cancellation by the customer with limited or no penalties, which could further result in a build-up in inventory and negatively affect our cash flows.

We believe that our operations and facilities are in substantial compliance with all applicable federal, state, and local laws and regulations covering the discharge of materials into, and protection of, the environment.

Research and Development.  The market for integrated yield enhancement systems is characterized by rapid and continuous technological development and product innovation. We believe that it is necessary to maintain our competitive position through continued and timely development of new products and enhancements to existing products. Accordingly, we devote a significant portion of our human and financial resources to research and development and seek to maintain close relationships with customers to remain responsive to their needs. For information regarding our research and development expenses during the last three years, see Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K, which is incorporated here by reference. As of September 30, 2007, we employed 136 research and development personnel, 74 of whom were located in North America and 62 of whom were located in the Asia-Pacific region.

We are focusing our current research and development on increasing the performance of our current array test and array repair systems, the design of our next generation systems, and the development of new technologies. We are committing significant engineering efforts toward product improvement and next generation product development. For example, during 2007 we announced the development of our ParagonAvios^tm Sensor Technology, which improves the throughput and reduces the cost of ownership of our ArrayChecker^tm product line. We will continue to invest in research and development to maintain technology leadership in our products. There can be no assurance that we will be successful in the introduction, marketing and cost-effective manufacture of any of our new products, that we will be able to develop and introduce new products on a timely basis, or that we will be able to enhance our existing products and processes to satisfy customer needs.

High-Performance Digital Imaging

Acquisition of Salvador Imaging.  During fiscal 2007, we purchased Salvador Imaging, an international supplier of high-performance digital cameras for defense, industrial and other applications. Our new High-Performance Digital Imaging business will combine the digital imaging core competencies of Photon Dynamics and Salvador Imaging as well as our operational and manufacturing strengths to develop highly sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for the military and security markets, and unique inspection capabilities in industrial applications. While we are developing evaluation units and are actively engaged in marketing and sales activities, the activity of Salvador Imaging for the period from the July 27, 2007 date of purchase through September 30, 2007 was immaterial to the Company’s consolidated financial statements.

Industry.  High-performance digital cameras are used in the defense, industrial and scientific/medical industries for a variety of applications. In the defense industry, high-performance digital camera applications include targeting, unmanned vehicle guidance, discrimination of decoy versus real targets and daytime and

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nighttime surveillance. Industrial customers use high-performance digital cameras for inspection, metrology and machine guidance. Scientific and medical industry applications include X-ray and fluoroscopy.

The principal types of high-performance digital cameras include charge-coupled device (“CCD”) cameras, complementary metal-oxide-semiconductor (“CMOS”) cameras, and electron multiplying charge-coupled device (“EMCCD”) cameras. CCD cameras are typically used in applications where very high quality imagery is needed, such as medical, scientific and astronomical applications. While CMOS cameras typically do not offer image quality as high as their CCD counterparts, CMOS offers the advantages of allowing for readouts at higher speeds and higher levels of on-chip circuit integration. CMOS cameras are typically used for industrial machine vision. In EMCCD cameras, an on-chip gain mechanism is employed, which makes it possible to capture images at extremely low light levels. Applications for EMCCDs include night-time perimeter security, military surveillance, astronomy and certain low-light medical applications ranging from cell biology to radiology.

Products.  We offer standard and custom CCD, CMOS and EMCCD cameras to meet the needs of a broad range of defense, industrial and scientific/medical markets. All of our camera products incorporate low noise, precision analog design coupled with proprietary thermal stabilization to provide high quality imaging performance.

Customers.  We sell our high-performance digital camera products to end customers and system integrators in the defense, scientific, machine vision and medical markets. Our two largest customers in the High-Performance Digital Imaging segment are Lockheed Martin and Remote Vet, which together accounted for less than one percent of our total revenue in fiscal 2007. The unique risks associated with depending on the U.S. government as a significant source of segment revenue are described further in Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K.

Sales, Service and Marketing.  Prior to its acquisition, Salvador Imaging’s principal customer had been Photon Dynamics and we have had limited revenue from our high-performance digital imaging products to date and limited experience selling these products to third parties. We rely on a combination of direct sales and a network of qualified sales representatives to sell our high-performance digital imaging products, and we service the products directly. As of September 30, 2007, we had only one employee dedicated to the sale and service of our high-performance digital imaging products at our Colorado Springs facility. In conjunction with the growth of the business, we intend to build our sales, service and marketing organization for these products.

Manufacturing.  We perform design, assembly, testing and quality control of our high performance digital cameras in-house at our Colorado Springs facility. We utilize an outsourcing strategy for the manufacture of a majority of our components and subassemblies. Production lead times are six to twelve weeks, and camera production is based on customer purchase orders and anticipated orders. As of September 30, 2007, we employed four manufacturing personnel at our Colorado Springs, Colorado facility.

We believe that our operations and facilities are in substantial compliance with all applicable federal, state, and local laws and regulations covering the discharge of materials into, and protection of, the environment. During 2007, Salvador Imaging obtained ISO 9000: 2001 certification and in January 2008, Salvador Imaging became certified under the International Traffic in Arms Regulations (ITAR), a set of U.S. government regulations that control the export and import of defense-related products and services.

Research and Development.  We are focusing our current research and development on highly sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for defense applications and cameras with unique inspection capabilities for industrial applications. As of September 30, 2007, we employed 17 research and development personnel at our Colorado Springs, Colorado facility.

Suppliers

Many of the parts, components and subassemblies (collectively “parts”) that we purchase from our suppliers are standard commercial products, although certain parts are made to our specifications. We use numerous vendors to supply parts for the manufacture and support of our products; however, we obtain several parts, components and subassemblies for our systems from a sole source or a limited group of suppliers. For example, we currently obtain material handling platforms, PCI boards, certain laser assemblies and certain pellicle products from various single

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source suppliers. Although we seek to reduce dependence on sole source and limited group suppliers, alternative sources of supply for certain pieces of equipment remain unavailable or may only be available on unfavorable terms. The partial or complete loss of a single source or limited group of suppliers or any delay in shipment from a single source or limited group of suppliers could negatively impact our results of operations, damage customer relationships and subject us to penalties from our customers for late delivery of customer orders. Further, a significant increase in the price of one or more of these pieces of equipment could harm our results of operations. To date, we have not experienced any significant damages or loss as a result of sourcing from a sole source or limited group of suppliers or any related delays in shipment.

Intellectual Property

We protect our proprietary technology through various methods such as patents and patent applications, trademarks, non-disclosure agreements and trade secrets. We have filed and obtained a number of United States and foreign patents and have also jointly filed patent applications in Japan. As of November 3, 2007, we have been issued 70 patents in the United States that are effective. The normal expiration dates of these patents range from 2007 to 2024. As of November 3, 2007, there are 23 pending patent applications in the United States. As of November 3, 2007, we have been issued 41 non-U.S. patents that are in force, with expiration dates beginning in 2010, and there are 76 non-U.S. pending patent applications. From time to time, we license our patents to third parties for use in fields of use other than the flat panel industry.

Our patents relate to various aspects of our yield enhancement solutions and other technology as set forth in the following table (as of November 3, 2007):

	Patents in Force
	U.S.		Non-U.S.
Yield enhancement products		43		31
Other		27		10
Total		70		41

We intend to continue to pursue the legal protection of our technology through intellectual property laws. However, we cannot be certain that the steps we have taken to protect our intellectual property rights will be adequate or that third parties will not infringe, challenge or misappropriate our proprietary rights.

Backlog

Our backlog consists of work-in-process and unshipped system orders, unearned revenue and systems in deferred gross margin. As of September 30, 2007, our backlog was approximately $60.5 million, compared to approximately $71.0 million as of September 30, 2006. We expect to ship or to recognize revenue on the majority of the September 2007 backlog within the next six to twelve months. All orders are subject to postponement or cancellation by the customer with limited or no penalties. Because of possible changes in product delivery schedules and cancellation of product orders, among other factors, our backlog may vary significantly and, at any particular date, is not necessarily indicative of actual sales for any succeeding period.

Competition

The worldwide markets for integrated yield enhancement systems and high-performance digital cameras are highly competitive. We face substantial competition from established companies, many of which have greater financial, engineering and manufacturing resources, larger service organizations and long-standing customer relationships with key existing and potential customers. We may also face future competition from new market entrants from other overseas and domestic sources.

Our competitors in the Flat Panel Display segment primarily include Micronics Japan, Applied Komatsu Technology, Shimadzu Corporation, LaserFront Technologies, NTN Corporation, Contrel Limited, LG Tech Center, Charm Engineering and Hoya Continuum Corporation. Our competitors in the High-Performance Digital Imaging segment include Roper Industries, Andor, Dalsa and Ball Aerospace.

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In both the Flat Panel Display segment and High-Performance Digital Imaging segment, we expect our competitors to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. In addition, our customers may choose to develop proprietary technology that may obviate or lessen their need to purchase our products. Moreover, increased competitive pressure may necessitate price-based competition, which could harm our business, financial condition and results of operations.

In the Flat Panel Display segment, we believe that we can compete effectively with our competitors by building on our substantial installed customer base, providing technologically superior, competitively priced products and emphasizing our easy-to-use user interfaces and customer support. However, realizing and maintaining such advantages will require a continued high level of investment by us in engineering, research and development, marketing and customer service and support. We may not have sufficient resources to continue to make such investments. Even if sufficient funds are available, we may not be able to make the technological advances in a timely manner necessary to maintain such competitive advantages in the Flat Panel Display segment.

Significant competitive factors in the market for our yield enhancement systems include system performance, ease of use, reliability, installed base and technical service and support. We believe that, while price and delivery are important competitive factors, our customers’ overriding requirement is for systems that easily and effectively incorporate automated and highly accurate inspection and repair capabilities into their existing manufacturing processes, thereby enhancing productivity.

Our yield enhancement systems for the flat panel display industry are intended to compete based upon performance and technical capabilities. These systems may compete with less expensive and more labor-intensive manual inspection devices.

Significant competitive factors in the market for our high performance digital cameras include performance, ease of use, reliability and technical service and support. We believe that while price and delivery are important competitive factors, our customers’ overriding requirement is for cameras that easily and effectively meet our customers’ requirements for demanding performance and reliability under harsh physical conditions.

Our high performance digital cameras are intended to compete based upon performance and technical capabilities, but may also compete with less expensive, lower performance cameras.

Employees

As of September 30, 2007, we employed 343 persons. No employees are represented by a labor union or covered by a collective bargaining agreement. We also utilize contract labor, predominantly in our manufacturing operations, which improves our ability to adjust manpower in response to changing demand for our products. Notwithstanding our high turnover rate, described in greater detail below, we consider our relationships with current employees to be generally satisfactory.

Competition is intense in the recruiting of personnel in both the flat panel display and the high-performance digital camera industries. Our future success may depend in part on our continued ability to hire and retain qualified management and technical employees. Our employee turnover in fiscal 2007 was 33% in total, including the voluntary resignation of 15% of our employees.

Business Combinations and Acquisitions

In addition to our efforts to develop new technologies from internal sources, we may also seek to acquire new technologies from external sources. Acquisitions involve numerous risks, including management issues and costs in connection with integration of the operations, technologies and products of the acquired companies, possible write-downs of impaired assets, and the potential loss of key employees of the acquired companies.

During fiscal 2007 we purchased Salvador Imaging, an international supplier of high-performance digital cameras for defense, industrial and other applications. This acquisition seeks to leverage our digital imaging core competencies as well as our operational and manufacturing strengths to develop highly sensitive color and

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monochrome cameras for new potential markets outside the flat panel display market. In October 2007, we entered into an agreement with LT Solar LLC to acquire an interest in certain technologies related to solar panel technology.

In fiscal 2006, we entered into agreements that committed us to provide funding and limited use licenses to certain of our intellectual property to an early-stage development company, NB Digital. This venture sought to leverage our technology in new potential markets; however, in fiscal 2007 we stopped funding NB Digital, which went into bankruptcy and ceased operations.

For further details regarding our business combinations and dispositions, please see Note 5 of “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. For further details regarding our October 2007 acquisition, please see Note 17 of “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K.

ITEM 1A.   RISK FACTORS

Our actual results could differ materially from those projected in the forward-looking statements included in this Annual Report on Form 10-K as a result of a number of factors, risks and uncertainties, including the risk factors set forth below and elsewhere in this Annual Report on Form 10-K. You should carefully consider the risks described below before investing in our securities. The risks described below are not the only ones facing us. Additional risks not currently known to us or that we currently believe are immaterial may also impair our business, results of operations, financial condition and liquidity.

We have organized our risks into the following categories:

•  Risks Relating to our Business

•  Risks Relating to Owning our Common Stock

•  Risks Relating to Our Restatements and Related Matters

RISKS RELATING TO OUR BUSINESS

We have sustained losses and we may sustain losses in the future.

We reported a net loss for the fiscal year ended September 30, 2007. Although we reported net income for the fiscal years ended September 30, 2006 and 2004, we reported a net loss for each of the fiscal years ended September 30, 2005, 2003 and 2002. In the future our revenue may decline, remain flat or grow at a rate slower than expected. In fiscal 2007, we experienced substantially lower levels of bookings and revenues due to factory investment delays by our customers, as discussed in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K.

Our ability to achieve and maintain profitability is dependent in part on the success of our efforts to increase revenues and to reduce operating expenses as a percentage of revenue through our ongoing cost-cutting measures, gross margin improvement programs and outsourcing of manufacturing to Asia. If demand for our products is not sustained and we do not react quickly to reduce discretionary and variable spending, this would impair our ability to achieve profitability on a going-forward basis. For all of these reasons, there is no assurance that we will be successful in achieving or maintaining increased revenue, reduced operating expenses, positive cash flows or profitability and we may incur losses going forward.

Our customers may cancel or defer their purchases at any time and on short notice, which could harm our operating results.

Our flat panel display business is substantially dependent on orders we receive and fill on a short-term basis. We do not have contracts with our customers that provide any assurance of future sales, and sales are typically made pursuant to individual purchase orders, often with short lead times. Accordingly, our customers:

•  may stop purchasing our products or defer their purchases at any time without penalty;

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•  are free to purchase products from our competitors;

•  are not required to make minimum purchases; and

•  have cancelled, and may in the future cancel, purchase orders that they place with us without reimbursing us for any costs incurred.

As a result, we cannot rely on orders in backlog as a reliable and consistent source of future revenue. Sales to any single customer may and do vary significantly from quarter to quarter. Our flat panel display customers generally do not place purchase orders more than twelve months in advance. In addition, our customers’ purchase orders have varied significantly from quarter to quarter. This means that customers who account for a significant portion of our revenues in one quarter may not and often do not place orders at the same level as the current quarter in the succeeding quarter, which makes it difficult to forecast our revenues in future periods. Moreover, our expense levels are based in part on our expectations of future revenue, and we may be unable to adjust costs in a timely manner in response to further revenue shortfalls. In addition, because certain parts used in our manufacturing process require longer lead times, if a customer cancels an order, we may be required to record additional inventory write-offs, which would have a negative impact on our gross margin. In addition, a small number of our flat panel display products are built without any advance customer commitment. All of these factors can result in significant quarterly fluctuations in our operating results.

Our operating results are difficult to predict and may vary from investors’ expectations, which could cause our stock price to fall.

We have experienced, and expect to continue to experience, significant fluctuations in our quarterly and annual results. Consequently, past financial results may not be indicative of future financial results. A substantial percentage of our revenue is derived from the sale of a small number of flat panel yield enhancement systems that ranged in price from approximately $450,000 to $3.4 million in fiscal 2007. Therefore, the timing of, and recognition of revenue from, the sale of a single system could have a significant impact on our quarterly and annual results. After we ship our products, customers may reject or delay acceptance, which would adversely impact our revenues and our stock price. Moreover, customers may cancel or reschedule shipments, and production difficulties could delay shipments.

Other factors which may influence our operating results in a particular quarter or fiscal year include:

•  the result of competitive pricing pressures;

•  the timing of the receipt of orders from major customers;

•  the result of sudden, unanticipated changes in customer requirements;

•  the cancellation or postponement of firm orders by a customer without compensation;

•  the receipt of final acceptance on new products;

•  the product mix that makes up our revenue;

•  the incurrence of warranty expenses;

•  our inability to reduce our expense levels quickly in the event of market downturns, due to the fact that a high percentage of our expenses, including those related to manufacturing, engineering, research and development, sales and marketing and general and administrative functions, is fixed in the short term;

•  the ability to obtain components from our single or limited source suppliers in a timely manner;

•  the ability to effectively implement our strategy of migrating or outsourcing manufacturing offshore;

•  the ability of our offshore manufacturing operations to timely produce and deliver products in the quantity and of the quality our customers require;

•  the costs of operations in the global markets in which we do business;

•  the effects of changing international economic conditions;

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•  the effects of currency exchange rate fluctuations;

•  the outcome of the appeal of litigation with a former executive officer;

•  the effects of worldwide political instability;

•  the ability to design, manufacture and introduce new products on a cost-effective and timely basis;

•  the delay between expenses to further develop marketing and service capabilities and the realization of benefits from those improved capabilities; and

•  the introduction of new products by our competitors.

Due to the factors noted above and other risks discussed in this section, we believe that quarter-to-quarter comparisons of our operating results may not be meaningful. In addition, as a result of these or other factors, our operating results could be significantly and adversely affected and our stock price could decline. In addition, it is possible that in some future quarter our operating results may be below the expectations of public market analysts and investors, which could cause our stock price to fall.

We have experienced multiple material weaknesses in our internal controls and procedures during our 2003 through 2007 fiscal years, including three material weaknesses identified during our 2007 fiscal year that have not yet been remediated. If we are unable to implement our remediation plan effectively or if other material weaknesses or control deficiencies develop that we are unable to address, the material weaknesses in our internal controls could have a significant adverse effect on our business, financial condition and results of operations, result in our failure to meet reporting obligations and adversely affect our stock price.

We have experienced one or more material weaknesses in our internal control over financial reporting during each of our 2003 through 2007 fiscal years. A material weakness is a deficiency, or combination of deficiencies, in internal controls over financial reporting such that there is a reasonable probability that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. As described in more detail in Item 9A, our internal review of customs practices and the resulting restatement of our consolidated financial statements led to the identification of three material weaknesses in internal control over financial reporting, which have not yet been successfully remediated. Our inability to maintain effective internal controls has strained our resources, caused us to delay filing periodic reports with the SEC and subjected us to potential delisting. In addition, we have experienced significant turnover in key financial positions, including three different chief financial officers in the last three years. This turnover has increased the difficulty of improving our financial controls. Our current chief financial officer has determined to leave the Company effective following completion and filing of this Annual Report on Form 10-K. In order to remediate our material weaknesses effectively, we will need to attract and retain a new chief financial officer and devote significant resources to building a new finance team. Although we intend to commit significant resources to rebuilding our finance team and remediating these material weaknesses, there can be no assurances that we will be successful in doing so, or that our revised internal controls and procedures will be effective in remediating our existing material weaknesses and preventing additional material weaknesses from occurring in the future. If we are unable to implement our remediation plan effectively or if other material weaknesses or control deficiencies develop, the material weaknesses in our internal controls could have a significant adverse effect on our business, financial condition and results of operations, result in our failure to meet reporting obligations and adversely affect our stock price. In addition, we will be required to hire additional employees to implement our remediation plan and improve our control environment, which could result in higher than anticipated operating expenses during the implementation of these changes and thereafter.

We have experienced significant employee turnover, including in several key financial positions. If we are unable to attract and retain key employees, it may disrupt our ability to improve our financial controls, meet our reporting obligations and effectively manage our business.

We depend on our employees and our ability to attract and retain key employees. We have recently experienced higher employee attrition, particularly in key financial positions. Our employee turnover in fiscal 2007 was 33% in total, including the voluntary resignation of 15% of our employees. We generally do not have employment contracts

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with our employees and do not maintain key person life insurance on any of our employees. There can be no assurance that we will be able to retain our existing employees or attract additional qualified personnel in the future. If we are unable retain qualified employees and hire additional key employees, including a new chief financial officer and additional finance staff, it may adversely affect relationships with key customers, disrupt our ability to improve our financial controls, meet our reporting obligations and effectively manage our business.

We have exposure to various foreign and domestic regulatory risks. Our failure to comply with governmental regulations could subject us to liability and additional expense.

We have exposure to various risks related to new, existing and sometimes inconsistent laws, rules and regulations that have been or may in the future be enacted by legislative bodies or regulatory agencies in the countries in which we operate and with which we must comply.

We are subject to a variety of laws of the United States and other countries related to the import and export of our products and technology, including shipments to South Korea, Taiwan, Japan and China. A failure to comply with these laws could subject us to additional expense and to civil and criminal liability. For example, in the first quarter of fiscal 2007, we recorded a liability of approximately $1.0 million as a result of our review of the our methodology for calculating certain customs duties in connection with the cross-border movements of warranty parts, in which we determined certain amounts had been underreported. In the third quarter of fiscal 2007, we began to voluntarily disclose our historical valuation practices to customs authorities in South Korea, Taiwan, Japan and China. As a result of this process, we currently estimate our total costs, including duties, penalties and interest as well as legal, accounting and other costs associated with the restatement, to be in the range of $11.0 million to $12.0 million. This updated estimate is based on both actual settlements with certain government agencies and our estimates of amounts that will be ultimately paid. We have not received waivers from any governmental agency and cannot guarantee that additional payment obligations will not arise related to these prior activities. The ultimate resolution of this matter or other matters could entail further expense in the form of duties, interest and penalties under applicable laws. We have not concluded any settlement with U.S. authorities with respect to our failure to make certain filings in connection with the export of warranty parts. We have commenced voluntary discussions with U.S. government agencies, including Customs, the Census Bureau and the Bureau of Industry and Security, regarding certain filing obligations that were not complied with in connection with our exports. Although the products in question were not restricted under export control laws and no fees were associated with these filings, the voluntary disclosure of our failure to comply with U.S. filing obligations may subject us to penalties and result in additional expenses, which could be material and the extent of which we are currently unable to estimate.

In addition, from time to time we enter into transfer pricing arrangements with our subsidiaries to establish sales prices for internal distributions of goods that have the effect of allocating taxes between the parent corporation and our subsidiaries. In general, these transfer prices have not been approved by any governmental entity and, therefore, may be challenged by the applicable tax authorities.

We employ a number of foreign nationals in our U.S. operations and, as a result, we are subject to various laws related to the status of those employees. We also send our U.S. employees to foreign countries from time to time and for varying durations of time to assist with our foreign operations. Depending on the durations of such arrangements, we may be required to withhold and pay personal income taxes in respect of the affected U.S. employees directly to the foreign tax authorities, and the affected U.S. employees may be required to register with various foreign governmental authorities. Our failure to comply with the foregoing laws and regulations or any other applicable laws and regulations could subject us to liability or the unfavorable treatment of our employees by immigration authorities.

If our flat panel display products experience performance, reliability or quality problems, our customers may reduce their orders.

We believe that future orders of our flat panel display products will depend in part on our ability to satisfy the performance, reliability and quality standards required by our customers. Particularly as customers seek increased yields, greater throughput and higher-quality end products, we must continually redesign our products to meet the needs of our customers. As with the introduction of any new product, our products may experience design and

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reliability issues. For example, our original Generation 7 ArrayChecker^tm and ArraySaver^tm systems required longer than anticipated time periods to bring them to full production due to design and reliability issues experienced by some of our customers. If our products have performance, reliability or quality problems, then we may experience:

•  delays in receiving final acceptance from our customers, which in turn delays recognition of the associated revenue;

•  cancellation of orders by customers;

•  assessment of penalties by customers;

•  delayed payment by customers;

•  renegotiation of our prices by customers;

•  reduced orders from our customers;

•  additional warranty and service expenses; and

•  higher manufacturing costs.

If we are unable to meet the technological, performance and reliability requirements of our customers, our revenue may decrease and our business could be harmed.

In addition, we typically provide a limited warranty on our flat panel display products for a period of 12 months from final acceptance by customers or 14 months from shipment, whichever is less. Actual warranty claims may, at times, exceed the estimated cost of warranty coverage we record in our warranty provision. For example, in the fourth quarter of fiscal 2006, we agreed to replace two of the four original Generation 7 ArrayChecker^tm test systems purchased by one customer with a newer version of our Generation 7 test systems under our warranty coverage of the purchased systems. Even though all four original Generation 7 systems were in full production, reliability and uptime issues had impacted the production capability of the fabrication lines in which they operated. The expected replacement of these systems resulted in additional warranty charges of approximately $3.0 million in the quarter ended September 30, 2006. Approximately $2.7 million of warranty liability associated with this exchange was satisfied during fiscal 2007 when the machines were replaced. Although we believe the problems associated with the two array test systems that were replaced were fixed in subsequent versions of our Generation 7 test systems, we may experience additional warranty costs on other products that are in excess of our estimated warranty costs. In the future, we may incur substantial warranty claim expenses on our products and actual warranty claims may exceed recorded provisions, resulting in harm to our business.

Capital investment by manufacturers of flat panel display products can be highly cyclical and may decline in the future.

Our flat panel display business depends in large part on capital expenditures by manufacturers of flat panel display products, which in turn depends on the current and anticipated market demand for the end products in that industry. The capital equipment procurement practices of flat panel display manufacturers has been highly cyclical. At the end of the first half of calendar year 2006, we saw an oversupply in the consumer market, causing manufacturers to respond by scaling back factory utilization rates and dropping panel average selling prices, which eroded the manufacturers’ profits. The majority of manufacturers scaled back their investment plans for calendar year 2007 as they evaluated television manufacturing costs, holiday season demand and consumer electronics market issues such as brand strength and high-definition programming formats and availability.

When cyclical fluctuations result in lower than expected revenue levels, operating results may be adversely affected and cost reduction measures may be necessary in order for us to remain competitive and financially sound. During a down cycle, we must be in a position to rapidly adjust our costs and expense structure to prevailing market conditions and to continue to motivate and retain our key employees. Adjusting to a downcycle may cause us to reduce or realign our manufacturing capacity, which may result in asset impairment charges in our manufacturing facilities. In addition, during periods of rapid growth, we must be able to increase manufacturing capacity and personnel to meet customer demand. We can provide no assurance that these objectives can be met in a timely

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manner in response to industry cycles. In addition, our need to invest in the engineering, research and development, and marketing required to penetrate targeted foreign markets and maintain extensive service and support capabilities limits our ability to reduce expenses during downturns.

We depend on sales to a few large customers in the flat panel display industry, and if we lose any of our large customers our revenue could decrease significantly.

The flat panel display industry is extremely concentrated with a small number of manufacturers producing the majority of the world’s glass panels for flat panel displays. If one or more of our major customers ceased or significantly curtailed their purchases, our revenue could drop significantly. We may be unable to replace sales to these customers. Sales to our greater than 10% customers in the last three fiscal years is as follows: four 10% customers accounted for 77% of our revenue in fiscal 2007; three 10% customers accounted for 76% of our revenue in fiscal 2006; and five 10% customers accounted for 67% of our revenue in fiscal 2005. None of our customers has entered into a long-term purchase agreement that would require the customer to purchase our products

We rely upon sales of a limited range of flat panel display products, and if demand for one product decreases for any reason it could cause our revenue to decline significantly.

The substantial majority of our revenue is expected to come from a limited range of products for the flat panel display industry. Although we are seeking to diversify our market base through the acquisition of Salvador Imaging, we currently expect revenue from the sales of our flat panel display product line to continue to constitute a majority of our revenue in the near future. As a result, we are highly reliant on the flat panel display industry. Any decline in demand for, or failure to achieve continued market acceptance of, our primary products or any new version of these products could harm our business. Continued market acceptance of our array test and array repair products is critical to our success.

We generate the substantial majority of our revenue from the sale of our ArrayChecker^tm and ArraySaver^tm test and repair equipment and customer support, which includes the sale of spare parts. In prior years we generated revenue from our PanelMaster^tm inspection equipment. However, in November 2006, we announced that we were discontinuing this product line. The discontinuation of our PanelMaster^tm product line increases our dependence on sales of our ArrayChecker^tm and ArraySaver^tm product lines and further limits our range of products.

We may not be able to develop and introduce new products that respond to evolving industry requirements in a timely manner, which could reduce our ability to compete effectively.

The markets for our products are characterized by rapidly changing technologies and frequent new product introductions. The failure to develop new products and introduce them successfully and in a timely manner could harm our competitive position and results of operations. We believe that our future success will depend in part upon our ability to continue to enhance our existing products and to develop and manufacture new products. For example, the size of glass substrates for flat panel displays and the resolution of flat panel displays have changed frequently and may continue to change, requiring us to redesign or reconfigure our flat panel display products.

We expect to continue to incur significant research and development costs. There can be no assurance that we will be successful in the introduction, marketing and cost-effective manufacture of any of our new products, that we will be able to timely develop and introduce new products and enhance our existing products and processes to satisfy customer needs or achieve market acceptance, or that the new markets for which we are developing new products or expect to sell current products will develop sufficiently.

In addition, we depend on close relationships with our customers and the willingness of those customers to share information with us, and the failure to maintain these relationships could harm our product development efforts.

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If we are not able to receive sufficient parts to meet our production requirements, we may experience significant delays in producing our products, which could decrease our revenue for an extended period of time.

We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers to supply these materials. We generally do not have guaranteed supply arrangements with our suppliers. Because of the variability and uniqueness of customers’ orders, we do not maintain an extensive inventory of material for manufacturing. Significant delays in receiving required materials could delay our shipments, subject us to penalties from our customers for late delivery of customer orders, harm our results of operations and damage customer relationships. In addition, we obtain some equipment for our systems from a single source or a limited group of suppliers. For example, we currently obtain material handling platforms, PCI boards, certain laser assemblies and certain pellicle products from single source suppliers. Although we seek to reduce dependence on sole and limited source suppliers, alternative sources of supply for this equipment remain unavailable or may only be available on unfavorable terms. The partial or complete loss of our sole and limited source suppliers could significantly delay our shipments or otherwise harm our results of operations and damage customer relationships. Further, a significant increase in the price of one or more of these pieces of equipment by a single or limited source supplier could harm our results of operations.

Substantially all of our revenue from flat panel display products is derived from sales to companies located outside the United States, which exposes us to risks that we would not experience with domestic sales.

We expect sales to flat panel display customers in foreign countries to continue to represent nearly all of our revenue in the foreseeable future. A number of factors may adversely affect our international sales and operations, including:

•  political instability and the possibility of hostilities, terrorist attacks, or war;

•  imposition of governmental controls;

•  fluctuations in interest and currency exchange rates;

•  customs and export and import license requirements;

•  restrictions on the export of technology;

•  limited foreign protection of intellectual property rights;

•  periodic local or international downturns;

•  decreases in productivity, temporary plant shutdowns or infrastructure service disruptions resulting from widespread health alerts including Severe Acute Respiratory Syndrome (“SARS”) and warnings of an avian flu pandemic;

•  changes in tariffs; and

•  difficulties in staffing and managing international operations.

If any of these factors occur, our operating results and revenue could be materially and adversely affected.

Our customer qualification and sales cycle is lengthy and unpredictable and requires us to incur substantial costs to make a sale, and if we fail to make a sale, our increased expenses may lead to lower profit margins.

Our flat panel display customers typically expend significant time and effort evaluating and qualifying our products and manufacturing process prior to placing an order. This evaluation and qualification process frequently results in a lengthy sales cycle, typically ranging from nine to twelve months and sometimes longer. During the period that our customers are evaluating our products and before they place an order with us, we may incur substantial sales, marketing and research and development expenses, expend significant management efforts, increase manufacturing capacity and order long lead-time supplies. Even after this evaluation process, it is possible

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that a potential customer will not purchase our products. We expect that our High-Performance Digital Imaging segment will also be characterized by lengthy sales cycles as we anticipate that customers in the defense, security and medical industries will also generally expend significant time and effort evaluating our products and processes prior to placing an order.

In addition, our customers’ purchases of our products are frequently subject to unplanned delays and rescheduling, particularly with respect to larger customers for which our products represent a very small percentage of their overall purchase activity. Unplanned delays in the purchase or installation of our products have occurred in the past, and may continue to occur, as a result of delays in the installation of other manufacturers’ equipment at a customer’s facilities. Long sales cycles may cause our revenues and operating results to vary significantly and unexpectedly from quarter to quarter, which could cause volatility in our stock price.

Our ability to efficiently and effectively implement our strategy of using both domestic and outsourced offshore manufacturing may impact our profitability.

Our ability to successfully compete in our current flat panel display markets may be determined in part by our ability to efficiently and effectively implement our strategy of using both domestic and offshore manufacturing. Our offshore manufacturing facilities may at times create excess capacity in our domestic manufacturing facilities which may in turn cause an increase in costs due to the under-utilization of our San Jose facilities. If our offshore manufacturing strategy is successful, we may increase our offshore capacity and move additional manufacturing offshore. This new offshore strategy contributed to an approximately $2.8 million impairment charge we recorded in the quarter ended March 31, 2007 as a result of excess capacity in one of our remaining domestic manufacturing facilities. If we continue to be successful in executing our offshore manufacturing strategy, it may result in additional asset impairment charges by creating excess capacity in our domestic manufacturing facilities.

In addition, a number of factors may adversely affect our existing international manufacturing operations and ability to execute our offshore manufacturing strategy, including:

•  political instability and the possibility of hostilities, terrorist attacks, or war;

•  imposition of governmental controls;

•  fluctuations in interest and currency exchange rates;

•  limited foreign protection of intellectual property rights;

•  trade restrictions;

•  periodic or local international downturns;

•  decreases in productivity, temporary plant shutdowns or infrastructure service disruptions resulting from widespread health alerts such as those relating to SARS and avian flu outbreaks; and

•  difficulties in staffing and managing international manufacturing.

If any of these factors occur, our operating results and revenue could be materially and adversely affected.

Any failure of, or other problems at or with, our third party manufacturers could delay shipments of our products, harm our relationships with our customers or otherwise negatively impact our business.

We use a wide range of materials in the production of our products, including custom electronic and mechanical components, and we use numerous suppliers to supply these materials. If any third party that we use to manufacture our products is unable to satisfy our quality requirements or provide us with the products and services in a timely manner, our shipments of these products may be delayed, our customer relationships may be harmed and our results of operations may be adversely impacted. There can be no assurance that our relationship with any third party that we use to manufacture our products will result in a reduction of our expenses or enable us to satisfy our customers’ quality requirements or to deliver our products to our customers in a timely manner.

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If we do not compete effectively in our target markets, we will lose market share.

The markets in which we compete are highly competitive. We face substantial competition from established competitors that have greater financial, engineering and manufacturing resources than us and have larger service organizations and long-standing customer relationships. Our competitors can be expected to continue to improve the design and performance of their products and to introduce new products with competitive price and performance characteristics. Competitive pressures may force price reductions that could harm our results of operations. Our customers may also develop technology and equipment that may reduce or eliminate their need to purchase our products. Although we believe we have certain technological and other advantages over our competitors, maintaining and capitalizing on these advantages will require us to continue a high level of investment in engineering, research and development, marketing and customer service support. There can be no assurance that we will have sufficient resources to continue to make these investments or that we will be able to make the technological advances necessary to maintain our competitive advantages.

Our success depends in large part on the strength of active matrix liquid crystal display technology in the flat panel display industry.

While our technology is applicable to other flat panel display technologies, our experience has been focused on applications for active matrix liquid crystal displays, the most prevalent and one of the highest performance flat panel displays available today. We derive a substantial majority of our revenue from flat panel display products, substantially all of which are based on the active matrix liquid crystal display technology. An industry shift away from active matrix liquid crystal display technology to existing or new competing technologies could reduce the demand for our existing products and require significant expenditures to develop new products, each of which could harm our business. For example, if the AMLCD television market has a significant shift to plasma technology, it would negatively affect LCD manufacturers’ fab planning and our business would be negatively impacted.

We may have difficulty integrating businesses or assets that we have acquired or developed in new ventures and may acquire or develop in the future, and we may not realize the benefits that we expect from these acquisitions and new ventures.

In addition to our efforts to develop new technologies from internal sources, we also may seek to acquire new technologies from external sources or partner with other companies to develop new technologies. As a part of this effort, we may make additional acquisitions of, or significant investments in, businesses with complementary products, services and/or technologies. For example, in the fourth quarter of our fiscal 2007 we purchased Salvador Imaging, through which we will seek to develop highly sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for the military and security markets, and unique inspection capabilities in industrial applications.

Integrating a business can be a complex, time-consuming and expensive process. If we are not able to do so effectively, we will not be able to realize the benefits that we expect to receive from either our past or future acquisitions and new ventures. For each acquisition or new venture, we must integrate separate technologies, product lines, business cultures and practices, employees and systems. Acquisitions and new ventures are subject to numerous risks, including:

•  difficulty in the assimilation of the technologies and products;

•  entering markets in which we have no or limited direct prior experience;

•  loss of key customers;

•  diversion of management resources;

•  incompatibility of business cultures or practices;

•  loss of key employees;

•  costs and delays in implementing common systems and procedures;

•  potential inefficiencies in delivering services to customers; and

•  assumption of unknown or undisclosed liabilities.

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Any of these difficulties could increase our operating costs or result in impairment of purchased assets, which could harm our financial performance.

In addition, we may also elect to change our strategic direction and may no longer have need for the acquired businesses or new technologies. For example, in fiscal 2007 we stopped funding NB Digital, which we acquired in November 2002 and which subsequently went into bankruptcy and ceased operations. In the third quarter of fiscal 2004, we sold all of our assets related to our TFT-LCD backlight inverter business acquired in September 2002. In 2003, we exited the printed circuit board assembly, cathode ray tube display and high quality glass inspection businesses. As a result, some or all of the technologies acquired in connection with certain of our prior acquisitions have been abandoned. Future acquisitions may also result in potentially dilutive issuances of equity securities, incurrence of debt and contingent liabilities and amortization expenses related to acquired intangible assets, which could harm our profitability.

We may never achieve or sustain profitability in our High-Performance Digital Imaging business segment.

We commenced operations in our High-Performance Digital Imaging segment with our acquisition of Salvador Imaging in July 2007. Because we have limited experience in this market segment, it is difficult for us to predict our operating results and the ultimate size of the market for our products. There can be no assurance that we will be successful in the introduction, marketing and cost-effective manufacture of any new products, that we will be able to develop and introduce new products on a timely basis, that we will be able to scale our operations from the current low volumes to more substantial commercial volumes, or that we will be able to enhance our existing products to satisfy customer needs. We expect operating expenses for this segment to increase over the next several years as we hire additional sales and marketing personnel and develop our technology and new products. In future periods, revenues could decline and, accordingly, we may not be able to achieve profitability in this segment. Even if we do achieve profitability in this segment, we may not be able to sustain or increase profitability on a consistent basis.

If the products developed within our High-Performance Digital Imaging segment become successful, we may derive a significant portion of our revenue from customers that receive their funding for our products from U.S. government contracts, which are subject to unique risks.

The defense industry is the chief market for products within our High-Performance Digital Imaging segment. If we are successful in developing and marketing our products in the segment, we may significantly increase our revenue derived directly or indirectly from U.S. government contracts awarded to our customers or us under various U.S. government programs. The funding of such programs is subject to the overall U.S. government budget and appropriation decisions and processes which are driven by numerous factors, including geo-political events and macroeconomic conditions that are beyond our control. In addition to normal business risks, contracts involving the U.S. government are subject to unique risks, including the following, which may be beyond our control.

The funding of U.S. government programs is subject to congressional appropriations.  Many of the U.S. government programs in which we or our customers may participate could extend for several years; however, these programs are normally funded annually. Long-term government contracts and related orders are subject to cancellation if appropriations for subsequent performance periods are not made. If we or our customers are successful in participating in a U.S. government program, the termination of funding for that U.S. government program would result in a loss of anticipated future revenues attributable to that program.

The U.S. government would have the ability to modify, curtail or terminate contracts.  The U.S. government may modify, curtail or terminate its contracts and subcontracts without prior notice at its convenience upon payment for work done and commitments made at the time of termination. Because our customers will likely depend on contracts with the U.S. government, modification, curtailment or termination of their contracts with the U.S. government could have an adverse effect on our results of operations and financial condition.

Our contract costs would be subject to audits by U.S. government agencies.  U.S. government representatives could have the right to audit the costs that we incur in connection with work performed as a subcontractor under a

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U.S. government contract, including allocated indirect costs. If an audit were to uncover improper or illegal activities, we could be subject to civil and criminal penalties and administrative sanctions.

Our business could be subject to potential U.S. government inquiries and investigations.  If we are successful in participating directly or indirectly in a U.S. government program, we would be subject to U.S. government inquiries and investigations of our business practices upon any findings of potential improprieties due to our participation in government contracts. Any such inquiry or investigation could potentially result in an adverse effect on our results of operations and financial condition.

Contracts with the U.S. government would be subject to specific procurement regulations and other requirements affecting us or our customers.  These requirements, although customary in U.S. government contracts, may increase our performance and compliance costs, which could have a negative effect on our financial condition. Our ability to do business with government contractors would be dependent on complying with various registration and licensing requirements, such as the International Traffic in Arms Regulations (ITAR) certification that we recently received for our High-Performance Digital Imaging business. Certain of our high-performance digital imaging cameras are subject to other restrictions and requirements under U.S. laws and regulations. Failure to comply with these regulations and requirements could cause our licenses or permits to be revoked or suspended, or lead to suspension or debarment, for cause, from U.S. government contracting or subcontracting.

Certain U.S. government programs are subject to security classification restrictions on information.  We may participate in programs that are subject to security classification restrictions (“restricted business”), which could limit our ability to discuss details about these programs, their risks or any disputes or claims relating to such programs. As a result, investors might have less insight into our restricted business than other businesses of the company or could experience less ability to evaluate fully the risks, disputes or claims associated with such restricted business.

Our business could be harmed if we fail to properly protect our intellectual property.

Our success depends largely on our ability to protect our intellectual property. While we attempt to protect our intellectual property through patents, copyrights and trade secrets in the United States and other countries, there can be no assurance that we will successfully protect our technology or that competitors will not be able to develop similar technology independently. We cannot assure you that the claims allowed on any patents held by us will be sufficiently broad to protect our technology against competition from third parties with similar technologies or products. In addition, we cannot assure you that any patents issued to us will not be challenged, invalidated or circumvented or that the rights granted there-under will provide competitive advantages to us. Moreover, the laws of some foreign countries do not protect intellectual property rights to the same extent as the laws of the United States, and we could experience various obstacles and high costs in protecting our intellectual property rights in foreign countries, including South Korea, where we recently announced our lease of a new manufacturing facility. If we are unable to obtain or maintain these protections, we may not be able to prevent third parties from using our intellectual property.

We also rely on trade secrets, proprietary know-how and continuing technological innovation to remain competitive. We have taken measures to protect our trade secrets and know-how, including the use of confidentiality agreements with our employees. However, it is possible that these agreements may be breached and that the available remedies for any breach will not be sufficient to compensate us for damages incurred.

Litigation may be necessary to enforce or defend against claims of intellectual property infringement, which could be expensive and, if we lose, could prevent us from selling our products.

Litigation may be necessary in the future to enforce our patents and other intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. Any litigation, regardless of the outcome, could be costly and require significant time and attention of key members of our management and technical personnel.

Our domestic and international competitors, many of which have substantially greater resources and have made substantial investments in competing technologies, may have patents that will prevent, limit or interfere with

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our ability to manufacture and sell our products. We have not conducted a comprehensive independent review of patents issued to third parties. Third parties may assert infringement claims, successful or otherwise, against us, and litigation may be necessary to defend against claims of infringement or invalidity. An adverse outcome in the defense of a patent suit could subject us to significant liabilities to third parties, require disputed rights to be licensed from third parties or require us to cease selling our products. Even successful defenses of patent suits can be costly and time-consuming.

Our corporate offices and manufacturing facilities and our customers’ manufacturing facilities may be subject to disruption from natural disasters.

Operations at our corporate offices and manufacturing facilities are subject to disruption for a variety of reasons, including work stoppages, acts of war, terrorism, fire, earthquake, energy shortages, flooding or other natural disasters. Our corporate offices and manufacturing facilities in California are located near major earthquake faults, which have experienced earthquakes in the past. The manufacturing facilities that we increasingly rely on in Asia are also subject to similar disruptions. Such disruptions could cause delays in shipments of products to our customers. We cannot ensure that alternate production capacity would be available if a major disruption were to occur or that, if it were available, it could be obtained on favorable terms. Such disruptions could result in cancellation of orders or loss of customers and could seriously harm our business. It could also significantly delay our research and engineering efforts for the development of new products, most of which is conducted at our California facilities.

Operations at our customers’ manufacturing facilities are subject to the same disruptions that may affect our facilities. Any such disruption could result in the delay of scheduled delivery dates for products ordered by affected customers, the cancellation of existing orders, and the delay of future orders, all of which could seriously harm our business.

We rely upon certain critical information systems for our daily business operation. Our inability to use or access these information systems at critical points in time could unfavorably impact the timeliness and efficiency of our business operation.

Our global operations are linked by information systems, including telecommunications, the internet, our corporate intranet, network communications, email and various computer hardware and software applications. Despite our network security measures, our products, tools and servers are vulnerable to computer viruses, break-ins, and similar disruptions from unauthorized tampering with our computer systems and with our products at customer sites. Any such event could have an adverse effect on our business, operating results, and financial condition.

We may experience difficulties with our enterprise resource planning (“ERP”) system and other IT systems. System failure or malfunctioning may result in disruption of operations and the inability to process transactions, and this could adversely affect our financial results.

System failure or malfunctioning could disrupt our ability to timely and accurately process and report key components of the results of our consolidated operations, our financial position and cash flows. Any disruptions or difficulties that may occur in connection with our ERP system or other systems could also adversely affect our ability to complete important business processes such as the evaluation of our internal controls and attestation activities pursuant to Section 404 of the Sarbanes-Oxley Act of 2002. If we encounter unforeseen problems with regard to our ERP system or other systems, our business could be adversely affected.

RISKS RELATING TO OWNING OUR COMMON STOCK

Our stock price may fluctuate significantly.

The market price of our common stock could fluctuate significantly in response to variations in quarterly operating results and other factors, such as:

•  the need to restate our consolidated financial statements;

•  announcements of technological innovations or new products by us or by our competitors;

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•  failure to comply with government regulations;

•  developments in patent or other property rights; and

•  developments in our relationships with our customers.

In addition, the stock market has in recent years experienced significant price fluctuations. These fluctuations often have been unrelated to the operating performance of the specific companies whose stock is traded. Broad market fluctuations, general economic condition and specific conditions in the flat panel display industry may adversely affect the market price of our common stock.

Some anti-takeover provisions may affect the price of our common stock.

Our Amended and Restated Articles of Incorporation authorize our board of directors to issue up to 5,000,000 shares of preferred stock. The board also has the authority to determine the price, rights, preferences and privileges, including voting rights, of those shares without any further vote or action by the shareholders. The rights of our shareholders will be subject to, and may be impaired by, the rights of the holders of any preferred stock that may be issued in the future. These and other provisions contained in our charter documents and applicable provisions of California law could serve to depress our stock price or discourage a hostile bid in which shareholders could receive a premium for their shares. In addition, these provisions could make it more difficult for a third party to acquire a majority of our outstanding voting stock or otherwise effect a change in control of us.

We do not anticipate paying cash dividends.

We have never declared or paid any cash dividends on our capital stock and do not anticipate paying cash dividends in the foreseeable future. Instead, we intend to apply any earnings to the expansion and development of our business.

RISKS RELATING TO OUR RESTATEMENTS AND RELATED MATTERS

Our current restatement of our consolidated financial statements and related events, as well as possible future restatements, may have a material adverse effect on our business.

As described in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 9A. “Controls and Procedures” of this Annual Report on Form 10-K, we have restated our financial results for the fiscal years ended September 30, 2003 through 2006. Our customers, suppliers, investors and current and prospective employees may react negatively to the restatement, which could have an adverse effect on our business and results of operations. As long as we continue to have one or more unremediated material weaknesses in our internal control over financial reporting, we may in the future identify additional reasons to restate our financial results. Furthermore, the threshold for causing us to restate financial information in the future is potentially very low in the current regulatory environment due in part to the fact that we currently, and in the near future, expect to operate at close to break-even levels of earnings or loss. If, as a result of any of the matters described above, we are required to amend this report or restate certain of our financial information, it may have a material adverse effect on our business and results of operations.

If we do not comply with the requirements of NASDAQ, our common stock may be delisted from the NASDAQ National Market.

We have received letters from the staff of NASDAQ stating that, as a result of the delayed filings of our June 30, 2007 Form 10-Q and our September 30, 2007 Form 10-K we are subject to delisting from the NASDAQ National Market. To date, NASDAQ has granted an exception to the listing requirement, pending further review, and subject to us filing our delinquent reports by specified dates. However, there can be no assurance that the Listing Council will decide to allow our common stock to remain listed on the NASDAQ National Market. In addition, if the SEC disagrees with the manner in which we have accounted for the financial impact of the restatement, we could experience further delays in filing subsequent SEC reports that could result in delisting of our common stock from the NASDAQ National Market.

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If our common stock is delisted from the NASDAQ National Market, it would subsequently trade on the Pink Sheets, which may reduce the price of the our common stock and the liquidity available to our stockholders. In addition, the trading of our common stock on the Pink Sheets would materially adversely affect our access to the capital markets, and the limited liquidity and potentially reduced price of our common stock could materially adversely affect our ability to raise capital through alternative financing sources on terms acceptable to the company or at all.

ITEM 1B.   UNRESOLVED STAFF COMMENTS

None.

ITEM 2.   PROPERTIES

Information regarding our principal properties at September 30, 2007 is as follows:

Location	Type	Principal Use	Footage		Ownership
San Jose, California	Office and plant	Headquarters, marketing, sales, administration, manufacturing, research, engineering		128,520		Leased
Markham, Ontario, Canada*	Office	Sublet		50,000		Leased
San Jose, California	Office and plant	Vacant		22,000		Owned
DaeJeon, Korea	Office	Sales, service, marketing, administration, research		12,000		Leased
Seongnam, Korea	Office	Sales, service, marketing, administration, research		11,000		Leased
Hsin Chu, Taiwan	Office	Sales, service, marketing, administration, research		10,236		Leased

* Terminated in November 2007.

We also lease office space for other, smaller research, sales and service offices in several locations around the world. In addition, we lease approximately 8,200 square feet of manufacturing and office space in South Korea and approximately 5,800 square feet of manufacturing and office space in Colorado Springs, Colorado, for use by Salvador Imaging. Our operating leases expire at various times through December 2010, with most having renewal options at the fair market value for additional periods up to five years. Additional information on these leases is included in Note 13 of the “Notes to Consolidated Financial Statements” in Part II, Item 8. “Financial Statements and Supplementary Data.” We believe our properties are adequately maintained and suitable for their intended use and that our production facilities have adequate capacity for our current needs.

ITEM 3.   LEGAL PROCEEDINGS

Photon Dynamics and certain of our directors and former officers were named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The trial of this case commenced on April 3, 2006. On a motion for non-suit, the court dismissed all claims against all directors on April 20, 2006. On May 5, 2006, as a result of jury verdict, judgments were entered in favor of our Company and our former officers. The plaintiff, a former officer of the Company, had asserted several causes of action arising out of alleged misrepresentations made to plaintiff regarding the existence and enforcement of our insider trading policy. The plaintiff had sought damages in excess of $6 million for defendants’ alleged refusal to allow plaintiff to sell shares of our stock in May of 2000, plus unspecified emotional distress and punitive damages. The plaintiff has the right to appeal the judgments. On June 30, 2006, the plaintiff filed a timely notice of appeal. On July 28, 2006, the Court awarded us approximately $445,000 in fees and costs. The award bears interest at the statutory rate of 10% simple interest per annum. Collection of the award was stayed during the plaintiff’s appeal of the verdict. On January 16, 2008, the Sixth District Court of Appeal for the State of California upheld the trial court’s judgment and award.

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As of December 31, 2007, we have paid approximately $6.3 million, net of VAT amounts refunded, to foreign customs authorities in connection with our settlements regarding underpayment of customs duties for warranty parts and expect to pay approximately $1.3 million more to settle all known amounts with foreign customs authorities. We have not received waivers from any governmental agency and cannot guarantee that additional payment obligations will not arise related to these prior activities. The ultimate resolution of this matter or other matters could entail further expense in the form of duties, interest and penalties under applicable laws. For example, we have not concluded any settlement with U.S. authorities with respect to our failure to make certain filings in connection with the export of warranty parts. We have commenced voluntary discussions with U.S. government agencies, including Customs, the Census Bureau and the Bureau of Industry and Security, regarding certain filing obligations that were not complied with in connection with our exports. Although the products in question were not restricted under export control laws and no fees were associated with these filings, the voluntary disclosure of our failure to comply with U.S. filing obligations may subject us to penalties and result in additional expenses, which could be material and the extent of which we are currently unable to estimate.

From time to time, we are subject to certain other legal proceedings and claims that arise in the ordinary course of business. Additionally, in the ordinary course of business we may potentially be subject to future legal proceedings that could individually, or in the aggregate, have a material adverse effect on our financial condition, liquidity or results of operations. Litigation in general, and intellectual property and securities litigation in particular, can be expensive and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict.

ITEM 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of our security holders during the quarter ended September 30, 2007.

PART II

ITEM 5.   MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES

Common Stock Market Price

Our common stock is traded on the NASDAQ National Market under the symbol “PHTN.” The following table sets forth the high and low closing sales prices of our common stock as traded on the NASDAQ National Market for the periods indicated.

	December 31,		March 31,		June 30,		September 30,
Fiscal 2007 Quarter Ended	2006		2007		2007		2007
High	$	11.76	$	12.80	$	10.99	$	9.09
Low	$	11.39	$	12.38	$	10.72	$	8.98

	December 31,		March 31,		June 30,		September 30,
Fiscal 2006 Quarter Ended	2005		2006		2006		2006
High	$	19.26	$	22.72	$	19.75	$	13.48
Low	$	16.74	$	17.47	$	12.52	$	10.30

The closing price for our common stock as reported by the NASDAQ National Market on January 2, 2008 was $8.08 per share. As of January 2, 2008, there were approximately 139 shareholders of record of our common stock.

Dividends

We have never declared or paid any cash dividends to our shareholders. We do not presently plan to pay cash dividends in the foreseeable future and intend to retain any future earnings for reinvestment in our business.

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Share Repurchase Program

On August 21, 2006, our Board of Directors approved a stock repurchase program authorizing us to repurchase up to a maximum of 1.1 million outstanding shares of our common stock. During fiscal 2006, the repurchases were made from time to time on the open market at prevailing prices and in negotiated transactions off the market as management deemed appropriate. The purchases were funded from available working capital, and the repurchased shares have either been retired or used for ongoing stock issuances. In fiscal 2007, we did not make any repurchases as management determined that additional purchases were not warranted. Although we do not anticipate any additional purchases, the timing and actual number of additional shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements and other market conditions.

In fiscal 2006, we repurchased the following shares under this plan:

					Total Shares
			Average		Purchased		Shares Yet
	Total Shares		Price Paid		as Part		to be Purchased
	Purchased		per Share		of the Plan		Under the Plan
August 1 through August 31, 2006		503,581	$	13.17		503,581		596,419
September 1 through September 30, 2006		26,020	$	13.35		529,601		570,399

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Performance Measurement Comparison

The following graph shows the total shareholder return of an investment of $100 in cash on September 30, 2000 for (i) Photon Dynamics’ Common Stock, (ii) the NASDAQ Stock Market (U.S.) Composite Index, and (iii) the Philadelphia Semiconductor Index. All values assume reinvestment of the full amount of all dividends and are calculated as of September 30 of each year:

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN*

Among Photon Dynamics, Inc., The NASDAQ Composite Index

And The Philadelphia Semiconductor Index

* $100 invested on 9.30.02 in stock or index-including reinvestment of dividends.

Fiscal year ending September 30.

ITEM 6.   SELECTED FINANCIAL DATA

The following tables include selected consolidated summary financial data for each of our last five fiscal years. As discussed in Note 2 “Restatements of Consolidated Financial Statements and Company Findings” of “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data,” our selected consolidated financial data as of and for our fiscal years ended September 30, 2006, 2005, 2004 and 2003 have been restated to correct our past accounting for Customs and Duties expense and certain other adjustments. This data should be read in conjunction with Part II, Item 8. “Financial Statements and Supplementary Data,” and with Part I, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K.

The consolidated statements of operations data for the years ended September 30, 2007, 2006 and 2005, and the consolidated balance sheet data as of September 30, 2007 and 2006 are derived from the audited consolidated financial statements included elsewhere in this report. The consolidated statements of operations data for the years ended September 30, 2004 and 2003, and the consolidated balance sheet data as of September 30, 2005, 2004 and 2003 are derived from audited consolidated financial statements not included in this report.

In fiscal 2003, we discontinued operations in two business segments: the printed circuit board assembly inspection business and the cathode ray tube display and high quality glass inspection business. Accordingly, the operating results of these businesses have been reclassified as discontinued operations for all periods presented. We currently operate in two business segments: the manufacture and servicing of test equipment for the flat panel display industry and the design and manufacture of high-performance digital cameras for the defense, industrial inspection and medical industries.

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As more fully described in Note 2, “Restatements of Consolidated Financial Statements and Company Findings” of “Notes to Consolidated Financial Statements” included under Part II, Item 8 of this Annual Report on Form 10-K, we have restated our consolidated financial results for our fiscal years 2003 through 2006. For purposes of comparison, the tables below show selected data as previously reported, the restatement adjustments that were made to the selected data, and selected data reflecting all such restatement adjustments. We have not issued restated financial statements for our 2003 through 2006 fiscal years, but selected unaudited information about the restatement adjustments for those periods is presented below. We have also recorded entries relating to periods prior to fiscal 2003, which resulted in a cumulative reduction in accumulated deficit as of October 1, 2002 of approximately $116,000. This adjustment is comprised mainly of customs and duties expenses, as discussed in more detail in Note 2.

	Year Ended September 30,
(As Previously Reported for the 2003 Through 2006 Fiscal Years)	2007			2006			2005			2004			2003
				As			As			As			As
				previously			previously			previously			previously
				reported			reported			reported			reported
	(In thousands, except per share data)
Consolidated Statements of Operations:
Revenue	$	74,267		$	172,872		$	125,813		$	141,870		$	67,196
Income (loss) from operations		(38,982	)		1,412			(21,161	)		6,860			(30,692	)
Income (loss) from continuing operations before discontinued operations		(35,072	)(1)		4,207	(2)		(19,567	)(3)		11,085	(4)		(27,780	)(5)
Income (loss) from discontinued operations		—			(127	)		256			(1,391	)		(44,592	)
Net income (loss)	$	(35,072	)	$	4,080		$	(19,311	)	$	9,694		$	(72,372	)
Income (loss) per share from continuing operations before discontinued operations:
Basic	$	(2.09	)(1)	$	0.25	(2)	$	(1.16	)(3)	$	0.67	(4)	$	(1.73	)(5)
Diluted	$	(2.09	)(1)	$	0.25	(2)	$	(1.16	)(3)	$	0.65	(4)	$	(1.73	)(5)
Income (loss) per share from discontinued operations:
Basic	$	—		$	(0.01	)	$	0.02		$	(0.08	)	$	(2.77	)
Diluted	$	—		$	(0.01	)	$	0.02		$	(0.08	)	$	(2.77	)
Net income (loss) per share:
Basic	$	(2.09	)(1)	$	0.24	(2)	$	(1.14	)(3)	$	0.58	(4)	$	(4.50	)(5)
Diluted	$	(2.09	)(1)	$	0.24	(2)	$	(1.14	)(3)	$	0.57	(4)	$	(4.50	)(5)
Consolidated Balance Sheets:
Cash, cash equivalents and short-term investments	$	83,810		$	102,769		$	93,026		$	84,155		$	116,469
Working capital		88,599			121,411			116,488			132,335			125,624
Total assets		148,261			177,613			183,684			207,900			161,919
Other non-current liabilities		5,419			119			1,008			1,528			193
Shareholders’ equity		118,184			144,381			142,594			159,959			144,143

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	Year Ended September 30,
	2007		2006			2005			2004			2003
(Restatement Adjustments for the 2003 Through 2006 Fiscal Years)			Adjustments(6)			Adjustments(6)			Adjustments(6)			Adjustments(6)
	(In thousands, except per share data)
Consolidated Statements of Operations:
Revenue	$	N/A	$	—		$	—		$	—		$	—
Income (loss) from operations		N/A		(1,486	)		(1,117	)		(550	)		(403	)
Income (loss) from continuing operations before discontinued operations		N/A		(2,039	)		(1,562	)		(713	)		(592	)
Income (loss) from discontinued operations		N/A		—			—			—			—
Net income (loss)	$	N/A	$	(2,039	)	$	(1,562	)	$	(713	)	$	(592	)
Income (loss) per share from continuing operations before discontinued operations:
Basic	$	N/A	$	(0.12	)	$	(0.09	)	$	(0.05	)	$	(0.03	)
Diluted	$	N/A	$	(0.12	)	$	(0.09	)	$	(0.04	)	$	(0.03	)
Income (loss) per share from discontinued operations:
Basic	$	N/A	$	—		$	—		$	—		$	—
Diluted	$	N/A	$	—		$	—		$	—		$	—
Net income (loss) per share:
Basic	$	N/A	$	(0.12	)	$	(0.09	)	$	(0.04	)	$	(0.04	)
Diluted	$	N/A	$	(0.12	)	$	(0.09	)	$	(0.04	)	$	(0.04	)
Consolidated Balance Sheets:
Cash, cash equivalents and short-term investments	$	N/A	$	—		$	—		$	—		$	—
Working capital		N/A		(5,116	)		(2,983	)		(1,421	)		(708	)
Total assets		N/A		3,157			1,798			911			491
Other non-current liabilities		N/A		—			—			—			—
Shareholders’ equity		N/A		(5,116	)		(2,983	)		(1,421	)		(708	)

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	Year Ended September 30,
	2007			2006			2005			2004			2003
(As Restated for the 2003 Through 2006 Fiscal Years)
				As restated			As restated			As restated			As restated
	(In thousands, except per share data)
Consolidated Statements of Operations:
Revenue	$	74,267		$	172,872		$	125,813		$	141,870		$	67,196
Income (loss) from operations		(38,982	)		(74	)		(22,278	)		6,310			(31,095	)
Income (loss) from continuing operations before discontinued operations		(35,072	)(1)		2,168	(2)		(21,129	)(3)		10,372	(4)		(28,372	)(5)
Income (loss) from discontinued operations		—			(127	)		256			(1,391	)		(44,592	)
Net income (loss)	$	(35,072	)	$	2,041		$	(20,873	)	$	8,981		$	(72,964	)
Income (loss) per share from continuing operations before discontinued operations:
Basic	$	(2.09	)(1)	$	0.13	(2)	$	(1.25	)(3)	$	0.62	(4)	$	(1.76	)(5)
Diluted	$	(2.09	)(1)	$	0.13	(2)	$	(1.25	)(3)	$	0.61	(4)	$	(1.76	)(5)
Income (loss) per share from discontinued operations:
Basic	$	—		$	(0.01	)	$	0.02		$	(0.08	)	$	(2.77	)
Diluted	$	—		$	(0.01	)	$	0.02		$	(0.08	)	$	(2.77	)
Net income (loss) per share:
Basic	$	(2.09	)(1)	$	0.12	(2)	$	(1.24	)(3)	$	0.54	(4)	$	(4.54	)(5)
Diluted	$	(2.09	)(1)	$	0.12	(2)	$	(1.24	)(3)	$	0.53	(4)	$	(4.54	)(5)
Consolidated Balance Sheets:
Cash, cash equivalents and short-term investments	$	83,810		$	102,769		$	93,026		$	84,155		$	116,469
Working capital		88,599			116,295			113,505			130,914			124,916
Total assets		148,261			180,770			185,482			208,811			162,410
Other non-current liabilities		5,419			119			1,008			1,528			193
Shareholders’ equity		118,184			139,265			139,611			158,538			143,435

(1)	Includes a restructuring charge of approximately $1.4 million related to a Company-wide restructuring and the discontinuation of the PanelMasterTM product line, an impairment charge of approximately $2.8 million related to the impairment of an idle manufacturing facility, net stock-based compensation of approximately $2.0 million related to our stock option plans and our employee stock purchase plan, an acquired in-process research and development charge of approximately $1.1 million in connection with the acquisition of Salvador Imaging and charges for amortization of intangibles of approximately $1.7 million.
(2)	Includes a restructuring charge of approximately $30,000 related to the restructuring of the Company’s Markham, Canada location, an impairment charge of approximately $81,000 related to the impairment of manufacturing capital equipment and charges for amortization of intangibles of approximately $1.5 million. Effective October 1, 2005, we adopted the provisions of SFAS No. 123R, “Share-Based Payments,” and as a result, fiscal 2006 includes net stock-based compensation of approximately $4.0 million related to our stock option plans and our employee stock purchase plan. There were no comparable charges in previous fiscal years.
(3)	Includes a restructuring charge of approximately $1.2 million related to the restructure of the Company’s Markham, Canada location, an impairment charge of approximately $637,000 related primarily to impairment of manufacturing capital equipment and charges for amortization of intangibles of approximately $1.5 million.
(4)	Includes a goodwill impairment charge of approximately $665,000, purchased intangible asset write-off of approximately $2.1 million and property and equipment impairment charges of approximately $234,000, all related to the suspension of the low-temperature poly-silicon (“LTPS”) and inverter product lines; acquired in-process research and development charge of approximately $210,000 in connection with the acquisition of

29

	certain assets from Quantum Composers, Inc.; gain on fixed assets of approximately $427,000 related to the sale of the TFT-LCD Backlight Inverter Business, and charges for amortization of intangibles of approximately $789,000.
(5)	Includes a goodwill impairment charge of approximately $10.0 million related to the Akcron and RTP Assets, purchased intangible asset write-off of approximately $3.5 million related to the Akcron and RTP Assets, and an acquired in-process research and development charge of approximately $2.5 million related to the acquisition of certain assets from Intevac related to Intevac’s Rapid Thermal Processing Division and the acquisition of substantially all the assets of Summit Imaging, and charges for amortization of intangibles of approximately $1.2 million.
(6)	For a discussion of the adjustments related to the restatement, see “Restatement of Financial Statements Internal Review off Customs Practices, Remediation Plan and Related Proceedings” in Part II, Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read in conjunction with our Consolidated Financial Statements and the related Notes to Consolidated Financial Statements in Part II, Item 8, “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Exchange Act. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties, including the risk factors set forth in Part I Item 1A. “Risk Factors,” and elsewhere in this Annual Report on Form 10-K. Generally, the use of words such as “may,” “will,” “could,” “would,” “should,” “plans,” “anticipates,” “relies,” “expects,” “intends,” “believes,” “estimates,” “predicts,” “potential,” “continue” or the negative of such terms, or other comparable terminology and similar expressions identify forward-looking statements. The information included in this Annual Report on Form 10-K is as of the filing date with the SEC and future events or circumstances could differ significantly from the forward-looking statements included herein. Accordingly, we caution readers not to place undue reliance on such statements.

BUSINESS AND COMPANY OVERVIEW

Our Company

We are a leading global supplier of integrated yield enhancement solutions for the flat panel display market. We utilize our advanced digital imaging technology to develop systems that enable flat panel display manufacturers to collect and analyze data from the production line and quickly diagnose and repair process-related defects, thereby allowing manufacturers to decrease material costs and improve throughput. Our customers use our systems to increase manufacturing yields of high performance flat panel displays used in a number of products, including notebook and desktop computers, televisions and advanced mobile electronic devices such as cellular phones, personal digital assistants and portable video games.

Flat Panel Display Market

We generate revenue from the sale of our ArrayChecker^tm and ArraySaver^tm test and repair equipment and customer support, which includes the sale of spare parts. We have also generated revenue from the sale of our PanelMasterTM inspection equipment, which was used primarily in the Cell Assembly phase of flat panel display manufacture; however, in November 2006, we announced the discontinuation of our PanelMaster^tm inspection products.

We sell our products to manufacturers in the flat panel display industry. Our customers are located primarily in South Korea, Taiwan, Japan, and China. We derive most of our revenue from a small number of customers, and we expect this to continue for the foreseeable future. A substantial percentage of our revenue is derived from the sale of a small number of yield enhancement systems that in fiscal 2007 ranged in price from $450,000 to $3.4 million. Therefore, the timing of the sale of a single system could have a significant impact on our quarterly results.

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While our products have been historically manufactured in San Jose, California, during the second quarter of our fiscal 2007, we began manufacture of certain of our ArraySaver^tm products in Daejon, Korea and have begun to outsource both our ArraySaver^tm and ArrayTester products to third party manufacturers. Our manufacturing activities consist primarily of final assembly and test of components and subassemblies, which are purchased from third party vendors. We schedule production based upon customer purchase orders and anticipated orders during the planning cycle. We generally expect to be able to accept a customer order, build the required machinery and ship to the customer within 20 to 36 weeks.

We do not consider our business to be seasonal in nature, but it is cyclical with respect to the capital equipment procurement practices of flat panel display manufacturers and is impacted by the investment patterns of these manufacturers in different global markets. We do consider consumer demand for flat panel display products to be seasonal, with peak demand occurring in the latter half of each calendar year. This end-user seasonality drives capacity decisions by flat panel display manufacturers and has a limited influence on the flat panel display manufacturers’ overall investment patterns. However, because new fabrication facilities and upgrades to existing facilities represent significant financial investments and take time to implement, we consider flat panel display manufacturers to have cyclical investment patterns.

Flat Panel Display Industry Trends

At the end of the first half of calendar year 2006, there was an oversupply of flat panel display products in the consumer market, particularly in the television market. Flat panel display manufacturers responded by scaling back factory utilization rates and dropping panel average selling prices, which eroded the manufacturers’ profits. As a result, our customers began delaying investment plans for additional capacity.

In calendar year 2007, the majority of flat panel display manufacturers scaled back their investment plans until they could evaluate television manufacturing costs, holiday season demand and consumer electronics market issues such as brand strength and high-definition programming formats and availability. As a result, we experienced both lower levels of bookings due to factory investment delays and lower revenue in our fiscal year 2007 as compared to fiscal year 2006. Demand for notebook, monitor and television LCD products was strong during 2007 compared to 2006. Relatively strong demand and the delay in adding new manufacturing capacity during the second half of 2006 and 2007 resulted in supply approaching equilibrium with demand. Industry sources show that panel prices have begun to stabilize due to tightening supply, which improved the profitability of LCD manufacturers in the second half of the 2007 calendar year. Flat panel display manufacturers’ efforts to balance supply with demand were realized, improving the health of the flat panel display industry. With supply and demand equilibrium, flat panel display prices stabilized and in some cases increased. Across the industry, flat panel display manufacturers returned to profitability in mid-2007. The combination of delayed manufacturing capacity investments over the past five quarters and strong demand for IT and television displays has created a capacity shortfall, particularly for larger-sized panels. Flat panel display manufacturers are now investing to add capacity into existing Generation 5, Generation 6 and Generation 7 lines as well as accelerating Generation 8 plans in order meet forecasted demand. Growth in notebook display demand and robust flat-screen television adoption fuel an optimistic outlook for stable supply and demand in calendar year 2008 and 2009. While we expect that flat panel display manufacturers will again begin to make new factory investments and upgrades to existing factories during the second half of calendar year 2008, we can provide no assurances that this anticipated industry recovery will occur.

In response to management’s review of our Company’s global operations in light of anticipated dynamics in the flat panel display market environment, in February 2007 we implemented a company-wide cost reduction plan designed to accelerate achieving the Company’s objective of consistent profitability. The plan included several cost cutting initiatives including a reduction in our work-force. As a result of the restructuring, we incurred severance-related restructuring charges of approximately $1.0 million during the three month period ended March 31, 2007. In addition, as a result of management’s commitment to our offshore manufacturing program we recorded approximately $2.8 million in impairment charges associated with writing down one of our U.S. manufacturing facilities to fair value and with writing off certain capital equipment used in the manufacturing process. By implementing this plan, we hope to better align our expenses with our core business strategy and lower our breakeven point, without substantially affecting key R&D investments or affecting customer support. We believe that going forward our

31

principal focus will be on achieving profitability in our core business and investing in new ventures that will provide future growth opportunities.

Leveraging Core Technologies

The core technology that drives our leadership in the flat panel display market is advanced digital imaging. In April 2007, we entered into agreements with Salvador Imaging, an international supplier of high-performance digital cameras for defense and industrial applications, to form a new venture that would address emerging low light markets. In July 2007, we entered into agreements with Salvador Imaging to acquire 100% of the issued and outstanding shares of Salvador Imaging.

Our new venture will combine the digital imaging core competencies of Photon Dynamics and Salvador Imaging as well as our operational and manufacturing strengths to develop highly sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for the military and security markets, and unique inspection capabilities in industrial applications. We are developing evaluation units and are actively engaged in marketing and sales activities; however, we anticipate that the sales cycle for these markets will be lengthy and it is uncertain if and when we will generate revenue from this new venture. The activity of Salvador Imaging for the period from the July 27, 2007 date of purchase through September 30, 2007 was immaterial to the Company’s consolidated financial statements.

Backlog

Our backlog consists of work-in-process and unshipped system orders, unearned revenue and systems in deferred gross margin. As of September 30, 2007, our backlog was approximately $60.5 million, compared to approximately $71.0 million as of September 30, 2006. We expect to ship or to recognize revenue on the majority of the September 2007 backlog within the next six to twelve months. All customer orders are subject to delay or cancellation and any assessable penalties or other provisions may not be collectible or enforceable against our customers due to the limited number of customers. We may also be unable to obtain reimbursement for any costs incurred on a cancelled or postponed order. Because of possible changes in product delivery schedules and cancellation of product orders, among other factors, our backlog may vary significantly and, at any particular date, is not necessarily indicative of actual sales for any succeeding period.

RESTATEMENT OF FINANCIAL STATEMENTS, INTERNAL REVIEW OF CUSTOMS PRACTICES, REMEDIATION PLAN AND RELATED PROCEEDINGS

Background on Restatements Related to Customs Duties for Warranty Parts

In the first quarter of fiscal 2007, our management voluntarily began a review of the Company’s practices with respect to the payment of customs duties for warranty parts in response to concerns raised by our chief financial officer and general counsel. Management, in consultation with our Audit Committee, determined in January 2007 that the Company had maintained incorrect classification and valuation practices with respect to the import of warranty parts into our South Korea, Taiwan, Japan and China field service locations, resulting in the underpayment of customs duties. At that time we estimated that the range of our liability was between approximately $1.0 million and $2.0 million. Because there was no basis to conclude that any amount within this range provided a better estimate than any other amount, we recorded a liability of approximately $1.0 million, which included underpaid duties, penalties and interest. We evaluated the impact and timing of the liability and concluded that the potential adjustment did not have a material effect on the financial statements for fiscal years ended September 30, 2002 through 2006. Accordingly, we recorded the estimated liability at December 31, 2006. Approximately $350,000 of the $1.0 million was recorded to our statement of operations, with the majority of this amount recorded to cost of sales, while approximately $680,000 was capitalized into warranty and spares inventory held at our foreign locations at December 31, 2006.

As the review continued into the third quarter of fiscal 2007, we commenced a process of voluntarily disclosing our historical valuation practices to customs authorities in South Korea, Taiwan, Japan and China with the goal of reaching settlements for past due duty amounts plus interest and penalties if applicable. In July 2007, we negotiated a settlement with the Korean Customs Service in South Korea for our primary South Korean field service location.

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This location accounted for the majority of total warranty parts exported by the Company over the five-year period under audit and the settlement represented the majority of total liability to be recorded. Based upon this settlement and assessing the status of our discussions in the other jurisdictions, we revised our estimated liability including associated costs from the approximately $1.0 million recorded at December 31, 2006 to a range of approximately $7.0 million to $8.0 million at June 30, 2007, net of refundable VAT amounts.

In light of the materiality of the revised estimate and that the underpaid duties, penalties and interest largely related to prior periods, our management and Audit Committee determined on July 16, 2007 that it was appropriate to restate: (i) our consolidated financial statements for the years ended September 30, 2004, 2005 and 2006 as contained in our Form 10-K for the year ended September 30, 2006; (ii) the unaudited quarterly financial data for the first two quarters in the fiscal year ended September 30, 2007; and (iii) the unaudited quarterly financial data for all quarters in the fiscal year ended September 30, 2006. Our management and Audit Committee discussed their conclusions with our independent registered public accounting firm. We disclosed these determinations in a Form 8-K on July 18, 2007.

Management’s internal review, conducted with the oversight of the Audit Committee and in consultation with outside advisers both in the United States and in the affected Asian countries, concluded that for a period of at least five years, there was a routine practice of underreporting the value of warranty parts shipped to and between Korea, Taiwan, China and Japan. A number of employees of the Company, including former executive officers, either knew or should have known that the Company’s customs practices were non-compliant.

We have continued to work with the remaining customs agencies and reached settlements in September and October of 2007 in South Korea, Taiwan, and China and are in the process of reaching settlement in Japan. As a result, we determined the customs duty and nonrefundable VAT, interest and penalty liability, including the effect of historical foreign exchange rates, to be as follows at September 30, 2007:

	September 30,
	2007
	(In thousands)
South Korea	$	3,917
Taiwan		2,130
Japan		49
China		1,148
Total liability		7,244
Amounts paid at September 30, 2007		(3,691	)
Net liability at September 30, 2007	$	3,553

In addition, we determined total refundable VAT in all locations to be approximately $4.1 million. As of September 30, 2007, we had paid and received a refund for approximately $3.5 million.

We currently estimate our total costs, including duties, penalties and interest as well as legal, accounting and other costs associated with the restatement, to be in the range of $11.0 million to $12.0 million. In addition, we have commenced voluntary discussions with U.S. government agencies, including Customs, the Census Bureau and the Bureau of Industry and Security, regarding certain filing obligations that were not complied with in connection with our exports. Although the products in question were not restricted under export control laws and no fees were associated with these filings, the voluntary disclosure of our failure to comply with U.S. filing obligations may subject us to penalties and result in additional expenses, which could be material and the extent of which we are currently unable to estimate.

The increased estimates as of June 30, 2007 and September 30, 2007 compared to the original estimate as of December 31, 2006 were primarily due to the following factors:

1. Increased Span of Korean Audit.  The December estimate assumed that duties would be subject to a two-year statute of limitations. However, the Korean customs authorities determined that a five-year statute of limitations was the appropriate period.

33

2. Foreign Currency Effect:  The December estimate was based on then-prevailing exchange rates. The customs authorities, however, determined that it was appropriate to use the exchange rates prevailing at the date of import into the country.

3. Lower Declared Values:  The December estimate assumed that the Company had valued warranty parts at 10% of standard cost when in fact a lower, de minimis value was often assigned for customs duty purposes.

4. Computed Value:  The December estimate assumed that it was appropriate to value parts based on inventory costs plus a calculated transfer-price mark-up (8%). As a result of the settlement with the Korean Customs Service, the June estimate was calculated using a mark-up based on the Company’s average historical gross margins.

5. Interest and Penalties:  The December estimate used an interest rate of 5% per annum and assumed penalties of between 7% and 10% of the underpaid amounts owed in Korea. After discussion with the Korean Customs Service, the interest rate and penalties totaled 20% of the underpaid amounts owed in Korea.

6. Value Added Tax (VAT) Recoverability:  The December estimate assumed that VAT paid in China and Taiwan would be refundable. After discussions with customs authorities in China and Taiwan, it was determined that VAT would not be deemed refundable in China and would only be deemed creditable against future VAT payments in Taiwan.

7. Excluded Parts:  The December estimate excluded certain parts that management believed had already been subject to audit by the Korean Customs Service After review, it was determined that these parts had not been audited and the revised estimates included these parts.

8. Drawback Calculation:  The December estimate assumed that duties on returned merchandise would be refundable. After discussions with the relevant customs authorities, the June estimate significantly reduced these drawback assumptions.

Adjustments identified as a result of the Company’s voluntary review and disclosure to customs authorities aggregate to the following effects on the Company’s consolidated statements of operations for all affected periods:

	Three Months Ended						Year Ended September 30,
	March 31,			December 31,
	2007			2006			2006		2005		2004		2003		2002
	(In thousands)
Consolidated Statement of Operations Data:
Understatement of cost of revenue	$	291	(1)	$	181	(2)	$	1,624	$	1,473	$	550	$	403	$	85
Overstatement (understatement) of interest income and other, net		19	(1)		67	(2)		553		445		164		190		31
Overstatement of net income (loss)		310	(1)		248	(2)		2,177		1,918		713		592		116

(1)	Includes the reversal of approximately $85,000 of additional charges related to the initial estimate of customs liabilities made by the Company in the quarter ended March 31, 2007. This amount included a charge of approximately $67,000 to Cost of revenue and approximately $16,000 to Interest income and other, net.
(2)	Includes the reversal of approximately $350,000 of charges from the initial estimate of customs liabilities made by the Company in the quarter ended December 31, 2006. This amount included a charge of approximately $220,000 to Cost of revenue and approximately $129,000 to Interest income and other, net.

The effect to the Company’s “Interest income and other, net” includes the effects of foreign currency transaction gains and losses incurred to adjust the customs liability to its foreign currency equivalent over the periods presented. The amounts presented above include the initial allocation of the $1.0 million liability recorded in January reallocated to the proper periods.

34

The aggregate effect to the Company’s consolidated balance sheet data are as follows for all affected periods include:

							September 30,
	March 31,			December 31,
	2007			2006			2006		2005		2004		2003		2002
									(In thousands)
Consolidated Balance Sheet Data:
Understatement of other current assets	$	3,808		$	3,551		$	3,157	$	1,798	$	911	$	491	$	81
Overstatement of other assets		14	(1)		682	(3)		—		—		—		—		—
Understatement of other current liabilities		10,217	(2)		8,632	(4)		8,673		5,137		2,332		1,199		197
Understatement of accumulated deficit		6,498			6,113			5,516		3,339		1,421		708		116

(1)	Includes the reversal of $14,000 of additional charges capitalized into field service inventory related to the initial estimate of customs liabilities made by the Company in the quarter ended March 31, 2007.
(2)	Includes the reversal of $89,000 of additional customs liabilities made by the Company in the quarter ended March 31, 2007.
(3)	Includes the reversal of the Company’s initial $682,000 of charges capitalized into field service inventory from the initial estimate of customs liabilities made by the Company in the quarter ended December 31, 2006.
(4)	Includes the reversal of $1.0 million of the original estimated customs liability made by the Company in the quarter ended December 31, 2006.

Background on Restatements Related to Other Accounting Issues

In the course of the preparation of our fiscal 2007 financial statements, we identified certain other errors that related to previously reported periods, including:

•  Over-expensing of certain invoices related to inventory receipts and operating expenses which affected fiscal 2005 and 2006 and the first two quarters of fiscal 2007;

•  An over-accrual of a fiscal 2005 management bonus that was reversed in the first quarter of fiscal 2006; and

•  An over-expensing of certain options related to former executive officers due to problems discovered in the supporting software, which affected fiscal 2006 and the first two quarters of fiscal 2007.

Adjustments identified as a result of these errors aggregate to the following effects on the Company’s consolidated statements of operations for all affected periods:

	Three Months Ended				Year Ended September 30,
	March 31,		December 31,
	2007		2006		2006			2005
	(In thousands)
Consolidated Statement of Operations Data:
Overstatement of cost of revenue	$	78	$	102	$	190		$	94
Over (under) statement of research and development		3		59		(157	)		225
Overstatement of selling, general and administrative		66		48		105			37
Understatement of net income (loss)		147		209		138			356

35

Identification of Material Weaknesses

Management identified the following material weaknesses in internal control over financial reporting as of September 30, 2007:

•  The absence of adequate processes for detecting noncompliance with applicable laws and regulations and our employee code of conduct, evaluating the effect of such noncompliance on our financial statements on a timely and accurate basis, and communicating such noncompliance and related evaluation to our Audit Committee;

•  The absence of adequate processes and programs in our control environment to educate employees on our employee code of conduct and applicable laws and regulations; and

•  Insufficient accounting and finance personnel with the knowledge and experience required to ensure an appropriate level of review of financial statement accounts.

As a result of the identified material weaknesses, our management concluded that, as of September 30, 2007 our internal control over financial reporting was not effective. The effectiveness of our internal control over financial reporting as of September 30, 2007 was audited by Ernst & Young LLP, our independent registered public accounting firm as stated in their report, which report is included in Item 8 of this Annual Report on Form 10-K.

Remediation of Material Weaknesses

Beginning the second quarter of fiscal 2007, we have undertaken the following actions in an effort to remediate the first and second material weaknesses described above:

•  Review and evaluation of our internal controls, including our internal reporting processes, to ensure that legal, regulatory and other matters that could have a significant financial statement effect are identified and evaluated and documented by management and escalated on a timely basis, where appropriate, to the Audit Committee.

•  Development, with the assistance of outside advisors, of new valuation and declaration processes to ensure compliance with all customs regulations of each of the countries into which we import parts, including replacing manual invoices with an automated customs commercial invoice process that requires review by legal and finance personnel.

•  Enhanced compliance and ethics training for employees, including implementation of an online compliance system in four languages, increasing awareness of the employee code of conduct through mandatory training for all employees, and reinforcing the ethics policy by requiring an annual ethics certification for all employees; and

•  With respect to personnel who were determined to have known, or who should have known, that the Company’s customs practices were non-compliant, certain of such personnel have been terminated or have otherwise left the Company, and others, including a former executive officer, have had their responsibilities and reporting relationships modified.

With respect to the third material weakness described above, we have initiated a search for qualified candidates for those positions identified as being advisable additions to the finance and accounting staff of the Company. In the interim, certain key positions are being performed by temporary employees and contractors until qualified candidates are found and commence employment with us. We are actively engaged in a search for a new chief financial officer with the goal of filling the position as soon as practicable. We are also working to fill other finance positions as soon as practicable.

We currently are unable to determine when these material weaknesses will be fully remediated and can provide no assurances on the timing of new hires as part of our remediation efforts.

36

Related Proceedings

NASDAQ Delisting Hearing:  As a result of the ongoing restatement activities we failed to file our Form 10-Q for the quarter ended June 30, 2007 when it was due in August 2007. This failure violated NASDAQ rules, as did our failure to file subsequent periodic reports. On October 25, 2007, we received notice from the NASDAQ Stock Market that the NASDAQ Listing Qualifications Panel had granted the Company’s request for continued listing on the NASDAQ Stock Market conditioned on the Company becoming current with its filings by December 19, 2007. On December 11, 2007 we requested, and on December 26, 2007 we were granted, a conditional extension from the NASDAQ Listing Qualifications Panel of the deadline by which we must become current in our filings to January 23, 2008. We have filed this Form 10-K for the year ended September 30, 2007, which includes the unaudited quarterly financial data for the quarter ended June 30, 2007 and the restated financial data for the periods set forth above, prior to the extended NASDAQ Stock Market deadline, which we believe satisfies the condition for continued listing.

CURRENT RESTATEMENT OF PREVIOUSLY ISSUED FINANCIAL STATEMENTS

This Annual Report on Form 10-K for our fiscal year ended September 30, 2007 includes restatements of the following previously filed financial statements and data (and related disclosures):

(a) The consolidated statements of operations, shareholders’ equity and cash flows for the fiscal years ended September 30, 2006 and 2005,

(b) The consolidated balance sheet as of September 30, 2006,

(c) The selected consolidated financial data as of and for the fiscal years ended September 30, 2003 through 2006,

(d) The unaudited quarterly financial data for the first two quarters in the fiscal year ended September 30, 2007 and for all quarters in the fiscal year ended September 30, 2006.

In addition to the restated financial statements included in this document, this Annual Report on Form 10-K also includes the unaudited quarterly financial data for the third quarter in the fiscal year ended September 30, 2007, which had not been previously filed on a Quarterly Report on Form 10-Q.

The impact of the restatement on periods prior to Fiscal 2003 was a net increase of $116,000 to opening accumulated deficit as of October 1, 2002.

37

The following tables represent the impact of the restatement on our previously reported consolidated statements of operations data for the fiscal years 2003 through 2006.

Consolidated Statements of Operations data for the year ended September 30, 2006

	Year Ended September 30, 2006
	As Previously						As
	Reported			Adjustments			Restated
	(In thousands, except per share data)
Revenue	$	172,872		$	—		$	172,872
Cost of revenue		112,771			1,434			114,205
Research and development		32,420			157			32,577
Selling, general and administrative		24,611			(105	)		24,506
Income (loss) from operations		1,412			(1,486	)		(74	)
Interest income and other, net		3,356			(553	)		2,803
Income from continuing operations before income taxes and discontinued operations		4,768			(2,039	)		2,729
Provision for income taxes		561			—			561
Income from continuing operations		4,207			(2,039	)		2,168
Loss from discontinued operations		(127	)		—			(127	)
Net income	$	4,080		$	(2,039	)	$	2,041
Net income per share from continuing operations:
Basic	$	0.25		$	(0.12	)	$	0.13
Diluted	$	0.25		$	(0.12	)	$	0.13
Net loss per share from discontinued operations:
Basic	$	(0.01	)	$	—		$	(0.01	)
Diluted	$	(0.01	)	$	—		$	(0.01	)
Net income per share:
Basic	$	0.24		$	(0.12	)	$	0.12
Diluted	$	0.24		$	(0.12	)	$	0.12
Weighted average number of shares:
Basic		16,978			16,978			16,978
Diluted		17,011			17,011			17,011

The following table summarizes the impact of the restatement to Cost of revenues, Research and development, Selling, general and administrative, Interest income and other, net, and Net income for the fiscal year ended September 30, 2006.

				Research		Selling,			Interest
	Cost of			and		General and			Income and			Net
	Revenue			Development		Administrative			Other, Net			Income
						(In thousands)
As previously reported	$	112,771		$	32,420	$	24,611		$	3,356		$	4,080
Adjustments:
Customs and duties		1,624			—		—			(553	)		(2,177	)
Other Accounting errors		(190	)		157		(105	)		—			138
As restated	$	114,205		$	32,577	$	24,506		$	2,803		$	2,041

38

Consolidated Statements of Operations data for the year ended September 30, 2005

	Year Ended September 30, 2005
	As Previously						As
	Reported			Adjustments			Restated
	(In thousands, except per share data)
Revenue	$	125,813		$	—		$	125,813
Cost of revenue		82,732			1,379			84,111
Research and development		36,275			(225	)		36,050
Selling, general and administrative		24,678			(37	)		24,641
Loss from operations		(21,161	)		(1,117	)		(22,278	)
Interest income and other, net		2,218			(445	)		1,773
Loss from continuing operations before income taxes and discontinued operations		(18,943	)		(1,562	)		(20,505	)
Provision for income taxes		624			—			624
Loss from continuing operations		(19,567	)		(1,562	)		(21,129	)
Income from discontinued operations		256			—			256
Net loss	$	(19,311	)	$	(1,562	)	$	(20,873	)
Net loss per share from continuing operations:
Basic	$	(1.16	)	$	(0.09	)	$	(1.25	)
Diluted	$	(1.16	)	$	(0.09	)	$	(1.25	)
Net income per share from discontinued operations:
Basic	$	0.02		$	—		$	0.02
Diluted	$	0.02		$	—		$	0.02
Net loss per share:
Basic	$	(1.14	)	$	(0.10	)	$	(1.24	)
Diluted	$	(1.14	)	$	(0.10	)	$	(1.24	)
Weighted average number of shares:
Basic		16,890			16,890			16,890
Diluted		16,890			16,890			16,890

The following table summarizes the impact of the restatement to Cost of revenues, Research and development, Selling, general and administrative, Interest income and other, net, and Net loss for the fiscal year ended September 30, 2005.

				Research			Selling,			Interest
	Cost of			and			General and			Income and			Net
	Revenue			Development			Administrative			Other, Net			Loss
	(In thousands)
As previously reported	$	82,732		$	36,275		$	24,678		$	2,218		$	19,311
Adjustments:
Customs and duties		1,473			—			—			(445	)		1,918
Other Accounting errors		(94	)		(225	)		(37	)		—			(356	)
As restated	$	84,111		$	36,050		$	24,641		$	1,773		$	20,873

39

Consolidated Statements of Operations data for the year ended September 30, 2004

	Year Ended September 30, 2004
	As Previously						As
	Reported			Adjustments			Restated
	(In thousands, except per share data)
Revenue	$	141,870		$	—		$	141,870
Cost of revenue		83,969			550			84,519
Income from operations		6,860			(550	)		6,310
Interest income and other, net		4,802			(164	)		4,638
Income from continuing operations before income taxes and discontinued operations		11,662			(713	)		10,949
Provision for income taxes		577			—			577
Income from continuing operations		11,085			(713	)		10,372
Loss from discontinued operations		(1,391	)		—			(1,391	)
Net income	$	9,694		$	(713	)	$	8,981
Net income per share from continuing operations:
Basic	$	0.67		$	(0.06	)	$	0.62
Diluted	$	0.65		$	(0.06	)	$	0.61
Net loss per share from discontinued operations:
Basic	$	(0.08	)	$	—		$	(0.08	)
Diluted	$	(0.08	)	$	—		$	(0.08	)
Net income per share:
Basic	$	0.58		$	(0.05	)	$	0.54
Diluted	$	0.57		$	(0.06	)	$	0.53
Weighted average number of shares:
Basic		16,631			16,631			16,631
Diluted		17,087			17,087			17,087

All adjustments in the fiscal year ended September 30, 2004 shown in the table above relate to the Company’s restatement for customs and duties issues.

40

Consolidated Statements of Operations data for the year ended September 30, 2003

	Year Ended September 30, 2003
	As Previously						As
	Reported			Adjustments			Restated
	(In thousands, except per share data)
Revenue	$	67,196		$	—		$	67,196
Cost of revenue		44,071			403			44,474
Loss from operations		(30,692	)		(403	)		(31,095	)
Interest income and other, net		2,968			(190	)		2,778
Loss from continuing operations before income taxes and discontinued operations		(27,724	)		(592	)		(28,316	)
Provision for income taxes		56			—			56
Loss from continuing operations		(27,780	)		(592	)		(28,372	)
Loss from discontinued operations		(44,592	)		—			(44,592	)
Net loss	$	(72,372	)	$	(592	)	$	(72,964	)
Net loss per share from continuing operations:
Basic	$	(1.73	)	$	(0.03	)	$	(1.76	)
Diluted	$	(1.73	)	$	(0.03	)	$	(1.76	)
Net loss per share from discontinued operations:
Basic	$	(2.77	)	$	—		$	(2.77	)
Diluted	$	(2.77	)	$	—		$	(2.77	)
Net loss per share:
Basic	$	(4.50	)	$	(0.04	)	$	(4.54	)
Diluted	$	(4.50	)	$	(0.04	)	$	(4.54	)
Weighted average number of shares:
Basic		16,089			16,089			16,089
Diluted		16,089			16,089			16,089

All adjustments in the fiscal year ended September 30, 2003 shown in the table above relate to the Company’s restatement for customs and duties issues.

41

Consolidated Quarterly Information

The following statements of operations data presents the impact of the restatement on our previously issued consolidated statements of operations for each of the quarters ended December 31, 2005, March 31, 2006, June 30, 2006, September 30, 2006, December 31, 2006 and March 31, 2007. Financial data for the quarter ended June 30, 2007 is also shown, but has not been previously reported and therefore is not restated; however, it is included for comparative purposes.

	Three Months Ended						Three Months Ended
	December 31, 2006						December 31, 2005
	As Previously			As			As Previously			As
	Reported			Restated			Reported			Restated
	(In thousands, except per share data)
Revenue	$	21,435		$	21,435		$	41,633		$	41,633
Cost of revenue		15,871			15,950			22,382			22,671
Research and development		7,995			7,936			8,071			8,249
Selling, general and administrative		4,930			4,882			6,851			6,834
Income (loss) from operations		(8,180	)		(8,152	)		3,895			3,445
Interest income and other, net		1,081			1,014			500			420
Income (loss) from continuing operations before income taxes and discontinued operations		(7,099	)		(7,138	)		4,395			3,865
Provision for income taxes		101			101			352			352
Income (loss) from continuing operations before discontinued operations		(7,200	)		(7,239	)		4,043			3,513
Loss from discontinued operations		—			—			(680	)		(680	)
Net income (loss)	$	(7,200	)	$	(7,239	)	$	3,363		$	2,833
Net income (loss) per share from continuing operations:
Basic	$	(0.43	)	$	(0.44	)	$	0.24		$	0.21
Diluted	$	(0.43	)	$	(0.44	)	$	0.24		$	0.21
Net loss per share from discontinued operations:
Basic	$	—		$	—		$	(0.04	)	$	(0.04	)
Diluted	$	—		$	—		$	(0.04	)	$	(0.04	)
Net income (loss) per share:
Basic	$	(0.43	)	$	(0.44	)	$	0.20		$	0.17
Diluted	$	(0.43	)	$	(0.44	)	$	0.20		$	0.17
Weighted average number of shares:
Basic		16,590			16,590			16,946			16,946
Diluted		16,590			16,590			17,047			17,047

42

	Three Months Ended						Three Months Ended
	March 31, 2007						March 31, 2006
	As Previously			As			As Previously		As
	Reported			Restated			Reported		Restated
	(In thousands, except per share data)
Revenue	$	13,928		$	13,928		$	50,322	$	50,322
Cost of revenue		13,391			13,604			33,069		33,381
Research and development		7,197			7,194			8,560		8,556
Selling, general and administrative		6,550			6,484			6,984		6,959
Income (loss) from operations		(17,433	)		(17,577	)		1,368		1,085
Interest income and other, net		2,015			1,996			1,019		808
Income (loss) from continuing operations before income taxes and discontinued operations		(15,418	)		(15,581	)		2,387		1,893
Provision for income taxes		105			105			199		199
Income (loss) from continuing operations before discontinued operations		(15,523	)		(15,686	)		2,188		1,694
Income (loss) from discontinued operations		—			—			334		334
Net income (loss)	$	(15,523	)	$	(15,686	)	$	2,522	$	2,028
Net income (loss) per share from continuing operations:
Basic	$	(0.94	)	$	(0.95	)	$	0.13	$	0.10
Diluted	$	(0.94	)	$	(0.95	)	$	0.13	$	0.10
Net income per share from discontinued operations:
Basic	$	—		$	—		$	0.02	$	0.02
Diluted	$	—		$	—		$	0.02	$	0.02
Net income (loss) per share:
Basic	$	(0.94	)	$	(0.95	)	$	0.15	$	0.12
Diluted	$	(0.94	)	$	(0.95	)	$	0.15	$	0.12
Weighted average number of shares:
Basic		16,591			16,591			17,018		17,018
Diluted		16,591			16,591			17,077		17,077

43

	Three			Three Months Ended
	Months			June 30, 2006
	Ended			As Previously			As
	June 30, 2007			Reported			Restated
	(In thousands, except per share data)
Revenue	$	14,430		$	51,658		$	51,658
Cost of revenue		11,215			32,178			32,573
Research and development		6,213			8,508			8,492
Selling, general and administrative		5,831			6,968			6,929
Income (loss) from operations		(8,988	)		3,582			3,242
Interest income and other, net		327			999			859
Income (loss) from continuing operations before income taxes and discontinued operations		(8,661	)		4,581			4,101
Provision for income taxes		72			205			205
Income (loss) from continuing operations before discontinued operations		(8,733	)		4,376			3,896
Loss from discontinued operations		—			(127	)		(127	)
Net income (loss)	$	(8,733	)	$	4,249		$	3,769
Net income (loss) per share from continuing operations:
Basic	$	(0.52	)	$	0.26		$	0.23
Diluted	$	(0.52	)	$	0.26		$	0.23
Net loss per share from discontinued operations:
Basic	$	—		$	(0.01	)	$	(0.01	)
Diluted	$	—		$	(0.01	)	$	(0.01	)
Net income (loss) per share:
Basic	$	(0.52	)	$	0.25		$	0.22
Diluted	$	(0.52	)	$	0.25		$	0.22
Weighted average number of shares:
Basic		16,635			17,047			17,047
Diluted		16,635			17,077			17,077

44

				Three Months Ended
	Three Months			September 30, 2006
	Ended			As Previously			As
	September 30, 2007			Reported			Restated
	(In thousands, except per share data)
Revenue	$	24,474		$	29,259		$	29,259
Cost of revenue		15,605			25,142			25,580
Research and development		5,404			7,281			7,280
Selling, general and administrative		5,879			3,808			3,784
Loss from operations		(4,265	)		(7,433	)		(7,846	)
Interest income and other, net		853			838			717
Loss from continuing operations before income taxes and discontinued operations		(3,412	)		(6,595	)		(7,129	)
Provision (benefit) for income taxes		3			(195	)		(195	)
Loss from continuing operations before discontinued operations		(3,415	)		(6,400	)		(6,934	)
Income from discontinued operations		—			346			346
Net loss	$	(3,415	)	$	(6,054	)	$	(6,588	)
Net loss per share from continuing operations:
Basic	$	(0.20	)	$	(0.38	)	$	(0.41	)
Diluted	$	(0.20	)	$	(0.38	)	$	(0.41	)
Net income per share from discontinued operations:
Basic	$	—		$	0.02		$	0.02
Diluted	$	—		$	0.02		$	0.02
Net loss per share:
Basic	$	(0.20	)	$	(0.36	)	$	(0.39	)
Diluted	$	(0.20	)	$	(0.36	)	$	(0.39	)
Weighted average number of shares:
Basic		17,434			16,849			16,849
Diluted		17,434			16,849			16,849

45

The following tables summarize the impact of the restatement to Cost of revenues, Research and development, Selling, general and administrative, Interest income and other, net, and Net loss for the restated quarters in the fiscal years ended September 30, 2006 and 2007.

	Fiscal 2007
	Three Months			Three Months
	Ended			Ended
	December 31, 2006			March 31, 2007
	(In thousands)
Cost of revenues:
As previously reported	$	15,871		$	13,391
Adjustments:
Customs and duties		181			291
Other accounting errors		(102	)		(78	)
As restated	$	15,950		$	13,604
Research and development:
As previously reported	$	7,995		$	7,197
Adjustments:
Customs and duties		—			—
Other accounting errors		(59	)		(3	)
As restated	$	7,936		$	7,194
Selling, general and administrative:
As previously reported	$	4,930		$	6,550
Adjustments:
Customs and duties		—			—
Other accounting errors		(48	)		(66	)
As restated	$	4,882		$	6,484
Interest income and other, net:
As previously reported	$	1,081		$	2,015
Adjustments:
Customs and duties		(67	)		19
Other accounting errors		—			—
As restated	$	1,014		$	1,996
Net income (loss):
As previously reported	$	(7,200	)	$	(15,523	)
Adjustments:
Customs and duties		(248	)		(310	)
Other accounting errors		209			147
As restated	$	(7,239	)	$	(15,686	)

46

	Fiscal 2006
	Three Months			Three Months			Three Months			Three Months
	Ended			Ended			Ended			Ended
	December 31, 2005			March 31, 2006			June 30, 2006			September 30, 2006
	(In thousands)
Cost of revenues:
As previously reported	$	22,382		$	33,069		$	32,178		$	25,142
Adjustments:
Customs and duties		358			316			474			476
Other accounting errors		(69	)		(4	)		(79	)		(38	)
As restated	$	22,671		$	33,381		$	32,573		$	25,580
Research and development:
As previously reported	$	8,071		$	8,560		$	8,508		$	7,281
Adjustments:
Customs and duties		—			—			—			—
Other accounting errors		178			(4	)		(16	)		(1	)
As restated	$	8,249		$	8,556		$	8,492		$	7,280
Selling, general and administrative:
As previously reported	$	6,851		$	6,984		$	6,968		$	3,808
Adjustments:
Customs and duties		—			—			—			—
Other accounting errors		(17	)		(25	)		(39	)		(24	)
As restated	$	6,834		$	6,959		$	6,929		$	3,784
Interest income and other, net:
As previously reported	$	500		$	1,019		$	999		$	838
Adjustments:
Customs and duties		(80	)		(211	)		(140	)		(121	)
Other accounting errors		—			—			—			—
As restated	$	420		$	808		$	859		$	717
Net income (loss):
As previously reported	$	3,363		$	2,522		$	4,249		$	(6,054	)
Adjustments:
Customs and duties		(438	)		(527	)		(614	)		(597	)
Other accounting errors		(92	)		33			134			63
As restated	$	2,833		$	2,028		$	3,769		$	(6,588	)

Results of fiscal 2007 Quarterly Operations

Revenues in each quarter of fiscal 2007 decreased over each of the comparative quarters in fiscal 2006 as our customers scaled back utilization of existing capacity while they re-assessed the timing of new factory investments and upgrades to existing factories based on then-current market conditions. Revenues did not decrease sequentially quarter over quarter in fiscal 2007 as revenues in each quarter were based on the investment patterns of flat panel display manufacturers, which in turn depended on the then-current and anticipated market demand for products utilizing flat panel displays.

47

Gross margins in each of the first three quarters of fiscal 2007 decreased over each of the comparative quarters in fiscal 2006, while gross margins in the fourth quarter of fiscal 2007 increased as compared to the fourth quarter of fiscal 2006. The decreases in gross margin in each of the first three quarter of fiscal 2007 as compared to the same quarters in the prior fiscal year were primarily due to a lower mix of higher-margin ArrayChecker^tm Systems.

Operating expenses in each quarter of fiscal 2007 generally included less research and development expenses as compared to the same quarters in the prior fiscal year due to lower spending on our Generation 6 and 7 test and repair product development programs and to savings from the restructuring plans initiated in the first and second quarters of fiscal 2007. Selling, general and administrative expenses in each of the first three quarters of fiscal 2007 decreased over each of the comparative quarters in fiscal 2006, while selling, general and administrative expenses in the fourth quarter of fiscal 2007 increased as compared to the fourth quarter of fiscal 2006. The decreases were due primarily to lower costs associated with audit and legal fees, stock compensation charges and savings from the restructuring plans initiated in the first and second quarters of fiscal 2007. The increase in selling general and administrative costs in the fourth quarter of fiscal 2007 as compared to the same quarter in fiscal 2006 was due in part to the legal and audit costs associated with the restatement of our financial statements as contained in this Annual Report on Form 10-K. In addition, we incurred restructuring charges of approximately $446,000 and $1.1 million in the first two quarters of fiscal 2007, respectively, associated with first-quarter discontinuation of our PanelMaster^tm product line and our second-quarter company-wide restructure. We incurred charges of approximately $2.8 million in the second quarter of fiscal 2007 for the impairment property and equipment including a $2.0 million charge for one of our U.S. manufacturing facilities.

Results of fiscal 2006 Quarterly Operations

Revenues in each quarter of fiscal 2006 increased over each the comparative quarters in fiscal 2005 as our customers continued their expansion of manufacturing capacity. Revenues did not increase sequentially, quarter over quarter in fiscal 2006 as revenues in each quarter were based on the investment patterns of flat panel display manufacturers, which in turn depended on the current and anticipated market demand for products utilizing flat panel displays. Revenues in the fourth quarter of fiscal 2006 were the lowest of the year, as flat panel display manufacturers began scaling back utilization of existing capacity while they re-assessed the timing of new factory investments and upgrades to existing factories based on then-current market conditions.

Gross margins in each of the first three quarters of fiscal 2006 increased over each of the comparative quarters in fiscal 2005, while gross margins in the fourth quarter of fiscal 2006 decreased as compared to the fourth quarter of fiscal 2005. The increases in gross margin in each of the first three quarter of fiscal 2006 as compared to the same quarters in the prior fiscal year were primarily due to a higher mix of higher-margin ArrayChecker^tm Systems. Cost of revenue for the fourth quarter of fiscal 2006 included a $3.0 million warranty expense charge related to our agreement to replace two of the four original Generation 7 test systems sold to a customer with a newer version of our Generation 7 test systems, as discussed earlier in this Annual Report.

Operating expenses in each quarter of fiscal 2006 generally included less research and development expenses as compared to the same quarters in the prior fiscal year due to lower spending on our Generation 6 and 7 test, repair and inspection product development programs and to the full-year savings from our April 2005 restructuring associated with the closing of our Markham, Canada location. These cost savings were partially offset by the impact of SFAS No. 123R to the fiscal 2006 quarterly research and development expenses, for which there were no comparable charges in the research and development expenses for the same periods of the prior fiscal year. Selling, general and administrative expenses in each of the first three quarters of fiscal 2006 increased over each of the comparative quarters in fiscal 2005, while selling, general and administrative expenses in the fourth quarter of fiscal 2006 decreased as compared to the fourth quarter of fiscal 2005. The increases in each of the first three quarters of fiscal 2006 as compared to the same quarters in the prior fiscal year were due primarily to costs associated with SFAS No. 123R and higher costs associated with audit and legal fees and increased headcount. In addition, the third and fourth quarter of fiscal 2006 included approximately $50,000 and $31,000 of charges to impair property and equipment.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of our financial statements and the related disclosures requires our management to make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Note 1 of the “Notes to Consolidated Financial Statements” included under Part II, Item 8. “Financial Statements and Supplementary Data,” in this Annual Report on Form 10-K describes significant accounting policies used in the preparation of our consolidated financial statements. Some of these significant accounting policies are considered to be critical accounting policies.

A critical accounting policy is defined as one that is both material to the presentation of our financial statements and requires management to make difficult, subjective or complex judgments that could have a material effect on our financial condition and results of operations.

Estimates and assumptions about future events and their effects cannot be determined with certainty. We base our estimates on historical experience and on various other assumptions that are believed to be applicable and reasonable under the circumstances. These estimates may change as new events occur, as additional information is obtained and as our operating environment changes. In addition, management is periodically faced with uncertainties, the outcomes of which are not within its control and will not be known for prolonged periods of time. These uncertainties are discussed in Part I, Item 1A “Risk Factors” in this Annual Report on Form 10-K.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

Note 1 of our “Notes to Consolidated Financial Statements” included in Part II, Item 8. “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K provides a description of our revenue recognition policy. For each arrangement for the sale and installation of equipment, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or the services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured, the latter of which is subject to judgment. If we determine that any of these criteria are not met, we defer revenue recognition until such time as we determine that all of the criteria are met.

In addition, for arrangements with multiple deliverables, we make additional judgments as to whether each item has value to the customer on a stand-alone basis, whether there is objective and reliable evidence of the fair value of the undelivered items and whether the amounts of revenue for each element are subject to refund. Our determination of whether deliverables within a multiple element arrangement can be treated separately for revenue recognition purposes involves significant estimates and judgments, such as whether fair value can be established on undelivered elements and/or whether delivered elements have stand-alone value to the customer. Changes to our assessment of the accounting units in an arrangement and/or our ability to establish fair values could significantly change the timing of revenue recognition.

We may, at various times, have a significant deferred gross margin balance relative to our consolidated revenue. Recognition of this deferred revenue over time can have a material impact on our consolidated revenue in any period and result in significant fluctuations.

We have a policy to record a provision as necessary for estimated sales returns in the same period as the related revenue is recorded, which is netted against revenue. These estimates are based on historical sales returns and other known factors which have not varied widely in the past and we do not reasonably expect these factors to significantly change in the foreseeable future. If the historical data we use to calculate these estimates does not properly reflect future returns, additional provisions may be required. Historically, we have not experienced the return of any of our flat panel display systems upon which we have recognized revenue. Due to the relatively high prices of our systems, the return of one of these systems as a sales return could have a material adverse effect on our results of operations.

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Allowance for Doubtful Accounts

Our trade receivables are derived primarily from sales to flat panel display manufacturers located in South Korea, Taiwan, Japan and China. In order to monitor potential credit losses, we perform periodic evaluations of our customers’ financial condition. We maintain an allowance for doubtful accounts for the potential inability of our customers to make required payments based upon our assessment of the expected collectibility of all accounts receivable. In estimating the provision, we consider (i) historical experience, (ii) the length of time the receivables are past due, (iii) any circumstances of which we are aware regarding a customer’s inability to meet its financial obligations, and (iv) other known factors. We review this provision periodically to assess the adequacy of the provision.

Historically, losses due to customer bad debts in our flat panel display business have been immaterial, and we expect that this will not change in the foreseeable future. However, if a single customer was unable to make payments, additional allowances may be required. Accordingly, the inability of a single customer to make required payments could have a material adverse effect on our results of operations.

Inventories

The valuation of inventory requires us to estimate obsolete or excess inventory and inventory that is not saleable. The determination of obsolete or excess inventory requires us to estimate the future demand for our products within specific time horizons, generally twelve months or less. If our demand forecast for specific products is greater than actual demand and we fail to reduce manufacturing output accordingly, we could be required to record additional inventory write-offs, which would have a negative impact on our gross margin.

We review the adequacy of our inventory valuation on a quarterly basis. For production inventory, our methodology involves matching our on-hand inventory and non-cancellable purchase orders with our demand forecast over the next twelve months on a part-by-part basis. We then evaluate the parts found to be in excess of the twelve-month demand and take appropriate write-downs and write-offs to reflect the risk of obsolescence. This methodology is significantly affected by the demand forecast assumption. Using a longer time period of estimated demand could result in reduced inventory adjustment requirements. Based on our past experience, we believe the twelve-month time period to best reflect the reasonable and relative obsolescence risks. If actual demand or usage were to be substantially lower than estimated, additional inventory adjustments for excess or obsolete inventory may be required.

Warranty

Our warranty policy generally states that we will provide warranty coverage for a period 12 months from final acceptance or 14 months from shipment, whichever is shorter. We record the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment, upon product shipment when the related revenue is recognized. Our warranty obligation is affected by product failure rates, consumption of field service parts and the efficiency by which the product failure is corrected. We estimate our warranty cost based on historical data related to these factors.

Goodwill and Intangible Assets

We do not amortize either goodwill or intangible assets with indefinite useful lives, but rather we review these assets for impairment at least annually and more frequently if there are indicators of impairment. The process for evaluating the potential impairment of goodwill is highly subjective and requires significant judgment at many points during the analysis. Should actual results differ from our estimates, revisions to the recorded amount of goodwill could be reported.

We amortize intangible assets with finite lives and other long-lived assets over their estimated useful lives and also subject them to evaluation for impairment. We review long-lived assets including intangible assets with finite lives for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable, such as a significant industry downturn, significant decline in the market value of the company, or significant reductions in projected future cash flows. We would recognize an impairment loss

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when estimated undiscounted future cash flows expected to result from the use of the asset and its eventual disposition is less than its carrying amount. We determine impairment, if any, using discounted cash flows. In assessing the recoverability of long-lived assets, including intangible assets, we must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, we may be required to record additional impairment charges for these assets.

Stock-Based Compensation

We estimate the fair value of stock options using a Black-Scholes valuation model, consistent with the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payments” (“SFAS No. 123R”) and SEC Staff Accounting Bulleting No. 107. SFAS No. 123R requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. The Black-Scholes option-pricing model requires the input of highly subjective assumptions, including the options, expected life and the price volatility of the underlying stock.

Contingencies and Litigation

We are subject to the possibility of losses from various contingencies. Considerable judgment is necessary to estimate the probability and amount of any loss from such contingencies. We make an assessment of the probability of an adverse judgment resulting from current and threatened litigation. We accrue the cost of an adverse judgment if, in our estimation and based on the advice of legal counsel, the adverse judgment is probable and we can reasonably estimate the ultimate cost of such a judgment.

We were not engaged in any significant litigation matter as of September 30, 2007, but are awaiting the result of an appeal by the plaintiff in the Amtower v. Photon Dynamics, Inc. lawsuit. This lawsuit is described in Part I, Item 3. “Legal Proceedings” in this Annual Report on Form 10-K. We believe that an adverse outcome in the appeal of the Amtower litigation could have a material adverse effect on our financial condition, results of operations and cash flows.

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RESULTS OF OPERATIONS

Fiscal Years Ended September 30, 2007, 2006 and 2005

The following table sets forth, for the periods indicated, the percentage of revenue of certain items in our Consolidated Statements of Operations.

	Year Ended September 30,
	2007			2006			2005
				As			As
				Restated			Restated
Revenue		100.0	%		100.0	%		100.0	%
Cost of revenue		75.9			66.1			66.9
Gross margin		24.1			33.9			33.1
Operating expenses:
Research and development		36.0			18.8			28.7
Selling, general and administrative		31.1			14.2			19.6
Restructuring charge		1.8			0.0			1.0
Impairment of property and equipment		3.8			0.0			0.5
Loss (gain) on sale of property and equipment		0.1			0.0			(0.1	)
Acquired in-process research and development		1.4			—			—
Amortization of intangible assets		2.3			0.9			1.2
Total operating expenses		76.6			34.0			50.9
Income (loss) from operations		(52.5	)		0.0			(17.7	)
Interest income and other, net		5.6			1.6			1.4
Income (loss) from continuing operations before income taxes and discontinued operations		(46.8	)		1.6			(16.3	)
Provision for income taxes		0.4			0.3			0.5
Income (loss) from continuing operations before discontinued operations		(47.2	)		1.3			(16.8	)
Income (loss) from discontinued operations		—			(0.1	)		0.2
Net income (loss)		(47.2	)%		1.2	%		(16.6	)%

Operating Segments

Prior to fiscal 2003, we operated in three operating segments. In fiscal 2003, we implemented plans to exit our printed circuit board assembly inspection business and our cathode ray tube display and high quality glass inspection business. The operating results of these former business segments have been presented as discontinued operations in our consolidated financial statements.

From fiscal 2003 to 2007 we operated in one segment: Flat Panel Display. A second operating segment, High-Performance Digital Imaging, was created in July 2007 when we purchased Salvador Imaging. For the year ended September 30, 2007, the results of operations of our new High-Performance Digital Imaging segment were immaterial, generating less than 1% of our total revenues.

Revenue

We primarily generate revenue from the sales of our ArrayChecker^tm and ArraySaver^tm test and repair equipment and customer support, which includes the sales of spare parts. In fiscal 2007, we generated limited revenue from sales of our high-performance camera products, which resulted from our fourth-quarter acquisition of Salvador Imaging. In addition, we had limited revenue in fiscal 2006 and 2005 from our PanelMaster^tm inspection equipment product line, which has been discontinued.

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Our revenue for fiscal 2007, 2006 and 2005, is as follows:

	Fiscal Year Ended September 30,							Fiscal Year Ended September 30,
	2007		Change			2006		2006		Change			2005
	(Dollars in thousands)
Revenue	$	74,267		(57	)%	$	172,872	$	172,872		37	%	$	125,813

Revenue decreased 57% in fiscal 2007 from fiscal 2006. As discussed earlier, the flat panel display manufacturers have scaled back utilization of existing capacity while they re-assess the timing of new factory investments and upgrades to existing factories. This process resulted in reductions and delays of many of our customers’ investment plans during fiscal 2007. Revenue increased 37% in fiscal 2006 from fiscal 2005 as our customers continued their expansion of manufacturing capacity. We expect that flat panel display manufacturers will again begin to make new factory investments and upgrades to existing factories during the second half of the 2008 calendar year, but we can provide no assurances that this anticipated industry recovery will occur.

ArrayChecker^tm and ArraySaver^tm Product Revenue

Our ArrayChecker^tm and ArraySaver^tm test and repair equipment operate in the Array phase of AMLCD production and are built to handle the different generation sizes of substrate glass. Total revenue from our test and repair equipment, by generation and by product, are as follows:

	Fiscal Year Ended
	September 30,
	2007			2006			2005
Revenue by generation:
Generation 6 and earlier		24	%		35	%		84	%
Generation 7 and 8		49	%		50	%		—
Revenue by product:
ArrayCheckertm		57	%		66	%		60	%
ArraySavertm		15	%		19	%		24	%

Total revenue from our Generation 6 and earlier generation test and repair products decreased sequentially from fiscal 2005 to fiscal 2007 while total revenue from our Generation 7 and 8 test and repair products began in fiscal 2006 and remained relatively flat in fiscal 2007. This represents a shift to our Generation 7 and 8 products among flat panel display manufacturers as manufacturers move to larger-size glass substrates in the manufacturing process. Our products in each new generation contain new performance and control features designed specifically to enhance yield improvement and process control in addition to being able to handle larger size glass substrate. As a result, historically we generally have experienced increases in our average selling prices of between 10% and 20% in each new generation product. As with prior generation products, our Generation 6, 7 and 8 ArrayChecker^tm products have greater average selling prices than previous generations. However, the average selling prices of our Generation 6 and 7 ArraySaver^tm products were relatively flat as compared to the prior generations due primarily to a more competitive environment in the array repair market. There is no assurance that we will be successful at achieving or sustaining average selling price increases on our Generation 7 and future generation products.

The revenue mix of our ArrayChecker^tm and ArraySaver^tm test and repair products has been driven by investment decisions of our customers as they invest in manufacturing capacity.

Revenue from our ArrayChecker^tm and ArraySaver^tm test and repair products includes revenue recognized at the time of shipment and revenue recognized upon final customer acceptance. Our sales terms are typically 60% to 90% of the sales price due upon shipment with that portion of the remaining amount due after installation and upon final customer acceptance. Revenue for fiscal 2007 included lower revenue related to the receipt of final customer acceptances following completed installation of our products compared with fiscal 2006, both as a percentage of revenue and in absolute dollar value. Revenue for fiscal 2006 included lower revenue related to the receipt of final customer acceptances following completed installation of our products compared with fiscal 2005, both as a percentage of revenue and in absolute dollar value.

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PanelMaster^tm Product Revenue

Our PanelMaster^tm inspection equipment operates primarily in the Cell Assembly phase of AMLCD production, inspecting glass that has been cut down to the size of the needed application. As such, our PanelMaster^tm product is not dependent on the initial glass substrate size and can function on either Generation 6 or Generation 7 fabrication lines. Consequently, we do not classify this product line by generations. As discussed above, due to a continued decline in demand for our PanelMaster^tm products, in November of 2006, we announced that while we would continue to support the current installed base, we were discontinuing the PanelMaster^tm product line and would no longer pursue new business for PanelMaster^tm systems, upgrades or enhancements for this product line.

Revenue from our PanelMaster^tm products represented less than 1% and approximately 6% of total revenue in fiscal 2007 and 2006, respectively. The revenue recognized in fiscal 2007 consists primarily of revenue related to final acceptance on systems shipped prior to fiscal 2007. While we may see limited revenue from the sale of spare parts to support the current installed base, we do not anticipate any future revenue from the sale of PanelMaster^tm systems.

Revenue from our PanelMaster^tm products represented approximately 6% of total revenue for both fiscal 2006 and 2005. Our inspection equipment was introduced in fiscal 2004 and the first production units were shipped in our fourth quarter of fiscal 2004. Because this was a new product line, we deferred 100% of the revenue until we received customer final acceptance. The revenue recognized in fiscal 2005 represents certain systems purchased by one customer from whom we received final acceptance in our fourth quarter of fiscal 2005.

Customer Support and Spare Parts Revenue

Revenues from customer support and spare parts represented approximately 28% and 9% of total revenue for fiscal 2007 and 2006, respectively. Revenue in fiscal 2007 was higher in absolute dollars than in the comparative prior year period due in part to an increase the installed base of tools at our customers’ facilities. Revenue in fiscal 2007 was higher as a percentage of total revenue than in the comparative prior year due to the more stable nature of our customer support and spare parts revenue. In periods where revenue from new ArrayChecker^tm and ArraySaver^tm products declines, revenue from support and spare parts increases as a percentage of total revenues.

Revenue from customer support and spare parts represented approximately 9% and 10% of total revenue for fiscal 2006 and 2005, respectively. Although revenue was relatively flat as a percentage of total revenue in both periods, revenue was higher in absolute dollars in fiscal 2006 over fiscal 2005 due in part to increased sales of service and spare parts as we increased the installed base of tools at our customers’ facilities.

High-Performance Digital Cameras

Revenues from our high-performance digital cameras represented less than 1% of total revenue in fiscal 2007, with no corresponding revenue in prior fiscal years. In the fourth quarter of fiscal 2007, we purchased Salvador Imaging, an international supplier of high-performance digital cameras for defense, industrial and other applications. In addition to acquiring their current product base of camera imaging systems, we hope to leverage our digital imaging core competencies with theirs to develop highly sensitive color and monochrome cameras that can be used to provide daytime and nighttime surveillance capabilities for the military and security markets. We are developing evaluation units and are actively engaged in marketing and sales activities; however, we anticipate that the sales cycle for these markets will be lengthy and it is uncertain if and when we will generate significant revenue from this new venture.

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International Revenue

Revenue by country for the periods indicated was as follows:

	Fiscal Year Ended September 30,							Fiscal Year Ended September 30,
	2007		Change			2006		2006		Change			2005
	(Dollars in millions)
South Korea	$	26.2		(77	)%	$	113.3	$	113.3		173	%	$	41.5
Taiwan		23.3		(43	)		41.1		41.1		(23	)		53.2
Japan		18.7		144			7.7		7.7		(55	)		17.0
China		4.7		(57	)		10.8		10.8		(24	)		14.1
United States		1.4		(100	)		—		—		—			—
	$	74.3		(57	)%	$	172.9	$	172.9		37	%	$	125.8

The changes in revenue from fiscal 2007 to fiscal 2006 and from fiscal 2006 to 2005 are a result of the investment patterns of flat panel display manufacturers, which in turn depends on the current and anticipated market demand for products utilizing flat panel displays.

In fiscal 2007, 2006 and 2005, we invoiced revenue of approximately $18.7 million, $7.4 million and $19.3 million, respectively, in currencies other than U.S. dollars, primarily Japanese yen.

Revenue Outlook

The combination of delayed manufacturing capacity investments over the past five quarters and strong demand for IT and television displays has created a capacity shortfall, particularly for larger-sized panels. Flat panel display manufacturers are now investing to add capacity into existing Generation 5, Generation 6 and Generation 7 lines as well as accelerating Generation 8 plans in order meet forecasted demand. Growth in notebook display demand and robust flat-screen television adoption fuel an optimistic revenue outlook for calendar years 2008 and 2009. While we expect that flat panel display manufacturers will again begin to make new factory investments and upgrades to existing factories during the second half of calendar year 2008, we can provide no assurances that this anticipated industry recovery will occur. In addition, we do not anticipate future investments made by flat panel display manufactures to approach the levels of investment during calendar years 2004 through 2006 and as such, do not expect our Flat Panel Display revenues to approach levels achieved in prior fiscal years. As stated above, forward looking statements such as these and the ones below regarding our expected financial results for fiscal 2008 are subject to risks and uncertainties. Please see Part I, Item 1A. “Risk Factors” in this Annual Report on Form 10-K for factors that could cause these forward looking statements to differ significantly from our actual results.

Gross Margin

	Fiscal Year Ended September 30,									Fiscal Year Ended September 30,
	2007			Change			2006			2006			Change			2005
							As			As						As
							restated			restated						restated
	(Dollars in thousands).
Gross Margin	$	17,893			(70	)%	$	58,667		$	58,667			41	%	$	41,702
Gross Margin Percentage		24	%		(29	)%		34	%		34	%		(3	)%		33	%

Gross margins, as a percentage of revenues, decreased in fiscal 2007 as compared to fiscal 2006, despite a relatively high mix of higher-margin ArrayChecker^tm systems and savings from decreased headcount in fiscal 2007, primarily due to:

•  Lower revenue related to the receipt of final customer acceptances following completed installation, which have higher margins associated with this portion of the sales price, as compared to the same period in the prior year;

•  Additional inventory reserves as a consequence of the industry slowdown; and,

•  The under-utilization of our San Jose facilities as a consequence of the industry slowdown.

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Gross margins, as a percentage of revenues, remained relatively flat in fiscal 2006 as compared to fiscal 2005, and were primarily due to a higher mix of higher-margin ArrayChecker^tm systems, offset by:

•  Lower revenue related to the receipt of final customer acceptances following completed installation, which have higher margins associated with this portion of the sales price, as compared to the same period in the prior year;

•  Costs associated with SFAS No. 123R for which there were no comparable charges in the same period of the prior fiscal year;

•  An additional write-down of excess inventory in our third quarter as a result of anticipated lower bookings and revenues; and

•  A one-time warranty charge for the replacement of two of our Generation 7 ArrayChecker^tm systems.

Key factors that may impact our future gross margins include:

•  Reduced production levels as a consequence of either industry slowdown, order cancellations or rescheduled product shipments requested by our customers;

•  Fluctuations in the level of revenue due to the cyclical nature of our customers’ capital expenditures.

•  Our revenue mix between higher-margin ArrayChecker^tm systems and lower-margin ArraySaver^tm systems;

•  Competitive pricing pressures, particularly in the array repair market;

•  Our ability to achieve cost reductions;

•  The additional costs in connection with inefficiencies of manufacturing newly-introduced products;

•  The success of our strategy of using domestic and offshore manufacturing and outsourcing as we migrate the manufacturing of our ArraySaver^tm systems to South Korea; and

•  Increased customer service costs associated with supporting potential increased demand from new and existing customers.

Research and Development

	Fiscal Year Ended September 30,									Fiscal Year Ended September 30,
	2007			Change			2006			2006			Change			2005
							As			As						As
							restated			restated						restated
	(Dollars in thousands)
Expense	$	26,747			(18	)%	$	32,577		$	32,577			(10	)%	$	36,050
Percent of Revenue		36	%					19	%		19	%					29	%

Our research and development expenses consist primarily of salaries, related personnel costs, depreciation, prototype materials and fees paid to consultants and outside service providers, all of which relate to the design, development, testing, pre-manufacturing and improvement of our products.

Our overall research and development spending decreased in fiscal 2007 as compared to fiscal 2006 in absolute dollars. Although we had lower spending on Generation 6 and 7 test and repair product development programs in the current fiscal year as compared to the prior fiscal year, these savings were offset by the launch of our Generation 10 product development program in anticipation of a move to Generation 10 substrate glass by our customers. In addition, we had savings from decreased headcount in fiscal 2007.

Our overall research and development spending decreased in fiscal 2006 as compared to fiscal 2005 in both absolute dollars and as a percentage of revenue due to lower spending on our Generation 6 and 7 test, repair and inspection product development programs and to savings from the restructuring associated with the closing of our Markham, Canada location. This decrease in research and development expenses occurred despite the impact of SFAS No. 123R in fiscal 2006, for which there were no comparable charges in fiscal 2005.

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We will continue to invest in research and development to maintain technology leadership in our products. Our customers must continually improve their display quality performance and production costs in order to be successful in the display market. To meet our customers’ needs, we must improve our product performance in defect detection, repair success, cost of ownership, ease of use and throughput for each of our product generations.

Selling, General and Administrative

	Fiscal Year Ended September 30,									Fiscal Year Ended September 30,
	2007			Change			2006			2006			Change			2005
							As			As						As
							restated			restated						restated
	(Dollars in thousands)
Expense	$	23,076			(6	)%	$	24,506		$	24,506			(1	)%	$	24,641
Percent of Revenue		31	%					14	%		14	%					20	%

Our selling, general and administrative expenses consist primarily of salaries and related expenses for marketing, sales, finance, administration and human resources personnel, as well as costs for auditing, commissions, insurance, legal and other corporate expenses.

Selling, general and administrative spending remained relatively flat in absolute dollars in fiscal 2007 compared to fiscal 2006. Savings due to lower costs associated with stock compensation charges and decreased headcount were offset by increased legal and audit fees associated with the restatement of our consolidated financial statements.

Selling, general and administrative spending remained relatively flat in absolute dollars in fiscal 2006 compared to fiscal 2005. Fiscal 2005 costs included approximately $1.6 million of one-time costs associated with an internal investigation by our audit committee and resulting restatement of our consolidated financial statements for fiscal 2004 and the first quarter of fiscal 2005. Fiscal 2006 costs include costs associated with SFAS No. 123R for which there were no comparable charges in fiscal 2005.

Restructuring Charge

	Fiscal Year Ended September 30,									Fiscal Year Ended September 30,
	2007			Change			2006			2006			Change			2005
	(Dollars in thousands)
Expense	$	1,368			4,460	%	$	30		$	30			(97	)%	$	1,197
Percent of Revenue		2	%					0	%		0	%					1	%

Our charges for restructuring in fiscal 2007 increased in absolute dollars as compared to fiscal 2006 due to the restructuring programs initiated by management in fiscal 2007 in response to the current dynamics of the flat panel display market.

February 2007 Restructuring

In February 2007, we recorded a restructuring charge of approximately $1.0 million associated with a Company-wide cost reduction plan designed to accelerate achieving the Company’s objective of consistent profitability. The charge was comprised of expenses for employee severance and related benefits as a result of planned termination of 56 employees, including 27 manufacturing personnel, 20 research and development engineers and 9 sales and administrative personnel. In the three months ended June 30, 2007, we adjusted the liability by approximately $95,000 for severance not paid. We do not anticipate any additional charges related to this restructuring.

Under this restructuring plan, we expect annual savings in salary and benefits costs of approximately $2.3 million to $2.7 million per fiscal year in both “Cost of revenue” and “Research and development,” while we expect annual savings in salary and benefits costs of approximately $1.0 million to $1.4 million in “Selling, general and administrative.”

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November 2006 Restructuring

In November 2006, we recorded a restructuring charge of approximately $446,000 associated with the discontinuation of our PanelMaster^tm products. The charge was comprised of expenses for employee severance and related benefits as a result of planned termination of employees and expenses for impairing certain manufacturing assets associated with the product line. We do not anticipate any additional charges related to this restructuring.

Under this restructuring plan, we expect annual savings in salary and benefits costs and depreciation of approximately $150,000 to $200,000 per fiscal year primarily in research and development.

April 2005 Restructuring

In April 2005, we recorded an initial restructuring charge of approximately $676,000 associated with a reduction in workforce and consolidation and closing of our facilities at our Markham, Canada location. The charge was comprised of approximately $430,000 for employee severance and related benefits as a result of planned terminations of up to 32 employees and approximately $246,000 for contract termination costs associated with excess facilities under a long-term operating lease agreement for facilities we vacated in June 2005.

Under the restructuring plan, certain employees were offered additional severance amounts and retention bonuses to stay through either September 2005 or March 2006. We accrued charges for these benefits ratably over the related service periods. We recorded additional restructuring charges of approximately $521,000 through September 30, 2005 and approximately $114,000 during the six months ended March 31, 2006 related to these severance and retention amounts. The fiscal 2006 charges were partially offset by an adjustment to the liability of approximately $84,000 related to bonuses not paid. All termination benefits were paid out by March 31, 2006.

Under this restructuring plan, we expect annual savings in salary and benefits costs, amortization and rent expense of approximately $1.6 million to $2.0 million per fiscal year, primarily in research and development. To date, our actual savings have approximated our expected savings.

Impairment Property and Equipment

	Fiscal Year Ended September 30,									Fiscal Year Ended September 30,
	2007			Change			2006			2006			Change			2005
	(Dollars in thousands)
Expense	$	2,834			3,399	%	$	81		$	81			(87	)%	$	637
Percent of Revenue		4	%					0	%		0	%					1	%

In fiscal 2007 we incurred total impairment charges of approximately $2.8 million as a result of management’s review of our Company’s global operations in light of the current and anticipated dynamics of the flat panel display market environment and to our commitment to transfer certain manufacturing to South Korea. As a result of this review and in conjunction with the Company’s restructuring, we determined that one of our U.S. manufacturing facilities was impaired, and we recorded an impairment charge of approximately $2.0 million based on the difference between the carrying amount of the asset over the asset’s appraised fair value. In addition, we recorded an impairment charge of approximately $834,000 related to the write-off of certain capital equipment that we determined had no additional future use.

In fiscal 2006 and 2005, we incurred total impairment charges of approximately $81,000 and $637,000, respectively, consisting primarily of manufacturing capital equipment that had no future use.

Loss (gain) on Sale of Property and Equipment

	Fiscal Year Ended									Fiscal Year Ended
	September 30,									September 30,
	2007			Change			2006			2006		Change			2005
	(Dollars in thousands)
Loss (Gain)	$	87			50	%	$	58		$	58		(162	)%	$	(93	)
Percent of Revenue		0	%					0	%				0	%		0	%

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In fiscal 2007 and 2006, we recorded a net loss on sale of property and equipment of approximately $87,000 and $58,000, respectively, on the sale of miscellaneous assets. In fiscal 2005, we recorded a net gain on sale of property and equipment of approximately $93,000 primarily due to the sale of a demonstration system.

Acquired In-Process Research and Development

	Fiscal Year Ended									Fiscal Year Ended
	September 30,									September 30,
	2007			Change			2006			2006			Change			2005
	(Dollars in thousands)
Expense	$	1,110			100	%	$	0		$	0			0	%	$	0
Percent of Revenue		1	%					0	%		0	%					0	%

We had no acquired in-process research and development charges in fiscal 2006 or 2005. In fiscal 2007, we acquired Salvador Imaging an international supplier of high-performance digital cameras for defense, industrial and other applications. The purchase price of this acquisition was allocated in accordance with FAS 141, “Business Combinations,” including in-process research and development charges that were expensed on the acquisition date as they represented ongoing research and development projects that had not yet reached technological feasibility and had no alternative future uses.

Acquired in-process research and development was identified and valued through interviews with executives of the company from which the assets were acquired, analysis of data concerning developmental products and their stage of development, the time and resources needed to complete the projects, their expected income generating ability, target markets and associated risks. The income approach, which includes an analysis of the markets, cash flows and risks associated with achieving such cash flows, was the primary technique we utilized in valuing in-process research and development. We discounted projected incremental cash flows back to their present value using discount rates of 32.0%, which was determined after consideration of our weighted average cost of capital and the weighted average return on assets.

In-process research and development related to Salvador Imaging involved the design of certain, next generation digital cameras. At the time of acquisition, the identified projects were, on average, approximately 20% complete, and the majority of the projects are expected to be complete by the end of the Company’s second quarter of fiscal 2008, with additional expected costs to complete of approximately $1.1 million.

Risks associated with our acquired in-process research and development include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets. The nature of the efforts required to develop the acquired in-process research and development into commercially viable products principally relate to the completion of all planning, designing, prototyping, verification and testing activities that are necessary to establish that the products can be produced to meet their design specifications, including functions, features and technical performance requirements. As such, the timing of completion and ultimate commercial application are affected by the successful completion of these activities and ultimately, market acceptance.

Amortization of Intangible Assets

	Fiscal Year Ended September 30,									Fiscal Year Ended September 30,
	2007			Change			2006			2006			Change			2005
	(Dollars in thousands)
Expense	$	1,653			11	%	$	1,489		$	1,489			(4	)%	$	1,548
Percent of Revenue		2	%					1	%		1	%					1	%

Amortization of intangibles increased in absolute dollars in fiscal 2007 compared to fiscal 2006. Although certain existing assets became fully amortized during the current year, we acquired additional intangible assets through our purchase of Salvador Imaging, and the amortization of these assets began in our fourth quarter.

Amortization of intangibles remained relatively flat in absolute dollars in fiscal 2006 compared to fiscal 2005 as the intangible asset base remained relatively stable in both years.

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Based on intangible assets recorded at September 30, 2007, and assuming no subsequent additions to, or impairment of the underlying assets, we expect our amortization to be approximately $3.4 million in fiscal 2008.

Interest Income and Other, Net

	Fiscal Year Ended September 30,									Fiscal Year Ended September 30,
	2007			Change			2006			2006			Change			2005
							As			As						As
							restated			restated						restated
	(Dollars in thousands)
Interest Income and Other, Net	$	4,190			49	%	$	2,803		$	2,803			58	%	$	1,773
Percent of Revenue		6	%					2	%		2	%					1	%

Interest income and other, net consists primarily of interest income, foreign currency exchange gains and losses and other miscellaneous income and expense.

The higher level of interest income and other, net, in fiscal 2007 compared to fiscal 2006 was primarily attributable to changes in interest income due to fluctuating interest rates on invested cash, to changes in levels of invested cash and to changes in the effects of foreign currency transaction gains and losses. In addition, in the quarter ended March 31, 2007, we substantially liquidated our Canadian subsidiary, Photon Dynamics Canada, Inc; and recorded a gain on our net investment of approximately $928,000 related to foreign currency translation adjustment gains that had accumulated in “Accumulated other comprehensive income (loss)” on our Consolidated Balance Sheet.

The higher level of interest income and other, net, in fiscal 2006 compared to fiscal 2005 was primarily attributable to an increase in interest income and to a decreased effect of transaction gains and losses. Interest income increased due both to higher average balances of cash and marketable securities in fiscal 2006 as compared to fiscal 2005 and to higher interest rates on invested cash in fiscal 2006 compared to rates in effect in fiscal 2005.

Provision for Income Taxes

	Fiscal Year Ended September 30,									Fiscal Year Ended September 30,
	2007			Change			2006			2006			Change			2005
	(Dollars in thousands)
Expense	$	280			(50	)%	$	561		$	561			(10	)%	$	624
Percent of Revenue		0	%					0	%		0	%					1	%

The fiscal 2007, 2006 and 2005 effective tax rates were (0.8)%, 20.2% and (3.0)%, respectively. The negative rates for fiscal 2007 and fiscal 2005 primarily related to foreign tax expense incurred regardless of our net operating losses and do not denote a tax benefit. The effective tax rate for fiscal 2007 was lower than the beneficial statutory rate primarily due to operating losses not benefited and to foreign taxes. The effective rate for fiscal 2006 is lower than the statutory rate primarily due to operating losses not benefited and to foreign taxes. The effective tax rate for fiscal 2005 was lower than the beneficial statutory rate primarily due to operating losses not benefited and to foreign taxes.

As of September 30, 2007, we have federal and state net operating loss carryforwards of approximately $121.2 million and $35.5 million, respectively. We expect that our effective tax rate will be less than the statutory tax rate in fiscal 2008.

We record a valuation allowance against our net deferred tax assets. Realization of our deferred tax assets depends on our generating sufficient taxable income in future years in appropriate tax jurisdictions to obtain benefit from the reversal of temporary differences and from net operating loss and credit carryforwards. In fiscal 2005, we determined there was sufficient future taxable income in Japan to release the valuation allowance related to temporary differences generated by the Japanese subsidiary in the amount of $85,000. Due to the uncertainty of the timing and the amount of such realization in the other tax jurisdictions, management concluded that a full valuation allowance was required for the net deferred tax assets generated in the other tax jurisdictions as of September 30, 2007.

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Our future effective income tax rate depends on various factors, such as tax legislation, the geographic composition of our pre-tax income, amount of and access to tax loss carryforwards, expenses incurred in connection with acquisitions that are not deductible for tax purposes, amounts of tax-exempt interest income and research and development credits as a percentage of aggregate pre-tax income, and the effectiveness of our tax planning strategies.

Stock-Based Compensation

Effective October 1, 2005, we adopted the provisions of SFAS No. 123R, “Share-Based Payments.” SFAS No. 123R establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award which is computed using the Black-Scholes option valuation model, and is recognized as expense over the employee’s requisite service period.

We previously applied Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations and provided the required pro forma disclosures of SFAS No. 123 “Accounting for Stock-Based Compensation.” No employee stock-based compensation was reflected in net income/loss in fiscal 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

Prior to adoption of SFAS No. 123R, in the fourth quarter of fiscal 2005, our Board of Directors approved the accelerated and full vesting of all unvested outstanding stock options to purchase shares of common stock of Photon Dynamics, Inc. that were held by current employees, including executive officers but excluding non-employee members of our Board of Directors, that had an exercise price greater than $25.00 and were issued under our Amended and Restated 1995 Stock Option Plan and 2001 Equity Incentive Plan. Options to purchase 340,718 shares were subject to this acceleration, which was effective as of September 1, 2005. The decision to accelerate the vesting of these options was made primarily to reduce future financial impact to our results of operations, since after analysis it was determined that the retention value of the underwater options was relatively small compared to the income charge to continue vesting these options following the adoption of SFAS No. 123R.

We elected to adopt the modified prospective transition method as provided by SFAS No. 123R. Under that transition method, compensation cost recognized in fiscal year 2006 and 2007 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested, as of October 1, 2005, based on the grant-date fair value estimated in accordance with the original provisions of SFAS No. 123; and (b) compensation cost for all share-based payments granted subsequent to October 1, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123R.

The effect of recording stock-based compensation for fiscal 2007, 2006 and 2005 was as follows:

	Fiscal Year Ended September 30,
	2007			2006			2005(2)
	As restated
	(In thousands)
Stock-based compensation expense included in continuing operations:
Cost of revenue	$	318		$	401		$	—
Research and development		400			676			—
Selling, general and administrative		1,255			2,908			—
Total stock-based compensation expense after income taxes(1)	$	1,973		$	3,985		$	—
Stock-based compensation expense by type of award:
Employee stock options	$	1,318		$	3,630		$	—
Employee stock purchase plan		498			470			—
Restricted stock awards		215			—			—
Amounts capitalized as inventory and deferred gross margin		(58	)		(115	)		—
Total stock-based compensation expense after income taxes(1)	$	1,973		$	3,985		$	—

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(1)	The income tax benefit on stock-based compensation for all periods presented was not material in all periods presented.
(2)	No employee stock-based compensation was reflected in net income/loss in fiscal 2005, as we accounted for options using APB 25 and all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

At September 30, 2007, the unrecorded stock-based compensation balance related to stock options was $1.2 million and will be recognized over an estimated remaining weighted average amortization period of 1.8 years, while the unrecorded stock-based compensation balance related to restricted stock units was approximately $1.2 million and will be recognized over an estimated remaining weighted average amortization period of 1.4 years.

On January 24, 2007, at our Annual Meeting of Shareholders, our shareholders approved an amendment to the 2005 Equity Incentive Plan to permit a one-time stock option exchange program whereby employees holding certain stock options having exercise prices significantly higher than the market price of our common stock were allowed to exchange those options for a lesser number of restricted share units. Our executive officers and members of our board of directors were not eligible to participate in the exchange. The stock option exchange took place on May 15, 2007. Of the 804,374 options eligible for exchange, employees elected to exchange 723,271 options, for which we issued 241,213 restricted stock units. This exchange qualified as a modification of the terms of the cancelled options under the provisions of SFAS No. 123R. Therefore, the total compensation cost of the newly-issued restricted stock units was measured at the date of cancellation and replacement and consisted of approximately $1.2 million of the grant-date fair value of the original options for which the requisite service was expected to be rendered at that date plus approximately $900,000 of incremental cost resulting from the cancellation and replacement. The incremental compensation cost was measured as the excess of the fair value of the restricted stock units over the fair value of the cancelled options at the cancellation date.

DISCONTINUED OPERATIONS

Prior to fiscal 2003, we conducted business in three operating segments: flat panel display products, cathode ray tube display and high quality glass inspection products and printed circuit board assembly inspection products. During fiscal 2003, we implemented plans to exit the printed circuit board assembly inspection business and the cathode ray tube display and high quality glass inspection business. Accordingly, the operating results of these former business segments have been presented as discontinued operations for all periods presented. We had no activity from these operations in fiscal 2007 and do not expect any further activity from these businesses.

Printed Circuit Board Assembly Inspection Business

	Fiscal Year Ended
	September 30,
	2007		2006			2005
	(In thousands)
Net Loss	$	—	$	(154	)	$	(56	)

The loss from discontinued operations for the year ended September 30, 2006, consists primarily of approximately $259,000 of legal costs related to the Amtower v. Photon Dynamics, Inc. lawsuit, offset by approximately $108,000 of deferred rent charges that were reversed in the quarter ended December 31, 2005 when the Company successfully renegotiated its remaining lease obligations for its Austin, Texas facility. Beginning in fiscal 2007, expenses associated with the appeal of the Amtower case are being taken to continuing operations.

The loss from discontinued operations for the year ended September 30, 2005, included approximately $113,000 of additional accruals for legal expenses related to the Amtower vs. Photon Dynamics, Inc. lawsuit and approximately $75,000 of other expenses, primarily legal and administrative, offset in part by approximately a $132,000 benefit for the reversal of a liability related to the settlement of vendor obligations.

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Cathode Ray Tube Display and High Quality Glass Inspection Business

	Fiscal Year Ended
	September 30,
	2007		2006		2005
	(In thousands)
Net Income	$	—	$	27	$	312

Income from discontinued operations for the year ended September 30, 2006, includes approximately $17,000 of adjustments to reduce the remaining estimated warranty provision.

The income from discontinued operations for the year ended September 30, 2005, includes approximately $288,000 for the reduction in certain reserves, including $143,000 related to warranty provisions and approximately $145,000 related to lease obligations settled at amounts less than originally estimated.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our growth primarily by a combination of cash flows from operations and public stock offerings. Working capital was approximately $88.6 million as of September 30, 2007, compared to approximately $116.3 million as of September 30, 2006. A major component of working capital is approximately $83.9 million of cash, cash equivalents and short-term investments as of September 30, 2007, compared to approximately $102.8 million as of September 30, 2006.

Our settlements with the customs authorities of each of the countries in which we do business has required us to make significant cash payments for delinquent amounts and related penalties. As of December 31, 2007, we have paid approximately $6.3 million, net of VAT amounts refunded, to foreign customs authorities in connection with our settlements regarding underpayment of customs duties for warranty parts and expect to pay $1.3 million more to settle all known amounts with foreign customs authorities. These cash payments will place additional demands on our cash resources. We have not received waivers from any governmental agency and cannot guarantee that additional payment obligations will not arise related to these prior activities. In addition, our cash resources will be impacted by the costs associated with our internal review of customs practices and the restatement of our consolidated financial statements.

Operating Activities of Continuing Operations.  Cash used in operating activities from continuing operations was approximately $15.4 million in fiscal 2007, while cash provided by operating activities from continuing operations was approximately $20.0 million and $13.7 million in fiscal 2006 and 2005, respectively.

In fiscal 2007, cash was used in operating activities by our net loss from continuing operations of approximately $35.1 million, adjusted by approximately $11.6 million of non-cash related items and by approximately $8.1 million of cash provided by changes in operating assets and liabilities. Non-cash related items consist primarily of approximately $6.2 million of depreciation and amortization charges, $2.8 million of impairment charges and approximately $2.0 million of stock-based compensation charges. Changes in working capital consists primarily of a net decrease of approximately $17.7 million of accounts receivable and a net decrease of approximately $5.2 million of inventory balances, offset in part by a net decrease of approximately $4.2 million of deferred gross margin and a net decrease of approximately $12.6 million in accounts payable and other liabilities. The decrease in accounts receivable was due primarily to collections on existing receivables. The decrease in inventories is due primarily to timing of delivery of products in our backlog and to lower levels of fourth quarter bookings due to market oversupply. Deferred gross margin fluctuates based upon the timing of acceptance of our products by our customers. The decrease in accounts payable is due primarily to reduced inventory levels.

In fiscal 2006, cash was provided by operating activities by our net income from continuing operations of approximately $2.2 million, adjusted by approximately $11.4 million of non-cash related items and by approximately $6.5 million of cash provided by changes in working capital. Non-cash related items consist primarily of approximately $7.2 million of depreciation and amortization charges and approximately $4.0 million of stock-based compensation charges. Changes in working capital consists primarily of a net decrease of approximately $14.2 million of inventory balances, offset in part by a net decrease of approximately $5.7 million of deferred gross margin. The decrease in inventories is due primarily to timing of delivery of products in our backlog and to lower

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levels of fourth quarter bookings due to market oversupply. Deferred gross margin fluctuates based upon the timing of acceptance of our products by our customers.

In fiscal 2005, cash was provided by operating activities despite our net loss of approximately $21.1 million primarily by collections of accounts receivables of approximately $31.3 million due to our higher revenues, especially in the latter half of the fiscal year. This source of cash was partially offset by a decrease in accounts payable and other liabilities of approximately $4.0 million.

Investing Activities of Continuing Operations.  Cash provided by investing activities from continuing operations was approximately $7.4 million and $15.1 million in fiscal 2007 and 2006, respectively. Cash used in investing activities from continuing operations was approximately $18.8 million in fiscal 2005.

In fiscal 2007, cash provided by investing activities was primarily the result of approximately $11.8 million in net maturities and sales of short-term investments, offset by approximately $2.4 million in capital expenditures and approximately $2.0 million in net cash used as part of the purchase price in the acquisition of Salvador Imaging.

In fiscal 2006, cash provided by investing activities was primarily the result of approximately $17.4 million in net maturities and sales of short-term investments, offset by approximately $2.3 million in capital expenditures.

In fiscal 2005, cash used by investing activities was primarily the result of approximately $14.2 million in net purchases of short-term investments and approximately $4.9 million in capital expenditures.

Financing Activities of Continuing Operations.  Cash provided by financing activities was approximately $1.3 million and $718,000 in fiscal 2007 and 2005, respectively. Cash used in financing activities was approximately $5.8 million in fiscal 2006.

In fiscal 2007, cash provided by financing activities resulted from sales of our common stock under our employee equity compensation plans of approximately $1.4 million, partially offset by capital lease payments of approximately $93,000.

In fiscal 2006, cash used in financing activities was primarily the result of approximately $7.0 million in stock repurchases, offset by approximately $1.8 million of sales of our common stock under our employee equity compensation plans.

In fiscal 2005, cash provided by financing activities resulted from sales of our common stock under our employee equity compensation plans of approximately $1.9 million, partially offset by net payments of short term obligations approximately $1.2 million.

The timing of and amounts received from employee stock option exercises are dependent upon the decisions of the respective option holders, and are not controlled by us. Therefore, funds raised from the issuance of common stock upon the exercise of employee stock options or employee stock purchases under our employee stock purchase plan should not be considered an indication of additional funds to be received in future periods.

In March 2000, we entered into a bank line of credit (“line of credit”) which had an initial term of one year. We had renegotiated this line of credit on an annual basis and had a $4.0 million borrowing capacity with an interest rate of floating prime. In October 2007, this line of credit expired and we did not renegotiate it. The line of credit was secured by substantially all of our assets and contained certain financial and other covenants. At September 30, 2007, no amounts were outstanding under the line of credit.

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Operating, Investing and Financing Activities of Discontinued Operations.  In fiscal 2003, we implemented plans to exit the printed circuit board assembly inspection business and the cathode ray tube display and high quality glass inspection business. Accordingly, the operating results of these business segments have been reclassified as discontinued operations. Net cash used by discontinued operations during fiscal 2007, 2006, and 2005 is as follows:

	Fiscal Year Ended
	2007		2006			2005
	(In thousands)
Cash flows from operating activities:
Printed circuit board business	$	—	$	(1,242	)	$	(543	)
Cathode ray tube display and high quality glass inspection business		—		(29	)		(97	)
Net cash used in operating activities from discontinued operations		—		(1,271	)		(640	)
Cash flows from financing activities:
Cathode ray tube display and high quality glass inspection business		—		—			(313	)
Net cash used in financing activities from discontinued operations		—		—			(313	)
Net decrease in cash and cash equivalents from discontinued operations:
Printed circuit board business		—		(1,242	)		(543	)
Cathode ray tube display and high quality glass inspection business		—		(29	)		(410	)
Net decrease in cash and cash equivalents from discontinued operations	$	—	$	(1,271	)	$	(953	)

Cash used in discontinued operations in fiscal 2006 consisted primarily of changes in working capital balances associated with costs related to the Amtower v. Photon Dynamics, Inc. lawsuit.

Cash used in discontinued operations in fiscal 2005 consisted primarily of changes in working capital balances, payments for settlement of prior inventory purchase commitments, and the settlement of a lawsuit.

Contractual Obligations

The following table summarizes the approximate contractual obligations that we have at September 30, 2007. These obligations include both non-cancelable obligations and other obligations that are generally non-cancelable except under certain limited conditions.

	Payments Due by Fiscal Year
	Total		2008		2009		2010		2011		2012		Thereafter
	(In thousands)
Purchase obligations	$	27,970	$	27,844	$	124	$	2	$	—	$	—	$	—
Operating lease obligations		9,868		3,433		2,881		2,830		723		1		—
Notes payable, including interest		5,600		—		2,800		2,800		—		—		—
Capital lease obligations		154		115		39		—		—		—		—
Total	$	43,592	$	31,392	$	5,844	$	5,632	$	723	$	1	$	—

We maintain certain open inventory purchase commitments with our suppliers to ensure a smooth and continuous supply chain for key components. Our liability under these purchase arrangements is generally restricted to purchase commitments over a forecasted time horizon as mutually agreed upon between the parties and is reflected in “purchase obligations” in the table above. The majority of these purchase commitments are covered by confirmed customer orders.

We have non-cancelable operating leases for various facilities in the United States, South Korea, Taiwan, Japan, China and Canada, certain of which permit us to renew the leases at the end of their respective lease terms. In August 2003, we signed a lease agreement for a 128,520 square-foot building in San Jose, California under a non-cancelable operating lease that expires in 2010, with two renewal options at fair market value for additional five

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year periods and represents the majority of the amounts reflected in the “operating lease obligations” in the table above.

In July 2007, in connection with the purchase of Salvador Imaging the Company issued a promissory note to a trust. The trustee, David W. Gardner, became an officer of the Company as a result of the acquisition. The note bears interest at an annual rate of 5%. At September 30, 2007 approximately $5.3 million was outstanding, which included approximately $47,000 in interest.

Working Capital

We believe that cash generated from operations, together with the liquidity provided by existing cash balances and borrowing capability, will be sufficient to meet our operating and capital requirements and obligations for at least the next twelve months. However, this forward-looking statement is based upon our current plans and assumptions, which may change, and our capital requirements may increase in future periods. In addition, we believe that success in our industry requires substantial capital in order to maintain the flexibility to take advantage of opportunities as they may arise. We may, from time to time, invest in or acquire complementary businesses, products or technologies and may seek additional equity or debt financing to fund such activities. There can be no assurance that such funding will be available to us on commercially reasonable terms, if at all, and if we were to proceed with acquisitions without this funding or with limited funding it would decrease our capital resources. The sale of additional equity or convertible debt securities could result in dilution to our existing shareholders.

Off-Balance Sheet Arrangements

As of September 30, 2007, we did not have any off-balance sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

Transactions with Related Parties

In July 2007, in connection with the purchase of Salvador Imaging, the Company issued a promissory note to a trust. The trustee, David W. Gardner, became an officer of the Company as a result of the acquisition. The note bears interest at an annual rate of 5%. At September 30, 2007 approximately $5.3 million was outstanding, which included approximately $47,000 in interest.

During fiscal 2005 we paid approximately $108,000 to Dr. Malcolm Thompson, who was our Executive Chairman of the Board from October 2003 until September 2005 and has been our Chairman of the Board since October 2005, for consulting services rendered to us. During fiscal 2006 and 2005, we recorded approximately $14,000 and $52,000 respectively, in stock ownership expense related to options granted to Dr. Thompson in connection with his services to us.

In the third quarter of fiscal 2004, in connection with the acquisition of Quantum Composers, Inc., the Company issued a series of promissory notes. The owner of Quantum Composers became an employee of Photon Dynamics as a result of the purchase. All remaining amounts were paid during fiscal 2007 and the individual is no longer an employee of Photon Dynamics.

IMPACT OF ACCOUNTING PRONOUNCEMENTS

In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Accounting Standards No. 141 (revised 2007) “Business Combinations (“SFAS No. 141R”). SFAS No. 141R retains the fundamental requirements in Statement 141 “Business Combinations” while providing additional definitions, such as the definition of the acquirer in a purchase and improvements in the application of how the acquisition method is applied. The provisions of SFAS No. 141R will be effective for our fiscal year beginning October 1, 2009. We are evaluating the impact of this statement on our results of operations, financial position and cash flows.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The provisions of SFAS No. 159 will be effective for

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our fiscal year beginning October 1, 2008. We are evaluating the impact of this statement, on our results of operations, financial position and cash flows.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 will be effective for our fiscal year beginning October 1, 2008. We are evaluating the impact of this statement, on our results of operations, financial position and cash flows.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosures. It will be effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this Interpretation is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period this Interpretation is adopted. The provisions of this Interpretation apply to all tax positions upon initial adoption of this Interpretation. Only tax positions that meet the recognition threshold criteria at the effective date may be recognized or continue to be recognized upon adoption of this Interpretation. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year, presented separately. The provisions of FIN 48 will be effective for our fiscal year beginning October 1, 2007. We are evaluating the impact of this statement, on our results of operations, financial position and cash flows.

ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

FOREIGN CURRENCY EXCHANGE RATE RISK

We are exposed to changes in foreign currency exchange rates primarily related to the operating results of our foreign affiliates. Actual changes in foreign exchange rates could adversely affect our operating results or financial condition. The potential impact depends upon the magnitude of the rate change. We believe our exposure to changes in foreign currency exchange rates for our cash, accounts receivable and accounts payable is limited as the majority of our cash, accounts receivable and accounts payable are denominated in U.S. dollars.

In fiscal 2007, 2006 and 2005, approximately $18.7 million, $7.4 million and $19.3 million, respectively, were invoiced in currencies other than U.S. dollars, primarily Japanese Yen.

As of September 30, 2007, we had approximately $4.8 million of our cash and cash equivalents and approximately $3.9 million of our accounts receivable denominated in currencies other than U.S. dollars, primarily Japanese yen. Our cash and cash equivalents and our accounts receivable denominated in foreign currency are subject to exchange rate risk and their value fluctuates with changes in exchange rates. A hypothetical 10% immediate and uniform adverse move in all currency exchange rates affecting our cash and cash equivalents and our accounts receivable from the rates at September 30, 2007 would have decreased the fair value of our cash and cash equivalents by approximately $439,000 and our accounts receivable by approximately $355,000.

As of September 30, 2007, we had forward exchange contracts to sell approximately $5.6 million in foreign currency in order to hedge certain accounts receivable denominated in Japanese yen. None of these contracts were held for trading purposes. Details of these securities is included in Note 8 of our “Notes to Condensed Consolidated Financial Statements” included in Part II, Item 8. “Financial Statements and Supplementary Data” in this Annual Report on Form 10-K. Gains and losses on these contracts are recognized in income. Our forward exchange contracts are subject to exchange rate risk and will fluctuate with the changes in exchange rates. A hypothetical 10% immediate and uniform adverse move in all currency exchange rates affecting the contracts from the rates at September 30, 2007 would decrease the fair value of the contracts by approximately $657,000.

Although a relatively considerable portion of our revenue in fiscal 2007 was denominated in currencies other than U.S. dollars, we expect that our revenue, cash, accounts receivable and accounts payable generally will be denominated in U.S. dollars and, therefore, our exposure to changes in foreign currency exchange rates for our cash,

67

accounts receivable and accounts payable is currently considered minimal. However, as more of our operations become overseas based and we begin additional selling in currencies other than the U.S. dollar, our exposure to foreign currencies may increase.

INTEREST RATE RISK

The primary objective of our investment activities is to preserve principal while maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we may invest in may be subject to market risk. To minimize this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities and certificates of deposit.

Our exposure to market risk relates primarily to interest rate fluctuations in connection with our cash and cash equivalents and our short-term investment portfolios. We enter into financial instruments for non-trading purposes and do not have derivative financial instruments in our portfolio. The following table presents principal amounts and related weighted average interest rates by year of maturity for our investment portfolio, substantially all of which is held in U.S. dollars:

													There					Fair
September 30, 2007	2008			2009			2010		2011		2012		After			Total		Value
	(Dollars in thousands)
Cash and cash equivalents (variable rate)	$	18,697			—			—		—		—		—		$	18,697	$	18,697
Average interest rate		5.30	%
Short-term investments (variable rate)		—			—			—		—		—	$	16,235		$	16,235	$	16,235
Average interest rate														6.04	%
Short-term investments (fixed rate)	$	26,441			—			—		—		—		—		$	26,441	$	26,405
Average interest rate		5.04	%
Long-term investments (fixed rate)		—		$	1,200			—		—		—		—		$	1,200	$	1,176
Average interest rate					4.97	%

													There					Fair
September 30, 2006	2007			2008			2009		2010		2011		After			Total		Value
	(Dollars in thousands)
Cash and cash equivalents (variable rate)	$	47,941			—			—		—		—		—		$	47,941	$	47,935
Average interest rate		3.98	%
Short-term investments (variable rate)		—			—			—		—		—	$	46,765		$	46,765	$	46,765
Average interest rate														5.25	%
Short-term investments (fixed rate)	$	8,102			—			—		—		—		—		$	8,102	$	8,069
Average interest rate		4.37	%
Long-term investments (fixed rate)		—		$	800			—		—		—		—		$	800	$	787
Average interest rate					3.67	%

The fixed rate securities, as with all fixed income instruments, are subject to interest rate risk and will fall in value if market interest rates increase.

68

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Consolidated Financial Statements

Description	Page
Reports of Independent Registered Public Accounting Firm		70
Consolidated Balance Sheets as of September 30, 2007 and 2006		73
Consolidated Statements of Operations for each of the three years in the period ended September 30, 2007		74
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended September 30, 2007		75
Consolidated Statements of Cash Flows for each of the three years in the period ended September 30, 2007		76
Notes to Consolidated Financial Statements		77

69

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Photon Dynamics, Inc.

We have audited the accompanying consolidated balance sheets of Photon Dynamics, Inc. as of September 30, 2007 and 2006, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended September 30, 2007. Our audits also included the financial statement schedule listed in the index at Item 15(a)(2). These financial statements and schedule are the responsibility of the management of Photon Dynamics, Inc. Our responsibility is to express an opinion on these financial statements and schedule 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 Photon Dynamics, Inc. as of September 30, 2007 and 2006, and the consolidated results of its operations and its cash flows for each of the three years in the period ended September 30, 2007, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Note 11 to the consolidated financial statements, in fiscal year 2006 Photon Dynamics, Inc. changed its method of accounting for share-based payments.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Photon Dynamics, Inc.’s internal control over financial reporting as of September 30, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report, dated January 21, 2008 expressed an adverse opinion on the effectiveness of internal control over financial reporting.

/s/  Ernst & Young LLP

Palo Alto, California

January 21, 2008

70

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Photon Dynamics, Inc.

We have audited Photon Dynamics, Inc.’s internal control over financial reporting as of September 30, 2007, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Photon Dynamics, Inc.’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 included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company’s internal control over financial reporting 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

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 financial statements for external purposes in accordance with generally accepted accounting principles. 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 generally accepted accounting principles, 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.

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.

As indicated in the accompanying Management’s Report on Internal Control Over Financial Reporting, management’s assessment of and conclusion on the effectiveness of internal control over financial reporting did not include the internal controls of Salvador Imaging, Inc., whose results are included in the 2007 consolidated financial statements of Photon Dynamics, Inc. and constituted $617,000 and $179,000 of total and net assets, respectively, as of September 30, 2007 and $504,000 and $526,000 of revenues and net loss, respectively, for the year then ended. Our audit of internal control over financial reporting of Photon Dynamics, Inc. also did not include an evaluation of the internal control over financial reporting of Salvador Imaging, Inc.

71

A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. In its assessment management has identified material weaknesses in controls over the processes for detecting, evaluating and communicating noncompliance with applicable laws and regulations and the Company’s code of conduct, the process and programs to maintain an effective control environment by educating employees on the Company’s code of conduct and applicable laws and regulations and maintaining sufficient knowledgeable and experienced accounting and finance personnel. These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2007 financial statements, and this report does not affect our report dated January 21, 2008 on those financial statements.

In our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, Photon Dynamics, Inc. has not maintained effective internal control over financial reporting as of September 30, 2007, based on the COSO criteria.

/s/  Ernst & Young LLP

Palo Alto, California

January 21, 2008

72

PHOTON DYNAMICS, INC.

CONSOLIDATED BALANCE SHEETS

	September 30,
	2007			2006
				As restated(1)
	(In thousands, except
	share data)
ASSETS
Current assets:
Cash and cash equivalents	$	41,170		$	47,935
Short-term investments		42,640			54,834
Accounts receivable, net of allowance for doubtful accounts of $239 and $406, respectively		11,934			29,341
Inventories		13,292			18,442
Refundable customs obligations		560			3,157
Other current assets		3,661			3,972
Total current assets		113,257			157,681
Long-term investments		1,176			787
Land, property and equipment, net		10,583			15,891
Other assets		5,365			4,542
Intangible assets, net		11,023			1,716
Goodwill		6,857			153
Total assets	$	148,261		$	180,770
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	4,217		$	7,257
Warranty		3,217			8,058
Employee notes payable		—			977
Customs obligations		4,114			8,673
Other current liabilities		9,874			8,967
Deferred gross margin		3,236			7,454
Total current liabilities		24,658			41,386
Long-term employee note payable		5,381			—
Other non-current liabilities		38			119
Total non-current liabilities		5,419			119
Commitments and contingencies (Note 13)
Shareholders’ equity:
Preferred stock, no par value, 5,000,000 shares authorized, none outstanding, as of September 30, 2007 and 2006, respectively		—			—
Common stock, no par value, 30,000,000 shares authorized, 17,740,663 and 16,526,782 shares issued and outstanding, as of September 30, 2007 and 2006, respectively		300,290			285,416
Accumulated deficit		(181,503	)		(146,431	)
Accumulated other comprehensive income (loss)		(603	)		280
Total shareholders’ equity		118,184			139,265
Total liabilities and shareholders’ equity	$	148,261		$	180,770

(1) See Note 2, “Restatements of Consolidated Financial Statements and Company Findings” in Notes to Consolidated Financial Statements.

See accompanying notes to consolidated financial statements.

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PHOTON DYNAMICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

	Year Ended September 30,
	2007			2006			2005
				As			As
				restated(1)			restated(1)
	(In thousands, except per share data)
Revenue	$	74,267		$	172,872		$	125,813
Cost of revenue		56,374			114,205			84,111
Gross margin		17,893			58,667			41,702
Operating expenses:
Research and development		26,747			32,577			36,050
Selling, general and administrative		23,076			24,506			24,641
Restructuring charge		1,368			30			1,197
Impairment of property and equipment		2,834			81			637
Loss (gain) on sale of property and equipment		87			58			(93	)
Acquired in-process research and development		1,110			—			—
Amortization of intangible assets		1,653			1,489			1,548
Total operating expenses		56,875			58,741			63,980
Loss from operations		(38,982	)		(74	)		(22,278	)
Interest income and other, net		4,190			2,803			1,773
Income (loss) from continuing operations before income taxes and discontinued operations		(34,792	)		2,729			(20,505	)
Provision for income taxes		280			561			624
Income (loss) from continuing operations before discontinued operations		(35,072	)		2,168			(21,129	)
Income (loss) from discontinued operations		—			(127	)		256
Net income (loss)	$	(35,072	)	$	2,041		$	(20,873	)
Income (loss) per share from continuing operations:
Basic	$	(2.09	)	$	0.13		$	(1.25	)
Diluted	$	(2.09	)	$	0.13		$	(1.25	)
Income (loss) per share from discontinued operations:
Basic	$	—		$	(0.01	)	$	0.02
Diluted	$	—		$	(0.01	)	$	0.02
Net income (loss) per share:
Basic	$	(2.09	)	$	0.12		$	(1.24	)
Diluted	$	(2.09	)	$	0.12		$	(1.24	)
Weighted average number of shares:
Basic		16,814			16,978			16,890
Diluted		16,814			17,011			16,890

(1) See Note 2, “Restatements of Consolidated Financial Statements and Company Findings” to in Notes Consolidated Financial Statements.

See accompanying notes to consolidated financial statements.

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PHOTON DYNAMICS, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

	Common Stock and									Accumulated
	Capital in Excess of									Other
	Par Value						Accumulated			Comprehensive
	Share			Amount			Deficit			Income (Loss)			Total
	(In thousands)
Balances at September 30, 2004, as restated(1)		16,859		$	285,790		$	(127,599	)	$	347		$	158,538
Components of comprehensive loss:
Net loss		—			—			(20,873	)		—			(20,873	)
Change in unrealized gain on investments		—			—			—			(138	)		(138	)
Currency translation adjustments		—			—			—			109			109
Total comprehensive loss														(20,902	)
Net issuance of common stock		131			1,797			—			—			1,797
Tax benefits of stock option transactions		—			126			—			—			126
Non-employee stock ownership expense		—			52			—			—			52
Balances at September 30, 2005, as restated(1)		16,990			287,765			(148,472	)		318			139,611
Components of comprehensive income:
Net income		—			—			2,041			—			2,041
Change in unrealized loss on investments		—			—			—			273			273
Currency translation adjustments		—			—			—			(311	)		(311	)
Total comprehensive income														2,003
Net issuance of common stock		116			1,788			—			—			1,788
Repurchase of common stock, net		(529	)		(6,993	)		—			—			(6,993	)
Cancellation of escrow shares		(50	)		(1,258	)		—			—			(1,258	)
Stock-based compensation		—			4,100			—			—			4,100
Non-employee stock ownership expense		—			14			—			—			14
Balances at September 30, 2006 as restated(1)		16,527			285,416			(146,431	)		280			139,265
Components of comprehensive income:
Net loss		—			—			(35,072	)		—			(35,072	)
Change in unrealized loss on investments		—			—			—			(9	)		(9	)
Currency translation adjustments		—			—			—			(874	)		(874	)
Total comprehensive loss														(35,955	)
Net issuance of common stock in acquisition		1,084			11,478			—			—			11,478
Net issuance of common stock for cash		130			1,365			—			—			1,365
Stock-based compensation		—			2,031			—			—			2,031
Balances at September 30, 2007		17,741		$	300,290		$	(181,503	)	$	(603	)	$	118,184

(1) See Note 2, “Restatements of Consolidated Financial Statements and Company Findings” in Notes to Consolidated Financial Statements.

See accompanying notes to consolidated financial statements.

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PHOTON DYNAMICS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

	Year Ended September 30,
	2007			2006			2005
				As			As
				restated(1)			restated(1)
	(In thousands)
Cash flows from operating activities:
Net income (loss) from continuing operations	$	(35,072	)	$	2,168		$	(21,129	)
Adjustments to reconcile net income (loss) from continuing operations to net cash provided by (used in) operating activities from continuing operations:
Depreciation		4,595			5,720			5,037
Amortization of intangible assets		1,653			1,489			1,548
Stock-based compensation		1,973			3,985			—
Foreign currency translation adjustment gain recognized upon liquidation of a subsidiary		(928	)		—			—
Acquired in process research and development		1,110			—			—
Impairment of property and equipment		2,834			81			637
Non-employee stock ownership expense		—			14			52
Restructuring charge		178			30			171
Loss (gain) on sale of property and equipment		87			58			(93	)
Accretion of non-interest bearing notes payable		70			39			64
Changes in assets and liabilities:
Accounts receivable		17,677			(2,274	)		31,274
Inventories		5,208			14,218			(829	)
Other current assets		2,353			(976	)		(1,017	)
Other assets		(268	)		(1,168	)		536
Accounts payable		(3,224	)		(5,502	)		(5,642	)
Other current liabilities		(9,351	)		7,735			1,617
Deferred gross margin		(4,218	)		(5,659	)		1,610
Other liabilities		(81	)		79			(91	)
Net cash provided by (used in) operating activities from continuing operations		(15,404	)		20,037			13,745
Net cash used in operating activities from discontinued operations		—			(1,271	)		(640	)
Net cash provided by (used in) operating activities		(15,404	)		18,766			13,105
Cash flows from investing activities:
Purchase of property and equipment		(2,391	)		(2,343	)		(4,880	)
Proceeds from sale of fixed assets					50			270
Acquisition of Salvador Imaging, net of cash assumed		(2,036	)		—			—
Purchase of short-term investments		(92,251	)		(125,928	)		(56,380	)
Maturities and sales of short-term investments		104,047			143,319			42,175
Net cash provided by (used in) investing activities from continuing operations		7,369			15,098			(18,815	)
Cash flows from financing activities:
Issuance of common stock, net		1,365			1,788			1,923
Repurchase of common stock		—			(6,993	)		—
Repayment of short-term notes		(93	)		(609	)		(1,205	)
Net cash provided by (used in) financing activities from continuing operations		1,272			(5,814	)		718
Net cash used in financing activities from discontinued operations		—			—			(313	)
Net cash provided by (used in) financing activities		1,272			(5,814	)		405
Effect of exchange rate changes on cash and cash equivalents		(2	)		(403	)		110
Net increase (decrease) in cash and cash equivalents from continuing operations		(6,765	)		28,918			(4,242	)
Net decrease in cash and cash equivalents from discontinued operations		—			(1,271	)		(953	)
Net increase (decrease) in cash and cash equivalents		(6,765	)		27,647			(5,195	)
Cash and cash equivalents at beginning of year		47,935			20,288			25,483
Cash and cash equivalents at end of year	$	41,170		$	47,935		$	20,288
Supplemental cash flow disclosures:
Income taxes paid	$	381		$	768		$	498
Interest paid		—			—			1
Supplemental non-cash financing and investing activities disclosure:
Value of note payable issued in the acquisition of Salvador Imaging		5,334			—			—
Value of shares issued in the acquisition of Salvador Imaging		11,478			—			—

(1) See Note 2, “Restatements of Consolidated Financial Statements and Company Findings” in Notes to Consolidated Financial Statements.

See accompanying notes to consolidated financial statements.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 — SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Operations and Principles of Consolidation.  Photon Dynamics, Inc. (“Photon Dynamics” or the “Company”) is a leading global supplier of integrated yield enhancement solutions for the flat panel display market. The Company utilizes its advanced digital imaging technology to develop systems that enable flat panel display manufacturers to collect and analyze data from the production line, and quickly diagnose and repair process-related defects, thereby allowing manufacturers to decrease material costs and improve throughput. The Company’s test and repair systems are used by manufacturers to collect data, analyze product quality and identify and repair product defects at critical steps in the active matrix liquid crystal display manufacturing process. The consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries that are not considered variable interest entities (“VIEs”) and all VIEs for which the Company is the primary beneficiary. All intercompany accounts and transactions have been eliminated.

The Company currently operates in two segments:  Flat Panel Display and High-Performance Digital Imaging. Flat Panel Display is the Company’s primary business segment, accounting for more than 99% of the Company’s consolidated revenues during fiscal 2007. The Company commenced operations in the High-Performance Digital Imaging segment with its acquisition in July 2007 of Salvador Imaging, Inc. (“Salvador Imaging”), an international supplier of high-performance digital cameras for markets other than the flat panel display industry, including defense, industrial and other applications. However, the operations of Salvador Imaging were not material to the Company’s fiscal 2007 financial statements.

Prior to January 2003, the Company conducted business in three operating segments. In fiscal 2003, the Company implemented plans to exit its printed circuit board assembly inspection business and its cathode ray tube display and high quality glass inspection business. The operating results of these former business segments have been presented as discontinued operations in the Company’s consolidated financial statements.

Management Estimates and Assumptions.  The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Examples of estimates made by management include estimates of product life cycles, restructuring charges, stock-based compensation volatility and forfeiture rates and litigation and contingency assessments. Examples of assumptions made by management include assumptions such as meeting the criteria for revenue recognition, the calculation of the allowance for doubtful accounts, inventory write-downs, warranty accruals and when investment impairments are other than temporary. Actual results could differ from those estimates and assumptions.

Fair Value of Financial Instruments.  The Company evaluates the estimated fair value of financial instruments using available market information and valuation methodologies. The use of different market assumptions and/or estimation methodologies could have a negative effect on the estimated fair value amounts. The fair value of the Company’s cash, cash equivalents, accounts receivable, accounts payable, forward exchange contracts, notes payable and other current liabilities approximates the carrying amount due to the relatively short maturity of these items.

Cash Equivalents and Short-Term Investments.  Cash equivalents consist of highly liquid investments with insignificant interest rate risk and original remaining maturity dates of three months or less from the date of acquisition. Short-term investments consist of highly-liquid investments with remaining maturities greater than three months from the date of acquisition. Long-term investments consist of highly-liquid investments with remaining maturities greater than one year from the balance sheet date, excluding those investments that the Company has the intent and ability to realize within twelve months from the balance sheet date without incurring losses, which are classified as short-term. The Company classifies all securities as available-for-sale and all securities are reported at fair value with any related unrealized gains and losses, net of tax, recorded in Shareholders’ equity under the caption “Accumulated other comprehensive income (loss).” The cost and fair

77

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

value of investments are based on the specific identification method. The Company periodically reviews its investment portfolios to determine if any investment is other-than-temporarily impaired due to changes in credit risk or other potential valuation concerns. All realized gains and losses and declines in fair value that are other-than-temporary are recorded in earnings in the period of occurrence.

Inventories.  Inventories, consisting of raw materials, work in process and finished goods, are stated at the lower of cost (first-in, first-out) or market. Inventory which is obsolete (defined as inventory that will no longer be used in the manufacturing process) or in excess of the forecasted usage is written down to its estimated market value based on projected demand, historical usage and other known factors. The Company reviews the appropriate valuation of its inventories on a quarterly basis. If actual demand were to decline below the Company’s forecasts, the Company may need to take additional inventory write-downs.

Land, Property and Equipment.  Property and equipment are recorded at cost. Depreciation of property and equipment is based on the straight-line method over the estimated useful lives of the assets which are thirty years for buildings, and three to five years for equipment and office furniture and fixtures. Leasehold improvements are amortized over the shorter of the remaining life of the lease or the useful life of the related asset. Land is recorded at cost, and is not depreciated. Amortization of assets recorded under capital leases is included with depreciation expense.

The Company periodically reviews its land, property and equipment to determine if facts and circumstances exist which indicate that the carrying amount of assets may not be recoverable or that the useful life is shorter than originally estimated. The Company assesses the recoverability of its assets held for use by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their remaining lives against their respective carrying amounts. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets.

Goodwill and Intangible Assets.  Goodwill is recorded when the purchase price of an acquisition exceeds the estimated fair value of the net identified tangible and intangible assets acquired. Goodwill is not amortized, but is reviewed for impairment annually during the fourth quarter of each fiscal year.

Acquisition-related intangibles, including purchased technology, license agreements and non-compete contracts, are presented at cost, net of accumulated amortization. Intangible assets are amortized on a straight-line basis over their estimated useful lives of two to seven years. The Company periodically reviews its identified intangible assets to determine if facts and circumstances exist which indicate that the useful life is shorter than originally estimated or that the carrying amount of assets may not be recoverable. If such facts and circumstances do exist, the Company assesses the recoverability of identified intangible assets by comparing the projected undiscounted net cash flows associated with the related asset or group of assets over their remaining lives against their respective carrying amounts. Impairment, if any, is based on the excess of the carrying amount over the fair value of those assets.

Accumulated Other Comprehensive Income (Loss).  The Company reports items required to be recognized under accounting standards as components of comprehensive income (loss), including unrealized gains and losses on available-for-sale securities and foreign currency translation adjustments, in Shareholders’ equity in its consolidated financial statements.

Concentrations and Other Risk.  The Company uses financial instruments that potentially subject it to concentrations of credit risk. Such instruments consist principally of cash equivalents, marketable securities, trade accounts receivable and financial instruments used in hedging activities.

The Company invests excess cash not required for use in operations in securities that the Company believes bear minimal risk of loss. These investments are of a short-term nature and include investments in auction rate preferred securities, commercial paper and government and corporate debt securities. The Company has not experienced any losses due to institutional failure or bankruptcy.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The Company’s customers are located in South Korea, Taiwan, Japan and China. The Company’s sales to these customers may be adversely affected by the overall health of these economies, including the effects of currency exchange rate fluctuations. The Company generally does not require collateral for its trade accounts receivable. The Company maintains a provision for potential credit losses based upon expected collectibility of all accounts receivable. For sales to some of its customers in certain geographic regions, the Company requires letters of credit. The majority of the Company’s revenue is invoiced in U.S. dollars although approximately $18.7 million, $7.4 million and $19.3 million of revenue that was recognized in fiscal 2007, 2006 and 2005, respectively, were invoiced in currencies other than the U.S. dollar, primarily Japanese Yen. The Company believes its credit evaluation prior to shipment, credit instruments such as letters of credit, and subsequent monitoring of customer status mitigates its credit risk.

The Company had foreign currency exchange contracts outstanding at September 30, 2007. These instruments were used to mitigate the impact of currency fluctuations on the Company’s income. The Company may be exposed to credit loss in the event of non-performance by counterparties on foreign exchange contracts it may use to mitigate the effect of exchange rate changes. These counterparties are large, international financial institutions and to date, no counterparty has failed to meet its financial obligations to the Company.

The Company’s products include certain components that are currently supplied by a sole-source vendor. The Company believes that other vendors would be able to provide similar components; however, the qualification of such vendors may require start-up time. In order to mitigate any adverse impacts from a disruption of supply, the Company attempts to maintain an adequate supply of critical single-sourced components.

Foreign Currency.  The functional currencies of the Company’s foreign subsidiaries are their respective local currencies. Accordingly, all assets and liabilities of the foreign operations are translated to U.S. dollars at current period-end exchange rates, and revenues and expenses are translated to U.S. dollars using weighted-average exchange rates in effect during the period. The gains and losses from the translation of these subsidiaries’ financial statements into the U.S. dollar are recorded directly into a separate component of shareholders’ equity under the caption “Accumulated other comprehensive income (loss).” Currency transaction gains and losses are included in the Company’s results of operations.

Derivative Financial Instruments.  The Company may use forward exchange contracts to mitigate the effect of exchange rate changes on a portion of, but not all, existing and anticipated foreign currency denominated transactions expected to occur within the following 18 months. The purpose of Photon Dynamics’ foreign currency program is to manage the effect of exchange rate fluctuations on certain foreign currency denominated revenues, cost and eventual cash flows. The Company believes these financial instruments do not subject it to speculative risk that would otherwise result from changes in currency exchange rates. The Company does not use derivative financial instruments for speculative or trading purposes.

The Company’s derivative instruments are recorded at fair value based on quoted market prices for comparable instruments. Gains and losses are recorded immediately in earnings.

At September 30, 2007, the Company had foreign currency forward exchange contracts to sell approximately $5.6 million in Japanese yen.

Warranty.  The Company’s warranty policy generally states that it will provide warranty coverage for a period of 12 months from final acceptance or 14 months from shipment, whichever is shorter. The Company records the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment upon product shipment, when the related revenue is recognized. The Company’s warranty obligation is affected by product failure rates, material usage rates and the efficiency by which the product failure is corrected. The Company reviews actual product failure rates and material usage rates on a periodic basis and adjusts the warranty liability as necessary.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Revenue Recognition.  Photon Dynamics derives revenue primarily from the sale and installation of equipment and spare part sales.

The Company recognizes revenue on the sale and installation of equipment when persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the selling price is fixed or determinable and collectibility is reasonably assured. Persuasive evidence of an arrangement exists when a sales quotation outlining the terms and conditions of the arrangement has been issued to the customer and a purchase order has been received from the customer accepting the terms of the sales quotation and stating, at a minimum, the number of systems ordered and the value of the overall arrangement.

The Company accounts for certain of its product sales as arrangements with multiple deliverables. For arrangements with multiple deliverables, the Company recognizes revenue for the delivered items if the delivered items have value to the customer on a standalone basis, the amount of revenue for delivered elements is not subject to refund, and delivery or performance of the undelivered items is considered probable and substantially in the control of the Company, the Company has met defined customer acceptance experience levels for the delivered items, and the fair value of undelivered items, such as installation and system upgrade rights, can be reliably determined. The Company allocates revenue to the delivered items based on the lesser of the amount due and billable upon shipment and the difference between the total amount due at time of shipment and the allocated fair value of the undelivered elements, with the remaining amount recognized after installation and acceptance when the final amount becomes due. Installation and other services are not essential to the functionality of the products as these services do not alter the product capabilities, do not require specialized skills or tools and can be performed by other vendors.

For new products that have not been demonstrated to meet product specifications, 100% of revenue is deferred until customer acceptance.

The Company recognizes revenue on the sale of spare parts when the product has been shipped, risk of loss has passed to the customer and collection of the resulting receivable is probable.

The Company has a policy to record a provision as necessary based on historical rates for estimated sales returns in the same period as the related revenue is recorded, which is netted against revenue.

Shipping Costs.  The Company’s shipping and handling costs are included under cost of sales for all periods presented. In those instances where the Company does bill for shipping and handling, the amounts billed are classified as revenue.

Advertising.  The Company expenses advertising costs as incurred. Advertising expense was $10,000, $38,000 and $56,000 for fiscal 2007, 2006 and 2005, respectively.

Research and Development Cost.  Costs to develop the Company’s products, which include both hardware and software components are expensed as incurred. Software incorporated in the Company’s products is an integral part of the overall product design process and costs to develop software, which is deemed to be incidental, are not tracked separately.

Income Taxes.  The Company accounts for income taxes in accordance with the liability method in accounting for income taxes. Under the liability method, deferred tax assets and liabilities are measured based on differences between the financial reporting and tax bases of assets and liabilities using enacted tax rates and laws that will be in effect when differences are expected to reverse.

The liability approach also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that a portion of the deferred tax asset will not be realized. Management has determined that all of the Company’s tax assets should be offset by a valuation allowance.

In addition, the calculation of the Company’s tax liabilities requires addressing uncertainties in the application of complex tax regulations. Photon Dynamics recognizes liabilities for anticipated tax audit issues in the U.S. and

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

other tax jurisdictions based on the Company’s estimate of whether, and the extent to which, additional tax payments are probable. If the Company ultimately determines that payment of these amounts is unnecessary, the Company will reverse the liability and recognize a tax benefit during the period in which the Company determines that the liability is no longer necessary. Photon Dynamics will record an additional charge in the Company’s provision for taxes in the period in which the Company determines that the recorded tax liability is less that the amount that the Company expects the ultimate assessment to be.

Earnings Per Share.  Basic earnings per share is calculated using the weighted-average number of shares of common stock outstanding. Diluted earnings per share is computed in the same manner and also gives effect to all dilutive common equivalent shares outstanding during the period. Common equivalent shares consist of stock options and unvested restricted stock units issued to employees under employee stock option plans.

Stock-Based Compensation.  Effective October 1, 2005, the Company estimates the fair value of employee stock options and employee stock purchase plans using the Black-Scholes valuation model, consistent with the provisions of SFAS No. 123R, SEC SAB No. 107 and its prior period pro forma disclosures of net earnings, including stock-based compensation (determined under a fair value method as prescribed by SFAS No. 123). The Black-Scholes option-pricing model requires the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock. Prior to October 1, 2005, the Company accounted for its stock-based awards under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and related Interpretations as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”).

Variable Interest Entity.  In November 2005, Photon Dynamics entered into agreements which committed the Company to provide funding to an early-stage development company subject to certain conditions and milestones. The funding was in the form of a convertible note. In addition, in exchange for providing a limited use license to certain of the Company’s intellectual property, the Company received an equity interest in the development company. For accounting purposes, Photon Dynamics was considered to be the primary beneficiary within the provisions of FASB Financial Interpretation No. 46 (revised 2003) “Consolidation of Variable Interest Entities.” Due to the nature of the agreement, the Company determined that since Photon Dynamics was essentially providing 100% of the funding, there was no offset for minority interest and so the Company consolidated 100% of the entity’s operations. This development-stage company ceased operations and was liquidated in fiscal 2007.

Reclassifications.  Certain prior-year and prior-quarter balances have been reclassified to conform to current financial statement presentation. These reclassifications had no impact on previously reported results of operations or shareholders’ equity.

Recent Accounting Pronouncements.  In December 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Accounting Standards No. 141 (revised 2007) “Business Combinations (“SFAS No. 141R”). SFAS No. 141R retains the fundamental requirements in Statement 141 “Business Combinations” while providing additional definitions, such as the definition of the acquirer in a purchase and improvements in the application of how the acquisition method is applied. The provisions of SFAS No. 141R will be effective for the Company in fiscal years beginning October 1, 2009. The Company is evaluating the impact of this statement on its results of operations, financial position and cash flows.

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, “The Fair Value for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115” (“SFAS No. 159”). SFAS No. 159 permits an entity to choose to measure many financial instruments and certain other items at fair value at specified election dates. Subsequent unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings. The provisions of SFAS No. 159 will be effective for the Company in fiscal years beginning October 1, 2008. The Company is evaluating the impact of this statement on its results of operations, financial position and cash flows.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. The provisions of SFAS No. 157 will be effective for the Company in fiscal years beginning October 1, 2008. The Company is evaluating the impact of this statement on its results of operations, financial position and cash flows.

In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109. It prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosures. It will be effective for fiscal years beginning after December 15, 2006. Earlier application of the provisions of this Interpretation is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period this Interpretation is adopted. The provisions of this Interpretation apply to all tax positions upon initial adoption of this Interpretation. Only tax positions that meet the recognition threshold criteria at the effective date may be recognized or continue to be recognized upon adoption of this Interpretation. The cumulative effect of applying the provisions of this Interpretation will be reported as an adjustment to the opening balance of retained earnings for that fiscal year, presented separately. The provisions of FIN 48 will be effective for the Company in fiscal years beginning October 1, 2007. The Company is evaluating the impact of this statement on its results of operations, financial position and cash flows.

NOTE 2 — RESTATEMENTS OF CONSOLIDATED FINANCIAL STATEMENTS AND COMPANY FINDINGS (Financial Information with Respect to Dates or Periods after September 30, 2007 are Unaudited)

Background on Restatements Related to Customs Duties for Warranty Parts

In the first quarter of fiscal 2007, the Company’s management voluntarily began a review of the Company’s practices with respect to the payment of customs duties for warranty parts in response to concerns raised by the Company’s chief financial officer and general counsel. Management, in consultation with the Audit Committee, determined in January 2007 that the Company had maintained incorrect classification and valuation practices with respect to the import of warranty parts into its South Korea, Taiwan, Japan and China field service locations, resulting in the underpayment of customs duties. At that time the Company estimated that the range of its liability was between approximately $1.0 million and $2.0 million. Because there was no basis to conclude that any amount within this range provided a better estimate than any other amount, the Company determined the liability to be recorded was the lower end of the range of approximately $1.0 million, which included underpaid duties, penalties and interest. The Company evaluated the impact and timing of the liability and concluded that the potential adjustment did not have a material impact on the financial statements for fiscal years ended September 30, 2002 through 2006. Accordingly, the Company recorded the estimated liability at December 31, 2006. Approximately $350,000 of the $1 million was recorded to the Company’s statement of operations, with the majority of this amount recorded to cost of sales, while approximately $680,000 was capitalized into warranty and spares inventory held at the Company’s foreign locations at December 31, 2006.

As the review continued into the third quarter of fiscal 2007, the Company commenced a process of voluntarily disclosing its historical valuation practices to customs authorities in South Korea, Taiwan, Japan and China with the goal of reaching settlements for past due duty amounts plus interest and penalties if applicable. In July 2007, the Company negotiated a settlement with the Korean Customs Service in South Korea for its primary South Korean field service location. This location accounted for the majority of total warranty parts exported by the Company over the five-year period under audit and the settlement represented the majority of total liability to be recorded.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Based upon this settlement and assessing the status of its discussions in the other jurisdictions, the Company revised its estimated liability from the approximately $1.0 million recorded at December 31, 2006 to a range of approximately $7.0 million to $8.0 million at June 30, 2007, net of refundable VAT amounts.

In light of the materiality of the revised estimate and that the underpaid duties, penalties and interest largely related to prior periods, management and the Audit Committee determined on July 16, 2007 that it was appropriate to restate: (i) the Company’s consolidated financial statements for the years ended September 30, 2004, 2005 and 2006 as contained in our Form 10-K for the year ended September 30, 2006; (ii) the Company’s unaudited quarterly financial data for the first two quarters in the fiscal year ended September 30, 2007; and (iii) the Company’s unaudited quarterly financial data for all quarters in the fiscal year ended September 30, 2006. Management and the Audit Committee discussed their conclusions with the Company’s independent registered public accounting firm. The Company disclosed these determinations in a Form 8-K on July 18, 2007. In late 2007, management decided to include all restatements in this fiscal 2007 Annual Report on Form 10-K.

The Company has continued to work with the remaining customs agencies and reached settlements in September and October of 2007 in South Korea, Taiwan, and China and is in the process of reaching a settlement in Japan. As a result, the Company determined the customs duty and nonrefundable VAT, interest and penalty liability, including the effect of historical foreign exchange rates, to be as follows at September 30, 2007:

	September 30,
	2007
	(In thousands)
South Korea	$	3,917
Taiwan		2,130
Japan		49
China		1,148
Total liability		7,244
Amounts paid at September 30, 2007		(3,691	)
Net liability at September 30, 2007	$	3,553

In addition, the Company determined total refundable VAT in all locations to be approximately $4.1 million. As of September 30, 2007, the Company had paid and received a refund for approximately $3.5 million.

The Company currently estimates its total costs, including duties, penalties and interest as well as legal, accounting and other costs associated with the restatement, to be in the range of $11.0 million to $12.0 million. In addition, the Company has not concluded any settlement with U.S. authorities with respect to its failure to make certain filings in connection with the export of warranty parts. The Company has commenced voluntary discussions with U.S. government agencies, including Customs, the Census Bureau and the Bureau of Industry and Security, regarding certain filing obligations that were not complied with in connection with its exports. Although the products in question were not restricted under export control laws and no fees were associated with these filings, the voluntary disclosure of the Company’s failure to comply with U.S. filing obligations may subject the Company to penalties and result in additional expenses, which could be material and the extent of which we are currently unable to estimate.

The increased estimates as of June 30, 2007 and September 30, 2007 compared to the original estimate as of December 31, 2006 were primarily due to the following factors:

1. Increased Span of Korean Audit:  The December estimate assumed that duties would be subject to a two-year statute of limitations. However, the Korean customs authorities determined that a five-year statute of limitations was the appropriate period.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

2. Foreign Currency Effect:  The December estimate was based on then-prevailing exchange rates. The customs authorities, however, determined that it was appropriate to use the exchange rates prevailing at the date of import into the country.

3. Lower Declared Values:  The December estimate assumed that the Company had valued warranty parts at 10% of standard cost when in fact a lower, de minimis value was often assigned for customs duty purposes.

4. Computed Value:  The December estimate assumed that it was appropriate to value parts based on inventory costs plus a calculated transfer-price mark-up (8%). As a result of the settlement with the Korean Customs Service, the June estimate was calculated using a mark-up based on the Company’s average historical gross margins.

5. Interest and Penalties:  The December estimate used an interest rate of 5% per annum and assumed penalties of between 7% and 10% of the underpaid amounts owed in Korea. After discussion with the Korean Customs Service, the interest rate and penalties totaled 20% of the underpaid amounts owed in Korea.

6. Value Added Tax (VAT) Recoverability:  The December estimate assumed that VAT paid in China and Taiwan would be refundable. After discussions with customs authorities in China and Taiwan, it was determined that VAT would not be deemed refundable in China and would only be deemed creditable against future VAT payments in Taiwan.

7. Excluded Parts:  The December estimate excluded certain parts that management believed had already been subject to audit by the Korean Customs Service. After review, it was determined that these parts had not been audited and the revised estimates included these parts.

8. Drawback Calculation:  The December estimate assumed that duties on returned merchandise would be refundable. After discussions with customs authorities, the revised estimates significantly reduced these drawback assumptions.

Background on Restatements Related to Other Accounting Issues

In the course of the preparation of the Company’s fiscal 2007 financial statements, management identified certain errors that related to previously reported periods, including:

•  Over-expensing of certain invoices related to inventory receipts and operating expenses which affected fiscal 2005 and 2006 and the first two quarters of fiscal 2007;

•  An over-accrual of a fiscal 2005 management bonus that was reversed in the first quarter of fiscal 2006; and

•  An over-expensing of certain options related to former executive officers due to problems discovered in the supporting software, which affected fiscal 2006 and the first two quarters of fiscal 2007.

These errors affected fiscal years 2006, 2005 and the first and second quarters of fiscal 2007.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Consolidated Financial Data for the fiscal year ended September 30, 2006

The following tables summarize the significant effects of the restatement on selected consolidated balance sheet data, on selected consolidated statements of operations data and on selected consolidated cash flow data for fiscal 2006:

	September 30,			Cumulative
	2006			Effect of Prior			Current-			September 30,
	As Previously			Period			Period			2006
	Reported			Adjustments*			Adjustments			As Restated
	(In thousands)
Consolidated Balance Sheet Data:
Other current assets and customs obligations	$	3,972		$	1,798		$	1,359		$	7,129
Accounts payable		7,657			(167	)		(233	)		7,257
Other current liabilities and customs obligations		8,967			4,948			3,725			17,640
Total current liabilities		33,113			4,781			3,492			41,386
Common Stock		285,510			—			(94	)		285,416
Accumulated deficit		(141,409	)		(2,983	)		(2,039	)		(146,431	)
Total liabilities and shareholders’ equity		177,613			1,798			1,359			180,770

* Amounts consist of the cumulative effect of prior period adjustments.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Year Ended September 30, 2006
	As Previously
	Reported			Adjustments			As Restated
	(In thousands, except per share data)
Consolidated Statement of Operations Data:
Revenue	$	172,872		$	—		$	172,872
Cost of revenue		112,771			1,434			114,205
Research and development		32,420			157			32,577
Selling, general and administrative		24,611			(105	)		24,506
Income (loss) from operations		1,412			(1,486	)		(74	)
Interest income and other, net		3,356			(553	)		2,803
Income from continuing operations before income taxes and discontinued operations		4,768			(2,039	)		2,729
Provision for income taxes		561			—			561
Income from continuing operations		4,207			(2,039	)		2,168
Loss from discontinued operations		(127	)		—			(127	)
Net income	$	4,080		$	(2,039	)	$	2,041
Net income per share from continuing operations:
Basic	$	0.25		$	(0.12	)	$	0.13
Diluted	$	0.25		$	(0.12	)	$	0.13
Net loss per share from discontinued operations:
Basic	$	(0.01	)	$	—		$	(0.01	)
Diluted	$	(0.01	)	$	—		$	(0.01	)
Net income per share:
Basic	$	0.24		$	(0.12	)	$	0.12
Diluted	$	0.24		$	(0.12	)	$	0.12
Weighted average number of shares:
Basic		16,978			16,978			16,978
Diluted		17,011			17,011			17,011

The following table summarizes the impact of the restatement to Cost of revenues, Research and development, Selling, general and administrative, Interest income and other, net, and Net income for the fiscal year ended September 30, 2006.

				Research		Selling,			Interest
	Cost of			and		General and			Income and			Net
	Revenue			Development		Administrative			Other, Net			Income
	(In thousands)
As previously reported	$	112,771		$	32,420	$	24,611		$	3,356		$	4,080
Adjustments:
Customs and duties		1,624			—		—			(553	)		(2,177	)
Other accounting errors		(190	)		157		(105	)		—			138
As restated	$	114,205		$	32,577	$	24,506		$	2,803		$	2,041

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Year Ended September 30, 2006
	As Previously
	Reported			Adjustments			As Restated
	(In thousands)
Consolidated Statement of Cash Flow Data
Cash flows from operating activities:
Net income from continuing operations	$	4,207		$	(2,039	)	$	2,168
Adjustments to reconcile net income from continuing operations to net cash provided operating activities from continuing operations:
Stock-based compensation		4,079			(94	)		3,985
Changes in assets and liabilities:
Other current assets		383			(1,359	)		(976	)
Accounts payable		(5,269	)		(233	)		(5,502	)
Other current liabilities		4,010			3,725			7,735
Net cash provided by operating activities from continuing operations		20,037			—			20,037
Net cash used in operating activities from discontinued operations		(1,271	)		—			(1,271	)
Net cash provided by operating activities		18,766			—			18,766
Cash flows from investing activities:
Net cash provided by investing activities from continuing operations		15,098			—			15,098
Cash flows from financing activities:
Net cash used in financing activities from continuing operations		(5,814	)		—			(5,814	)
Effect of exchange rate changes on cash and cash equivalents		(403	)		—			(403	)
Net increase in cash and cash equivalents from continuing operations		28,918			—			28,918
Net decrease in cash and cash equivalents from discontinued operations		(1,271	)		—			(1,271	)
Net increase in cash and cash equivalents		27,647			—			27,647
Cash and cash equivalents at beginning of year		20,288			—			20,288
Cash and cash equivalents at end of year	$	47,935		$	—		$	47,935

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Consolidated Financial Data for the fiscal year ended September 30, 2005

The following tables summarize the significant effects of the restatement on selected consolidated balance sheet data, on selected consolidated statements of operations data and on selected consolidated cash flow data for fiscal 2005:

	Year Ended September 30, 2005
	As Previously
	Reported			Adjustments			As Restated
	(In thousands, except per share data)
Consolidated Statement of Operations Data:
Revenue	$	125,813		$	—		$	125,813
Cost of revenue		82,732			1,379			84,111
Research and development		36,275			(225	)		36,050
Selling, general and administrative		24,678			(37	)		24,641
Loss from operations		(21,161	)		(1,117	)		(22,278	)
Interest income and other, net		2,218			(445	)		1,773
Loss from continuing operations before income taxes and discontinued operations		(18,943	)		(1,562	)		(20,505	)
Provision for income taxes		624			—			624
Loss from continuing operations		(19,567	)		(1,562	)		(21,129	)
Income from discontinued operations		256			—			256
Net loss	$	(19,311	)	$	(1,562	)	$	(20,873	)
Net loss per share from continuing operations:
Basic	$	(1.16	)	$	(0.09	)	$	(1.25	)
Diluted	$	(1.16	)	$	(0.09	)	$	(1.25	)
Net income per share from discontinued operations:
Basic	$	0.02		$	—		$	0.02
Diluted	$	0.02		$	—		$	0.02
Net loss per share:
Basic	$	(1.14	)	$	(0.10	)	$	(1.24	)
Diluted	$	(1.14	)	$	(0.10	)	$	(1.24	)
Weighted average number of shares:
Basic		16,890			16,890			16,890
Diluted		16,890			16,890			16,890

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following table summarizes the impact of the restatement to Cost of revenues, Research and development, Selling, general and administrative, Interest income and other, net, and Net loss for the fiscal year ended September 30, 2005.

				Research			Selling,			Interest
	Cost of			and			General and			Income and			Net
	Revenue			Development			Administrative			Other, Net			Loss
	(In thousands)
As previously reported	$	82,732		$	36,275		$	24,678		$	2,218		$	19,311
Adjustments:
Customs and duties		1,473			—			—			(445	)		1,918
Other accounting errors		(94	)		(225	)		(37	)		—			(356	)
As restated	$	84,111		$	36,050		$	24,641		$	1,773		$	20,873

	Year Ended September 30, 2005
	As Previously
	Reported			Adjustments			As Restated
	(In thousands)
Consolidated Statement of Cash Flow Data
Cash flows from operating activities:
Net loss from continuing operations	$	(19,567	)	$	(1,562	)	$	(21,129	)
Changes in assets and liabilities:
Other current assets		(130	)		(887	)		(1,017	)
Accounts payable		(5,475	)		(167	)		(5,642	)
Other current liabilities		(999	)		2,616			1,617
Net cash provided by operating activities from continuing operations		13,745			—			13,745
Net cash used in operating activities from discontinued operations		(640	)		—			(640	)
Net cash provided by operating activities		13,105			—			13,105
Cash flows from investing activities:
Net cash used in investing activities from continuing operations		(18,815	)		—			(18,815	)
Cash flows from financing activities:
Net cash provided by financing activities from continuing operations		718			—			718
Net cash used in financing activities from discontinued operations		(313	)		—			(313	)
Net cash provided by financing activities		405			—			405
Effect of exchange rate changes on cash and cash equivalents		110			—			110
Net decrease in cash and cash equivalents from continuing operations		(4,242	)		—			(4,242	)
Net decrease in cash and cash equivalents from discontinued operations		(953	)		—			(953	)
Net decrease in cash and cash equivalents		(5,195	)		—			(5,195	)
Cash and cash equivalents at beginning of year		25,483			—			25,483
Cash and cash equivalents at end of year	$	20,288		$	—		$	20,288

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

NOTE 3 — FINANCIAL STATEMENT COMPONENTS

	September 30,
	2007			2006
	(In thousands)
Consolidated Balance Sheet
Inventories:
Raw materials	$	7,465		$	10,740
Work-in-process		4,491			7,036
Finished goods		1,336			666
Total	$	13,292		$	18,442
Land, property and equipment:
Land and building	$	5,055		$	7,056
Equipment		15,665			15,952
Office furniture and fixtures		2,479			2,864
Leasehold improvements		8,442			8,591
		31,631			34,463
Less: accumulated depreciation and amortization		(21,048	)		(18,572	)
Total	$	10,583		$	15,891
Other current liabilities:
Compensation	$	4,897		$	3,460
Vendor obligation		673			942
Professional fees		2,441			891
Customer deposits		—			1,500
Other accrued expenses		1,863			2,174
Total	$	9,874		$	8,967
Deferred gross margin:
Deferred system sales	$	10,269		$	12,217
Deferred cost of revenue related to system sales		(7,033	)		(4,763	)
Total	$	3,236		$	7,454
Accumulated other comprehensive income:
Foreign currency translation adjustments	$	(543	)	$	332
Unrealized losses on available-for-sale securities		(60	)		(52	)
Total	$	(603	)	$	280

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Year Ended September 30,
	2007			2006			2005
				As			As
				restated			restated
	(In thousands)
Consolidated Statements of Operations
Interest income and other, net
Interest income	$	4,490		$	3,741		$	2,187
Interest expense		(627	)		(429	)		(373	)
Foreign exchange gain (loss)		532	(1)		(335	)		210
Other		(205	)		(174	)		(251	)
Total	$	4,190		$	2,803		$	1,773

(1) In fiscal 2007, the Company substantially liquidated its net investment in its Canadian subsidiary, Photon Dynamics Canada, Inc., for financial statement purposes. In accordance with the provisions of Statement of Financial Accounting Standards No. 52, “Foreign Currency Translation” the Company recorded a gain on its net investment in this subsidiary of approximately $928,000, composed of translation adjustment gains that had accumulated in “Accumulated other comprehensive income (loss)” on the Consolidated Balance Sheet.

NOTE 4 — DISCONTINUED OPERATIONS

Printed Circuit Board Assembly Inspection Business

The Company formerly had a business which sold printed circuit board assembly inspection products which was discontinued in January, 2003.

Loss from discontinued operations of the Printed Circuit Board Assembly Inspection business were approximately $0, $154,000 and $56,000 in fiscal 2007, 2006 and 2005, respectively. The loss from discontinued operations for the year ended September 30, 2006, included approximately $259,000 of legal costs related to the Amtower v. Photon Dynamics, Inc. lawsuit, offset by approximately $108,000 of deferred rent charges that were reversed in the quarter ended December 31, 2005 when the Company successfully renegotiated its remaining lease obligations for its Austin, Texas facility. The loss from discontinued operations for the year ended September 30, 2005, included approximately $132,000 for the reversal of a liability related to the settlement of vendor obligations, approximately $113,000 of legal expenses related to the Amtower v. Photon Dynamics Inc. lawsuit, and approximately $75,000 in other expenses, primarily legal and administrative.

Other current assets at September 30, 2007 and 2006 include approximately $640,000 and $597,000, respectively, related to discontinued operations of the Printed Circuit Board Assembly Inspection business. These assets consist primarily of court-awarded legal fees and insurance reimbursements related to the Amtower v. Photon Dynamics, Inc. lawsuit. This lawsuit, which was filed on April 30, 2001, was taken to trial in April 2006 and in May 2006, judgments were entered in favor of the Company and its former officers. In June 2006, the plaintiff filed a timely notice of appeal. The court award for fees and costs incurred bears interest at the statutory rate of 10% simple interest per annum. Collection of the award was stayed during the plaintiff’s appeal of the verdict. On January 16, 2008, the Sixth District Court of Appeals for the State of California upheld the trial court’s judgment and award.

Other current liabilities at September 30, 2007 and 2006 included approximately $0 and $200,000, respectively, related to potential vendor obligations, which were resolved during fiscal 2007 and resulted in a reversal of the liability.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Cathode Ray Tube Display and High Quality Glass Inspection Business

The Company formerly had a business which sold cathode ray tube display and high quality glass inspection products which was discontinued in June, 2003.

Income from discontinued operations of the Cathode Ray Tube Display and High Quality Glass Inspection Business was approximately $0, $27,000 and $312,000 in fiscal 2007, 2006 and 2005. Income from discontinued operations for the year ended September 30, 2006, included approximately $17,000 of adjustments to reduce the estimated warranty liability. Income from discontinued operations for the year ended September 30, 2005, included approximately $288,000 for the reduction in certain reserves, including $143,000 related to warranty provisions and approximately $145,000 related to lease obligations settled at amounts less than originally estimated.

Other current liabilities at September 30, 2007 and 2006 include approximately $1,000 and $19,000, respectively, related to remaining operating lease obligations which continue through October 2007.

NOTE 5 — ACQUISITIONS

Year ended September 30, 2007 Acquisitions

On July 27, 2007, the Company purchased Salvador Imaging, an international supplier of high-performance digital cameras. The aggregate purchase price consisted of (i) 1,084,406 shares of Photon Dynamics’ common stock valued at approximately $11.5 million, (ii) approximately $2.7 million in cash and (iii) a promissory note in the amount of approximately $5.3 million with principal payable in two equal installments in October 2008 and January 2010 (see Note 16). In addition, the Company incurred approximately $45,000 in acquisition-related expenses, consisting primarily of legal, consulting and accounting fees. The operating results of Salvador Imaging from the purchase date of July 27, 2007 through September 30, 2007 are included in the Company’s fiscal 2007 consolidated statement of operations.

On April 23, 2007, Photon Dynamics had entered into a joint venture agreement with Salvador Imaging. This joint venture resulted in the formation of Salvador Systems LLC. Under terms of the agreements to acquire Salvador Imaging, the joint venture agreement and the related licensing agreements were terminated and Salvador Systems LLC was absorbed into Salvador Imaging upon the Company’s acquisition of Salvador Imaging. Salvador Imaging operates as a wholly-owned subsidiary of Photon Dynamics, Inc.

Purchase Price Allocation and Pro Forma Information

The acquisition of Salvador Imaging was accounted for as business combination under the purchase method of accounting in accordance with Statement of Financial Accounting Standards No. 141, “Business Combinations,” (“SFAS No. 141”). The value of the 1,084,406 shares of common stock issued by the Company in the acquisition was based on the average price of the Company’s stock on July 27, 2007, the date the stock was issued.

The purchase price was allocated by management to the assets acquired and liabilities assumed taking into account an independent appraisal of their respective fair values. To determine the value of the developed and core technologies, the expected future cash flows attributed to all existing technology were discounted, taking into account risks related to the characteristics and application of the technology, existing and future markets and assessments of the life cycle stage of the technology. The value attributed to the backlog was related to purchase orders that had been received prior to the close of the acquisition, determined as the expected discounted cash flow resulting from the revenue related to the shipment of such orders, less normal profit margins.

The value of in-process research and development was determined based on the expected cash flow attributed to the in-process projects, taking into account revenue that was attributable to previously developed technology, the level of effort to date in the in-process research and development, the percentage of completion of the projects and the level of risk associated with the in-process technology. The projects identified as in-process were those that were underway as of the acquisition date and that will, after the applicable closing date, require additional effort in order

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

to establish technological feasibility and have no alternative future uses. These projects have identifiable technological risk factors that indicate that even though successful completion is expected, it is not assured. The value of in-process research and development has been included in the Company’s results of operations.

The Company applied discount factors to the projected cash flows of the acquired technology in order to determine the present value, based on discount rates with inherent risk and expected growth of the developed, core and in-process technologies. The discount rates used for the developed, core and in-process technologies for the acquisition of Salvador Imaging were 28%, 28% and 32%, respectively.

A summary of the allocation of the purchase prices is as follows:

	Allocation
	Value
	(In thousands)
Net fair value of acquired tangible assets and assumed liabilities	$	750
Developed technology		6,340
Core technology		1,580
In-process research and development		1,110
Customer relationships		910
Backlog		110
Tradename		640
Non-compete agreement		1,380
Goodwill		6,704
Total	$	19,524

The $1.1 million of acquired in-process research and development assets were written off at the date of acquisition in accordance with SFAS No. 141. The $6.7 million of goodwill was assigned to the High-Performance Digital Imaging segment and is not expected to be deductible for tax purposes.

The core technology, developed technology customer relationships and tradename are each being amortized over four years from the date of acquisition, while the non-compete agreement is being amortized over three years from the date of acquisition. The backlog is being amortized to cost of sales at the time revenue is recognized for the related customer orders.

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The following pro-forma information presents the results of continuing operations of the Company for the years ended September 30, 2007 and 2006 as if Salvador Imaging had been acquired as of October 1, 2005. The pro-forma information does not purport to be indicative of what would have occurred had the acquisition been made as of these dates or of results that may occur in the future. The pro forma results exclude nonrecurring charges, such as the write-off of purchased in-process research and development or the effects of amortization of intangible assets, which resulted directly from these transactions. The unaudited pro forma information is as follows:

	Year Ended September 30,
	2007			2006
	(In thousands except per share data, unaudited)
Total revenue	$	76,000		$	173,434
Income (loss) from continuing operations		(34,238	)		2,601
Net income (loss)		(34,238	)		2,474
Pro forma income (loss) per share from continuing operations:
Basic	$	(2.04	)	$	0.15
Diluted	$	(2.04	)	$	0.15
Pro forma income (loss) per share:
Basic	$	(2.04	)	$	0.15
Diluted	$	(2.04	)	$	0.15

NOTE 6 — GOODWILL AND OTHER PURCHASED INTANGIBLE ASSETS

Goodwill

The carrying value of goodwill was approximately $6.9 million and $153,000 at September 30, 2007 and 2006, respectively. During the fourth quarter of fiscal 2007, the Company added approximately $6.7 million in goodwill related to the purchase of Salvador Imaging (see Note 5). There were no additions or adjustments to goodwill during fiscal 2006.

There have been no significant events or circumstances negatively affecting the valuation of goodwill at September 30, 2007 subsequent to the Company’s annual impairment test performed during the fourth quarter of fiscal 2007.

Intangible Assets

The components of intangible assets as of September 30, 2007 were as follows:

							Non
	Developed			Core			Compete			Customer			Trade
	Technology			Technology			Contract			Relations			Name			Backlog			Total
	(In thousands)
Gross carrying amount at September 30, 2007	$	7,346		$	3,988		$	2,348		$	910		$	640		$	110		$	15,342
Accumulated amortization		(1,094	)		(2,111	)		(1,041	)		(38	)		(27	)		(8	)		(4,319	)
Net carrying amount at September 30, 2007	$	6,252		$	1,877		$	1,307		$	872		$	613		$	102		$	11,023

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The components of intangible assets as of September 30, 2006 were as follows:

										Non
	Developed			Core			License			Compete
	Technology			Technology			Agreement			Contract			Total
	(In thousands)
Gross carrying amount at September 30, 2006	$	1,006		$	2,408		$	1,138		$	968		$	5,520
Accumulated amortization		(578	)		(1,504	)		(948	)		(774	)		(3,804	)
Net carrying amount at September 30, 2006	$	428		$	904		$	190		$	194		$	1,716

The following table summarizes the activity during the fiscal years ended September 30, 2007 and 2006:

										Non
	Developed			Core			License			Compete			Customer			Trade
	Technology			Technology			Agreement			Contract			Relations			Name			Backlog			Total
	(In thousands)
Balance as of September 30, 2005	$	680		$	1,506		$	570		$	449		$	—		$	—		$	—		$	3,205
Amortization during the period		(252	)		(602	)		(380	)		(255	)		—			—			—			(1,489	)
Balance as of September 30, 2006	$	428		$	904		$	190		$	194		$	—		$	—		$	—		$	1,716
Acquired during the period		6,340			1,580			—			1,380			910			640			110			10,960
Amortization during the period		(516	)		(607	)		(190	)		(267	)		(38	)		(27	)		(8	)		(1,653	)
Balance as of September 30, 2007	$	6,252		$	1,877		$	—		$	1,307		$	872		$	613		$	102		$	11,023

Based on intangible assets recorded at September 30, 2007, and assuming no subsequent additions to, or impairment of, the underlying assets, the remaining estimated amortization expense relating to intangible assets at September 30, 2007, is approximately $3.4 million, $2.9 million, $2.8 million and $1.9 million in fiscal 2008 through 2011, respectively.

In assessing the recoverability of its intangible assets, the Company must make assumptions regarding estimated future cash flows and other factors to determine the fair value of the respective assets. It is reasonably possible that these estimates, or their related assumptions, may change in the future, in which case the Company may be required to record additional impairment charges for these assets.

NOTE 7 — RESTRUCTURING AND OTHER CHARGES

March 2007 Impairment of Property and Equipment

During the three months ended March 31, 2007, the Company recorded approximately $2.8 million of charges to impair property and equipment.

As a result of the successful implementation of the Company’s offshore manufacturing program, management performed an impairment assessment of its manufacturing facilities and equipment. Based on that assessment management determined that the Company’s 128,520 square foot U.S. facility leased by the Company was not impaired; however, the 22,000 square foot U.S. manufacturing facility owned by the Company was impaired. In accordance with the provisions of Statement of Financial Accounting Standards No. 144, “Accounting for the

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Impairment or Disposal of Long-lived Assets,” (“SFAS No. 144”) the Company recorded an impairment charge of approximately $2.0 million in the three months ended March 31, 2007. This charge was based on the difference between the carrying amount of the asset over the assets’ appraised fair value. In addition, during the three months ended March 31, 2007, the Company incurred an impairment charge of approximately $834,000 as a result of the write-off of certain capital equipment that was determined to have no additional future use.

February 2007 Restructure

On February 21, 2007, the Company announced the implementation of a company-wide cost reduction plan approved by the board of directors and designed to accelerate the Company’s objective of achieving consistent profitability. Management’s goal was to size the Company’s business in response to the current flat panel display market. The Company recorded this restructuring plan in accordance with Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”).

The restructuring plan consisted entirely of reducing the Company’s workforce. Management approved and implemented the plan and determined the benefits that would be offered to the employees being terminated. Management determined that terminations affecting 56 employees would occur on February 21, 2007. All affected employees were notified of their termination and the benefits package was explained in sufficient detail such that each affected employee was able to determine the type and amount of benefits they were entitled to receive.

The Company recorded a restructuring charge of approximately $1.0 million in the three months ended March 31, 2007, which was comprised of employee severance and related benefits. In the three months ended June 30, 2007, the Company reversed approximately $95,000 of the initial charge for severance benefits not paid. These charges are reflected in “Restructuring charge” in the Company’s Consolidated Statements of Operations.

The following table summarizes the liability since inception:

	One-Time
	Termination
	Benefits
	(In thousands)
Inception of liability	$	1,017
Cash payments		(926	)
Adjustments to the liability		(91	)
Balance at September 30, 2007	$	—

Adjustments to the liability represent severance not paid and foreign currency translation effects on the liability.

November 2006 Restructure

On November 16, 2006, the Company announced its intention to discontinue its PanelMaster^tm product line. The Company recorded this restructuring plan in accordance with SFAS No. 146.

The restructuring plan included reducing the Company’s workforce and impairing certain manufacturing assets associated with the PanelMaster^tm product line. Management approved and implemented the plan and determined the benefits that would be offered to the employees being terminated. Management determined that terminations affecting ten employees would take place in November and December 2006. In November 2006 all ten of the affected employees were notified of their termination and the benefits package was explained in sufficient detail such that each affected employee was able to determine the type and amount of benefits they were entitled to receive.

The Company recorded a restructuring charge of approximately $446,000 in the three months ended December 31, 2006, which was comprised of employee severance and related benefits and the impairing certain

96

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

manufacturing assets associated with the product line. These charges are reflected in “Restructuring charge” in the Company’s Consolidated Statements of Operations. All severance amounts were paid out in the six months ended March 31, 2007.

The following table summarizes the liability since inception:

	One-Time
	Termination			Other
	Benefits			Costs			Total
	(In thousands)
Inception of liability	$	173		$	273		$	446
Cash payments		(171	)		—			(171	)
Adjustments to the liability		(2	)		(273	)		(275	)
Balance at September 30, 2007	$	—		$	—		$	—

Adjustments to the liability represent the write-off of certain capital equipment that had no additional future use and foreign currency translation effects on the liability.

September 2006 Impairment of Property and Equipment

During the three months ended September 30, 2006, the Company recorded approximately $81,000 of charges to impair property and equipment for manufacturing capital equipment that had no future use

September 2005 Impairment of Property and Equipment

During the three months ended September 30, 2005, the Company recorded approximately $637,000 of charges to impair property and equipment for manufacturing capital equipment that had no future use

April 2005 Restructure

During the third quarter of fiscal 2005, the Company implemented a restructuring plan to relocate all activities in its Markham, Canada location — consisting of research and development related to the Company’s PanelMaster^tm inspection systems — to the Company’s Daejon, South Korea and San Jose, California locations. The Company recorded this restructuring plan in accordance with SFAS No. 146.

The restructuring plan included reducing its workforce and closing its Markham, Canada location. Management approved and implemented the plan and determined the benefits that would be offered to the employees being terminated. Management determined that terminations affecting up to 32 employees would take place in three phases through March 31, 2006. Certain of these employees were offered permanent employment elsewhere in the Company and those that accepted were provided with certain relocation benefits in lieu of severance benefits. In the third quarter of fiscal 2005, all 32 of the affected employees were notified of their termination and the benefits package was explained in sufficient detail such that each affected employee was able to determine the type and amount of benefits they were entitled to receive.

The Company recorded an initial restructuring charge of approximately $676,000 in its third quarter of fiscal 2005, which was comprised of approximately $430,000 for employee severance and related benefits and approximately $246,000 related to contract termination costs associated with excess facilities. The charge for excess facilities relates to rent obligations under long term operating lease agreements which are to be paid in cash through October 2007, net of a sublease agreement the Company entered into in April 2005, and to costs associated with the book value of leasehold improvements. The Company recorded a total restructuring charge of approximately $1.2 million in the fiscal year ended September 30, 2005. The Company recorded an additional restructuring charge of approximately $114,000 during the six months ended March 31, 2006, which represented the ratable charges for employee severance and related retention benefits that were to be paid on March 31, 2006. This

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

charge was offset by approximately $84,000 of adjustments to the liability for bonuses not paid. These charges are reflected in “Restructuring charge” in the Company’s Consolidated Statements of Operations.

The following table summarizes the liability since inception:

	One-Time			Contract
	Termination			Termination
	Benefits			Costs			Total
	(In thousands)
Inception of liability	$	430		$	246		$	676
Cash payments		(526	)		(21	)		(547	)
Costs incurred and charged to expense		521			—			521
Adjustments to the liability		24			(166	)		(142	)
Balance at September 30, 2005		449			59			508
Cash payments		(492	)		(16	)		(508	)
Costs incurred and charged to expense		114			—			114
Adjustments to the liability		(71	)		(5	)		(76	)
Balance at September 30, 2006		—			38			38
Cash payments		—			(14	)		(14	)
Adjustments to the liability		—			1			1
Balance at September 30, 2007	$	—		$	25		$	25

As of September 30, 2007, the remaining liability of approximately $25,000 is reflected in “Other current liabilities” in the Company’s Consolidated Balance Sheets and relates primarily to the lease of the Markham, Canada facility, which continues through October 2007. All termination benefits were paid out by March 31, 2006. Adjustments to the liability represent an adjustment to bonus amounts accrued and to foreign currency translation effects on the liability.

NOTE 8 — FINANCIAL INSTRUMENTS

Short Term Investments

The amortized cost and estimated fair value of securities available-for-sale, by type, are as follows:

			Gross		Gross
	Amortized		Unrealized		Unrealized			Estimated
	Cost		Gains		Losses			Fair Value
	(In thousands)
September 30, 2007
Corporate debt securities	$	23,641	$	1	$	(63	)	$	23,579
Auction rate preferred securities		16,235		—		—			16,235
Mortgage-backed securities		4,000		3		—			4,003
Money market bank deposits and other		18,697		—		—			18,697
Total available-for-sale investments	$	62,573	$	4	$	(64	)	$	62,513
Amounts included in:
Cash equivalents	$	18,697	$	—	$	—		$	18,697
Short-term investments		42,676		4		(40	)		42,640
Long-term investments		1,200		—		(24	)		1,176
Total available-for-sale investments	$	62,573	$	4	$	(64	)	$	62,513

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

			Gross		Gross
	Amortized		Unrealized		Unrealized			Estimated
	Cost		Gains		Losses			Fair Value
	(In thousands)
September 30, 2006
Auction rate preferred securities	$	46,765	$	—	$	—		$	46,765
Corporate debt securities		20,849		—		(48	)		20,801
Mortgage-backed securities		2,000		—		(4	)		1,996
Money market bank deposits and other		22,167		—		—			22,167
Total available-for-sale investments	$	91,781	$	—	$	(52	)	$	91,729
Amounts included in:
Cash equivalents	$	36,114	$	—	$	(6	)	$	36,108
Short-term investments		54,867		—		(33	)		54,834
Long-term investments		800		—		(13	)		787
Total available-for-sale investments	$	91,781	$	—	$	(52	)	$	91,729

The contractual maturities of the Company’s marketable securities as of September 30, 2007, regardless of the consolidated balance sheet classification, are as follows:

			Estimated
	Cost		Fair Value
	(In thousands)
Due in less than one year	$	45,138	$	45,102
Due in 1 to 3 years		1,200		1,176
Due in 3 to 5 years		—		—
Due in 5 to 10 years		—		—
Due in greater than 10 years		16,235		16,235
Total cost and estimated fair values	$	62,573	$	62,513

Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.

Securities with contractual maturities over ten years are auction rate securities. While the contractual maturities are long-term, the Company believes the securities are highly liquid and that the Company can take advantage of interest rate re-set periods of between one and twenty-eight days to liquidate the securities. Management has the ability and intent, if necessary, to liquidate these investments to fund operations within the next twelve months and accordingly has classified these investments as Short-term investments in current assets in the Consolidated Balance Sheets.

Net realized gains and losses for the years ended September 30, 2007, 2006 and 2005 were not material to the Company’s financial position or results of operations and have been included in “Interest income and other, net” in

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the Consolidated Statements of Operations in the respective period. The breakdown of marketable securities with unrealized losses at September 30, 2007 is as follows:

	In a Loss Position					In a Loss Position
	for Less Than					for 12 Months
	12 Months					or Greater					Total
			Gross					Gross					Gross
			Unrealized					Unrealized					Unrealized
	FMV		Losses			FMV		Losses			FMV		Losses
	(In thousands)
Corporate debt securities	$	20,476	$	(63	)	$	800	$	(1	)	$	21,276	$	(64	)

The gross unrealized losses related to the Company’s investments are due to changes in interest rates and bond yields. The longer the duration of a security, the more susceptible it is to changes in market interest rates and bond yields. As yields increase, those securities with a lower yield-at-cost show a mark-to-market unrealized loss. The Company views these unrealized losses as temporary in nature and believes it has the ability to realize the full value of all these investments.

The Company periodically reviews its investment portfolio for possible impairment due to changes in credit risk or other potential valuation concerns. The Company believes that no investment held at September 30, 2007 was impaired. While certain available-for-sale securities have fair values that are below cost, the Company believes that the decline in market value is due to changes in interest rates and bond yields and not due to increased credit risk.

Derivative Financial Instruments

Photon Dynamics may use financial instruments, such as forward exchange and currency option contracts, to hedge a portion of, but not all, existing and anticipated foreign currency denominated transactions or existing account balances. The terms of currency instruments used for hedging purposes are generally consistent with the timing of the transactions or balances being hedged. Under its foreign currency risk management strategy, the Company utilizes derivative instruments to protect against unanticipated fluctuations in earnings and cash flows caused by volatility in currency exchange rates. However, these derivative instruments do not fully hedge the Company’s exposure to foreign exchange rate risk. This financial exposure is monitored and managed by the Company as an integral part of its overall risk management program, which focuses on the volatility in the financial markets and seeks to reduce the potentially adverse effects that the volatility of these markets may have on its operating results.

The Company accounts for its derivatives instruments according to Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS No. 133”), which requires that all derivatives be recorded on the balance sheet at fair value. Changes in the fair value of derivatives that do not qualify, or are not effective as hedges, must be recognized currently in earnings. The Company does not use derivative financial instruments for speculative or trading purposes, nor does it hold or issue leveraged derivative financial instruments.

The Company conducts business internationally in several currencies. As such, it is exposed to fluctuations in foreign currency exchange rates. The Company’s exposure to foreign exchange rate fluctuations arises in part from: (1) translation of the financial results of foreign subsidiaries into U.S. dollars in consolidation; (2) the re-measurement of non-functional currency assets, liabilities and intercompany balances into U.S. dollars for financial reporting purposes; and (3) non-U.S. dollar denominated sales to foreign customers. The Company defines its exposure as the risk of changes in the functional-currency-equivalent cash flows (generally U.S. dollars) attributable to changes in the related foreign currency exchange rates.

In June 2007, the Company entered into forward sales contracts in order to manage foreign currency risk associated with certain trade accounts receivable denominated in Japanese yen. These contracts require the Company to exchange currencies at rates agreed upon at the contract’s inception and have terms designed to match

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

the timing of payment from the yen-denominated accounts receivable. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the balance of the accounts receivable, these financial instruments mitigate the risk that might otherwise result from certain changes in currency exchange rates between U.S. dollars and Japanese Yen. The Company did not designate these forward sales contracts as hedging instruments, as defined by SFAS No. 133, and, as such, records the changes in the fair value of these derivatives immediately in “Interest income and other, net” in the Company’s condensed consolidated statements of operations. At September 30, 2007, the Company had foreign exchange forward contracts to sell approximately $5.6 million in Japanese Yen. The change in fair value of the contracts was not material. The contract expired in November 2007.

NOTE 9 — INCOME TAXES

The provision for income taxes related to continuing operations consists of the following:

	Year Ended September 30,
	2007			2006		2005
	(In thousands)
Current:
Federal	$	27		$	175	$	23
State		76			2		8
Foreign		210			356		678
Deferred:
Foreign		(33	)		28		(85	)
Provision for income taxes	$	280		$	561	$	624

Income (loss) before income taxes related to continuing operations consists of the following:

	Year Ended September 30,
	2007			2006		2005
				As restated		As restated
	(In thousands)
Domestic	$	(36,755	)	$	1,379	$	(28,558	)
Foreign		1,963			1,350		8,053
Income (loss) before income taxes	$	(34,792	)	$	2,729	$	(20,505	)

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The significant components of the Company’s deferred income tax assets are as follows:

	September 30,
	2007			2006
				As restated
	(In thousands)
Deferred tax assets:
Net operating loss carryforwards	$	44,310		$	31,782
Research credit carryforwards		9,049			9,585
Foreign research and development expenditures		10,885			10,884
Purchased intangibles		3,755			3,005
Inventory write-downs		5,807			5,198
Depreciation		2,060			1,555
Allowance for doubtful accounts		89			152
Expenses not currently deductible		3,744			5,310
Stock-based compensation		1,714			1,399
Deferred revenue		3,360			4,500
Total deferred tax assets		84,773			73,370
Valuation allowance		(84,685	)		(73,312	)
Net deferred tax assets		88			58
Deferred tax liabilities		—			—
Total net deferred tax assets	$	88		$	58

Deferred tax assets reflect net operating loss and credit carryforwards and the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes.

The valuation allowance increased by approximately $11.4 million in fiscal 2007 and decreased by approximately $359,000 in fiscal 2006. As of September 30, 2007, approximately $14.5 million of the valuation allowance is related to the benefits attributable to stock option deductions which will be credited to paid-in capital when realized.

As of September 30, 2007, the Company has federal and state net operating loss carryforwards of approximately $121.2 million and $35.5 million, respectively. The federal net operating loss carryforwards will begin expiring in fiscal year 2022 if not utilized. The state net operating loss carryforwards will expire at various times beginning in fiscal year 2013 if not utilized. The Company also has federal and state research and development tax credit carryforwards of approximately $5.1 million and $5.4 million, respectively. The federal credits expire on an annual basis through fiscal year 2025 if not utilized. The state credits have an indefinite carryforward period.

As of September 30, 2007, the Company has cumulative foreign loss carryforwards for Canadian income tax purposes of approximately $2.0 million. These foreign loss carryforwards will expire on an annual basis through fiscal year 2027 if not utilized. The Company has cumulative Canadian scientific research and development expenditures (“SR&D”) available for deduction in future years of approximately $18.4 million. These deductible SR&D can be carried forward to reduce future Canadian taxable income indefinitely. The Company also has SR&D credit carryforwards of approximately $5.0 million, which continue to expire on an annual basis through fiscal year 2015. In consideration of the fiscal 2005 restructuring of the Canadian operation, which closed the Canadian facility and moved all research and development activity elsewhere in the Company, and the varying future expiration dates of the available tax loss and credit carryforwards, the Company does not expect to realize any tax benefit associated with these attributes.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Under certain provisions of the Internal Revenue Code of 1986, as amended, the availability of the Company’s domestic net operating loss and tax credit carryforwards may be subject to limitation if it should be determined that there has been a change in ownership of more than 50% of the value of the Company’s stock. Such determination could limit the utilization of net operating loss and tax credit carryforwards.

The reconciliation of the U.S. federal statutory income tax rate to the Company’s effective income tax rate is as follows:

	Year Ended September 30,
	2007			2006			2005
				As restated			As restated
	(In thousands)
Expected provision (benefit) at federal statutory rate	$	(12,175	)	$	955		$	(7,177	)
Foreign income tax rate differences		99			(79	)		593
Losses (benefited)/not benefited		11,961			(827	)		6,986
Disallowed business meals, entertainment and penalties		50			196			206
Nondeductible stock-based compensation		114			173			—
Nondeductible VIE losses		231			143			—
Other individually immaterial items		—			—			16
Provision for income taxes	$	280		$	561		$	624

NOTE 10 — SHAREHOLDER’S EQUITY

Stock Option Exchange Program.  On January 24, 2007, at the Company’s Annual Meeting of Shareholders, the Company’s shareholders approved an amendment to the 2005 Equity Incentive Plan to permit a one-time stock option exchange program whereby employees holding certain stock options having exercise prices significantly higher than the Company’s market price for its common stock would be allowed to exchange those options for a lesser number of restricted share units. The Company’s executive officers and members of the Company’s board of directors were not eligible to participate in the exchange. This exchange took place on May 15, 2007. Of the 804,374 options eligible for exchange, employees elected to exchange 723,271 options, for which the Company issued 241,213 restricted stock units (see Note 11).

Common Stock Repurchase Program.  On August 21, 2006, the Company’s Board of Directors approved a stock repurchase program authorizing the Company to repurchase up to a maximum of 1.1 million outstanding shares of the Company’s common stock. During fiscal 2006, the repurchases were made from time to time on the open market at prevailing prices and in negotiated transactions off the market as management deems appropriate. The Company did not repurchase its shares during any period in which the Company was in possession of material non-public information. The purchases were funded from available working capital, and the repurchased shares were either retired or used for ongoing stock issuances. There is no guarantee as to the exact number of shares that will be repurchased. In fiscal 2007, the Company made no additional repurchases as management determined that additional purchases were not warranted. Although the Company does not anticipate any additional purchases, the timing and actual number of additional shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements and other market conditions. In fiscal 2006, the Company repurchased the following shares under this plan:

					Total Shares
			Average		Purchased		Shares Yet
	Total Shares		Price Paid		as Part		to be Purchased
	Purchased		per Share		of the Plan		Under the Plan
August 1 through August 31, 2006		503,581	$	13.17		503,581		596,419
September 1 through September 30, 2006		26,020	$	13.35		529,601		570,399

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The aggregate repurchase price of approximately $7.0 million was reflected as a reduction of common stock in the consolidated financial statements.

Settlement of Escrow Shares.  During the quarter ended March 31, 2006, the Company reached resolution on shares held in escrow. In July 2001, the Company had entered into a share purchase agreement with Intelligent Reasoning Systems, Inc. (“IRSI”) and under the agreement issued 699,010 shares of Photon Dynamics, Inc. common stock. A total of 57,195 shares remained in an escrow account pending resolution of the Company’s claim against the escrow related to the Austin, Texas, facility lease acquired as part of the purchase of IRSI. During the quarter ended December 31, 2005, the Company settled its lease obligations and filed a claim against the escrowed shares. During the quarter ended March 31, 2006, the Company’s claim against the escrowed shares was accepted and the Company received 50,319 shares, while the remaining 6,876 shares were distributed to the former shareholders of IRSI. The Company cancelled the 50,319 shares and the balance of the approximately $1.3 million in the escrow receivable account at the time of share cancellation was recorded as a reduction of common stock in the consolidated financial statements.

Stock Ownership Expense.  During fiscal 2006 and 2005, the Company recorded approximately $14,000 and $52,000 in stock ownership expense related to options granted to a member of its Board of Directors for consulting services (see Note 15). The fair value of these options was computed using the Black-Scholes option-pricing model and revalued in accordance with Emerging Issues Task Force No. 96-18, “Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.”

Shares Reserved.  The Company has reserved shares of common stock for future issuance as follows:

	September 30,
	2007
Stock options and awards outstanding		1,529,778
Stock options and awards, available for grant		1,739,630
Shares for employee stock purchase plan		829,915
Exchange shares for previous acquisitions		32,699
Total		4,132,022

NOTE 11 — STOCK-BASED COMPENSATION PLANS AND OTHER EMPLOYEE BENEFITS

Effective October 1, 2005, Photon Dynamics adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004) “Share-Based Payments” (“SFAS No. 123R”). SFAS No. 123R establishes accounting for stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured on the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period. Prior to October 1, 2005, the Company accounted for its stock-based awards under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and related Interpretations as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“SFAS No. 123”).

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

The effect of recording stock-based compensation for fiscal years ended September 30, 2007 and 2006 is as follows:

	Year Ended September 30,
	2007			2006
				As restated
	(In thousands)
Stock-based compensation expense included in continuing operations:
Cost of revenue	$	318		$	401
Research and development		400			676
Selling, general and administrative		1,255			2,908
Total stock-based compensation expense after income taxes(1)	$	1,973		$	3,985
Stock-based compensation expense by type of award:
Employee stock options	$	1,318		$	3,630
Employee stock purchase plan		498			470
Restricted stock awards		215			—
Amounts capitalized as inventory and deferred gross margin		(58	)		(115	)
Total stock-based compensation expense after income taxes(1)	$	1,973		$	3,985

(1) The income tax benefit on stock-based compensation for all periods presented was not material.

Prior to the adoption of SFAS No. 123R, the Company provided disclosures required under SFAS No. 123, as amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosures.” No employee stock-based compensation was reflected in net income for fiscal year 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.

The pro forma information under SFAS No. 123 for the years ended September 30, 2005 is as follows:

	Year Ended
	September 30, 2005
	As restated
	(In thousands,
	except per share data)
Net loss — as reported	$	(20,873	)
Less: total stock-based employee compensation expense determined under fair value based method for all awards		(9,534	)
Net loss — pro forma	$	(30,407	)
Basic net loss per share — as reported	$	(1.24	)
Diluted net loss per share — as reported	$	(1.24	)
Basic net loss per share — pro forma	$	(1.80	)
Diluted net loss per share — pro forma	$	(1.80	)

On September 1, 2005, the Company’s Board of Directors approved the accelerated and full vesting of all unvested outstanding stock options to purchase shares of common stock of Photon Dynamics, Inc. that were held by current employees, including executive officers, but excluding non-employee members of the Company’s Board of Directors, that had an exercise price greater than $25.00 issued under the Company’s Amended and Restated 1995

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Stock Option Plan and 2001 Equity Incentive Plan. Options to purchase 340,718 shares were subject to this acceleration, which was effective as of September 1, 2005. The decision to accelerate the vesting of these options was made primarily to reduce future financial impact to the Company’s results of operations, since after analysis it was determined that the retention value of the underwater options was relatively small compared to the income charge to continue vesting these options following the adoption of SFAS No. 123R by the Company on October 1, 2005.

Under the accounting guidance of APB 25, the accelerated vesting did not result in any compensation to be recognized in the Company’s Consolidated Statement of Operations as these unvested stock options had no intrinsic value. The effect of the vesting acceleration was the recognition of incremental additional stock-based employee compensation of approximately $3.6 million in the quarter ended September 30, 2005, which is reflected in the Company’s fiscal 2005 pro-forma disclosure, above. This stock-based employee compensation expense amount would otherwise in part have been recognized in the Company’s consolidated statement of operations in future periods after the adoption of SFAS 123R in the first quarter of fiscal 2006.

Equity Incentive and Other Programs

The Company’s equity incentive program is a long-term retention program that is intended to attract and retain qualified management and technical employees and align stockholder and employee interests. At September 30, 2007, the equity incentive program consisted of:

The 2005 Equity Incentive Plan.  Under this plan, officers, key employees, consultants and all other employees may be granted restricted stock units, options to purchase shares of the Company’s stock, and other types of equity awards. This plan permits the grant of equity awards for up to 2,250,000 shares of common stock. Under this plan, stock options generally have a vesting period of 50 to 60 months, are generally exercisable for a period of seven to ten years from the date of issuance and are granted at prices not less than the fair market value of the Company’s common stock at the grant date. Certain option awards provide for accelerated vesting if there is a change of control. Restricted stock units may be granted under the Equity Incentive Plan with varying criteria such as time-based or performance-based vesting. Under the 2005 Equity Incentive Plan, restricted stock units generally vest annually over a three- to four-year period from the date of grant. Restricted stock units issued in the Company’s one-time stock option exchange program vest over a two- to three-year period from the date of exchange.

2006 Non-Employee Directors’ Stock Incentive Plan.  Under this plan, non-employee directors may be granted restricted stock units, options to purchase shares of the Company’s stock, and other types of equity awards. This plan permits the grant of equity awards for up to 600,000 shares of common stock. Under this plan, stock options generally have a vesting period of 12 to 48 months, are generally exercisable for a period of ten years from the date of issuance and are granted at prices not less than the fair market value of the Company’s common stock at the grant date. Restricted stock units may be granted under this plan with varying criteria such as time-based vesting. Under this plan, restricted stock units generally vest annually over a three- to four-year period from the date of grant.

Prior to vesting, restricted stock units under both plans do not have dividend equivalent rights, do not have voting rights, and the shares underlying the restricted stock units are not considered issued and outstanding. Shares are issued on the date the restricted stock units vest. The majority of shares issued are net of statutory withholding requirements that are paid by Photon Dynamics on behalf of its directors and employees. As a result, the actual number of shares issued will be less than the number of restricted stock units granted. Furthermore, the liability for most of the withholding amounts to be paid by Photon Dynamics will be recorded as a reduction in Common Stock when the restricted stock units vest.

In addition to its equity incentive programs, the Company’s employee stock purchase plan provides that eligible employees may contribute up to 10% of their eligible earnings through accumulated payroll deductions

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

toward the semi-annual purchase of the Company’s common stock. Participants purchase shares on the last day of each offering period. The price at which shares are purchased is equal to 85% of the lower of the fair market value of a share of common stock on the first day of the offering period or the purchase date. Offering periods are typically six months in length.

Valuation and Other Assumption

The fair value of each option award is estimated on the date of grant using the Black-Scholes valuation model using a multiple options approach, consistent with the provisions of SFAS No. 123R and SEC SAB No. 107. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. The Black-Scholes valuation model requires the input of the following assumptions:

Expected Volatility.  The Company estimates the volatility of its stock options at the date of grant using implied volatilities from traded options on the Company’s stock. The Company believes that the use of implied volatility is more reflective of market conditions and a better indicator of expected volatility than the use of historical volatility.

Expected Term.  The expected term of options granted is derived from a numerical model of the Company’s stock price and represents the period of time that options granted are expected to be outstanding. The Company uses historical data to estimate option exercise and employee termination within the valuation model.

Risk-Free Interest Rate.  The risk-free rate is based on a risk-free zero-coupon spot interest rate at the time of grant with remaining terms equivalent to the expected term of the option grants.

Expected Dividends.  The Company has never declared or paid any cash dividends and does not presently plan to pay cash dividends in the foreseeable future. Consequently, the Company uses an expected dividend yield of zero in the Black-Scholes valuation model.

Forfeitures.  The Company uses historical data and future expectations of employee turnover to estimate pre-vesting forfeitures. As required by SFAS No. 123R, the Company records stock-based compensation expense only for those awards that are expected to vest. In the three months ended December 31, 2006, the Company adjusted its estimated forfeiture rate in order to better reflect the actual number of instruments for which the requisite service will be rendered. As required by SFAS No. 123R, the Company calculated a cumulative adjustment to compensation cost for the effect on current and prior periods of this change in estimate. This adjustment, consisting of approximately $300,000 reduction of compensation expense, was recorded in the three months ended December 31, 2006.

The fair value of each option award in the fiscal years ended September 30, 2007, 2006 and 2005 used the following weighted-average valuation assumptions:

	Fiscal			Fiscal			Fiscal
	2007			2006			2005
Stock option plan:
Expected stock price volatility		43	%		44	%		69	%
Risk free interest rate		4.7	%		4.5	%		3.4	%
Expected life of options (years)		3.4			3.7			5.3
Expected dividends		None			None			None

The fair value of the Company’s employee stock purchase plan is estimated on the first day of the offering period using the Black-Scholes valuation model, consistent with the provisions of SFAS No. 123R, SEC SAB No. 107, and FASB Technical Bulletin No. 97-1, “Accounting under Statement 123 for Certain Employee Stock Purchase Plans with a Look-Back Option.” The Company determined the fair value of the stock purchased

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

under its stock purchase plan in the fiscal years ended September 30, 2007, 2006 and 2005 using the following weighted-average valuation assumptions:

	Fiscal			Fiscal			Fiscal
	2007			2006			2005
Stock purchase plan:
Expected stock price volatility		43	%		44	%		80	%
Risk free interest rate		4.6	%		4.6	%		1.7	%
Expected life of options (years)		0.5			0.5			1.6
Expected dividends		None			None			None

SFAS No. 123R requires the use of option pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived exchange traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the option’s expected life and the price volatility of the underlying stock.

Compensation expense on restricted stock units is determined using the fair value of Photon Dynamics’ common stock on the date of the grant. The resulting compensation expense is recognized over the related service period.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Equity Incentive Plan

The following table summarizes the combined activity under the equity incentive plans for the indicated periods:

									Weighted-
									Average
	Awards						Weighted-		Remaining
	Available			Options			Average		Contract		Aggregate
	for Grant			Outstanding			Exercise Price		Term (in years)		Intrinsic Value
											(In thousands)
Balances at September 30, 2004		859,004			1,632,209		$	27.73
Additional shares reserved		1,200,000			—			—
Options granted		(797,800	)		797,800			19.37
Options canceled/expired		402,104			(399,144	)		28.89
Options exercised		—			(84,591	)		13.59
Balances at September 30, 2005		1,663,308			1,946,274		$	24.64
Plan shares expired(1)		(789,818	)		—			—
Options granted		(472,950	)		472,950			18.37
Options canceled/expired		397,796			(397,796	)		25.36
Options exercised		—			(70,733	)		15.06
Balances at September 30, 2006		798,336			1,950,695		$	23.28
Additional shares reserved		1,000,000			—			—
Plan shares expired(1)		(474,204	)		—			—
Options granted		(454,375	)		454,375			11.42
Restricted stock units granted(2)		(304,338	)		—
Restricted stock units canceled(2)		20,142			—
Options canceled/expired		1,154,069			(1,154,069	)		23.01
Options exercised		—			(5,419	)		4.91
Balances at September 30, 2007		1,739,630			1,245,582		$	19.29		5.6	$	103
Vested and expected to vest at September 30, 2007					1,052,907		$	20.51		5.5	$	103
Exercisable at September 30, 2007					779,927		$	23.21		5.0	$	103

(1)	The Company’s 1995 Amended and Restated Stock Option Plan expired in November 2005. Option shares that were available for grant at the time of cancellation and all outstanding option shares that subsequently are cancelled or expire are no longer available for grant.
(2)	Any restricted stock units granted under the 2005 Equity Incentive Plan or 2006 Non-Employee Directors’ Stock Incentive Plan shall be counted against the total number of shares issuable under the Plans. Additional detail of restricted stock units outstanding are shown below.

The aggregate intrinsic value in the table above represents the total pretax intrinsic value, based on the Company’s closing stock price of $9.05 as of September 28, 2007, which would have been received by the option holders had all option holders with in-the-money options exercised their options as of that date.

The weighted average grant date fair value of options granted during fiscal 2007, 2006 and 2005 was $4.04, $6.94 and $12.39 per share, respectively. The total intrinsic value of options exercised during the fiscal year ended September 30, 2007 was approximately $37,000. The total cash received from employees as a result of stock option

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

exercises during fiscal 2007, 2006 and 2005 was approximately $27,000, $1.1 million and $1.1 million, respectively. In connection with these exercises, the tax benefits realized by the Company was minimal.

The Company settles employee stock option exercises with newly issued common shares.

As of September 30, 2007, the unrecorded deferred stock-based compensation balance related to stock options was $1.2 million and will be recognized over an estimated remaining weighted average amortization period of 1.8 years.

Restricted Stock Units

The Company began granting restricted stock units in fiscal 2007. The following table summarizes the restricted stock unit activity for the indicated period:

				Weighted-Average
	Number			Grant Date
	of Shares			Fair Value
Unvested restricted stock units at September 30, 2006		—		$	—
Granted		304,338		$	10.43
Vested		—		$	—
Forfeited		(20,142	)	$	10.43
Unvested restricted stock units at September 30, 2007		284,196		$	10.43

As of September 30, 2007, there was approximately $1.2 million of unrecognized stock-based compensation related to restricted stock units granted under the Company’s equity incentive plans. The unrecognized stock-based compensation is expected to be recognized over an estimated remaining weighted average amortization period of 1.4 years.

The Company’s shareholder-approved one-time exchange of options for a lesser number of restricted stock units occurred on May 15, 2007. This exchange qualified as a modification of the terms of the cancelled options under the provisions of SFAS No. 123R. Therefore, the total compensation cost of the newly-issued restricted stock units was measured at the date of cancellation and replacement and consisted of approximately $1.2 million of the grant-date fair value of the original options for which the requisite service was expected to be rendered at that date plus approximately $900,000 of incremental cost resulting from the cancellation and replacement. The incremental compensation cost was measured as the excess of the fair value of the restricted stock units over the fair value of the cancelled options at the cancellation date.

Employee Stock Purchase Plan

The compensation cost in connection with the employee stock purchase plan in the fiscal years ended September 30, 2007 and 2006 was approximately $498,000 and $470,000, respectively. The weighted-average fair value of shares issued in fiscal 2007 and 2006 was $3.60 and $5.27, respectively. As the employee stock purchase plan was non-compensatory under APB 25, no compensation expense was recorded in connection with the plan in the fiscal year ended September 30, 2005. In fiscal 2007, 2006 and 2005, employees purchased 124,776, 45,309 and 47,188 shares, respectively. Total cash received from employees for the issuance of shares under the employee stock purchase plan was approximately $1,338,000, $722,000 and $646,000 during fiscal 2007, 2006 and 2005, respectively.

The Plan shares are replenished through shareholder approval at the Annual Shareholder meeting. At September 30, 2007, a total of 829,915 shares were reserved and available for issuance under this Plan.

Other Employee Benefit Plans

Retirement Savings Plan.  The Company has a retirement savings plan that qualifies as a deferred salary arrangement under Section 401(k) of the Internal Revenue Code. In fiscal 2007, 2006 and 2005, the Company matched

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

50% on the first 7% up to $3,500 per year of an eligible employee’s contribution. The total charge to operations under the 401(k) program was approximately $463,000, $506,000 and $469,000 in fiscal 2007, 2006 and 2005, respectively.

NOTE 12 — NET INCOME (LOSS) PER SHARE

Basic earnings (loss) per share is computed by dividing income (loss) available to common shareholders by the weighted-average number of shares of common stock outstanding during the period. Diluted earnings (loss) per share is computed by dividing income (loss) available to common shareholders by the weighted-average number of shares of common stock outstanding during the period increased, in periods of net income, to include the number of additional shares of common stock that would have been outstanding if the dilutive potential shares of common stock had been issued. The dilutive effect of outstanding options and restricted stock units is reflected in diluted earnings per share by application of the treasury stock method, which includes consideration of stock-based compensation required by SFAS No. 123R and Statement of Financial Accounting Standards No. 128, “Earnings per Share.”

The following table sets forth the computation of basic and diluted net income (loss) per share:

	Year Ended September 30,
	2007			2006			2005
				As			As
				restated			restated
	(In thousands, except per share data)
Numerator:
Net income (loss) from continuing operations before discontinued operations	$	(35,072	)	$	2,168		$	(21,129	)
Net income (loss) from discontinued operations		—			(127	)		256
Net income (loss)	$	(35,072	)	$	2,041		$	(20,873	)
Denominator:
Weighted average shares for basic net income (loss) per share		16,814			16,978			16,890
Effect of dilutive securities: Employee stock options		—	(1)		33			—	(1)
Weighted average shares for diluted net income (loss) per share		16,814			17,011			16,890
Earnings per share:
Basic net income (loss) per share:
Net income (loss) from continuing operations	$	(2.09	)	$	0.13		$	(1.25	)
Net income (loss) from discontinued operations		—			(0.01	)		0.02
Net income (loss) per share	$	(2.09	)	$	0.12		$	(1.24	)
Diluted net income (loss) per share:
Net income (loss) from continuing operations	$	(2.09	)	$	0.13		$	(1.25	)
Net income (loss) from discontinued operations		—			(0.01	)(2)		0.02
Net income (loss) per share	$	(2.09	)	$	0.12		$	(1.24	)

(1) The effect of potentially dilutive securities from employee stock options and restricted stock units to purchase 299,792 and 124,060 shares at September 30, 2007 and 2005, respectively, were not included in the computation of diluted net loss per share as the effect is antidilutive.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

(2) In accordance with Statement of Accounting Standards No. 128 “Earnings Per Share,” the Company included the effect of dilutive securities from employee stock options to purchase 33,000 shares in its calculation of fiscal 2006 diluted net loss from discontinued operations.

The number of options set forth in the following table are not included in the computation of diluted earnings per share because the exercise price, including unamortized stock-based compensation net of tax benefits, was greater than the average market price of common shares. As a result, their effect would have been anti-dilutive.

	Year Ended September 30,
	2007		2006		2005
	(In thousands)
Number of shares		1,714		1,949		1,203

NOTE 13 — COMMITMENTS AND CONTINGENCIES

Operating and Capital Leases

The Company has non-cancelable operating leases for various facilities in the United States, South Korea, Taiwan, Japan, China and Canada. Total rent expense under all operating leases was approximately $2.7 million, $2.6 million and $2.9 million for the fiscal years ended September 30, 2007, 2006 and 2005, respectively. Certain of these leases contain provisions which permit the Company to renew the leases at the end of their respective lease terms. Rent expense was net of sublease income of approximately $357,000, $356,000 and $186,000 for the fiscal years ended September 30, 2007, 2006 and 2005, respectively.

Future minimum lease commitments under operating leases at September 30, 2007, are approximately $3.4 million, $2.9 million, $2.8 million, $723,000, and $1,000 in fiscal 2008 through 2012, respectively. Operating lease obligations consist primarily of the Company’s lease agreement for its headquarters in San Jose, California, which is leased under a non-cancelable operating lease that expires in 2010, with two renewal options at fair market value for additional five year periods.

At September 30, 2007 and 2006, the Company had equipment with a net book value of approximately $240,000 and $195,000 under capital leases, respectively. Total expense under these capital leases was approximately $95,000 and $17,000 for the fiscal years ended September 30, 2007 and 2006, respectively. Future minimum lease commitments under capital leases at September 30, 2007, are approximately $115,000 and $39,000 in fiscal 2008 and 2009, respectively.

Line of Credit

In March 2000, the Company entered into a bank line of credit (“line of credit”) which had an initial term of one year. The Company had renegotiated the line of credit on an annual basis and had a $4.0 million borrowing capacity on the line of credit with an interest rate of floating prime. In October, 2007, this line of credit expired and was not renewed. The line of credit was secured by substantially all of the Company’s assets and contained certain financial and other covenants. At September 30, 2007 and 2006, there were no amounts outstanding under the line of credit.

Purchase Agreements

The Company maintains certain open inventory purchase commitments with its suppliers to ensure a smooth and continuous supply chain for key components. The Company’s liability in these purchase commitments is generally restricted to a forecasted time horizon as mutually agreed upon between the parties. The Company’s open purchase commitments were $28.0 million as of September 30, 2007, including cancelable purchase commitments.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Retention Bonus

The Company entered into an agreement with certain key employees of Summit Imaging, Inc. in 2003 whereby the Company paid incentive bonuses to retain the identified employees. The key employees included David W. Gardner, who was the owner of Summit Imaging, Inc. and subsequently was rehired as an officer of the Company as a result of the acquisition of Salvador Imaging in July 2007. The Summit Imaging retention agreement provided for a total bonus payment of $1.5 million, which was to be paid in four annual installments beginning on April 1, 2004. In August of 2005, the Company entered into separation agreements with these employees. The agreement contained contingent provisions for the original bonus to be paid. As of September 30, 2006 and 2005, the Company had accrued approximately $188,000 and $375,000, respectively, through charges to earnings which is included in “Other current liabilities” in the consolidated financial statements. At September 30, 2007, all amounts had been paid out.

Warranty Obligations

The Company generally offers warranty coverage for a period of 12 months from final acceptance or 14 months from shipment, whichever is shorter. Upon product shipment, the Company records the estimated cost of warranty coverage, primarily material and labor to repair and service the equipment. Factors that affect the Company’s warranty liability include the number of installed units under warranty, product failure rates, material usage rates and the efficiency by which the product failure is corrected. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amount as necessary.

Changes in the Company’s product liability during fiscal 2007 and 2006 were as follows:

	Fiscal			Fiscal
	2007			2006
	(In thousands)
Beginning balance	$	8,058		$	5,346
Estimated warranty cost of new shipments during the period		4,528			5,903
Warranty charges during the period		(10,143	)		(5,112	)
Changes in liability for pre-existing warranties, including expirations		774			1,921
Ending balance	$	3,217		$	8,058

The fiscal 2006 ending balance includes amounts related to the Company’s agreement with one customer to replace two ArrayChecker^tm systems. In the fourth quarter of fiscal 2006, the Company agreed to replace two of the four original Generation 7 test systems sold to a customer with a newer version of our Generation 7 test systems. Even though all four original Generation 7 systems had been used by the customer in full production, reliability and uptime issues impacted the production capability of the fabrication lines in which they operated. The replacement systems cost of approximately $3.0 million was accrued as warranty expense in the quarter ended September 30, 2006. Approximately $2.7 million of warranty liability associated with this exchange was satisfied during fiscal 2007 when the machines were replaced.

Guarantees

Subject to certain limitations, Photon Dynamics indemnifies its current and former officers and directors for certain events or occurrences. Although the maximum potential amount of future payments the Company could be required to make under these agreements is theoretically unlimited, based on prior experience, we believe the fair value of this liability is de minimums and no liability has been recorded.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Legal Proceedings

The Company and certain of its directors and former officers were named as defendants in a lawsuit captioned Amtower v. Photon Dynamics, Inc., No. CV797876, filed on April 30, 2001 in the Superior Court of the State of California, County of Santa Clara. The trial of this case commenced on April 3, 2006. On a motion for non-suit, the court dismissed all claims against all directors on April 20, 2006. On May 5, 2006, as a result of jury verdict, judgments were entered in favor of the Company and its former officers. The plaintiff, a former officer of the Company, had asserted several causes of action arising out of alleged misrepresentations made to the plaintiff regarding the existence and enforcement of the Company’s insider trading policy. The plaintiff had sought damages in excess of $6 million for defendants’ alleged refusal to allow plaintiff to sell shares of the Company’s stock in May of 2000, plus unspecified emotional distress and punitive damages. The plaintiff has the right to appeal the judgments. On June 30, 2006, the plaintiff filed a timely notice of appeal. On July 28, 2006, the Court awarded the Company approximately $445,000 in fees and costs. The award bears interest at the statutory rate of 10% simple interest per annum. Collection of the award was stayed during the plaintiff’s appeal of the verdict. On January 16, 2008, the Sixth District Court of Appeals for the State of California upheld the trial court’s judgment and award.

As of December 31, 2007, the Company has paid approximately $6.3 million, net of VAT amounts refund, to foreign customs authorities in connection with its settlements regarding underpayment of customs duties for warranty parts and expects to pay $1.3 million more to settle all known amounts with foreign customs authorities. The Company has not received waivers from any governmental agency and cannot guarantee that additional payment obligations will not arise related to these prior activities. The ultimate resolution of this matter or other matters could entail further expense in the form of duties, interest and penalties under applicable laws. For example, the Company has commenced voluntary discussions with U.S. government agencies, including Customs, the Census Bureau and the Bureau of Industry and Security, regarding certain filing obligations that were not complied with in connection with its exports. Although the products in question were not restricted under export control laws and no fees were associated with these filings, the voluntary disclosure of the Company’s failure to comply with U.S. filing obligations may subject the Company to penalties and result in additional expenses. The Company is unable to estimate the extent of such possible penalties and expenses.

From time to time, Photon Dynamics is involved in claims and legal and administrative proceedings that arise in the ordinary course of business. Based on currently available information, management does not believe that the ultimate outcome of these unresolved matters, individually and in the aggregate, is likely to have a material adverse effect on the Company’s financial position or results of operations. However, litigation and administrative proceedings are subject to inherent uncertainties and the Company’s view of these matters may change in the future. Were an unfavorable outcome to occur, there exists the possibility of a material adverse impact on Photon Dynamic’s financial position and results of operations for the period in which the unfavorable outcome occurs, and potentially in future periods.

NOTE 14 — SEGMENT REPORTING AND GEOGRAPHIC INFORMATION

Statement of Accounting Financial Standards No. 131, “Disclosures About Segments of an Enterprise and Related Information,” establishes standards for reporting information about operating segments. Operating segments are defined as components of an enterprise about which separate financial information is available that is evaluated regularly by the chief operating decision maker, or decision making group, in deciding how to allocate resources and in assessing performance of the company. The Company’s chief operating decision maker is considered to be the Company’s Chief Executive Officer (“CEO”).

Prior to 2007, the Company operated in one segment, Flat Panel Display. A second operating segment, High-Performance Digital Imaging, was created in July, 2007 when the Company purchased Salvador Imaging (see Note 5). The CEO reviews information pertaining to reportable segments to the operating income level. There are no significant inter-segment sales or transfers. For the year ended September 30, 2007, more than 99% of the Company’s total revenues were generated by the Flat Panel Display segment.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

In fiscal 2007, 2006 and 2005, the Company sold its products for the flat panel display industry directly to customers in South Korea, Taiwan, Japan and China. For geographical reporting, revenue is attributed to the geographic location to which the product was shipped. Long-lived assets consist primarily of property, plant and equipment, goodwill, and intangible assets, and are attributed to the geographic location in which they are located.

The following is a summary of revenue by geographic area based on location where the product was shipped:

	Year Ended September 30,
	2007		2006		2005
	(In thousands)
Revenue:
South Korea	$	26,197	$	113,288	$	41,474
Taiwan		23,332		41,108		53,159
Japan		18,681		7,665		17,044
China		4,655		10,811		14,136
United States		1,402		—		—
Total	$	74,267	$	172,872	$	125,813

The following is a summary of revenue by product line:

	Year Ended September 30,
	2007			2006			2005
	(Percent of total revenue)
Revenue:
ArrayCheckertm		57	%		66	%		60	%
ArraySavertm		15			19			24
PanelMastertm		1			6			6
Customer spares and other		27			9			10
Total		100	%		100	%		100	%

Sales to individual unaffiliated customers in excess of 10% of total revenue were as follows:

	Year Ended September 30,
	2007			2006			2005
	(Percent of total revenue)
Customer A		24	%		*			12	%
Customer B		20	%		39	%		22	%
Customer C		17	%		12	%		*
Customer D		16	%		25	%		10	%
Customer E		*			*			12	%
Customer F		*			*			11	%

* Customer accounted for less than 10% of total revenue for the period.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Accounts receivable from individual unaffiliated customers in excess of 10% of total gross accounts receivable were as follows:

	September 30,
	2007			2006
	(Percent of total receivable)
Customer A		28	%		16	%
Customer B		26	%		16	%
Customer C		19	%		37	%
Customer D		*			21	%

* Customer accounted for less than 10% of total gross accounts receivable for the period.

Long-lived assets by geographical area were as follows:

	September 30,
	2007		2006
	(In thousands)
United States	$	27,518	$	16,234
South Korea		756		1,229
Other		189		297
Total	$	28,463	$	17,760

NOTE 15 — RELATED PARTY TRANSACTIONS

In July 2007, in connection with the purchase of Salvador Imaging the Company issued a promissory note to a trust (see Note 16). The trustee, David W. Gardner, became an officer of the Company as a result of the acquisition.

During fiscal 2005, the Company paid $108,000 to one board member for consulting services rendered to the Company. During fiscal 2006 and 2005, the Company recorded approximately $14,000 and $52,000, respectively, in stock ownership expense related to options granted to this consultant.

In the third quarter of fiscal 2004, in connection with the acquisition of Quantum Composers, Inc., the Company issued a series of promissory notes (see Note 16). The owner of Quantum Composers became an employee of Photon Dynamics as a result of the purchase.

NOTE 16 — NOTES PAYABLE

In the fourth quarter of fiscal 2007, the Company issued $5.3 million in a promissory note in connection with the acquisition of Salvador Imaging. The note bears interest at 5%. At September 30, 2007 approximately $5.4 million was outstanding, which included approximately $47,000 in interest. Approximately $2.7 million in principle related to this note will be due in October 2008 and approximately $2.6 million in principle due in January 2010.

In the third quarter of fiscal 2004, the Company issued $2.0 million in a series of six promissory notes in connection with the acquisition of Quantum Composers, Inc. The notes were non-interest bearing and matured at various times through June 25, 2007. The initial discount on the notes of $127,000 was calculated based on an imputed interest rate of 6%. The outstanding balance on the promissory notes, net of unamortized discount, was approximately $977,000 at September 30, 2006 and the remaining amount was repaid in fiscal 2007.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

NOTE 17 — SUBSEQUENT EVENTS (UNAUDITED)

On December 1, 2007 the Company entered into an agreement with LT Solar LLC to acquire a 22.5% interest in technologies related to solar panel technology in exchange for a $2,000,000 funding commitment over 12 months. In addition, the Company also expects to spend approximately $1.0 million for capital expenditures on equipment for LT Solar LLC in fiscal 2008 as well as provide various resources, such as personnel and facilities, on a non-refundable basis to the new venture. In connection with the transaction, one of our executive officers, Wendell T. Blonigan, will have a significant portion of his performance bonus dependent on the success of this venture.

NOTE 18 — QUARTERLY CONSOLIDATED RESULTS OF OPERATIONS (UNAUDITED)

The following financial data present the impact of the restatement on Photon Dynamics, Inc.’s previously issued condensed consolidated quarterly information and includes:

•  The condensed consolidated quarterly statements of operations for each of the quarters ended March 31, 2007, December 30, 2006, September 30, 2006, June 30, 2006, March 31, 2006 and December 31, 2005,

•  The condensed consolidated balance sheets as of March 31, 2007, December 30, 2006, June 30, 2006, March 31, 2006 and December 31, 2005,

•  The condensed consolidated statements of cash flows for year-to-date periods in each of the quarters ended March 31, 2007, December 30, 2006, June 30, 2006, March 31, 2006 and December 31, 2005.

Financial data for the quarter ended June 30, 2007 is also shown, but has not been previously reported and therefore is not restated; however, it is included for comparative purposes. In addition the condensed consolidated quarterly statements of operations for the quarter ended September 30, 2007 is included for comparative purposes.

Refer to Note 2, “Restatements of Consolidated Financial Statements and Company Findings” of “Notes to Consolidated Financial Statements” for a description of the nature of the adjustments.

The Company believes all adjustments necessary for a fair presentation of the results for the periods presented have been made.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Statements of Operations (unaudited)

	Three Months Ended						Three Months Ended
	December 31, 2006						December 31, 2005
	As Previously			As			As Previously			As
	Reported			Restated			Reported			Restated
	(In thousands, except per share data)
Revenue	$	21,435		$	21,435		$	41,633		$	41,633
Cost of revenue		15,871			15,950			22,382			22,671
Gross margin		5,564			5,485			19,251			18,962
Operating expenses:
Research and development		7,995			7,936			8,071			8,249
Selling, general and administrative		4,930			4,882			6,851			6,834
Restructuring charge		446			446			62			62
Amortization of intangible assets		373			373			372			372
Total operating expenses		13,744			13,637			15,356			15,517
Income (loss) from operations		(8,180	)		(8,152	)		3,895			3,445
Interest income and other, net		1,081			1,014			500			420
Income (loss) from continuing operations before income taxes and discontinued operations		(7,099	)		(7,138	)		4,395			3,865
Provision for income taxes		101			101			352			352
Income (loss) from continuing operations before discontinued operations		(7,200	)		(7,239	)		4,043			3,513
Loss from discontinued operations		—			—			(680	)		(680	)
Net income (loss)	$	(7,200	)	$	(7,239	)	$	3,363		$	2,833
Net income (loss) per share from continuing operations:
Basic	$	(0.43	)	$	(0.44	)	$	0.24		$	0.21
Diluted	$	(0.43	)	$	(0.44	)	$	0.24		$	0.21
Net loss per share from discontinued operations:
Basic	$	—		$	—		$	(0.04	)	$	(0.04	)
Diluted	$	—		$	—		$	(0.04	)	$	(0.04	)
Net income (loss) per share:
Basic	$	(0.43	)	$	(0.44	)	$	0.20		$	0.17
Diluted	$	(0.43	)	$	(0.44	)	$	0.20		$	0.17
Weighted average number of shares:
Basic		16,590			16,590			16,946			16,946
Diluted		16,590			16,590			17,047			17,047

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Statements of Operations (unaudited)

	Three Months Ended						Six Months Ended
	March 31, 2007						March 31, 2007
	As Previously			As			As Previously			As
	Reported			Restated			Reported			Restated
	(In thousands, except per share data)
Revenue	$	13,928		$	13,928		$	35,363		$	35,363
Cost of revenue		13,391			13,604			29,262			29,554
Gross margin		537			324			6,101			5,809
Operating expenses:
Research and development		7,197			7,194			15,192			15,130
Selling, general and administrative		6,550			6,484			11,480			11,366
Restructuring charge		1,017			1,017			1,463			1,463
Impairment of property and equipment		2,834			2,834			2,834			2,834
Amortization of intangible assets		372			372			745			745
Total operating expenses		17,970			17,901			31,714			31,538
Loss from operations		(17,433	)		(17,577	)		(25,613	)		(25,729	)
Interest income and other, net		2,015			1,996			3,096			3,010
Loss from continuing operations before income taxes and discontinued operations		(15,418	)		(15,581	)		(22,517	)		(22,719	)
Provision for income taxes		105			105			206			206
Loss from continuing operations before discontinued operations		(15,523	)		(15,686	)		(22,723	)		(22,925	)
Income (loss) from discontinued operations		—			—			—			—
Net loss	$	(15,523	)	$	(15,686	)	$	(22,723	)	$	(22,925	)
Net loss per share from continuing operations:
Basic	$	(0.94	)	$	(0.95	)	$	(1.37	)	$	(1.38	)
Diluted	$	(0.94	)	$	(0.95	)	$	(1.37	)	$	(1.38	)
Net income (loss) per share from discontinued operations:
Basic	$	—		$	—		$	—		$	—
Diluted	$	—		$	—		$	—		$	—
Net loss per share:
Basic	$	(0.94	)	$	(0.95	)	$	(1.37	)	$	(1.38	)
Diluted	$	(0.94	)	$	(0.95	)	$	(1.37	)	$	(1.38	)
Weighted average number of shares:
Basic		16,591			16,591			16,590			16,590
Diluted		16,591			16,591			16,590			16,590

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Statements of Operations (unaudited)

	Three Months Ended						Six Months Ended
	March 31, 2006						March 31, 2006
	As Previously			As			As Previously			As
	Reported			Restated			Reported			Restated
	(In thousands, except per share data)
Revenue	$	50,322		$	50,322		$	91,955		$	91,955
Cost of revenue		33,069			33,381			55,451			56,052
Gross margin		17,253			16,941			36,504			35,903
Operating expenses:
Research and development		8,560			8,556			16,631			16,805
Selling, general and administrative		6,984			6,959			13,835			13,793
Restructuring charge (benefit)		(32	)		(32	)		30			30
Amortization of intangible assets		373			373			745			745
Total operating expenses		15,885			15,856			31,241			31,373
Income from operations		1,368			1,085			5,263			4,530
Interest income and other, net		1,019			808			1,519			1,228
Income from continuing operations before income taxes and discontinued operations		2,387			1,893			6,782			5,758
Provision for income taxes		199			199			551			551
Income from continuing operations before discontinued operations		2,188			1,694			6,231			5,207
Income (loss) from discontinued operations		334			334			(346	)		(346	)
Net income	$	2,522		$	2,028		$	5,885		$	4,861
Net income per share from continuing operations:
Basic	$	0.13		$	0.10		$	0.37		$	(0.31	)
Diluted	$	0.13		$	0.10		$	0.37		$	(0.31	)
Net income (loss) per share from discontinued operations:
Basic	$	0.02		$	0.02		$	(0.02	)	$	(0.02	)
Diluted	$	0.02		$	0.02		$	(0.02	)	$	(0.02	)
Net income per share:
Basic	$	0.15		$	0.12		$	0.35		$	(0.29	)
Diluted	$	0.15		$	0.12		$	0.34		$	(0.28	)
Weighted average number of shares:
Basic		17,018			17,018			17,011			17,011
Diluted		17,077			17,077			17,062			17,062

120

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Statements of Operations (unaudited)

	Three			Nine
	Months			Months
	Ended			Ended
	June 30,			June 30,
	2007			2007
	(In thousands, except per share data)
Revenue	$	14,430		$	49,793
Cost of revenue		11,215			40,769
Gross margin		3,215			9,024
Operating expenses:
Research and development		6,213			21,343
Selling, general and administrative		5,831			17,197
Restructuring charge		(95	)		1,368
Impairment of property and equipment		—			2,834
Amortization of intangible assets		254			999
Total operating expenses		12,203			43,741
Loss from operations		(8,988	)		(34,717	)
Interest income and other, net		327			3,337
Loss from continuing operations before income taxes and discontinued operations		(8,661	)		(31,380	)
Provision for income taxes		72			278
Loss from continuing operations before discontinued operations		(8,733	)		(31,658	)
Income (loss) from discontinued operations		—			—
Net loss	$	(8,733	)	$	(31,658	)
Net loss per share from continuing operations:
Basic	$	(0.52	)	$	(1.91	)
Diluted	$	(0.52	)	$	(1.91	)
Net income (loss) per share from discontinued operations:
Basic	$	—		$	—
Diluted	$	—		$	—
Net loss per share:
Basic	$	(0.52	)	$	(1.91	)
Diluted	$	(0.52	)	$	(1.91	)
Weighted average number of shares:
Basic		16,635			16,605
Diluted		16,635			16,605

121

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Statements of Operations (unaudited)

	Three Months Ended
	June 30, 2006						Nine Months Ended
	As						June 30, 2006
	Previously			As			As Previously			As
	Reported			Restated			Reported			Restated
	(In thousands, except per share data)
Revenue	$	51,658		$	51,658		$	143,613		$	143,613
Cost of revenue		32,178			32,573			87,629			88,625
Gross margin		19,480			19,085			55,984			54,988
Operating expenses:
Research and development		8,508			8,492			25,139			25,297
Selling, general and administrative		6,968			6,929			20,803			20,722
Restructuring charge		—			—			30			30
Impairment of property and equipment		50			50			50			50
Amortization of intangible assets		372			372			1,117			1,117
Total operating expenses		15,898			15,843			47,139			47,216
Income from operations		3,582			3,242			8,845			7,772
Interest income and other, net		999			859			2,518			2,087
Income from continuing operations before income taxes and discontinued operations		4,581			4,101			11,363			9,859
Provision for income taxes		205			205			756			756
Income from continuing operations before discontinued operations		4,376			3,896			10,607			9,103
Loss from discontinued operations		(127	)		(127	)		(473	)		(473	)
Net income	$	4,249		$	3,769		$	10,134		$	8,630
Net income per share from continuing operations:
Basic	$	0.26		$	0.23		$	0.62		$	0.53
Diluted	$	0.26		$	0.23		$	0.62		$	0.53
Net loss per share from discontinued operations:
Basic	$	(0.01	)	$	(0.01	)	$	(0.03	)	$	(0.03	)
Diluted	$	(0.01	)	$	(0.01	)	$	(0.03	)	$	(0.03	)
Net income per share:
Basic	$	0.25		$	0.22		$	0.60		$	0.51
Diluted	$	0.25		$	0.22		$	0.59		$	0.51
Weighted average number of shares:
Basic		17,047			17,047			17,023			17,023
Diluted		17,077			17,077			17,065			17,065

122

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Statements of Operations (unaudited)

	Three Months			Three Months Ended
	Ended			September 30, 2006
	September 30,			As Previously			As
	2007			Reported			Restated
	(In thousands, except per share data)
Revenue	$	24,474		$	29,259		$	29,259
Cost of revenue		15,605			25,142			25,580
Gross margin		8,869			4,117			3,679
Operating expenses:
Research and development		5,404			7,281			7,280
Selling, general and administrative		5,879			3,808			3,784
Impairment of property and equipment		—			31			31
Loss on sale of fixed assets		87			58			58
Acquired in-process research and development		1,110			—			—
Amortization of intangible assets		654			372			372
Total operating expenses		13,134			11,550			11,525
Loss from operations		(4,265	)		(7,433	)		(7,846	)
Interest income and other, net		853			838			717
Loss from continuing operations before income taxes and discontinued operations		(3,412	)		(6,595	)		(7,129	)
Provision (benefit) for income taxes		3			(195	)		(195	)
Loss from continuing operations before discontinued operations		(3,415	)		(6,400	)		(6,934	)
Income from discontinued operations		—			346			346
Net loss	$	(3,415	)	$	(6,054	)	$	(6,588	)
Net loss per share from continuing operations:
Basic	$	(0.20	)	$	(0.38	)	$	(0.41	)
Diluted	$	(0.20	)	$	(0.38	)	$	(0.41	)
Net income per share from discontinued operations:
Basic	$	—		$	0.02		$	0.02
Diluted	$	—		$	0.02		$	0.02
Net loss per share:
Basic	$	(0.20	)	$	(0.36	)	$	(0.39	)
Diluted	$	(0.20	)	$	(0.36	)	$	(0.39	)
Weighted average number of shares:
Basic		17,434			16,849			16,849
Diluted		17,434			16,849			16,849

123

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Balance Sheets (unaudited)

	December 31, 2005						March 31, 2006						June 30, 2006
	As Previously			As			As Previously			As			As Previously			As
	Reported			Restated			Reported			Restated			Reported			Restated
	(In thousands, except per share data)
ASSETS
Current assets:
Cash and cash equivalents	$	20,376		$	20,376		$	19,600		$	19,600		$	22,483		$	22,483
Short-term investments		72,347			72,347			68,713			68,713			68,147			68,147
Accounts receivable, net		28,361			28,361			38,523			38,523			57,253			57,253
Inventories		31,392			31,392			31,183			31,183			19,754			19,754
Refundable customs obligations		—			2,033			—			2,403			—			2,753
Other current assets		3,252			3,252			4,390			4,390			4,379			4,379
Total current assets		155,728			157,761			162,409			164,812			172,016			174,769
Land, property and equipment, net		18,116			18,116			17,805			17,805			16,867			16,867
Other assets		5,172			5,172			3,632			3,632			4,197			4,197
Intangible assets, net		2,833			2,833			2,460			2,460			2,088			2,088
Goodwill		153			153			153			153			153			153
Total assets	$	182,002		$	184,035		$	186,459		$	188,862		$	195,321		$	198,074
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	9,413		$	9,173		$	13,169		$	12,921		$	10,337		$	9,977
Warranty		3,898			3,898			4,784			4,784			5,367			5,367
Customs obligations		—			5,810			—			6,707			—			7,671
Other current liabilities		14,093			14,093			11,194			11,194			13,126			13,126
Deferred gross margin		6,251			6,251			5,393			5,393			10,016			10,016
Total current liabilities		33,655			39,225			34,540			40,999			38,846			46,157
Other non-current liabilities		973			973			982			982			19			19
Commitments and contingencies
Shareholders’ equity:
Common stock		289,153			289,129			290,300			290,251			291,554			291,483
Accumulated deficit		(142,126	)		(145,639	)		(139,604	)		(143,611	)		(135,355	)		(139,842	)
Accumulated other comprehensive income		347			347			241			241			257			257
Total shareholders’ equity		147,374			143,837			150,937			146,881			156,456			151,898
Total liabilities and shareholders’ equity	$	182,002		$	184,035		$	186,459		$	188,862		$	195,321		$	198,074

124

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Balance Sheets (unaudited)

	December 31, 2006						March 31, 2007
	As Previously			As			As Previously			As
	Reported			Restated			Reported			Restated			June 30, 2007
	(In thousands, except per share data)
ASSETS
Current assets:
Cash and cash equivalents	$	19,085		$	19,085		$	25,253		$	25,253			$	28,253
Short-term investments		78,009			78,009			56,815			56,815				55,909
Accounts receivable, net		18,055			18,055			14,255			14,255				18,927
Inventories		24,938			24,938			26,187			26,187				18,097
Refundable customs obligations		—			3,551			—			3,808				4,082
Other current assets		3,902			3,902			3,432			3,432				3,518
Total current assets		143,989			147,540			125,942			129,750				128,786
Long-term investments		—			—			8,389			8,389				4,147
Land, property and equipment, net		15,054			15,054			11,200			11,200				10,210
Other assets		6,063			5,381			5,489			4,793				4,826
Intangible assets, net		1,343			1,343			971			971				717
Goodwill		153			153			153			153				153
Total assets	$	166,602		$	169,471		$	152,144		$	155,256			$	148,839
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	7,199		$	6,638		$	7,217		$	6,572			$	7,033
Warranty		7,858			7,858			7,418			7,418				4,691
Customs obligations		—			9,663			—			10,306				11,144
Other current liabilities		10,276			9,245			11,807			10,687				9,679
Deferred gross margin		2,841			2,841			2,985			2,985				6,603
Total current liabilities		28,174			36,245			29,427			37,968				39,150
Other non-current liabilities		118			118			107			107				95
Commitments and contingencies
Shareholders’ equity:
Common stock		286,681			286,539			287,433			287,228				288,376
Accumulated deficit		(148,609	)		(153,670	)		(164,132	)		(169,356	)			(178,088	)
Accumulated other comprehensive income		238			238			(691	)		(691	)			(693	)
Total shareholders’ equity		138,310			133,107			122,610			117,181				109,595
Total liabilities and shareholders’ equity	$	166,602		$	169,471		$	152,144		$	155,256			$	148,839

125

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Statements of Cash Flows (unaudited)

	Fiscal 2007
	Three Months Ended						Six Months Ended
	December 31, 2006						March 31, 2007						Nine Months
	As Previously			As			As Previously			As			Ended
	Reported			Restated			Reported			Restated			June 30, 2007
	(In thousands)
Cash flows from operating activities:
Net loss from continuing operations	$	(7,200	)	$	(7,239	)	$	(22,723	)	$	(22,925	)		$	(31,658	)
Adjustments to reconcile net loss from continuing operations to net cash used in operating activities from continuing operations:
Depreciation		1,217			1,217			2,541			2,541				3,653
Amortization of intangible assets		373			373			745			745				999
Stock-based compensation		400			352			1,117			1,006				1,513
Foreign currency translation adjustment gain recognized upon liquidation of a subsidiary		—			—			(928	)		(928	)			(928	)
Impairment of property and equipment		—			—			2,834			2,834				2,834
Restructuring charge		273			273			273			273				178
Accretion of non-interest bearing notes payable		8			8			15			15				23
Changes in assets and liabilities:
Accounts receivable		11,286			11,286			15,086			15,086				10,414
Inventories		(6,435	)		(6,435	)		(7,663	)		(7,663	)			428
Other current assets		132			(261	)		540			(111	)			(471	)
Other assets		(1,521	)		(839	)		(947	)		(251	)			(284	)
Accounts payable		(458	)		(619	)		(440	)		(685	)			(224	)
Other current liabilities		139			98			1,249			1,762				(1,022	)
Deferred gross margin		(4,613	)		(4,613	)		(4,469	)		(4,469	)			(851	)
Other liabilities		(1	)		(1	)		(12	)		(12	)			(24	)
Net cash used in operating activities from continuing operations		(6,400	)		(6,400	)		(12,782	)		(12,782	)			(15,419	)
Net cash used in operating activities from discontinued operations		(56	)		(56	)		—			—				—
Net cash used in operating activities		(6,456	)		(6,456	)		(12,782	)		(12,782	)			(15,419	)
Cash flows from investing activities:
Purchase of property and equipment		(687	)		(687	)		(923	)		(923	)			(1,040	)
Purchase of short-term investments		(41,795	)		(41,795	)		(63,815	)		(63,815	)			(82,711	)
Maturities and sales of short-term investments		19,373			19,373			54,228			54,228				78,264
Net cash used in investing activities from continuing operations		(23,109	)		(23,109	)		(10,510	)		(10,510	)			(5,487	)
Cash flows from financing activities:
Issuance of common stock, net		710			710			724			724				1,364
Capital lease repayments		(21	)		(21	)		(41	)		(41	)			(68	)
Net cash provided by financing activities from continuing operations		689			689			683			683				1,296
Effect of exchange rate changes on cash and cash equivalents		26			26			(73	)		(73	)			(72	)
Net decrease in cash and cash equivalents from continuing operations		(28,794	)		(28,794	)		(22,682	)		(22,682	)			(19,682	)
Net decrease in cash and cash equivalents from discontinued operations		(56	)		(56	)		—			—				—
Net decrease in cash and cash equivalents		(28,850	)		(28,850	)		(22,682	)		(22,682	)			(19,682	)
Cash and cash equivalents at beginning of year		47,935			47,935			47,935			47,935				47,935
Cash and cash equivalents at end of period	$	19,085		$	19,085		$	25,253		$	25,253			$	28,253

126

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Condensed Consolidated Statements of Cash Flows (unaudited)

	Fiscal 2006
	Three Months Ended						Six Months Ended						Nine Months Ended
	December 31, 2005						March 31, 2006						June 30, 2006
	As						As						As
	Previously			As			Previously			As			Previously			As
	Reported			Restated			Reported			Restated			Reported			Restated
	(In thousands)
Cash flows from operating activities:
Net income from continuing operations	$	4,043		$	3,513		$	6,231		$	5,207		$	10,607		$	9,103
Adjustments to reconcile net income from continuing operations to net cash used in operating activities from continuing operations:
Depreciation		1,439			1,439			2,959			2,959			4,326			4,326
Amortization of intangible assets		372			372			745			745			1,117			1,117
Stock-based compensation		985			961			2,003			1,954			2,954			2,883
Impairment of property and equipment		—			—			—			—			50			50
Non-employee stock ownership expense		6			6			14			14			14			14
Restructuring charge		—			—			—			—			30			30
Loss on sale of property and equipment		6			6			—			—			—			—
Accretion of non-interest bearing notes payable		9			9			22			22			31			31
Changes in assets and liabilities:
Accounts receivable		(1,294	)		(1,294	)		(11,456	)		(11,456	)		(30,185	)		(30,185	)
Inventories		1,188			1,188			1,521			1,521			13,084			13,084
Other current assets		505			270			(634	)		(1,239	)		(622	)		(1,577	)
Other assets		(541	)		(541	)		48			48			(319	)		(319	)
Accounts payable		(3,513	)		(3,586	)		243			162			(2,589	)		(2,782	)
Other current liabilities		3,611			4,473			1,789			3,548			4,109			6,832
Deferred gross margin		(6,862	)		(6,862	)		(7,720	)		(7,720	)		(3,097	)		(3,097	)
Other liabilities		(40	)		(40	)		(30	)		(30	)		(40	)		(40	)
Net cash used in operating activities from continuing operations		(86	)		(86	)		(4,265	)		(4,265	)		(531	)		(531	)
Net cash used in operating activities from discontinued operations		(413	)		(413	)		(580	)		(580	)		(1,169	)		(1,169	)
Net cash used in operating activities		(499	)		(499	)		(4,845	)		(4,845	)		(1,700	)		(1,700	)
Cash flows from investing activities:
Purchase of property and equipment		(195	)		(195	)		(1,408	)		(1,408	)		(1,887	)		(1,887	)
Purchase of short-term investments		(16,323	)		(16,323	)		(43,175	)		(43,175	)		(100,288	)		(100,288	)
Maturities and sales of short-term investments		16,788			16,788			47,383			47,383			105,103			105,103
Net cash provided by investing activities from continuing operations		270			270			2,800			2,800			2,928			2,928
Cash flows from financing activities:
Issuance of common stock, net		362			362			1,617			1,617			1,785			1,785
Repayment of short-term notes		—			—			—			—			(533	)		(533	)
Net cash provided by financing activities from continuing operations		362			362			1,617			1,617			1,252			1,252
Effect of exchange rate changes on cash and cash equivalents		(45	)		(45	)		(260	)		(260	)		(285	)		(285	)
Net increase (decrease) in cash and cash equivalents from continuing operations		501			501			(108	)		(108	)		3,364			3,364
Net decrease in cash and cash equivalents from discontinued operations		(413	)		(413	)		(580	)		(580	)		(1,169	)		(1,169	)
Net increase (decrease) in cash and cash equivalents		88			88			(688	)		(688	)		2,195			2,195
Cash and cash equivalents at beginning of year		20,288			20,288			20,288			20,288			20,288			20,288
Cash and cash equivalents at end of period	$	20,376		$	20,376		$	19,600		$	19,600		$	22,483		$	22,483

127

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Supplemental Information (unaudited)

Adjustments

The following tables summarize the adjustments to Costs of revenues, Research and development, Selling, general and administrative, Interest income and other, net, and Net income (loss). Refer to Note 2, “Restatements of Consolidated Financial Statements and Company Findings” of “Notes to Consolidated Financial Statements” in the accompanying consolidated financial statements for a description of the adjustments.

	Fiscal 2007
	Three Months			Three Months
	Ended			Ended
	December 31, 2006			March 31, 2007
	(In thousands)
Cost of revenues:
As previously reported	$	15,871		$	13,391
Adjustments:
Customs and duties		181			291
Other accounting errors		(102	)		(78	)
As restated	$	15,950		$	13,604
Research and development:
As previously reported	$	7,995		$	7,197
Adjustments:
Customs and duties		—			—
Other accounting errors		(59	)		(3	)
As restated	$	7,936		$	7,194
Selling, general and administrative:
As previously reported	$	4,930		$	6,550
Adjustments:
Customs and duties		—			—
Other accounting errors		(48	)		(66	)
As restated	$	4,882		$	6,484
Interest income and other, net:
As previously reported	$	1,081		$	2,015
Adjustments:
Customs and duties		(67	)		19
Other accounting errors		—			—
As restated	$	1,014		$	1,996
Net income (loss):
As previously reported	$	(7,200	)	$	(15,523	)
Adjustments:
Customs and duties		(248	)		(310	)
Other accounting errors		209			147
As restated	$	(7,239	)	$	(15,686	)

128

PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Fiscal 2007
	Six Months
	Ended
	March 31, 2007
	(In thousands)
Cost of revenues:
As previously reported	$	29,262
Adjustments:
Customs and duties		472
Other accounting errors		(180	)
As restated	$	29,554
Research and development:
As previously reported	$	15,192
Adjustments:
Customs and duties		—
Other accounting errors		(62	)
As restated	$	15,130
Selling, general and administrative:
As previously reported	$	11,480
Adjustments:
Customs and duties		—
Other accounting errors		(114	)
As restated	$	11,366
Interest income and other, net:
As previously reported	$	3,096
Adjustments:
Customs and duties		(86	)
Other accounting errors		—
As restated	$	3,010
Net income (loss):
As previously reported	$	(22,723	)
Adjustments:
Customs and duties		(557	)
Other accounting errors		355
As restated	$	(22,925	)

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Fiscal 2006
	Three Months			Three Months			Three Months			Three Months
	Ended			Ended			Ended			Ended
	December 31,			March 31,			June 30,			September 30,
	2005			2006			2006			2006
	(In thousands)
Cost of revenues:
As previously reported	$	22,382		$	33,069		$	32,178		$	25,142
Adjustments:
Customs and duties		358			316			474			476
Other accounting errors		(69	)		(4	)		(79	)		(38	)
As restated	$	22,671		$	33,381		$	32,573		$	25,580
Research and development:
As previously reported	$	8,071		$	8,560		$	8,508		$	7,281
Adjustments:
Customs and duties		—			—			—			—
Other accounting errors		178			(4	)		(16	)		(1	)
As restated	$	8,249		$	8,556		$	8,492		$	7,280
Selling, general and administrative:
As previously reported	$	6,851		$	6,984		$	6,968		$	3,808
Adjustments:
Customs and duties		—			—			—			—
Other accounting errors		(17	)		(25	)		(39	)		(24	)
As restated	$	6,834		$	6,959		$	6,929		$	3,784
Interest income and other, net:
As previously reported	$	500		$	1,019		$	999		$	838
Adjustments:
Customs and duties		(80	)		(211	)		(140	)		(121	)
Other accounting errors		—			—			—			—
As restated	$	420		$	808		$	859		$	717
Net income (loss):
As previously reported	$	3,363		$	2,522		$	4,249		$	(6,054	)
Adjustments:
Customs and duties		(438	)		(527	)		(614	)		(597	)
Other accounting errors		(92	)		33			134			63
As restated	$	2,833		$	2,028		$	3,769		$	(6,588	)

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PHOTON DYNAMICS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	Fiscal 2006
	Six Months			Nine Months			Twelve Months
	Ended			Ended			Ended
	March 31,			June 30,			September 30,
	2006			2006			2006
	(In thousands)
Cost of revenues:
As previously reported	$	55,451		$	87,629		$	112,771
Adjustments:
Customs and duties		674			1,148			1,624
Other accounting errors		(73	)		(152	)		(190	)
As restated	$	56,052		$	88,625		$	114,205
Research and development:
As previously reported	$	16,631		$	25,139		$	32,420
Adjustments:
Customs and duties		—			—			—
Other accounting errors		174			158			157
As restated	$	16,805		$	25,297		$	32,577
Selling, general and administrative:
As previously reported	$	13,835		$	20,803		$	24,611
Adjustments:
Customs and duties		—			—			—
Other accounting errors		(42	)		(81	)		(105	)
As restated	$	13,793		$	20,722		$	24,506
Interest income and other, net:
As previously reported	$	1,519		$	2,518		$	3,356
Adjustments:
Customs and duties		(291	)		(431	)		(553	)
Other accounting errors		—			—			—
As restated	$	1,228		$	2,087		$	2,803
Net income (loss):
As previously reported	$	5,885		$	10,134		$	4,080
Adjustments:
Customs and duties		(965	)		(1,579	)		(2,176	)
Other accounting errors		(59	)		75			138
As restated	$	4,861		$	8,630		$	2,042

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ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

There were no changes in or disagreements with Ernst & Young LLP on accounting and financial disclosure required to be reported under this Item 9.

ITEM 9A.   CONTROLS AND PROCEDURES

Restatement of Previously Issued Financial Statements

In the first quarter of fiscal 2007, our management voluntarily began a review of the Company’s practices with respect to the payment of customs duties for warranty parts in response to concerns raised by our chief financial officer and general counsel. Management, in consultation with our Audit Committee, determined in January 2007 that the Company had maintained incorrect classification and valuation practices with respect to the import of warranty parts into our South Korea, Japan, Taiwan and China field service locations, resulting in the underpayment of customs duties. At that time we estimated that the range of our liability was between approximately $1.0 million and $2.0 million. Because there was no basis to conclude that any amount within this range provided a better estimate than any other amount, we recorded a liability of approximately $1.0 million, which included underpaid duties, penalties and interest. We evaluated the impact and timing of the liability and concluded that the potential adjustment did not have a material effect on the financial statements for fiscal years ended September 30, 2002 through 2006. Accordingly, we recorded the estimated liability in the quarter ended December 31, 2006. Approximately $350,000 of the $1.0 million was recorded to our statement of operations, with the majority of this amount recorded to cost of sales, while approximately $680,000 was capitalized into warranty and spares inventory held at our foreign locations at December 31, 2006.

As the review continued into the third quarter of fiscal 2007, we commenced a process of voluntarily disclosing our historical valuation practices to customs authorities in South Korea, Japan, Taiwan and China with the goal of reaching settlements for past due duty amounts plus interest and penalties if applicable. In July 2007, we negotiated a settlement with the Korean Customs Service in South Korea for our South Korean field service location. This location accounted for the majority of total warranty parts exported by the Company over the five-year period under audit and the settlement represented the majority of total liability to be recorded. Based upon this settlement and assessing the status of our discussions in the other jurisdictions, we revised our estimated liability, including associated costs, from the approximately $1.0 million recorded at December 31, 2006 to a range of approximately $7.0 million to $8.0 million at June 30, 2007. We have continued to work with the remaining customs agencies and reached settlements in September and October of 2007 in South Korea, Taiwan, and China and are in the process of reaching settlement in Japan. As a result, we determined the customs duty and nonrefundable VAT and interest liability, including the effect of historical foreign exchange rates, to be approximately $7.6 million as of September 30, 2007. We currently estimate our total costs, including duties, penalties and interest but also legal, accounting and other costs associated with the restatement, to be in the range of $11.0 million to $12.0 million.

In light of the revised estimate as of June 30, 2007, our management and Audit Committee determined on July 16, 2007 that it was appropriate to restate: (i) our consolidated financial statements for the years ended September 30, 2004, 2005 and 2006 as contained in our Form 10-K for the year ended September 30, 2006; (ii) the unaudited quarterly financial data for the first two quarters in the fiscal year ended September 30, 2007; and (iii) the unaudited quarterly financial data for all quarters in the fiscal year ended September 30, 2006 (as more fully described in Note 2, Restatement of Financial Statements, included in this Form 10-K). In reaching this conclusion and in connection with the restatement process, our management and Audit Committee has also determined that our disclosure controls and procedures and our internal control over financial reporting were not effective as of September 30, 2007, as more fully described in this section under “Evaluation of Disclosure Controls and Procedures” and “Management’s Report on Internal Control Over Financial Reporting.”

Evaluation of Disclosure Controls and Procedures

Photon Dynamics maintains disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) that are designed to ensure that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed,

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summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Based on our management’s evaluation (with the participation of our chief executive officer and chief financial officer), our chief executive officer and chief financial officer have concluded that, as of September 30, 2007, in light of the material weaknesses described below, our disclosure controls and procedures were not effective to provide reasonable assurance that the information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.

Notwithstanding the material weaknesses, the restated annual and interim financial statements fairly present, in all material respects, the financial condition, results of operations and cash flows of the Company as of and for the periods presented in accordance with generally accepted accounting principles.

Management’s Report on Internal Control Over Financial Reporting

Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rules 13a-15(f) and 15d-15(f) under the Securities and Exchange Act of 1934. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States.

Internal control over the financial reporting includes those policies and procedures that: (i) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) 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.

A material weakness is a deficiency, or combination of deficiencies, in internal controls over financial reporting such that there is a reasonable probability that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis. Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of the design and operational effectiveness of our internal control over financial reporting as of September 30, 2007, the end of the fiscal year covered by this report, based on the framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control — Integrated Framework. Based on this evaluation, management concluded that as of September 30, 2007, there were control deficiencies that constituted material weaknesses, as described below. Our evaluation of and conclusion on the design and operational effectiveness of internal control over financial reporting did not include the internal controls of Salvador Imaging, which is included in our 2007 consolidated financial statements and constituted $617,000 and $179,000 of total and net assets, respectively, as of September 30, 2007 and $504,000 and $526,000 of revenues and net loss, respectively, for the year then ended.

Description of Material Weaknesses as of September 30, 2007

Management identified the following material weaknesses in internal control over financial reporting as of September 30, 2007:

•  The absence of adequate processes for detecting noncompliance with applicable laws and regulations and our employee code of conduct, evaluating the effect of such noncompliance on our financial statements on a

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timely and accurate basis, and communicating such noncompliance and related evaluation to our Audit Committee;

•  The absence of adequate processes and programs in our control environment to educate employees on our employee code of conduct and applicable laws and regulations; and

•  Insufficient accounting and finance personnel with the knowledge and experience required to ensure an appropriate level of review of financial statement accounts.

The above weaknesses resulted in the restatement of the Company’s previously issued financial statements as presented in this Annual Report on Form 10-K and adjustments to our fiscal 2007 financial statements.

As a result of the identified material weaknesses, our management concluded that, as of September 30, 2007, our internal control over financial reporting was not effective. The effectiveness of our internal control over financial reporting as of September 30, 2007 was audited by Ernst & Young LLP, our independent registered public accounting firm as stated in their report, which report is included in Item 8 of this Annual Report on Form 10-K.

Remediation of Material Weaknesses

Beginning the second quarter of fiscal 2007, we have undertaken the following actions in an effort to remediate the first and second material weaknesses described above:

•  Review and evaluation of our internal controls, including our internal reporting processes, to ensure that legal, regulatory and other matters that could have a significant financial statement effect are identified and evaluated and documented by management and escalated on a timely basis, where appropriate, to the Audit Committee.

•  Development, with the assistance of outside advisors, of new valuation and declaration processes to ensure compliance with all customs regulations of each of the countries into which we import parts, including replacing manual invoices with an automated customs commercial invoice process that requires review by legal and finance personnel.

•  Enhanced compliance and ethics training for employees, including implementation of an online compliance system in four languages, increasing awareness of the employee code of conduct through mandatory training for all employees, and reinforcing the ethics policy by requiring an annual ethics certification for all employees; and

•  With respect to personnel who were determined to have known, or who should have known, that the Company’s customs practices were non-compliant, certain of such personnel have been terminated or have otherwise left the Company, and others, including a former executive officer, have had their responsibilities and reporting relationships modified.

With respect to the third material weakness described above, we have initiated a search for qualified candidates for those positions identified as being advisable additions to the finance and accounting staff of the Company. In the interim, certain key positions are being performed by temporary employees and contractors until qualified candidates are found and commence employment with us. We are actively engaged in a search for a new chief financial officer with the goal of filling the position as soon as practicable. We are also working to fill other finance positions as soon as practicable.

We currently are unable to determine when these material weaknesses will be fully remediated and can provide no assurances on the timing of new hires as part of our remediation efforts.

Inherent Limitations of Disclosure Controls and Procedures and Internal Control Over Financial Reporting.

Our management, including the chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and implemented, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the

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fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. The inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistakes. Control systems can also be circumvented by the individual acts of some persons, by collusion of two or more people or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the fourth quarter of fiscal 2007 that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

CEO and CFO Certifications

We have attached as exhibits to this Annual Report on Form 10-K the certifications of our Chief Executive Officer and Chief Financial Officer, which are required in accordance with the Exchange Act. We recommend that this Item 9A be read in conjunction with the certifications for a more complete understanding of the subject matter presented.

ITEM 9B.   OTHER INFORMATION

Not applicable.

PART III

Certain information required by Part III is omitted from this Annual Report on Form 10-K since we intend to file our definitive Proxy Statement for our 2008 Annual Meeting of Shareholders pursuant to Regulation 14A of the Exchange Act (the “Proxy Statement”) not later than 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K, and certain information to be included in the Proxy Statement is incorporated herein by reference.

ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

(1) The information required by this Item may be found in our Proxy Statement, to be filed in connection with our 2008 Annual Meeting of Shareholders. Such information is incorporated herein by reference.

Photon Dynamics, Inc. has adopted a Code of Business Conduct and Ethics that applies to all of its directors, officers and employees. The Code of Business Conduct and Ethics is posted on our website at: www.photondynamcis.com in the section entitled “Corporate Governance Management.” This website address is provided for reference only. Information contained on our website is not incorporated by reference in or made part of this Annual Report on Form 10-K or our other filings with or reports furnished to the SEC.

ITEM 11.   EXECUTIVE COMPENSATION

The information required by this Item may be found under the section entitled “Executive Compensation” appearing in our Proxy Statement, to be filed in connection with our 2008 Annual Meeting of Shareholders. Such information is incorporated herein by reference.

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ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

(1) The information required by this Item with respect to security ownership of certain beneficial owners and management may be found in the section entitled “Security Ownership of Certain Beneficial Owners and Management” appearing in our Proxy Statement, to be filed in connection with our 2008 Annual Meeting of Shareholders. Such information is incorporated herein by reference.

(2) The information required by this Item with respect to securities authorized for issuance under our equity compensation plans may be found in the section entitled “Equity Compensation Plan Information” appearing in our Proxy Statement, to be filed in connection with our 2008 Annual Meeting of Shareholders. Such information is incorporated herein by reference.

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item may be found in the section entitled “Certain Relationships and Related Transactions” appearing in our Proxy Statement, to be filed in connection with our 2008 Annual Meeting of Shareholders. Such information is incorporated herein by reference.

ITEM 14.   PRINCIPAL INDEPENDENT REGISTERED PUBLIC ACCOUNTANT FIRM FEES AND SERVICES

The information required by this Item may be found in the section entitled “Proposal 5 — Ratification of Selection of Independent Registered Public Accounting Firm” appearing in our Proxy Statement, to be filed in connection with our 2008 Annual Meeting of Shareholders. Such information is incorporated herein by reference.

PART IV

ITEM 15.   EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(a) 1. Financial Statements

See Index to Consolidated Financial Statements in Item 8 of this Annual Report on Form 10-K, which is incorporated herein by reference.

2. Financial Statement Schedules

The following financial statement schedule is filed as part of this annual report on Form 10-K. All other financial statement schedules have been omitted because they are either not applicable or the required information is shown in the consolidated financial statements or notes thereto.

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SCHEDULE II

PHOTON DYNAMICS, INC.

VALUATION AND QUALIFYING ACCOUNT

	Balance at		Charged to			Charged to					Balance at
	Beginning		(Credited to)			Other					End of
	of Period		Expense			Accounts		Deductions			Period
	(In thousands)
Allowance for doubtful accounts:
Fiscal 2007	$	406		233			—		(400	)	$	239
Fiscal 2006	$	153		270			—		(17	)	$	406
Fiscal 2005	$	497		(324	)		—		(20	)	$	153

3.   Exhibits

See the Exhibit Index which follows the signature page of this Annual Report on Form 10-K, which is incorporated herein by reference.

(b)   Exhibits

See Item 15(a) above.

(c)   Financial Statement Schedules

See Item 15(a) above.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) 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.

PHOTON DYNAMICS, INC.

By:  /s/  JEFFREY A. HAWTHORNE

Jeffrey A. Hawthorne

President and Chief Executive Officer

Dated: January 23, 2008

POWER OF ATTORNEY

KNOW ALL PERSONS BY THESE PRESENT, that each person whose signature appears below constitutes and appoints Jeffrey A. Hawthorne as his or her attorney-in-fact, each with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the SEC, granting unto said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith and about the premises, as fully to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent, or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

Signature	Title	Date
/s/  JEFFREY A. HAWTHORNE Jeffrey A. Hawthorne	President, Chief Executive Officer and Director (Principal Executive Officer)	January 23, 2008
/s/  MICHAEL SCHRADLE Michael Schradle	Chief Financial Officer (Principal Financial and Accounting Officer)	January 23, 2008
/s/  MALCOLM J. THOMPSON Malcolm J. Thompson	Chairman of the Board and Director	January 23, 2008
/s/  NICHOLAS BRATHWAITE Nicholas Brathwaite	Director	January 23, 2008
/s/  TERRY CARLITZ Terry Carlitz	Director	January 23, 2008
/s/  MICHAEL J. KIM Michael J. Kim	Director	January 23, 2008

138

Signature	Title	Date
/s/  EDWARD ROGAS JR. Edward Rogas Jr.	Director	January 23, 2008
/s/  CURT WOZNIAK Curt Wozniak	Director	January 23, 2008
/s/  DONALD C. FRASER Donald C. Fraser	Director	January 23, 2008

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EXHIBIT INDEX

Number	Exhibit
3.1(H)	Amended and Restated Articles of Incorporation of the Registrant.
3.2(C)	Bylaws of the Registrant and amendments thereto.
3.3(H)	Certificate of Amendment to Articles of Incorporation of the Registrant.
4.1	Reference is made to Exhibits 3.1, 3.2 and 3.3.
10.1(J)*	Form of Indemnification Agreement between the Registrant and each of its executive officers and directors.
10.3.1(B)	Lease Agreement between Berg & Berg Developers and the Registrant, dated August 6, 1996.
10.3.2(V)	Third Amendment to Lease Agreement between Mission West Properties L.P. II (fka Berg & Berg Developers) and the Registrant dated August 12, 2003.
10.9(P)*	Agreement Regarding Change of Control between the Registrant and Jeffrey Hawthorne dated December 13, 2005.
10.20.1(L)*	Amended and Restated 1995 Stock Option Plan, as amended.
10.20.2(P)	Form of Stock Option Agreement under 1995 Stock Option Plan, as amended.
10.22.1(M)*	2001 Equity Incentive Plan, as amended.
10.22.2(W)	Form of Stock Option Agreement under 2001 Equity Incentive Plan, as amended.
10.25.1(Q)	Lease Agreement between Bruce N. Huntley Contracting Limited and Image Processing Systems Inc. dated September 17, 1997.
10.25.2(Q)	Option to Renew Agreement between Bruce N. Huntley Contracting Limited and Photon Dynamics Canada Inc. dated May 24, 2002.
10.25.3(A)	Offer to Sublease, dated April 15, 2005 among Photon Dynamics Canada, Inc., Service Results Technology, and Huntley Contracting Limited.
10.29(R)*	Offer Letter between the Registrant and Richard Okumoto dated April 21, 2003.
10.30.1(V)*	Consulting Agreement between the Registrant and Malcolm Thompson dated July 28, 2003.
10.30.2(V)*	Amendment to Consulting Agreement between the Registrant and Malcolm Thompson dated September 1, 2003.
10.34(S)	Settlement and License Agreement, dated November 10, 2003, between Photon Dynamics, Inc., Shimadzu Corporation, Panelvision Technology, Inc. and Guillermo Toro-Lira.
10.35.1(T)*	Consulting Agreement, dated March 18, 2004, between the Registrant and Malcolm Thompson.
10.35.2(Y)*	Amendment to Consulting Agreement between the Registrant and Malcolm Thompson, dated December 22, 2004.
10.36(T)	Termination and Assignment Agreement, dated February 27, 2004, between Photon Dynamics, Inc. and Ishikawajima-Harima Heavy Industries Co. Ltd.
10.38.1(W)*	Offer Letter between the Registrant and Mark Merrill dated April 27, 2004.
10.38.2(X)*	Amendment to Employment Agreement, dated April 5, 2005, between Photon Dynamics, Inc. and Mark Merrill.
10.42(Z)	Letter Agreement between the Registrant and Malcolm Thompson, dated April 8, 2005.
10.44.1(G)	Photon Dynamics, Inc. 2005 Equity Incentive Plan, as amended.
10.44.2(G)	Form of Stock Option Agreement for use in the 2005 Equity Incentive Plan, as amended.
10.44.3(G)	Form of Restricted Stock Unit Agreement for use in the 2005 Equity Incentive Plan, as amended.
10.45(N)	Photon Dynamics, Inc. 2005 Employee Stock Purchase Plan.
10.46.1(N)	Photon Dynamics, Inc. 2005 Non-Employee Directors’ Stock Option Plan.
10.46.2(P)	Form of Stock Option Agreement for use in the 2005 Non-Employee Director’s Stock Option Plan.
10.47.1(U)	Photon Dynamics, Inc. 2006 Non-Employee Director’s Stock Incentive Plan.
10.47.2(U)	Form of Stock Option Agreement for use in the 2006 Non-Employee Director’s Stock Incentive Plan.

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Number	Exhibit
10.47.3(G)	Form of Restricted Stock Unit Agreement for use in the 2006 Non-Employee Director’s Stock Incentive Plan.
10.48(X)*	Offer letter, dated April 29, 2005, between Photon Dynamics, Inc. and Maureen Lamb.
10.49(A)*	Separation Agreement, dated May 5, 2005, between Photon Dynamics, Inc., and Richard Okumoto.
10.50(X)*	Amendment to Employment Agreement, dated April 5, 2005, between Photon Dynamics, Inc. and Steve Song.
10.53(D)*	Photon Dynamics, Inc. Fiscal 2006 Management Incentive Plan.
10.54(F)*	Compensation for Outside Directors, Effective May 24, 2006.
10.55(AA)	Agreement between the Company and Michael Schradle dated December 10, 2007
10.56	Agreement and Plan of Merger and Reorganization among Salvador Imaging, Inc., David Gardner, Salvador Foundation Charitable Remainder Unitrust, James R. Long, Patricia Long, Kerry Rhea, Lisa J. Rhea, Photon Dynamics, Inc., Salvador Acquisition, Inc., Salvador Acquisition, LLC and David Gardner, as Shareholders’ Representative, dated July 27, 2007.
21.1	Subsidiaries of the Registrant.
23.1	Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm.
24.1	Power of Attorney (included on the signature pages hereto).
31.1	Certification required by Rule 13a-14(a) or Rule 15d-14(a).
31.2	Certification required by Rule 13a-14(a) or Rule 15d-14(a).
32.1**	Certifications required by Rule 13a-14(b) or Rule 15d-14(b) and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350).

Key to Exhibits:

(A)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q for the quarter ended June 30, 2005 (Commission File No. 000-27234) as filed with SEC on August 9, 2005, and incorporated herein by reference.
(B)	Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-KSB for the fiscal year ended September 30, 1996 (Commission File No. 000-27234) as filed with the SEC on December 30, 1996, and incorporated herein by reference.
(C)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q for the quarter ended December 31, 2005 (Commission File No. 000-27234) as filed with SEC on February 9, 2006, and incorporated herein by reference.
(D)	Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K (Commission File No. 000-27234) as filed with SEC on January 24, 2006, and incorporated herein by reference.
(E)	Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K (Commission File No. 000-27234) as filed with the SEC on July 25, 2001, and incorporated herein by reference.
(F)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q for the quarter ended June 30, 2006 (Commission File No. 000-27234) as filed with SEC on August 9, 2006, and incorporated herein by reference.
(G)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q for the quarter ended December 31, 2006 (Commission File No. 000-27234) as filed with SEC on February 14, 2007, and incorporated herein by reference.
(H)	Previously filed as an exhibit to the Registrant’s Registration Statement on Form S-1 (Reg. No. 333-76650) as filed with the SEC on January 14, 2002, as amended, and incorporated by reference herein.
(I)	Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K (Commission File No. 000-27234) as filed with the SEC on January 7, 2002, and incorporated herein by reference. Confidential treatment has been granted for portions of this exhibit.
(J)	Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K (Commission File No. 000-27234) as filed with the SEC on December 20, 2004, and incorporated herein by reference.

141

(K)	Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K/A (Commission File No. 000-27234) as filed with the SEC on July 29, 2002, and incorporated herein by reference.
(L)	Previously filed as an exhibit to the Registrant’s Registration Statement on Form S-8 (Reg. No. 333-117021) as filed with the SEC on June 30, 2004, and incorporated herein by reference.
(M)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q (Commission File No. 000-27234) for the quarter ended March 31, 2003 as filed with the SEC on May 9, 2003, and incorporated herein by reference.
(N)	Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K (Commission File No. 000-27234) as filed with the SEC on March 9, 2005 and incorporated herein by reference.
(O)	Previously filed as an exhibit to the Registrant’s Registration Statement on Form S-3 (Reg. No. 333-49444) as filed with the SEC on November 7, 2000 and incorporated herein by reference.
(P)	Previously filed as an exhibit to the Registrant’s Registration Annual Report on Form 10-K for the fiscal year ended September 30, 2005 (Commission File No. 000-27234) as filed with the SEC on December 14, 2006, and incorporated herein by reference.
(Q)	Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the fiscal year ended September 30, 2002 (Commission File No. 000-27234) as filed with the SEC on December 11, 2002, and incorporated here by reference.
(R)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q for the quarter ended June 30, 2003 (Commission File No. 000-27234) as filed with SEC on August 14, 2003, and incorporated herein by reference.
(S)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q for the quarter ended December 31, 2003 (Commission File No. 000-27234) as filed with SEC on February 17, 2004, and incorporated herein by reference. Confidential treatment has been granted for portions of Exhibit 10.34.
(T)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q for the quarter ended March 31, 2004 (Commission File No. 000-27234) as filed with SEC on May 14, 2004, and incorporated herein by reference. Confidential treatment has been granted for portions of Exhibit 10.36.
(U)	Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K (Commission File No. 000-27234), filed with the SEC on January 31, 2007, and incorporated herein by reference.
(V)	Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the fiscal year ended September 30, 2003 (Commission File No. 000-27234) as filed with the SEC on December 24, 2003, and incorporated here by reference.
(W)	Previously filed as an exhibit to the Registrant’s Annual Report on Form 10-K for the fiscal year ended September 30, 2004 (Commission File No. 000-27234) as filed with the SEC on December 14, 2004, and incorporated here by reference.
(X)	Previously filed as an exhibit to the Registrant’s Current Report on Form 8-K (Commission File No. 000-27234), filed with the SEC on November 9, 2005, and incorporated herein by reference.
(Y)	Previously filed as an exhibit to the Registrant’s Quarterly Report Form on Form 10-Q for the quarter ended December 31, 2004 (Commission File No. 000-27234) as filed with SEC on February 9, 2005, and incorporated herein by reference.
(Z)	Previously filed as an exhibit to the Registrant’s Current Report on form 8-K (Commission File No. 000-27234) as filed with the SEC on April 11, 2005, and incorporated herein by reference.
(AA)	Previously filed as an exhibit to the Registrant’s Current Report on form 8-K (Commission File No. 000-27234) as filed with the SEC on December 11, 2007, and incorporated herein by reference.
*	Indicates a management contract or compensatory plan or arrangement.
**	The certification attached as Exhibit 32.1 accompanies the Annual Report on Form 10-K pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not be deemed “filed” by the Company for purposes of Section 18 of the Securities Exchange Act of 1934, as amended.

142

EX-10.56

Exhibit 10.56

EXECUTION VERSION

AGREEMENT AND PLAN OF MERGER AND REORGANIZATION

dated as of

July 27, 2007

among

SALVADOR IMAGING, INC.,

DAVID GARDNER,

SALVADOR FOUNDATION CHARITABLE REMAINDER UNITRUST,

JAMES R. LONG,

PATRICIA LONG,

KERRY RHEA,

LISA J. RHEA,

PHOTON DYNAMICS, INC.,

SALVADOR ACQUISITION, INC.,

SALVADOR ACQUISITION, LLC

and

DAVID GARDNER, as Shareholders’ Representative

TABLE OF CONTENTS

	Page
ARTICLE 1 Definitions
Section 1.01. Definitions		2
Section 1.02. Other Definitional and Interpretative Provisions		6
ARTICLE 2 The Merger
Section 2.01. The Mergers		7
Section 2.02. Merger Consideration		8
Section 2.03. Conversion of Shares		9
Section 2.04. Conversion of Shares in the Second Merger		9
Section 2.05. Surrender and Payment		10
Section 2.06. Fractional Shares		11
Section 2.07. Withholding Rights		11
Section 2.08. Lost Certificates		11
ARTICLE 3 Initial Surviving Corporation; The Surviving Entity
Section 3.01. Articles of Incorporation and Bylaws of the Initial Surviving Corporation		12
Section 3.02. Directors and Officers		12
Section 3.03. Certificate of Formation and Limited Liability Company		12
Section 3.04. Managers and Officers		12
ARTICLE 4 Representations and Warranties of the Company
Section 4.01. Corporate Existence and Power		13
Section 4.02. Corporate Authorization		13
Section 4.03. Capitalization		13
Section 4.04. Ownership of Shares; Stock Option Plan		14
Section 4.05. Subsidiaries		14
Section 4.06. Authorizations		14
Section 4.07. Governmental Authorization		14
Section 4.08. Non-contravention		15
Section 4.09. Financial Statements		15
Section 4.10. Absence of Certain Changes		15
Section 4.11. No Undisclosed Liabilities		17
Section 4.12. Agreements, Contracts and Commitments		17
Section 4.13. Validity of Contracts		19
Section 4.14. No Renegotiations		20

i

	Page
Section 4.15. Products and Services		20
Section 4.16. Intellectual Property		20
Section 4.17. Insurance Coverage		24
Section 4.18. Litigation		24
Section 4.19. Licenses and Permits		24
Section 4.20. Compliance with Laws and Court Orders		25
Section 4.21. Finders’ Fees		25
Section 4.22. Employee Benefit Plans		25
ARTICLE 5 Representations and Warranties of Sellers
Section 5.01. Private Placement Qualification		26
ARTICLE 6 Representations and Warranties of Parent
Section 6.01. Corporate Existence and Power		27
Section 6.02. Corporate Authorization		27
Section 6.03. Governmental Authorization		27
Section 6.04. Non-contravention		27
Section 6.05. SEC Filings		28
Section 6.06. Parent Common Stock		28
ARTICLE 7 Covenants
Section 7.01. Obligations of the Merger Subsidiaries		28
Section 7.02. Parent Financial Covenant		28
Section 7.03. Employee Benefits		28
Section 7.04. Further Assurances		29
ARTICLE 8 Tax Matters
Section 8.01. Tax Definitions		29
Section 8.02. Tax Representations		30
Section 8.03. Covenants		31
Section 8.04. Cooperation on Tax Matters		32
Section 8.05. Tax Indemnification		33
Section 8.06. Certain Disputes		34
Section 8.07. Purchase Price Adjustment		35
Section 8.08. Tax-Free Reorganization Treatment		35
Section 8.09. Survival		35

ii

	Page
ARTICLE 9 Survival of Representations and Warranties; Indemnification
Section 9.01. Survival of Representation and Warranties		35
Section 9.02. Indemnification		36
Section 9.03. Indemnification Notice		38
Section 9.04. Shareholders’ Representative		38
Section 9.05. No Claims for Disclosed Matters		40
ARTICLE 10 Miscellaneous
Section 10.01. Notices		40
Section 10.02. Amendments and Waivers		42
Section 10.03. Expenses		42
Section 10.04. Successors and Assigns		42
Section 10.05. Governing Law		42
Section 10.06. Jurisdiction		42
Section 10.07. WAIVER OF JURY TRIAL		43
Section 10.08. Counterparts; Effectiveness		43
Section 10.09. Entire Agreement		43
Section 10.10. Captions		43
Section 10.11. Severability		43
Section 10.12. Specific Performance		43

iii

INDEX TO ANNEXES

Annex I	Written Consent of the Shareholders
Annex II	Merger Consideration
Annex III	Registration Rights Agreement
Annex IV	David Gardner Employment Agreement
Annex V	James R. Long Employment Agreement
Annex VI	Kerry Rhea Employment Agreement
Annex VII	Gardner Non-competition Agreement
Annex VIII	Gardner Assignment Agreement
Annex IX	Promissory Note

iv

AGREEMENT AND PLAN OF MERGER AND REORGANIZATION

     AGREEMENT AND PLAN OF MERGER AND REORGANIZATION (this “Agreement”) dated as of July 27, 2007 among Salvador Imaging, Inc., a Colorado corporation (the “Company”), David Gardner, Salvador Foundation Charitable Remainder Unitrust (“Trust”), James R. Long, Patricia Long, Kerry Rhea, Lisa J. Rhea (together with Trust, David Gardner, James R. Long, Patricia Long and Kerry Rhea, the “Sellers”), Photon Dynamics, Inc., a California corporation (“Parent”), Salvador Acquisition, Inc., a Delaware corporation and a wholly-owned subsidiary of Parent (“Merger Subsidiary I”), Salvador Acquisition, LLC, a Delaware limited liability company and a wholly-owned subsidiary of Parent (“Merger Subsidiary II” and, together with Merger Subsidiary I, the “Merger Subsidiaries”), and David Gardner, as shareholders’ representative (“Shareholders’ Representative”).

     WHEREAS, upon the terms and subject to the conditions of this Agreement and in accordance with Colorado Law and Delaware Law, Parent, the Sellers and the Company will enter into a business combination transaction pursuant to which Merger Subsidiary I will merge with and into the Company (the “First Merger”), with the Initial Surviving Corporation (as defined herein) then merging with and into Merger Subsidiary II (the “Second Merger” and, together with the First Merger, the “Mergers”).

     WHEREAS, it is intended that the Mergers will together qualify for U.S. federal income tax purposes as a reorganization within the meaning of Section 368(a)(1)(A) of the U.S. Internal Revenue Code of 1986, as amended (the “Code”).

     WHEREAS, the Board of Directors of the Company (i) has determined that the Mergers are fair to, and in the best interests of, the Company and its shareholders and has approved and adopted this Agreement and the transactions contemplated by this Agreement and (ii) has recommended the approval and adoption of this Agreement by the shareholders of the Company in accordance with Colorado Law.

     WHEREAS, concurrently with the execution and delivery of this Agreement, the Company has obtained the irrevocable approval and adoption by the Sellers, which constitute all of the holders of the Company’s capital stock, of this Agreement and the Mergers contemplated hereby pursuant to a written consent in the form of Annex I hereto (the “Written Consent”) signed by each of the Sellers;

     WHEREAS, concurrently with the execution and delivery of this Agreement, and as a condition and inducement to Parent’s, Merger Subsidiary I’s and Merger Subsidiary II’s willingness to enter into this agreement, David Gardner, James R. Long and Kerry Rhea have entered into employment agreements in the forms attached hereto as Annexes IV, V and VI, respectively

(the “Key Employee Employment Agreements”), and David Gardner has entered into a non-competition agreement (the “Gardner Non-competition Agreement”) an agreement to assign his rights under that certain License Agreement among David Gardner, the Company and Salvador Systems LLC, a Delaware limited liability company and a wholly-owned subsidiary of Parent (the “Gardner Assignment Agreement”), in the forms attached hereto as Annexes VII and VIII, respectively; and

     WHEREAS, the Company and the Sellers, on the one hand, and Parent and the Merger Subsidiaries, on the other hand, desire to make certain representations, warranties, covenants and other agreements in connection with the Mergers.

     NOW, THEREFORE, in consideration of the foregoing and the mutual covenants and agreements herein contained, and intending to be legally bound hereby, Parent, the Sellers, the Merger Subsidiaries and the Company hereby agree as follows:

Article 1
Definitions

     Section 1.01. Definitions. (a) As used herein, the following terms have the following meanings:

     “Affiliate” means, with respect to any Person, any other Person directly or indirectly controlling, controlled by, or under common control with such Person.

     “Applicable Law” means, with respect to any Person, any federal, state or local law (statutory, common or otherwise), constitution, treaty, convention, ordinance, code, rule, regulation, order, injunction, judgment, decree, ruling or other similar requirement enacted, adopted, promulgated or applied by a Governmental Authority that is binding upon or applicable to such Person, as amended unless expressly specified otherwise.

     “Business Day” means a day, other than Saturday, Sunday or other day on which commercial banks in New York, New York are authorized or required by Applicable Law to close.

     “Colorado Law” means the Business Corporation Act and the Corporations and Associations Act of the State of Colorado.

     “Company Balance Sheet” means the internally prepared balance sheet of the Company as of June 30, 2007.

     “Company Balance Sheet Date” means June 30, 2007.

2

     “Company Stock” means the common stock of the Company.

     “Delaware Law” means the General Corporation Act of the State of Delaware and the LLC Act.

     “ERISA” means the Employee Retirement Income Security Act of 1974.

     “ERISA Affiliate” of any entity means any other entity that, together with such entity, would be treated as a single employer under Section 414 of the Code.

     “GAAP” means generally accepted accounting principles in the United States.

     “Governmental Authority” means any transnational, domestic or foreign federal, state or local, governmental authority, court or agency, including any political subdivision thereof.

     “Intellectual Property Rights” means (i) inventions, whether or not patentable, reduced to practice or made the subject of one or more pending patent applications, (ii) national and multinational statutory invention registrations, patents and patent applications (including all reissues, divisions, continuations, continuations-in-part, extensions and reexaminations thereof) registered or applied for in the United States and all other nations throughout the world, all improvements to the inventions disclosed in each such registration, patent or patent application, (iii) rights of publicity, (iv) trademarks, service marks, trade dress, logos, domain names, trade names and corporate names (whether or not registered) in the United States and all other nations throughout the world, including all variations, derivations, combinations, registrations and applications for registration of the foregoing and all goodwill associated therewith, (v) copyrights (whether or not registered) and registrations and applications for registration thereof in the United States and all other nations throughout the world, including all derivative works, moral rights, renewals, extensions, reversions or restorations associated with such copyrights, now or hereafter provided by law, regardless of the medium of fixation or means of expression, (vi) mask works, (vii) computer software (including source code, object code, firmware, operating systems and specifications), (viii) trade secrets and, whether or not confidential, business information (including pricing and cost information, business and marketing plans and customer and supplier lists) and know-how (including manufacturing and production processes and techniques and research and development information), (ix) industrial designs (whether or not registered), (x) databases and data collections, (xi) copies and tangible embodiments of any of the foregoing, in whatever form or medium, (xii) all rights to obtain and rights to apply for patents, and to register trademarks and copyrights, (xiii) all rights in all of the foregoing provided by treaties, conventions and common law and (xiv) all rights to sue or recover and retain damages and costs and attorneys’ fees for past, present and future infringement or misappropriation of any of the foregoing.

3

     “knowledge” in the case of the Company, means the knowledge of its officers and David Gardner as of the time of the execution of this Agreement and, in the case of Parent, means the knowledge of its “executive officers” within the meaning of the 1934 Act as of the time of execution of this Agreement.

     “Licensed Intellectual Property Rights” means all Intellectual Property Rights owned by a third party and licensed or sublicensed to the Company or for which the Company has obtained a covenant not to be sued.

     “Lien” means, with respect to any property or asset, any mortgage, lien, pledge, charge, security interest, encumbrance or other adverse claim of any kind in respect of such property or asset. For purposes of this Agreement, a Person shall be deemed to own subject to a Lien any property or asset that it has acquired or holds subject to the interest of a vendor or lessor under any conditional sale agreement, capital lease or other title retention agreement relating to such property or asset.

     “LLC Act” means the Delaware Limited Liability Company Act.

     “Material Adverse Effect” means, with respect to any Person, a material adverse effect on the condition (financial or otherwise), business, assets or results of operations or prospects of such Person and its Subsidiaries, taken as a whole.

     “1933 Act” means the Securities Act of 1933, as amended.

     “1934 Act” means the Securities Exchange Act of 1934, as amended.

     “Owned Intellectual Property Rights” means all Intellectual Property Rights owned by the Company.

     “Parent Disclosure Schedule” means the disclosure schedule dated the date hereof regarding this Agreement that has been provided by Parent to the Company.

     “Parent SEC Documents” means (i) the annual reports of Parent on Form 10-K for its fiscal year ended September 30, 2006, the quarterly reports of Parent on Form 10-Q for its fiscal quarters ended December 31, 2006 and March 31, 2007, (iii) its proxy or information statements relating to meetings of or actions taken without a meeting by Parent’s shareholders since September 30, 2006, and (iv) all of its other reports filed with the SEC since September 30, 2006.

     “Parent Stock” means the common stock of Parent.

     “Person” means an individual, corporation, partnership, limited liability company, association, trust or other entity or organization, including a government or political subdivision or an agency or instrumentality thereof.

4

     “SEC” means the Securities and Exchange Commission.

     “Shareholder” means a holder of Company Stock as of the date hereof.

     “Subsidiary” means, with respect to any Person, any entity of which securities or other ownership interests having ordinary voting power to elect a majority of the board of directors or other persons performing similar functions are at any time directly or indirectly owned by such Person.

     “Third Party” means any Person, including as defined in Section 13(d) of the 1934 Act, other than Parent or any of its Affiliates.

     (b) Each of the following terms is defined in the Section set forth opposite such term:

Term	Section
Accounting Referee		8.06
Agreement	Preamble
Average Parent Stock Price		2.02
Certificates		2.05
Closing		2.01
Closing Cash Consideration		2.02
Closing Date		2.01
Code	Recitals
Company	Preamble
Company Disclosure Schedules	Article 4
Company Securities		4.03
Cover		7.02
Damages		9.02
Diligence Binder	Article 4
Effective Time		2.01
Employees		7.03
Employee Plans		4.22
Exchange Agent		2.05
Indemnification Notice		9.03
Indemnified Party		9.02
Initial Surviving Corporation		2.01
Key Employee Employment Agreements	Recitals
Late Payment		2.02
Loss		8.05
Material Contract		4.12
Merger		2.01
Merger Consideration		2.02
Merger Subsidiaries	Preamble
Note		2.02
Objection Notice		9.03
Parent	Preamble

5

Term	Section
Parent Indemnitee		8.01
Payment Event		10.03
Permits		4.19
Post-Closing Tax Period		8.01
Pre-Closing Tax Period		8.01
Registration Rights Agreement		2.02
Returns		8.02
Schedule	Article 4
Second Effective Time		2.01
Sellers	Preamble
Shareholders’ Representative	Preamble
Surviving Entity		2.01
Returns		8.02
Tax		8.01
Taxing Authority		8.01
Threshold Amount		9.02
Total Cash Consideration		2.02
Total Stock Consideration		2.02
Written Consent	Recitals

     Section 1.02. Other Definitional and Interpretative Provisions. The words “hereof”, “herein” and “hereunder” and words of like import used in this Agreement shall refer to this Agreement as a whole and not to any particular provision of this Agreement. The captions herein are included for convenience of reference only and shall be ignored in the construction or interpretation hereof. References to Articles, Sections, Exhibits and Schedules are to Articles, Sections, Exhibits and Schedules of this Agreement unless otherwise specified. All Exhibits and Schedules annexed hereto or referred to herein are hereby incorporated in and made a part of this Agreement as if set forth in full herein. Any capitalized terms used in any Exhibit or Schedule but not otherwise defined therein, shall have the meaning as defined in this Agreement. Any singular term in this Agreement shall be deemed to include the plural, and any plural term the singular. Whenever the words “include”, “includes” or “including” are used in this Agreement, they shall be deemed to be followed by the words “without limitation”, whether or not they are in fact followed by those words or words of like import. “Writing”, “written” and comparable terms refer to printing, typing and other means of reproducing words (including electronic media) in a visible form. References to any agreement or contract are to that agreement or contract as amended, modified or supplemented from time to time in accordance with the terms hereof and thereof; provided that with respect to any agreement or contract listed on any schedules hereto, all such amendments, modifications or supplements must also be listed in the appropriate schedule. References to any Person include the successors and permitted assigns of that Person. References from or through any date mean, unless otherwise specified, from and including or

6

through and including, respectively. References to “law”, “laws” or to a particular statute or law shall be deemed also to include any Applicable Law.

Article 2
The Merger

     Section 2.01. The Mergers.

     (a) As soon as practicable after execution of this Agreement by all parties hereto, the consummation of the transactions contemplated by this Agreement (the “Closing”, such date, the “Closing Date”) will be held at the offices of Davis Polk & Wardwell, 1600 El Camino Real, Menlo Park, California 94025, or at such other place as the parties may agree. On the Closing Date, the Company and Merger Subsidiary I will file a statement of merger with the Colorado Secretary of State, a certificate of merger with the Delaware Secretary of State and make all other filings or recordings required by Colorado Law and Delaware Law in connection with the First Merger. The First Merger shall become effective at such time (the “Effective Time”) as the statement of merger and certificate of merger are duly filed with the Secretaries of State of the States of Colorado and Delaware, respectively, or at such later time as may be specified in the statement of merger and certificate of merger.

     (b) At the Effective Time, Merger Subsidiary I shall be merged with and into the Company in accordance with Colorado Law and Delaware Law, whereupon the separate existence of Merger Subsidiary I shall cease, and the Company shall be the surviving corporation (the “Initial Surviving Corporation”).

     (c) From and after the Effective Time, the Initial Surviving Corporation shall possess all the rights, powers, privileges and franchises and be subject to all of the obligations, liabilities, restrictions and disabilities of the Company and Merger Subsidiary I, all as provided under Colorado Law and Delaware Law.

     (d) Immediately following the Effective Time, the Initial Surviving Corporation and Merger Subsidiary II shall file a statement of merger with the Colorado Secretary of State, a certificate of merger with the Delaware Secretary of State and make all other filings or recordings required by Colorado Law and the LLC Act in connection with the Second Merger. The Second Merger shall become effective at such time (the “Second Effective Time”) as the statement of merger and certificate of merger are duly filed with the Secretaries of State of the States of Colorado and Delaware, respectively, or at such later time as may be specified in the statement of merger and certificate of merger.

     (e) At the Second Effective Time, the Initial Surviving Corporation shall be merged with and into Merger Subsidiary II in accordance with Colorado Law and the LLC Act, whereupon the separate existence of the Initial Surviving

7

Corporation shall cease, and Merger Subsidiary II shall be the surviving entity (the “Surviving Entity”).

     (f) From and after the Second Effective Time, the Surviving Entity shall possess all the rights, powers, privileges and franchises and be subject to all of the obligations, liabilities, restrictions and disabilities of the Initial Surviving Corporation and Merger Subsidiary II, all as provided under Colorado Law and the LLC Act.

     (g) Following the Closing, Parent shall take the necessary action to wind up Salvador Systems, LLC, a Delaware limited liability company, and a wholly-owned Subsidiary of Parent.

     Section 2.02. Merger Consideration. At the Effective Time, the merger consideration (the “Merger Consideration”) shall be calculated as follows:

     (a) Cash Consideration. Subject to the indemnification provisions of Article 8 and Article 9, the total amount of cash consideration (the “Total Cash Consideration”) shall be calculated as $8,000,000, less the amount by which the Company’s legal, accounting and other out-of-pocket costs associated with the transaction exceeds $60,000. The Total Cash Consideration shall be payable to Trust as follows:

     (i) $2,666,666, less the amount by which the Company’s legal, accounting and other out-of-pocket costs associated with the transaction exceeds $60,000, payable at Closing.

     (ii) The sum of $5,333,334 shall be paid by delivery of a non-negotiable promissory note delivered by Parent to Trust, in the form attached hereto as Annex IX (the “Note”). The Note shall bear interest at the rate of five percent (5%) per annum, with principal and interest payable as follows:

     (A) Interest on the outstanding principal balance shall be paid quarterly, commencing on September 30, 2007 and payable on the last day of each calendar quarter thereafter;

     (B) principal in the amount of $2,666,667 shall be payable on the date of the fifteen month anniversary of the Closing Date; and

     (C) the remaining principal balance of $2,666,667 shall be payable on the date of the thirty month anniversary of the Closing Date.

     If any payment of principal or interest under the Note is not paid to the holder of the Note upon the date that is due under the Note (a “Late Payment”),

8

the holder of the Note shall send a notice to Parent in accordance with Section 10.01 of this Agreement notifying Parent of such Late Payment. Parent shall have thirty days from the receipt of such notice to satisfy its obligation with respect to such Late Payment without penalty. If Parent’s obligation with respect to the Late Payment has not been satisfied during the 30-day period, then the outstanding principal balance of the Note shall bear interest at the rate of ten percent (10%) per annum from the date that the Late Payment was originally due until the date that Parent fully satisfies its obligation with respect to such Late Payment.

     (b) Stock Consideration. The total amount of stock consideration (the “Total Stock Consideration”) shall be 1,084,406 shares of Parent Stock. David Gardner, James R. Long, Patricia Long, Kerry Rhea and Lisa H. Rhea shall receive the Total Stock Consideration ratably in accordance with their percentage ownership of the Company Stock, as provided in Annex II, attached hereto.

     (c) Stock Consideration Registration Rights. The Parent Stock being issued as Merger Consideration shall not be registered under the federal securities laws or under any state or foreign securities laws, and may not be sold, transferred, offered for sale, pledged, hypothecated or otherwise disposed of unless such transaction is pursuant to the terms of an effective registration statement under the 1933 Act and are registered under any applicable state or foreign securities laws or pursuant to an exemption from registration thereunder. Those Sellers receiving Parent Stock as Merger Consideration shall have registration rights as set forth in a registration rights agreement in the form attached hereto as Annex III (the “Registration Rights Agreement”).

     Section 2.03. Conversion of Shares. At the Effective Time, by virtue of the Merger and without any action on the part of any party,

     (a) except as otherwise provided in Section 2.03(b), each share of Company Stock issued and outstanding immediately prior to the Effective Time shall be converted into the right to receive the Merger Consideration in accordance with Section 2.02.

     (b) each share of Company Stock held by the Company as treasury stock or owned by Parent immediately prior to the Effective Time shall be canceled, and no payment shall be made with respect thereto; and

     (c) each share of common stock of Merger Subsidiary I outstanding immediately prior to the Effective Time shall be converted into and become one share of common stock of the Initial Surviving Corporation and shall constitute the only outstanding shares of capital stock of the Initial Surviving Corporation.

     Section 2.04. Conversion of Shares in the Second Merger. At the Second Effective Time, (i) each share of common stock of the Initial Surviving Corporation outstanding immediately prior to the Second Effective Time shall be converted into and become one unit of the Surviving Entity and shall constitute

9

the only outstanding equity interests of the Surviving Entity and (ii) each unit of Merger Subsidiary II outstanding immediately prior to the Second Effective Time shall be cancelled.

     Section 2.05. Surrender and Payment. (a) Parent will act as exchange agent (the “Exchange Agent”) for the purpose of exchanging certificates representing the shares of Company Stock (the “Certificates”) for the Merger Consideration payable in respect of the shares of Common Stock evidenced by each such certificate.

     (b) Annex II to this agreement is a payment schedule setting forth (i) the name and address of each Shareholder entitled to distribution of the Merger Consideration pursuant to Section 2.02 (ii) the amount and form of consideration to which each such Shareholder is entitled upon compliance with Section 2.05(c) or Section 2.05(d), and (iii) the wire transfer account information for each Shareholder, together with any supporting schedules and documentation (showing the number of shares held immediately prior to such time by each such Person, together with calculations of each such Person’s percentage ownership of the Company Stock and the amount then payable to such Person). The Shareholders’ Representative shall be responsible for instructing the Exchange Agent as to the distribution of such amounts. Parent (including Parent acting as Exchange Agent) may rely on the instructions of the Shareholders’ Representative for distributions and shall have no responsibility or liability with respect thereto; provided that the distribution instructions of the Shareholders’ Representative are followed.

     (c) Each holder of outstanding Company Stock that has been converted into the right to receive the Merger Consideration will be entitled to receive, upon surrender to the Exchange Agent of a Certificate, the Merger Consideration payable for each share of Company Stock represented by such Certificate. Until so surrendered, from and after the Effective Time each such Certificate shall represent for all purposes only the right to receive such Merger Consideration.

     (d) If any portion of the Merger Consideration is to be paid to a Person other than the Person in whose name the surrendered Certificate is registered, it shall be a condition to such payment that (i) either such Certificate shall be properly endorsed or shall otherwise be in proper form for transfer and (ii) the Person requesting such payment shall pay to the Exchange Agent any transfer or other taxes required as a result of such payment to a Person other than the registered holder of such Certificate or establish to the satisfaction of the Exchange Agent that such tax has been paid or is not payable.

     (e) After the Effective Time, there shall be no further registration of transfers of shares of Company Stock. If, after the Effective Time, Certificates are presented to the Surviving Corporation, they shall be canceled and exchanged for the Merger Consideration provided for, and in accordance with the procedures set forth, in this Article 2.

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     (f) Parent shall not be liable to any Company Shareholder for any amounts paid to a public official pursuant to applicable abandoned property, escheat or similar laws.

     (g) No dividends or other distributions with respect to securities of Parent constituting part of the Merger Consideration, and no cash payment in lieu of fractional shares as provided in Section 2.06, shall be paid to the holder of any Certificates not surrendered until such Certificates are surrendered as provided in this Section. Following such surrender, there shall be paid, without interest, to the Person in whose name the securities of Parent have been registered, (i) at the time of such surrender, the amount of any cash payable in lieu of fractional shares to which such Person is entitled pursuant to Section 2.06 and the amount of all dividends or other distributions with a record date after the Effective Time previously paid or payable on the date of such surrender with respect to such securities, and (ii) at the appropriate payment date, the amount of dividends or other distributions with a record date after the Effective Time and prior to surrender and with a payment date subsequent to surrender payable with respect to such securities.

     Section 2.06. Fractional Shares. No fractional shares of Parent Stock shall be issued in the First Merger. All fractional shares of Parent Stock that a holder of shares of Company Stock would otherwise be entitled to receive as a result of the First Merger shall be aggregated and if a fractional share results from such aggregation, such holder shall be entitled to receive, in lieu thereof, an amount in cash without interest determined by multiplying the closing sale price of a share of Parent Stock on the NASDAQ Global Market on the trading day immediately preceding the Effective Time by the fraction of a share of Parent Stock to which such holder would otherwise have been entitled.

     Section 2.07. Withholding Rights. Each of the Surviving Entity, the Initial Surviving Corporation, the Exchange Agent and Parent shall be entitled to deduct and withhold from the consideration otherwise payable to any Person pursuant to this Article 2 such amounts as it is required to deduct and withhold with respect to the making of such payment under any provision of federal, state, local or foreign tax law. If the Surviving Entity, the Initial Surviving Corporation, the Exchange Agent or Parent, as the case may be, so withholds amounts, such amounts shall be treated for all purposes of this Agreement as having been paid to the holder of the shares of Company Stock in respect of which the Surviving Entity, the Initial Surviving Corporation, the Exchange Agent or Parent, as the case may be, made such deduction and withholding.

     Section 2.08. Lost Certificates. If any Certificate shall have been lost, stolen or destroyed, upon the making of an affidavit of that fact by the Person claiming such Certificate to be lost, stolen or destroyed and, if required by the Surviving Corporation, the posting by such Person of a bond, in such reasonable amount as the Surviving Corporation may direct, as indemnity against any claim that may be made against it with respect to such Certificate, the Exchange Agent

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will issue, in exchange for such lost, stolen or destroyed Certificate, the Merger Consideration to be paid in respect of the shares of Company Stock represented by such Certificate, as contemplated by this Article 2.

Article 3
Initial Surviving Corporation; The Surviving Entity

     Section 3.01. Articles of Incorporation and Bylaws of the Initial Surviving Corporation. At the Effective Time, (i) the articles of incorporation of the Company as in effect immediately prior to the Effective Time shall be the articles of incorporation of the Initial Surviving Corporation, until thereafter amended as provided under Colorado Law and such articles of incorporation and (ii) the bylaws of the Company as in effect immediately prior to the Effective Time shall be the bylaws of the Initial Surviving Corporation, until thereafter amended in accordance with Colorado Law and as provided in the articles of incorporation of the Initial Surviving Corporation and such bylaws.

     Section 3.02. Directors and Officers. The directors and officers of Merger Subsidiary I immediately prior to the Effective Time shall be the directors and officers of the Initial Surviving Corporation, each to hold such office in accordance with the provisions of Colorado Law and the articles of incorporation and bylaws of the Initial Surviving Corporation.

     Section 3.03. Certificate of Formation and Limited Liability Company. The certificate of formation and limited liability company agreement of Merger Subsidiary II in effect immediately prior to the Second Effective Time shall be the certificate of formation and limited liability company agreement of the Surviving Entity unless and until amended in accordance with their terms and applicable law.

     Section 3.04. Managers and Officers. The managers and officers of Merger Subsidiary II immediately prior to the Second Effective Time shall be the managers and officers of the Surviving Entity, each to hold office in accordance with the provisions of the LLC Act and the certificate of formation and limited liability company agreement of the Surviving Entity.

Article 4
Representations and Warranties of the Company

     Except (i) as disclosed to Parent in the materials included in the binder of materials collected by the Company in response to Parent’s request for certain information delivered herewith (the “Disclosure Binder”) or (ii) as specifically disclosed in the schedules attached hereto (each a “Schedule” and, together with

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the Disclosure Binder, the “Company Disclosure Schedules”) the Company and David Gardner, jointly and severally, represent and warrant to Parent that:

     Section 4.01. Corporate Existence and Power. The Company is a corporation duly incorporated, validly existing and in good standing under the laws of the State of Colorado and has all corporate powers required to carry on its business as now conducted. The Company has heretofore delivered to Parent true and complete copies of the certificate of incorporation and bylaws of the Company as currently in effect. The Company is not in violation of any of the provisions of its certificate of incorporation or bylaws. The execution, delivery and performance by the Company of this Agreement and the consummation of the transactions contemplated hereby do not and will not contravene, conflict with, or result in any violation or breach of any provision of the certificate of incorporation or bylaws of the Company.

     Section 4.02. Corporate Authorization. (a) The execution, delivery and performance by the Company of this Agreement and the consummation by the Company of the transactions contemplated hereby are within the Company’s corporate powers and have been duly authorized by all necessary corporate action on the part of the Company. This Agreement constitutes a valid and binding agreement of the Company, subject to bankruptcy, insolvency, fraudulent transfer, reorganization, moratorium or similar laws relating to affecting creditors’ rights generally and to general principles of equity (regardless of whether enforcement is considered in a proceeding in equity or at law).

     (b) At a meeting duly called and held, the Company’s Board of Directors (which meeting was not attended by Kevin Heher, who recused himself due to his position as an employee of Parent, has (i) determined that this Agreement and the transactions contemplated hereby are fair to and in the best interests of the Company’s shareholders, (ii) approved and adopted this Agreement and the transactions contemplated hereby and (iii) resolved to recommend approval and adoption of this Agreement by its shareholders.

     (c) The Written Consent delivered concurrently with the execution of this Agreement constitutes a valid and effective approval of this Agreement, the Merger and the other transactions contemplated hereby by the Company’s shareholders and no other votes, approvals or consents of the holders of any of the Company’s capital stock are necessary in connection with the adoption of this Agreement or the consummation of the Merger.

     Section 4.03. Capitalization. (a) The authorized capital stock of the Company consists of 5,000,000 shares of Company Stock, of which 100,000 shares are issued and outstanding. All outstanding shares of capital stock of the Company have been duly authorized and validly issued and are fully paid and nonassessable. No Company Affiliate owns any shares of capital stock of the Company.

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     (b) Except as set forth in this Section 4.03, there are no outstanding (i) shares of capital stock or voting securities of the Company, (ii) securities of the Company convertible into or exchangeable for shares of capital stock or voting securities of the Company or (iii) options or other rights to acquire from the Company, or other obligation of the Company to issue, any capital stock, voting securities or securities convertible into or exchangeable for capital stock or voting securities of the Company (the items in clauses (i), (ii), and (iii) being referred to collectively as the “Company Securities”). There are no outstanding obligations of the Company to repurchase, redeem or otherwise acquire any of the Company Securities.

     (c) With the exception of those Agreement Concerning Shares among and between David Gardner, James R. Long, Patricia Long, Kerry Rhea and Lisa H. Rhea dated June 29, 2007, there are no voting trusts, proxies, or other agreements or understandings with respect to the voting stock of the Company or any other matters involving any securities of the Company.

     Section 4.04. Ownership of Shares; Stock Option Plan. As of the date hereof, all of the outstanding shares of Company Stock are owned of record by the Persons, and in the respective amounts, set forth in Annex II of this Agreement. The Company has not adopted or maintained any stock option plan or other plan providing for equity compensation to any Person. No more than thirty-five (35) of the holders of the Company Stock are and, at the Effective Time, will be unaccredited investors within the meaning of Section (a) of Regulation D, Rule 501 of the Securities Act. At the Effective Time, each holder of Company Stock who is not an accredited investor within the meaning of said section will be represented by a duly authorized “purchaser representative,” as defined in Section (h), of Regulation D, Rule 501 of the Securities Act.

     Section 4.05. Subsidiaries. The Company has no Subsidiaries.

     Section 4.06. Authorizations. The Company has all governmental licenses, authorizations, permits, consents and approvals required to carry on its business as now conducted, except for those licenses, authorizations, permits, consents and approvals the absence of which would not have, individually or in the aggregate, a Material Adverse Effect on the Company. The Company is duly qualified to do business as a foreign corporation and is in good standing in each jurisdiction where such qualification is necessary, except for those jurisdictions where failure to be so qualified would not have, individually or in the aggregate, a Material Adverse Effect on the Company.

     Section 4.07. Governmental Authorization. The execution, delivery and performance by the Company of this Agreement and the consummation by the Company of the transactions contemplated hereby require no action by or in respect of, or filing with, any Governmental Authority other than (i) the filing of a statement of merger with respect to the Merger with the Colorado Secretary of State and appropriate documents with the relevant authorities of other states in

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which the Company is qualified to do business, (ii) compliance with any applicable requirements of the 1933 Act, the 1934 Act, and any other applicable U.S. state or federal securities laws and (iii) any actions or filings the absence of which would not be reasonably expected to have, individually or in the aggregate, a Material Adverse Effect on the Company or to impair the ability of the Company to consummate the transactions contemplated by this Agreement.

     Section 4.08. Non-contravention. The execution, delivery and performance by the Company of this Agreement and the consummation of the transactions contemplated hereby do not and will not (i) contravene, conflict with or result in a violation or breach of any provision of any Applicable Law, (ii) require any consent or other action by any Person under, constitute a default, or an event that, with or without notice or lapse of time or both, could become a default, under, or cause or permit the termination, cancellation, acceleration or other change of any right or obligation or the loss of any benefit to which the Company is entitled under any provision of any agreement or other instrument binding upon the Company or any license, franchise, permit, certificate, approval or other similar authorization affecting, or relating in any way to, the assets or business of the Company or (iii) result in the creation or imposition of any Lien on any asset of the Company.

     Section 4.09. Financial Statements. The internally-prepared balance sheet as of June 30, 2007 and the related statement of income for the year ended June 30, 2007 of the Company provided to Parent and attached hereto as Schedule 4.09 fairly present, the financial position of the Company as of the June 30, 2007 and their results of operations for the period then ended. Such financial statements include all material adjustments that are necessary for a fair presentation of the financial position and results of operations of the Company as of the dates thereof and for the periods covered thereby.

     Section 4.10. Absence of Certain Changes. Except as otherwise disclosed herein or in the Company Disclosure Schedules, since the Company Balance Sheet Date, the business of the Company has been conducted in the ordinary course consistent with past practices and there has not been:

     (a) any event, occurrence, development or state of circumstances or facts that has had or could reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect on the Company;

     (b) any declaration, setting aside or payment of any dividend or other distribution with respect to any shares of capital stock of the Company;

     (c) with respect to any outstanding shares of capital stock or other securities of, or other ownership interests in, the Company, any direct or indirect (i) reclassification, combination, split or subdivision or (ii) redemption, repurchase, purchase or other acquisition by the Company, except for repurchases

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by the Company of Company Stock made in connection with the termination of employment of Company employees;

     (d) any incurrence, assumption or guarantee by the Company of any indebtedness for borrowed money;

     (e) any creation or other incurrence by the Company of any material Lien on any material asset;

     (f) any making of any loan, advance or capital contributions to or investment in any Person, except for reasonable advances to employees and consultants for travel and business expenses in the ordinary course of business consistent with past practices;

     (g) any damage, destruction or other casualty loss (whether or not covered by insurance) affecting the business or assets of the Company that has had or could reasonably be expected to have, individually or in the aggregate, a Material Adverse Effect on the Company;

     (h) any transaction or commitment made, or any contract or agreement entered into, by the Company relating to its assets or business (including the acquisition or disposition of any assets) or any relinquishment by the Company of any contract or other right, in either case, material to the Company other than those contemplated by this Agreement and other than the sale or nonexclusive license of Company products to the Company’s customers in the ordinary course of business;

     (i) any change in any method of accounting or accounting principles or practice by the Company, except for any such change required by reason of a concurrent change in GAAP;

     (j) any (i) grant of any severance or termination pay to (or amendment to any existing arrangement with) any director, officer or employee of the Company, (ii) increase in benefits payable to any director, officer or employee of the Company under any existing severance or termination pay policies or employment agreements, (iii) entering into any employment, deferred compensation or other similar agreement (or any amendment to any such existing agreement) with any director, officer or employee of the Company, (iv) establishment, adoption or amendment (except as required by applicable law) of any collective bargaining, bonus, profit-sharing, thrift, pension, retirement, deferred compensation, compensation, stock option, restricted stock or other benefit plan or arrangement covering any director, officer or employee of the Company, (v) increase in compensation, bonus or other benefits payable to any director of the Company, or, (vi) except in the ordinary course of business, increase in compensation, bonus or other benefits payable to any officer or employee of the Company;

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     (k) any hiring, employment, or entry into a contact or agreement with any new employees or independent contractors other than as contemplated herein;

     (l) any labor dispute, other than routine individual grievances, or any activity or proceeding by a labor union or representative thereof to organize any employees of the Company, which employees were not subject to a collective bargaining agreement at the Company Balance Sheet Date, or any lockouts, strikes, slowdowns, work stoppages or threats thereof by or with respect to such employees;

     (m) any receipt of notice by the Company of any actual or threatened termination by any customer, supplier, distributor or other Person in connection with, and material to, the business of the Company;

     (n) any material change in pricing or royalties set or charged by the Company to its customers or licensees or in pricing or royalties set or charged by suppliers or licensors to the Company;

     (o) any material capital expenditure, or commitment for a capital expenditure, for additions or improvements to property, plant and equipment; or

     (p) Any legally binding agreement by the Company or any officer or employee thereof in their capacities as such to do any of the things described in the preceding clauses (a) through (o) (other than negotiations with Parent and its representatives regarding the transactions contemplated by this Agreement).

     Section 4.11. No Undisclosed Liabilities. There are no liabilities or obligations of the Company of any kind whatsoever, whether accrued, contingent, absolute, determined, determinable or otherwise, and there is no existing condition, situation or set of circumstances that could reasonably be expected to result in such a liability or obligation, other than:

     (a) liabilities or obligations disclosed and provided for in the Company Balance Sheet or in the notes thereto, and

     (b) liabilities or obligations incurred in the ordinary course of business consistent with past practices since the Company Balance Sheet Date that would not reasonably be expected to be, individually or in the aggregate, material to the Company.

     Section 4.12. Agreements, Contracts and Commitments. (a) Except as provided to Parent in the Disclosure Binder delivered herewith, the Company is not a party to or bound by:

     (i) any lease or sublease (whether of real or personal property) providing for annual rentals of $25,000 or more;

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     (ii) any agreement for the purchase or license of materials, supplies, goods, services, equipment or other tangible or intangible assets providing for either (A) annual payments by the Company of $50,000 or more or (B) aggregate payments by the Company of $50,000 or more;

     (iii) any license, sales, distribution or other similar agreement providing for the sale or license by the Company of materials, supplies, goods, services, equipment or other assets that provides for either (A) annual payments to the Company of $50,000 or more or (B) aggregate payments to the Company of $50,000 or more;

     (iv) any partnership, joint venture or other similar agreement or arrangement, other than those related to Salvador Systems LLC;

     (v) any agreement, contract or commitment relating to the acquisition or disposition of any business (whether by merger, sale of stock, sale of assets or otherwise);

     (vi) any agreement relating to indebtedness for borrowed money or the deferred purchase price of property (in either case, whether incurred, assumed, guaranteed or secured by any asset), except any such agreement with an aggregate outstanding principal amount not exceeding $50,000 and which may be prepaid on not more than 30 days’ notice without the payment of any penalty;

     (vii) except for agreements by the Company with customers in the ordinary course of business consistent with past practices, any option (other than employee stock options), license, franchise or similar agreement;

     (viii) any alliance, agency, dealer, sales representative, marketing, distribution, original equipment manufacturer, remarketer, joint marketing, channel partner or other similar agreement that does not provide for termination without compensation upon no more than 30 days notice;

     (ix) any development or collaboration agreement or other agreement for development of products and services for the Company;

     (x) any agreement that limits the freedom of the Company to compete in any line of business or with any Person or in any area or which could reasonably be expected to so limit the freedom of the Company after the Effective Time;

     (xi) any mortgages, indentures, loans or credit agreements, security agreements or other agreements or instruments relating to the borrowing of money or extension of credit, other than those mortgages,

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indentures, loans or credit agreements, security agreements or other agreements or instruments that are not, individually or in the aggregate, material to the Company;

     (xii) any agreement with any Affiliate of the Company, with any director or officer of the Company, or with any “associate” or any member of the “immediate family” (as such terms are respectively defined in Rules 12b-2 and 16a-1 of the 1934 Act) of any such director or officer; or

     (xiii) any employment or consulting agreement, contract or commitment with an employee or individual consultant or salesperson or consulting or sales agreement, contract or commitment with a firm or other organization other than as contemplated under this Agreement;

     (xiv) any employment or consulting agreement or any agreement with severance, change in control or similar arrangements, that will result in any obligation (absolute or contingent) of the Company to make any payment as a result of the consummation of the Merger, termination of employment or both;

     (xv) any agreement or plan, including, without limitation, any stock option plan, stock appreciation rights plan or stock purchase plan, any of the benefits of which will be increased, or the vesting of benefits of which will be accelerated, by the occurrence of any of the transactions contemplated by this Agreement or the value of any of the benefits of which will be calculated on the basis of any of the transactions contemplated by this Agreement; or

     (xvi) any other agreement, commitment, arrangement or plan not made in the ordinary course of business that is material to the Company, including without limitation, any agreement involving annual payments by any customer to the Company in excess of $150,000.

     Section 4.13. Validity of Contracts. Each agreement, contract, plan, lease, arrangement or commitment disclosed required to be disclosed pursuant to this Article (each, a “Material Contract”) is a valid and binding agreement of the Company and is in full force and effect with respect to the Company and, to the knowledge of the Company, each other party thereto, and none of the Company or, to the knowledge of the Company, any other party thereto is in default or breach in any material respect under the terms of any such agreement, contract, plan, lease, arrangement or commitment, and, to the knowledge of the Company, no event or circumstance has occurred that, with notice or lapse of time or both, would reasonably be expected to constitute any event of default thereunder. True and complete copies of each such agreement, contract, plan, lease, arrangement or commitment have been made available to Parent. The Company has fulfilled all material obligations required pursuant to each Material Contract to have been performed by the Company prior to the date hereof, and to the knowledge of the

19

Company, without giving effect to the Merger, the Company will be able to fulfill, when due, all of its obligations under the Material Contracts that remain to be performed after the date hereof.

     Section 4.14. No Renegotiations. To the knowledge of the Company, no person is renegotiating, or has a right (absent any default or breach of a Material Contract) pursuant to the terms of any Material Contract to renegotiate, any material amount paid or payable to the Company under any Material Contract or any other material term or provision of any Material Contract. The Company has not received any written or verbal indication of an intention to terminate any of the Material Contracts by any of the parties to any of the Material Contracts.

     Section 4.15. Products and Services. To the knowledge of the Company, each of the products and services produced, sold or licensed by the Company is, and at all times up to and including the sale thereof has been, (i) in compliance with the terms and requirements of any applicable warranty or other contract between the Company and such Person, (ii) in conformance with any promises or affirmations of fact made in connection with its sale, (iii) in compliance in all material respects with Applicable Law and (iv) fit for the ordinary purposes for which it is intended to be used. Except for any deficiencies that can be corrected without incurring material expense, each product that has been sold by the Company to any Person was free of any design defects, construction defects or other defects or deficiencies at the time of sale. All repair services and other services that have been performed by the Company were performed properly and in full conformity with the terms and requirements of all applicable warranties and other Contracts and with Applicable Law, except for any deficiencies that can be corrected without incurring material expense. To the Company’s knowledge, the Company will not incur or otherwise become subject to any material liability arising directly or indirectly from any product manufactured or sold, or any repair services or other services performed by, the Company on or at any time prior to the Closing Date. There are no material unresolved claims or threatened claims by any customer or other Person against the Company (i) under or based upon any warranty provided by or on behalf of the Company that have been received by the Company in writing, or (ii) under or based upon any other warranty relating to any product sold by the Company or any services performed by the Company. To the Company’s knowledge no event has occurred, and no condition or circumstance exists, that could reasonably be expected (with or without notice or lapse of time) to directly or indirectly give rise to or serve as a basis for the assertion of any such claim. No product manufactured or sold by the Company has been the subject of any recall or other similar action; and no event has occurred, and to the Company’s knowledge no condition or circumstance exists, that could (with or without notice or lapse of time) directly or indirectly give rise to or serve as a basis for any such recall or other similar action relating to any such product.

     Section 4.16. Intellectual Property. (a) Schedule 4.16(a)(i) contains a true and complete list of (A) all registrations or applications for registrations

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included in the Owned Intellectual Property Rights and (B) all unregistered Owned Intellectual Property Rights which are material to the business of the Company as now conducted. The Disclosure Binder includes all agreements (whether written or otherwise, including license agreements, research agreements, development agreements, distribution agreements, settlement agreements, consent to use agreements and covenants not to sue, but excluding licenses for commercial off the shelf computer software that are generally available on nondiscriminatory pricing terms and have an aggregate acquisition cost of $500 or less) to which the Company is a party or otherwise bound and pursuant to which the Company grants or obtains the right to use or a covenant not to be sued under, any Intellectual Property Right.

     (b) To the knowledge of the Company having performed reasonable due diligence, the Licensed Intellectual Property Rights and the Owned Intellectual Property Rights together constitute all the Intellectual Property Rights necessary to, or used or held for use in, the conduct of the business of the Company as currently conducted and as proposed by the Company to be conducted. There exist no restrictions on the disclosure, use, license or transfer of the Owned Intellectual Property Rights. The consummation of the transactions contemplated by this Agreement will not alter, encumber, impair or extinguish any Owned Intellectual Property Rights or Licensed Intellectual Property Rights.

     (c) The Company has not given to any Person an indemnity in connection with any Intellectual Property Right.

     (d) To the knowledge of the Company having performed reasonable due diligence, the Company has not infringed, misappropriated or otherwise violated any Intellectual Property Right of any third person. There is no claim, action, suit, investigation or proceeding pending against, or, to the knowledge of the Company, threatened against or affecting, the Company or, any present or former officer, director or employee of the Company (i) based upon, or challenging or seeking to deny or restrict, the rights of the Company in any of the Owned Intellectual Property Rights and the Licensed Intellectual Property Rights, (ii) alleging that the use of the Owned Intellectual Property Rights or the Licensed Intellectual Property Rights or any services provided, processes used or products manufactured, used, imported, offered for sale or sold by the Company do or may conflict with, misappropriate, infringe or otherwise violate any Intellectual Property Right of any third party or (iii) alleging that the Company infringed, misappropriated or otherwise violated any Intellectual Property Right of any third party. The Company has not received from any third party an offer to license any Intellectual Property Rights of such third party.

     (e) None of the Owned Intellectual Property Rights and Licensed Intellectual Property Rights material to the operation of the business of the Company has been adjudged invalid or unenforceable in whole or part, nor has the Company received from any third party a communication alleging that any such Owned Intellectual Property Rights and Licensed Intellectual Property

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Rights are invalid or unenforceable in whole or part. To the knowledge of the Company, all such Owned Intellectual Property Rights and Licensed Intellectual Property Rights are valid and enforceable.

     (f) Other than those Owned Intellectual Property Rights that the Company co-owns with Parent or any of its Subsidiaries, the Company is the sole owner of all Owned Intellectual Property Rights and hold all right, title and interest in and to all Owned Intellectual Property Rights and the Licensed Intellectual Property Rights, free and clear of any Lien. Except as provided for in agreements included in the Disclosure Binder, no Third Party holds any license rights, immunities from suit, or analogous rights under the Owned Intellectual Property Rights or under any exclusively licensed Licensed Intellectual Property Rights. In each case where a patent or patent application, trademark registration or trademark application, service mark registration or service mark application, or copyright registration or copyright application included in the Owned Intellectual Property is held by assignment, the assignment has been duly recorded with the governmental authority from which the patent or registration issued or before which the application or application for registration is pending. The Company has taken all actions necessary to maintain and protect the Owned Intellectual Property Rights and their rights in the Licensed Intellectual Property Rights, including payment of applicable maintenance fees and filing of applicable statements of use.

     (g) To the knowledge of the Company, no Person has infringed, misappropriated or otherwise violated any Owned Intellectual Property Right or Licensed Intellectual Property Right in a manner that would have a material effect on the operation of the business of the Company. The Company has taken reasonable steps in accordance with normal industry practice to maintain the confidentiality of all Intellectual Property Rights material to the business or operation of the Company and the value of which to the Company is contingent upon maintaining the confidentiality thereof. None of the Intellectual Property Rights that are material to the business or operation of the Company and the value of which to the Company is contingent upon maintaining the confidentiality thereof has been disclosed other than to employees, representatives and agents of the Company all of whom are bound by written confidentiality agreements substantially in the form previously disclosed to Buyer.

     (h) The Company has taken reasonable steps in accordance with normal industry practice to preserve and maintain reasonably complete notes and records relating to the Owned Intellectual Property Rights and the Licensed Intellectual Property Rights.

     (i) With respect to all patents and patent applications set forth in Schedule 4.16(a)(i): (i) each has been prosecuted in material compliance with all applicable rules, policies, and procedures of the United States Patent and Trademark Office or applicable foreign patent agencies and (ii) to the knowledge of the Company, there is no material prior art relevant thereto that may render the

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claims unpatentable, invalid, or unenforceable. With respect to pending applications and applications for registration of the Owned Intellectual Property Rights and the Licensed Intellectual Property Rights that are material to the business or operation of the Company, the Company is not aware of any reason that could reasonably be expected to prevent any such application or application for registration from being granted with coverage substantially equivalent to the latest amended version of the pending application or application for registration. None of the trademarks, service marks, applications for trademarks and applications for service marks included in the Owned Intellectual Property Rights that are material to the business or operation of the Company has been the subject of an opposition or cancellation procedure. None of the patents and patent applications included in the Owned Intellectual Property Rights that are material to the business or operation of the Company has been the subject of an interference, protest, public use proceeding or third party reexamination request.

     (j) All products sold by the Company or any licensee of the Company and covered by a patent, trademark or copyright included in the Owned Intellectual Property Rights have been marked with the notice (applicable as of the date hereof) of all nations requiring such notice in order to collect damages.

     (k) To the extent that any Intellectual Property Right has been developed or created by a Third Party (including any current or former employee of the Company) for the Company, the Company has a written agreement with such Third Party with respect thereto, and the Company thereby has obtained ownership of and is the exclusive owner of such Intellectual Property Right.

     (l) No government, university, college, or other educational institution or research center has any ownership or licensed interest in any Owned Intellectual Property Rights or any exclusively licensed Licensed Intellectual Property Rights.

     (m) There are no actions that must be taken by the Company within 120 days of the Closing Date, including the payment of any registration, maintenance or renewal fees or the filing of any responses to office actions by the patent, copyright, trademark or other authorities in the United States or foreign jurisdictions, documents, applications or certificates for the purposes of obtaining, maintaining, perfecting or preserving or renewing any patents and patent applications, registered copyrights and copyright applications, registered trademarks and trademark applications and any other Intellectual Property Right that is the subject of an application, certificate, filing, registration or other document issued by, filed with, or recorded by, any private, state, government or other public legal authority (“Registered Intellectual Property Rights”) included in the Owned Intellectual Property Rights or exclusively licensed with the right to control prosecution or maintenance and included in the Licensed Intellectual Property Rights. The Company has not claimed any status in the application for or registration of any Registered Intellectual Property Rights,

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including “small business status” in connection with U.S. patents and applications, that would not be applicable to Buyer.

     (n) The Company has not received a written opinion of counsel with respect to the invalidity, non-infringement or unenforceability of any patent or patent application.

     Section 4.17. Insurance Coverage. There is no claim by the Company pending under any of such policies or bonds as to which coverage has been questioned, denied or disputed by the underwriters of such policies or bonds or in respect of which such underwriters have reserved their rights. All premiums due and payable as of the date of this Agreement under all such policies and bonds have been timely paid and the Company has otherwise complied fully with the terms and conditions of all such policies and bonds. Such policies of insurance and bonds (or other policies and bonds providing substantially similar insurance coverage) have been in effect since 2001 and remain in full force and effect. The Company has no knowledge of any threatened termination of, premium increase with respect to, or material alteration of coverage under, any of such policies or bonds. Such policies and bonds are of the type and in amounts customarily carried by Persons conducting businesses similar to those of the Company. The Company shall after the Effective Time continue to have coverage under such policies and bonds with respect to events occurring prior to the Effective Time.

     Section 4.18. Litigation. There is no action, suit, investigation or proceeding (or any basis therefor) pending against, or, to the knowledge of the Company, threatened against or affecting, the Company, any present or former officer, director or employee of the Company or any Person for whom the Company may be liable or any of their respective properties or that in any manner challenges or seeks to prevent, enjoin, alter or delay the Merger or any of the other transactions contemplated hereby before any court, arbitrator or mediator or before or by any Governmental Authority.

     Section 4.19. Licenses and Permits. Except as disclosed to Parent in the Company Disclosure Schedules, there are no material licenses, franchises, permits, certificates, approvals, security clearances or other similar authorizations affecting, or relating in any way to, the assets or business of the Company (the “Permits”). The Permits are valid and in full force and effect. The Company is not in default under, and no condition exists that with notice or lapse of time or both would reasonably be expected to constitute a default under, the Permits. None of the Permits will be terminated or impaired or become terminable, in whole or in part, as a result of the transactions contemplated hereby. The Company has made all material filings with governmental entities and have received all material permits, registrations, licenses, franchises, certifications and other approvals necessary to conduct and operate its business as currently conducted or operated by it and to permit the Company to own or use its assets in the manner in which such assets are currently owned or used.

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     Section 4.20. Compliance with Laws and Court Orders. To the knowledge of the Company, (i) the Company is and has all times since its inception been conducted in compliance with, and (ii) has not been threatened to be charged with or given notice of any violation of, any Applicable Law.

     Section 4.21. Finders’ Fees. There is no investment banker, broker, finder or other intermediary that has been retained by or is authorized to act on behalf of the Company or any of its shareholders who might be entitled to any fee or commission from the Company or any of its Affiliates in connection with the transactions contemplated by this Agreement.

     Section 4.22. Employee Benefit Plans. (a) Schedule 4.22(a) contains a correct and complete list identifying each “employee benefit plan,” as defined in Section 3(3) of ERISA, each employment, severance or similar contract, plan, arrangement or policy and each other plan or arrangement (written or oral) providing for compensation, bonuses, profit-sharing, stock option or other stock related rights or other forms of incentive or deferred compensation, vacation benefits, insurance (including any self-insured arrangements), health or medical benefits, employee assistance program, disability or sick leave benefits, workers’ compensation, supplemental unemployment benefits, severance benefits and post-employment or retirement benefits (including compensation, pension, health, medical or life insurance benefits) which is maintained, administered or contributed to by the Company or any ERISA Affiliate and covers any employee or former employee of the Company, or with respect to which the Company has any liability. Copies of such plans (and, if applicable, related trust or funding agreements or insurance policies) and all amendments thereto and written interpretations thereof have been furnished to Parent together with the most recent annual report (Form 5500 including, if applicable, Schedule B thereto) and tax return (Form 990) prepared in connection with any such plan or trust. Such plans are referred to collectively herein as the “Employee Plans.”

     (b) The consummation of the transactions contemplated by this Agreement will not (either alone or together with any other event) entitle any employee or independent contractor of the Company to severance pay or accelerate the time of payment or vesting or trigger any payment of funding (through a grantor trust or otherwise) of compensation or benefits under, increase the amount payable or trigger any other material obligation pursuant to, any Employee Plan.

     (c) There is no contract, plan or arrangement (written or otherwise) covering any employee or former employee of the Company that, individually or collectively, would entitle any employee or former employee to any severance or other payment solely as a result of the transactions contemplated hereby, or could give rise to the payment of any amount that would not be deductible pursuant to the terms of Section 280G or 162(m) of the Code.

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     (d) There has been no amendment to, written interpretation or announcement (whether or not written) by the Company or any of its Affiliates relating to, or change in employee participation or coverage under, an Employee Plan which would increase materially the expense of maintaining such Employee Plan above the level of the expense incurred in respect thereof for the fiscal year ended December 31, 2006.

     (e) There is no action, suit, investigation, audit or proceeding pending against or involving or, to the knowledge of the Company, threatened against or involving, any Employee Plan before any arbitrator, mediator or Governmental Authority.

     (f) No employee or former employee of the Company will become entitled to any bonus, retirement, severance, job security or similar benefit or enhanced such benefit (including acceleration of vesting or exercise of an incentive award) as a result of the transactions contemplated hereby.

     (g) The Company is in material compliance with all currently applicable laws respecting employment and employment practices, terms and conditions of employment and wages and hours, and is not engaged in any unfair labor practice. There is no unfair labor practice complaint pending or, to the knowledge of the Company, threatened against the Company before the National Labor Relations Board.

     (h) The Company has provided to Parent a true and complete list of the names, titles (if applicable), annual salaries or wage rates and other compensation of all employees of the Company. The Company has no knowledge that any of its officers or any other key employee of the Company intends to resign or retire as a result of the transactions contemplated by this Agreement or otherwise within one year after the Effective Time.

Article 5
Representations and Warranties of Sellers

     Section 5.01. Private Placement Qualification. As of the date hereof and through the Effective Time, each Seller represents that it will either be (i) an accredited investor, as defined in Section (a) of Regulation D, Rule 501 of the 1933 Act, or (ii) represented by a duly authorized “purchaser representative,” as defined in Section (h), of Regulation D, Rule 501 of the 1933 Act. Each Seller acknowledges (i) that it is informed as to the risks of the transactions hereby contemplated and of its ownership of Parent Stock, (ii) that it has had access to all material information concerning Parent and has had the opportunity to ask questions of Parent’s representatives; and (iii) that any Parent Stock received as Merger Consideration have not been registered under the federal securities laws or under any state or foreign securities laws, and that such Parent Stock may not be sold, transferred, offered for sale, pledged, hypothecated or otherwise disposed

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of unless such transaction is pursuant to the terms of an effective registration statement under the 1933 Act and are registered under any applicable state or foreign securities laws or pursuant to an exemption from registration thereunder.

Article 6
Representations and Warranties of Parent

     Except as set forth in the Parent Disclosure Schedule, Parent represents and warrants to the Company that:

     Section 6.01. Corporate Existence and Power. Each of Parent and the Merger Subsidiaries has been duly incorporated or organized, as the case may be, validly existing and in good standing under the laws of its jurisdiction of incorporation or organization and has all corporate or limited liability company powers and all governmental licenses, authorizations, permits, consents and approvals required to carry on its business as now conducted, except for those licenses, authorizations, permits, consents and approvals the absence of which would not have, individually or in the aggregate, a Material Adverse Effect on Parent.

     Section 6.02. Corporate Authorization. The execution, delivery and performance by Parent and the Merger Subsidiaries of this Agreement and the consummation by Parent and the Merger Subsidiaries of the transactions contemplated hereby are within the corporate or limited liability company powers of Parent and the Merger Subsidiaries and have been duly authorized by all necessary corporate and limited liability company action. This Agreement constitutes a valid and binding agreement of each of Parent and the Merger Subsidiaries.

     Section 6.03. Governmental Authorization. The execution, delivery and performance by Parent and the Merger Subsidiaries of this Agreement and the consummation by Parent and the Merger Subsidiaries of the transactions contemplated hereby require no action by or in respect of, or filing with, any Governmental Authority, other than (i) the filing of a statement of merger with respect to the Merger with the Colorado Secretary of State and appropriate documents with the relevant authorities of other states in which Parent is qualified to do business, (ii) compliance with any applicable requirements of the 1933 Act, the 1934 Act and any other U.S. state or federal securities laws and (iii) any actions or filings the absence of which would not be reasonably expected to have, individually or in the aggregate, a Material Adverse Effect on Parent or materially to impair the ability of Parent and the Merger Subsidiaries to consummate the transactions contemplated by this Agreement.

     Section 6.04. Non-contravention. The execution, delivery and performance by Parent and the Merger Subsidiaries of this Agreement and the consummation by Parent and Merger Subsidiary of the transactions contemplated

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hereby do not and will not (i) contravene, conflict with, or result in any violation or breach of any provision of the certificate of incorporation or bylaws or limited liability company agreement of Parent or the Merger Subsidiaries or (ii) assuming compliance with the matters referred to in Section 6.03, contravene, conflict with or result in a violation or breach of any provision of any Applicable Law, except for such contraventions, conflicts and violations that would not be reasonably expected to have, individually or in the aggregate, a Material Adverse Effect on Parent or materially to impair the ability of Parent and the Merger Subsidiaries to consummate the transactions contemplated by this Agreement.

     Section 6.05. SEC Filings. (a) To the knowledge of Parent, as of its filing date, each Parent SEC Document complied as to form in all material respects with the applicable requirements of the 1933 Act and 1934 Act, as the case may be.

     (b) To the knowledge of Parent, as of its filing date, each Parent SEC Document filed pursuant to the 1934 Act did not contain any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made therein, in the light of the circumstances under which they were made, not misleading.

     Section 6.06. Parent Common Stock. The shares of Parent Stock to be issued as Merger Consideration have been duly authorized and, when issued and delivered in accordance with the terms of this Agreement, will have been validly issued and will be fully paid and nonassessable and the issuance thereof is not subject to any preemptive or other similar right.

Article 7
Covenants

     Section 7.01. Obligations of the Merger Subsidiaries. Parent shall take all action necessary to cause the Merger Subsidiaries to perform its obligations under this Agreement.

     Section 7.02. Parent Financial Covenant. Parent shall maintain at all times an amount of free and unrestricted cash equal to two times the amount owing on any outstanding balance of the Note (“Cover”). In the event that Parent fails to maintain Cover for a period of thirty (30) consecutive days, Parent shall make its best efforts to obtain an unconditional standby letter of credit in an amount equal to the amount owing on the outstanding balance of the Note.

     Section 7.03. Employee Benefits. (a) Parent shall offer to employees of the Company (the “Employees”), as soon as practicable after the Closing Date, health and welfare benefits comparable to the benefits offered by Parent to Parent employees, which benefits shall be subject to change at any time by Parent in its sole discretion. Until Parent offers such benefits to the Employees, Parent shall provided health care benefits comparable to the benefits received by the

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Employees under the Company’s health plan, which benefits shall be subject to change at any time by Parent in its sole discretion.

     (b) Parent shall credit the Employees with service consistent with their most recent date of hire with the Company as shown on the books and records of the Company for purposes of (i) eligibility to participate in Parent’s health and welfare plans and (ii) eligibility and vesting (but not benefit accrual) in any retirement plans of Parent.

     Section 7.04. Further Assurances. (a) At and after the Effective Time, the officers and directors of the Surviving Entity shall be authorized to execute and deliver, in the name and on behalf of the Company or the Merger Subsidiaries, any deeds, bills of sale, assignments or assurances and to take and do, in the name and on behalf of the Company or the Merger Subsidiaries, any other actions and things to vest, perfect or confirm of record or otherwise in the Surviving Entity any and all right, title and interest in, to and under any of the rights, properties or assets of the Company acquired or to be acquired by the Surviving Entity as a result of, or in connection with, the Merger.

     (b) Each Seller shall, from time to time, execute and deliver, or cause to be executed and delivered, such additional or further transfers, waivers, assignments, endorsements and other instruments, or take any such other actions, as Parent or the Merger Subsidiaries may reasonably request to carry out the transactions expressly set forth in this Agreement.

Article 8
Tax Matters

     Section 8.01. Tax Definitions. The following terms, as used herein, have the following meanings:

     “Parent Indemnitee” means Parent, any of its Affiliates and, effective upon the Closing, the Surviving Entity.

     “Post-Closing Tax Period” means any Tax period beginning after the Closing Date; and, with respect to a Tax period that begins on or before the Closing Date and ends thereafter, the portion of such Tax period beginning after the Closing Date.

     “Pre-Closing Tax Period” means any Tax period ending on or before the Closing Date; and, with respect to a Tax period that begins on or before the Closing Date and ends thereafter, the portion of such Tax period ending on the Closing Date.

     “Tax” means (i) any tax, governmental fee or other like assessment or charge of any kind whatsoever (including, but not limited to, withholding on

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amounts paid to or by any Person), together with any interest, penalty, addition to tax or additional amount imposed by any governmental authority (a “Taxing Authority”) responsible for the imposition of any such tax (domestic or foreign), and any liability for any of the foregoing as transferee, (ii) in the case of the Company, liability for the payment of any amount of the type described in clause (i) as a result of being or having been before the Effective Time a member of an affiliated, consolidated, combined or unitary group, or a party to any agreement or arrangement, as a result of which liability of the Company to a Taxing Authority is determined or taken into account with reference to the activities of any other Person and (iii) liability of the Company for the payment of any amount with respect to the payment of any amount imposed on any Person of the type described in (i) or (ii) as a result of any existing express or implied agreement or arrangement (including, but not limited to, a tax sharing agreement, an indemnification agreement or arrangement).

     “Tax Asset” means any net operating loss, net capital loss, investment tax credit, foreign tax credit, charitable deduction or any other credit or tax attribute that could be carried forward or back to reduce Taxes (including without limitation deductions and credits related to alternative minimum Taxes).

     Section 8.02. Tax Representations. The Company represents and warrants to Parent that:

     (a) Filing and Payment. Except as set forth on Schedule 8.02(a) of the Company Disclosure Schedule, (i) all Tax returns, statements, reports, elections, declarations, disclosures, schedules and forms (including estimated tax or information returns and reports) filed or required to be filed with any Taxing Authority (“Returns”) by or on behalf of the Company prior to the Closing Date, have been filed when due in accordance with all applicable laws; (ii) as of the time of filing, such Returns were true and complete in all material respects; and (iii) all Taxes shown as due and payable on the Returns that have been filed have been timely paid, or withheld and remitted, to the appropriate Taxing Authority.

     (b) Financial Records. Except as set forth on Schedule 8.02(b) of the Company Disclosure Schedule, (i) the charges, accruals and reserves for Taxes with respect to the Company reflected on the books of the Company (excluding any provision for deferred income taxes reflecting either differences between the treatment of items for accounting and income tax purposes or carryforwards) are adequate to cover Tax liabilities accruing through the end of the last period for which the Company ordinarily records items on its books; and (ii) since the end of the last period for which the Company ordinarily records items on its books, the Company has not incurred or accrued any liability for Taxes other than in the ordinary course of business.

     (c) Procedure and Compliance. Except as set forth on Schedule 8.02(c) of the Company Disclosure Schedule, (i) no Returns filed with respect to Tax years of the Company through the Tax year ended December 31, 2006 have been

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subject to examination by any Taxing Authority and no notice to commence an examination has been received by the Company or any Seller; (ii) the Company has not granted any extension or waiver of the statute of limitations period applicable to any Return, which period (after giving effect to such extension or waiver) has not yet expired; (iii) there is no claim, audit, action, suit, proceeding, or investigation now pending or, to the knowledge of the Company, threatened against or with respect to the Company in respect of any Tax or Return; and (iv) no adjustment that would increase the Tax liability of the Company has been made, proposed or threatened in writing by a Taxing Authority during any audit of a Pre-Closing Tax Period which could reasonably be expected to be made, proposed or threatened in an audit of any subsequent Pre-Closing Tax Period or Post-Closing Tax Period.

     (d) Taxing Jurisdictions. Schedule 8.02 of the Company Disclosure Schedule sets forth a list of all jurisdictions (whether foreign or domestic) to which any Tax is properly payable by the Company.

     (e) S Corporation Status. The Company (and any predecessor of the Company) was at all times during its existence until June 28, 2007 a validly electing S corporation, within the meaning of Sections 1361 and 1362 of the Code. On June 29, 2007, the Company’s status as an S Corporation terminated. The Company has not made any election under Treasury Regulations Section 301.7701-3 to be taxed other than as a corporation for U.S. federal income tax purposes.

     (f) FIRPTA Certificate. Parent has received a certification signed by the Company to the effect that no interest in the Company constitutes a United States real property interest, as defined in Section 897 of the Code.

     Section 8.03. Covenants.

     (a) Without the prior written consent of Parent, none of the Sellers or the Company shall, to the extent it may affect or relate to the Company, make or change any Tax election, change any annual Tax accounting period, adopt or change any method of Tax accounting, file any amended Return, enter into any closing agreement, settle any Tax claim or assessment, surrender any right to claim a Tax refund, offset or other reduction in Tax liability, consent to any extension or waiver of the limitations period applicable to any Tax claim or assessment or take or omit to take any other action, if any such action or omission would have the effect of increasing the Tax liability or reducing any tax asset of the Company, Parent or any Affiliate of Parent.

     (b) Shareholders’ Representative shall prepare or cause to be prepared and file or cause to be filed all Returns for the Company for all periods ending on or prior to the Closing Date that are filed after the Closing Date. Shareholders’ Representative shall permit Parent to review and comment on each such Return described in the preceding sentence at least 30 days prior to the due date for such

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Return, and shall provide Parent with all related workpapers. Such Returns shall be prepared in a manner consistent with the Company’s prior practice. Shareholders’ Representative shall not file any Returns described in this Section 8.03(c) without the prior written consent of Parent (which shall not be unreasonably withheld). In the event that there is a dispute regarding the Returns, Section 8.07 shall apply. To the extent permitted by applicable law, the Sellers shall include any income, gain, loss, deduction or other Tax items for such periods on their Returns in a manner consistent with the Schedule K-1s furnished by the Company to the Sellers for such periods.

     (c) Prior to the Closing, the Company shall not make any payment of, or in respect of, any Tax to any Person or any Taxing Authority, except to the extent such payment is in respect of a Tax that is due or payable or has been properly estimated in accordance with applicable law as applied in a manner consistent with past practice of the Company.

     (d) All transfer, documentary, sales, use, stamp, registration, value added and other such Taxes and fees (including any penalties and interest) incurred in connection with transactions contemplated by this Agreement (including any real property transfer Tax and any similar Tax (for the avoidance of doubt, excluding state and federal income taxes, if any, payable by the Company in connection with the transactions contemplated by this Agreement)) shall be paid by Sellers (in proportion to their percentage ownership of the Company Stock, as set forth in Annex II to this Agreement) when due, and the Company will file all necessary Returns and other documentation with respect to all such Taxes and fees, with the costs of such Returns and other documentation to be borne by Sellers (in proportion to their percentage ownership of the Company Stock, as set forth in Annex II to this Agreement), and if required by applicable law, Parent will, and will cause its Affiliates to, join in the execution of any such Returns and other documentation.

     Section 8.04. Cooperation on Tax Matters.

     (a) Parent and the Sellers shall cooperate fully, as and to the extent reasonably requested by the other party, in connection with the preparation and filing of any Return (including any report required pursuant to Section 6043 of the Code and all Treasury Regulations promulgated thereunder), any audit, litigation or other proceeding with respect to Taxes. Such cooperation shall include the retention and (upon another party’s request) the provision of records and information which are reasonably relevant to any such audit, litigation or other proceeding and making employees available on a mutually convenient basis to provide additional information and explanation of any material provided hereunder. Parent and the Sellers agree (i) to retain all books and records with respect to Tax matters pertinent to the Company relating to any Pre-Closing Tax Period, and to abide by all record retention agreements entered into with any Taxing Authority, and (ii) to give the other party reasonable written notice prior to destroying or discarding any such books and records and, if the other party so

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requests, Parent or the Sellers, as the case may be, shall allow the other party to take possession of such books and records.

     (b) Parent and the Sellers further agree, upon request, to use all reasonable efforts to obtain any certificate or other document from any Governmental Authority or customer of the Company or any other Person as may be necessary to mitigate, reduce or eliminate any Tax that could be imposed (including but not limited to with respect to the transactions contemplated hereby).

     Section 8.05. Tax Indemnification.

     (a) Each of David Gardner and Trust, jointly and severally, by adopting this Agreement, shall hereby agree to indemnify each Parent Indemnitee against and agree to hold each Parent Indemnitee harmless from any:

     (u) Tax of the Company described in clause (i) of the definition of Tax related to a Pre-Closing Tax Period,

     (v) Tax described in clause (ii) or (iii) of the definition of Tax,

     (w) Tax of the Company resulting from a breach of the provisions of Section 8.02 or Section 8.03,

     (x) Tax resulting from the application of Section 280G of the Code to any payment made pursuant to this Agreement or to any payment made as a result of, or in connection with, any transaction contemplated by this Agreement,

     (y) liabilities, costs, expenses (including, without limitation, reasonable expenses of investigation and attorneys’ fees and expenses), losses, damages, assessments, settlements or judgments arising out of or incident to the imposition, assessment or assertion of any Tax described in (u), (v), (w), (x) or (y),

     (the sum of (u), (v), (w), (x), and (y), of this Section 8.05(a) being referred to herein as a “Loss”).

     (b) For purposes of this Section, in the case of any Taxes that are imposed on a periodic basis and are payable for a Tax period that includes (but does not end on) the Closing Date, the portion of such Tax related to the portion of such Tax period ending on and including the Closing Date shall (x) in the case of any Taxes other than gross receipts, sales or use Taxes and Taxes based upon or related to income, be deemed to be the amount of such Tax for the entire Tax period multiplied by a fraction the numerator of which is the number of days in the Tax period ending on and including the Closing Date and the denominator of which is the number of days in the entire Tax period, and (y) in the case of any

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Tax based upon or related to income and any gross receipts, sales or use Tax, be deemed equal to the amount which would be payable if the relevant Tax period ended on the Closing Date. All determinations necessary to give effect to the allocation set forth in the foregoing clause (y) shall be made in a manner consistent with prior practice of the Company.

     (c) Not later than 30 days after receipt by Shareholders’ Representative of written notice from Parent stating that any Loss has been incurred by a Parent Indemnitee and the amount thereof and of the indemnity payment requested, the Sellers shall discharge their obligation to indemnify the Parent Indemnitee against such Loss by paying to Parent an amount equal to the amount of such Loss. Notwithstanding the foregoing, if Parent provides Shareholders’ Representative with written notice of at least 30 days prior to the date on which the relevant Loss is required to be paid by any Parent Indemnitee, within that 30-day period the Sellers shall discharge their obligation to indemnify the Parent Indemnitee against such Loss by making payments to the relevant Taxing Authority or Parent, as directed by Parent, in an aggregate amount equal to the amount of such Loss. The payment by a Parent Indemnitee of any Loss shall not relieve Sellers of their obligation under this Section 8.05.

     (d) Parent agrees to give prompt notice to Shareholders’ Representative of any Loss or the assertion of any claim, or the commencement of any suit, action or proceeding in respect of which indemnity may be sought hereunder which Parent deems to be within the ambit of this Section 8.05 (specifying with reasonable particularity the basis therefor) and will give Shareholders’ Representative such information with respect thereto as Shareholders’ Representative may reasonably request. Shareholders’ Representative may, at the Sellers’ expense, participate in the defense of any such suit, action or proceeding (including any Tax audit). Parent shall keep Shareholders’ Representative reasonably informed of all developments on a timely basis and Parent shall not resolve any such suit, action or proceeding in a manner that could reasonably be expected to have an adverse impact on the Sellers’ indemnification obligations under this Agreement without Shareholders’ Representative written consent, which shall not be unreasonably withheld. All of the parties hereto shall cooperate in the defense or prosecution of any claim.

     (e) No investigation by Parent or any of its Affiliates at or prior to the Closing Date shall relieve the Sellers of any liability hereunder.

     (f) Any claim of any Parent Indemnitee under this Section may be made and enforced by Parent on behalf of such Parent Indemnitee.

     Section 8.06. Certain Disputes. Disputes arising under Section 8.05 and not resolved by mutual agreement within 30 days shall be resolved by a nationally recognized accounting firm with no material relationship with Parent, the Sellers or their Affiliates (the “Accounting Referee”), chosen and mutually acceptable to both Parent and the Sellers within five days of the date on which the need to

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choose the Accounting Referee arises. The Accounting Referee shall resolve any disputed items within 30 days of having the item referred to it pursuant to such procedures as it may require. The costs, fees and expenses of the Accounting Referee shall be borne equally by Parent and the Sellers in proportion to their percentage ownership of the Company Stock, as set forth in Annex II to this Agreement.

     Section 8.07. Purchase Price Adjustment. Any amount paid by the Sellers or Parent under Article 8 or Article 9 will be treated as an adjustment to the Merger Consideration.

     Section 8.08. Tax-Free Reorganization Treatment. The parties intend (assuming no shares of Parent Stock are used to satisfy obligations under Article 9), if the Mergers are consummated, that the First and Second Mergers be treated as one integrated transaction, qualifying as a “reorganization” described in Code Section 368(a)(1)(A) and for this Agreement to constitute a “plan of reorganization” within the meaning of Treasury Regulations Section 1.368-2(g). The parties agree to file all state and federal income tax returns in a manner consistent with the intent and form of this transaction.

     Section 8.09. Survival. Notwithstanding anything in this Agreement to the contrary, the provisions of this Article 8 other than Section 8.08, shall survive for the full period of the applicable statutes of limitations (giving effect to any waiver, mitigation or extension thereof).

Article 9
Survival of Representations and Warranties; Indemnification

     Section 9.01. Survival of Representation and Warranties. The representations and warranties of the parties hereto contained in this Agreement shall survive the Effective Time until the second anniversary of the Closing Date (the “Survival Period”), provided that the representations and warranties in Sections 4.01, 4.02, 4.07, 4.08, 4.18 and 4.21 shall survive indefinitely or until the latest date permitted by law and the representations and warranties contained in Article 8 shall survive in accordance with the terms of Section 8.09. The covenants and agreements of the parties hereto contained in this Agreement or in any certificate or other writing delivered pursuant hereto or in connection herewith shall survive the Closing Date indefinitely or for the shorter period explicitly specified therein, except that for such covenants and agreements that survive for such shorter period, breaches thereof shall survive indefinitely or until the latest date permitted by law. Notwithstanding the preceding sentences, any breach of representation, warranty, covenant or agreement in respect of which indemnity is being sought under this Agreement shall survive the time at which it would otherwise terminate pursuant to the preceding sentences, if written notice of the inaccuracy or breach thereof giving rise to such right of indemnity shall have been given to the party against whom such indemnity may be sought prior to

35

such time, but only to the extent of the indemnity being sought. All of Parent’s and the Merger Subsidiaries’ representations and warranties contained herein or in any instrument delivered pursuant to this Agreement shall terminate at the Effective Time.

     Section 9.02. Indemnification. (a) Subject to the limitations made herein, Trust and David Gardner (the “Indemnifying Parties” shall jointly and severally indemnify, defend and hold harmless Parent and its Affiliates (including, after the Second Effective Time, the Surviving Entity), officers, directors, employees, agents, successors and assigns (collectively, the “Indemnified Parties”) for any and all damage, losses, liability, expenses, interest, awards, judgments and penalties (including reasonable expenses of investigation and reasonable attorneys’ and consultants’ fees and expenses in connection with any action, suit or proceeding whether involving a third party claim or a claim solely between the parties hereto but excluding any incidental, indirect or consequential damages, losses, liabilities or expenses, and excluding any lost profits or diminution in value) (“Damages”), incurred or suffered by any Indemnified Party arising out of any misrepresentation or breach of warranty (without giving effect to any qualification as to materiality or Material Adverse Effect contained therein in determining the amount of any Damages) or breach of covenant or agreement made or to be performed by the Company pursuant to this Agreement, in each case, other than Damages relating to Taxes, which shall be governed by Article 8.

     (b) The Sellers acknowledge and agree to the manner of indemnification payments provided for in this Article 9, notwithstanding that not all Sellers are subject to indemnification obligations under this Article 9. The Sellers shall be free to make arrangements among themselves as regards to the sharing of indemnification payments made pursuant to this Article 9.

     (c) No Indemnified Party shall be entitled to indemnification pursuant to this Article 9 until such time as the total amount of all Damages that have been directly or indirectly suffered or incurred by any one or more of the Indemnified Parties, or to which any one or more of the Indemnified Parties has or have otherwise become subject, exceeds $200,000 in the aggregate (the “Threshold Amount”). At such time, the Indemnified Parties shall be entitled to be indemnified against and compensated only for the portion of such Damages exceeding the Threshold Amount. For the avoidance of doubt, indemnification claims pursuant to Article 8 shall not be subject to this Section 9.02(c).

     (d) The maximum aggregate indemnification obligation of the Indemnifying Parties under this Article 9 shall be $10,000,000.

     (e) David Gardner may, at his election, discharge any indemnifiable claim for indemnification hereunder (in whole or in part) by surrendering shares of Parent Stock to Parent. For claims made during the two year period following the Closing Date, the delivery of such shares of Parent Stock shall operate for all purposes as a complete discharge of the obligation to pay Damages pursuant to an

36

indemnifiable claim in an amount equal to the product of (w) the number of shares of Parent Stock delivered by David Gardner pursuant to this Section 9.02(e) and (x) $11.066. For claims made after the two-year anniversary of the Closing Date, the delivery of such shares of Parent Stock shall operate for all purposes as a complete discharge of the obligation to pay Damages pursuant to an indemnifiable claim in an amount equal to the product of (y) the number of shares of Parent Stock delivered by David Gardner pursuant to this Section 9.02(e) and (z) the closing price of Parent Stock on The Nasdaq Global Market (or other applicable national exchange) on the Business Day prior to delivery of the Indemnification Notice setting forth the indemnifiable claim.

     (f) Any amounts owed by Trust for indemnification claims pursuant to Article 8 or Article 9 shall be satisfied first by causing Parent to withhold amounts remaining due and payable on the Note by Parent. The withholding and deduction of any such sum shall operate for all purposes as a complete discharge (to the extent of such sum) of the obligation to pay the amount from which such sum was withheld and deducted. In the event that Trust’s indemnification obligation exceeds the balance due on the Note, the Trust shall be responsible for such excess indemnification obligation.

     (g) In the event that an Indemnified Party has delivered an Indemnification Notice pursuant to Section 9.03, Parent may withhold payments due on the Note up to the amount of alleged Damages set forth in the Indemnification Notice until the resolution of such claim. Any amounts to be withheld shall be withheld first from the last payment of principal due on the Note, and then against earlier payments of principal to the extent that the alleged Damages exceed the amount due on the last payment of principal on the Note. Upon the final determination of the matter asserted in the Indemnification Notice, any amounts remaining to be paid on the Note after offsetting for any Damages determined to be owed by Trust pursuant to the matter asserted in such Indemnification Notice, less any amounts for which an Indemnification Notice has been delivered but not yet determined, shall be paid in accordance with the terms of this Agreement and the Note.

     (h) The representations and warranties (as modified by the Company Disclosure Schedule) and the covenants and agreements of the Company, and the rights and remedies that may be exercised by the Indemnified Parties, shall not be limited or otherwise affected by or as a result of any information furnished to, or any investigation made by or knowledge of, any Indemnified Party.

     (i) In all matters relating to Article 8 or Article 9, the Shareholders’ Representative shall be the only party entitled to assert the rights of the Shareholders, and the Shareholders’ Representative shall perform all of the obligations of the Shareholders hereunder. Parent shall be entitled to rely on all statements, representations and decisions of the Shareholders’ Representative.

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     Section 9.03. Indemnification Notice. (a) Any Indemnified Party seeking indemnification under this Agreement shall give the Shareholders’ Representative notice of any matter that such Indemnified Party has determined has given rise to a right of indemnification under this Agreement, prior to the expiration of the applicable representations and warranties as set forth in Section 9.01. Such Indemnification Notice shall specify (i) the specific provisions of this Agreement in respect of which such right of indemnification is claimed or arises (ii) the amount of Damages being claimed by the Indemnified Party, if known, and method of computation thereof, and (iii) the facts and circumstances supporting such claim (an “Indemnification Notice”). The Shareholders’ Representative may object in a written statement to the claim made by the Indemnified Party in an Indemnification Notice by delivering a notice of such objection to the Indemnified Party prior to the expiration of the thirtieth (30th) day after delivery of the Indemnification Notice to the Shareholders’ Representative (an “Objection Notice”). If the Shareholders’ Representative does not object in writing within such 30-day period, such failure to so object shall be an irrevocable acknowledgment by the Shareholders’ Representative that the Indemnified Party is entitled to the full amount of Damages set forth in such Indemnification Notice.

     (b) In case the Shareholders’ Representative delivers an Objection Notice in accordance with Section 9.03, the Shareholders’ Representative and the Indemnified Party shall attempt in good faith to agree upon the rights of the respective parties with respect to each of such claims. Within ten (10) Business Days after an Objection Notice is delivered to the Indemnified Party, the Shareholder’s Representative and a person having authority on behalf of the Indemnified Party to settle the dispute shall meet at a mutually acceptable time and place to attempt to resolve the dispute. If the Shareholders’ Representative and the Indemnified Party should agree upon the rights of the respective parties with respect to each of such claims, a memorandum setting forth such agreement shall be prepared and signed by both parties.

     Section 9.04. Shareholders’ Representative. (a) Effective upon and pursuant to this Agreement, the Shareholders’ Representative shall be hereby appointed as the representative of the holders of Company Stock and as the attorney-in-fact and agent for and on behalf of each holder of Company Stock solely with respect to any claims by any Indemnified Party under Article 8 or Article 9 of this Agreement. The Shareholders’ Representative hereby accepts such appointment. The Shareholders’ Representative shall have the authority to take any and all actions and make any decisions required or permitted to be taken by the Shareholders’ Representative under this Agreement, including the exercise of the power to (i) agree to, negotiate, enter into settlements and compromises of, commence any suit, action or proceeding, and comply with orders of courts with respect to, claims by any Indemnified Party under Article 8 or Article 9 of this Agreement, and (ii) take all actions necessary in the judgment of the Shareholders’ Representative for the accomplishment of the foregoing. The Shareholders’ Representative will have sole authority and power to act on behalf

38

of each former shareholder of the Company with respect to the disposition, settlement or other handling of all claims for indemnification under this Agreement and all related rights or obligations of the former shareholders of the Company arising under this Agreement. The Shareholders’ Representative shall use commercially reasonable efforts, based on contact information available to the Shareholders’ Representative, to keep the former shareholders of the Company reasonably informed with respect to actions of the Shareholders’ Representative pursuant to the authority granted the Shareholders’ Representative under this Agreement. Each former shareholder of the Company shall promptly provide written notice to the Shareholders’ Representative of any change of address of such shareholder.

     (b) In all matters relating to the disposition, settlement or other handling of claims pursuant to Article 8 under this Agreement, the Shareholders’ Representative (or his or her successor) shall be the only party entitled to assert the rights of the former shareholders of the Company. A decision, act, consent or instruction of the Shareholders’ Representative hereunder shall constitute a decision, act, consent or instruction of all former holders of Company Stock and shall be final, binding and conclusive upon each of such shareholders, and Parent may rely upon any such decision, act, consent or instruction of the Shareholders’ Representative as being the decision, act, consent or instruction of each and every such holder of Company Stock. Parent shall be relieved from any liability to any Person for any acts done by them in accordance with such decision, act, consent or instruction of the Shareholders’ Representative.

     (c) The Shareholders’ Representative shall have the right to recover from payments due on the Note, prior to any distribution to Trust, the Shareholders’ Representative’s reasonable out-of-pocket expenses incurred in serving in that capacity (the “Shareholders’ Representative’s Expenses”). In the event outstanding payments on the Note are insufficient to satisfy the Shareholders’ Representative’s Expenses, then each Shareholder will be obligated to pay a percentage of the Shareholders’ Representative’s Expenses in excess of such funds proportionate to that holder’s percentage ownership of the Company Stock.

     (d) The Shareholders’ Representative will incur no liability with respect to any action taken or suffered by any party in reliance upon any notice, direction, instruction, consent, statement or other document believed by such Shareholders’ Representative to be genuine and to have been signed by the proper person (and shall have no responsibility to determine the authenticity thereof), nor for any other action or inaction, except his own gross negligence, bad faith or willful misconduct. In all questions arising under this Agreement, the Shareholders’ Representative may rely on the advice of outside counsel, and the Shareholders’ Representative will not be liable to anyone for anything done, omitted or suffered in good faith by the Shareholders’ Representative based on such advice.

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     (e) The holders of Company Stock shall severally but not jointly indemnify the Shareholders’ Representative and hold the Shareholders’ Representative harmless against any loss, liability or expense incurred without gross negligence, bad faith or willful misconduct, to the extent permitted by applicable law, on the part of the Shareholders’ Representative and arising out of or in connection with the acceptance or administration of the Shareholders’ Representative’s duties hereunder, including the reasonable fees and expenses of any legal counsel retained by the Shareholders’ Representative.

     (f) At any time during the Survival Period, a majority-in-interest of holders of Company Stock may, by written consent, appoint a new representative as the Shareholders’ Representative. Notice together with a copy of the written consent appointing such new representative and bearing the signatures of holders of a majority-in-interest of those holders must be delivered to Parent not less than ten (10) calendar days prior to such appointment. Such appointment will be effective upon the later of the date indicated in the consent or the date such consent is received by Parent

     (g) In the event that the Shareholders’ Representative becomes unable or unwilling to continue in his or its capacity as Shareholders’ Representative, or if the Shareholders’ Representative resigns as a Shareholders’ Representative, a majority-in-interest of the holders of Company Stock may, by written consent, appoint a new representative as the Shareholders’ Representative. Notice and a copy of the written consent appointing such new representative and bearing the signatures of the holders of a majority-in-interest of such holders must be delivered to Parent. Such appointment will be effective upon the later of the date indicated in the consent or the date such consent is received by Parent.

     Section 9.05. No Claims for Disclosed Matters. No Indemnified Party may assert a claim for indemnification with respect to any matter which has been disclosed to Parent in the Company Disclosure Schedules.

Article 10
Miscellaneous

     Section 10.01. Notices. All notices, requests and other communications to any party hereunder shall be in writing and delivered either (i) in person or (ii) by a nationally recognized courier service and shall be given,

     if to Parent or Merger Subsidiaries, to:

Photon Dynamics, Inc.
5970 Optical Court
San Jose, California 95138
Attention: General Counsel

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     with a copy to:

Davis Polk & Wardwell
1600 El Camino Real
Menlo Park, California 94025
Attention: William M. Kelly, Esq.

     if to the Company, to:

Salvador Imaging, Inc.
4815 List Drive, Suite 104
Colorado Springs, Colorado 80919
Attention: David Gardner

     with a copy to:

Rothgerber Johnson & Lyons LLP
90 South Cascade Avenue, Suite 1100
Colorado Springs, Colorado 80903
Attention: H. William Mahaffey, Esq.

     if to the Sellers or to the Shareholder’s Representative, to:

David Gardner
4815 List Drive, Suite 104
Colorado Springs, Colorado 80919
Attention: David Gardner

     with a copy to:

Rothgerber Johnson & Lyons LLP
90 South Cascade Avenue, Suite 1100
Colorado Springs, Colorado 80903
Attention: H. William Mahaffey, Esq.

or to such other address as such party may hereafter specify for the purpose by notice to the other parties hereto. All such notices, requests and other communications shall be deemed received on the date of receipt by the recipient thereof if received prior to 5:00 p.m. on a Business Day in the place of receipt. Otherwise, any such notice, request or communication shall be deemed to have been received on the next succeeding Business Day in the place of receipt.

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     Section 10.02. Amendments and Waivers. (a) Any provision of this Agreement may be amended or waived prior to the Effective Time if, but only if, such amendment or waiver is in writing and is signed, in the case of an amendment, by each party to this Agreement or, in the case of a waiver, by each party against whom the waiver is to be effective; provided that, after the Company Shareholder Approval without their further approval, no such amendment or waiver shall reduce the amount or change the kind of consideration to be received in exchange for the shares of Company Stock.

     (b) No failure or delay by any party in exercising any right, power or privilege hereunder shall operate as a waiver thereof nor shall any single or partial exercise thereof preclude any other or further exercise thereof or the exercise of any other right, power or privilege. The rights and remedies herein provided shall be cumulative and not exclusive of any rights or remedies provided by Applicable Law.

     Section 10.03. Expenses. Except as otherwise provided herein, all costs and expenses incurred in connection with this Agreement shall be paid by the party incurring such cost or expense.

     Section 10.04. Successors and Assigns. The provisions of this Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns; provided that no party may assign, delegate or otherwise transfer any of its rights or obligations under this Agreement without the consent of each other party hereto; except that Parent or The Merger Subsidiaries may transfer or assign its rights and obligations under this Agreement, in whole or from time to time in part, to one or more of their Affiliates at any time; provided that no such transfer or assignment shall relieve Parent of its obligations hereunder or enlarge, alter or change any obligation of any other party hereto or due to Parent.

     Section 10.05. Governing Law. This Agreement shall be governed by and construed in accordance with the laws of the State of Colorado, without regard to the conflicts of law rules of such state.

     Section 10.06. Jurisdiction. The parties hereto agree that any suit, action or proceeding seeking to enforce any provision of, or based on any matter arising out of or in connection with, this Agreement or the transactions contemplated hereby shall be brought in any federal court located in the State of Colorado or any Colorado state court, and each of the parties hereby irrevocably consents to the jurisdiction of such courts (and of the appropriate appellate courts therefrom) in any such suit, action or proceeding and irrevocably waives, to the fullest extent permitted by law, any objection that it may now or hereafter have to the laying of the venue of any such suit, action or proceeding in any such court or that any such suit, action or proceeding brought in any such court has been brought in an inconvenient forum. Process in any such suit, action or proceeding may be served on any party anywhere in the world, whether within or without the jurisdiction of

42

any such court. Without limiting the foregoing, each party agrees that service of process on such party as provided in Section 10.01 shall be deemed effective service of process on such party.

     Section 10.07. WAIVER OF JURY TRIAL. EACH OF THE PARTIES HERETO HEREBY IRREVOCABLY WAIVES ANY AND ALL RIGHT TO TRIAL BY JURY IN ANY LEGAL PROCEEDING ARISING OUT OF OR RELATED TO THIS AGREEMENT OR THE TRANSACTIONS CONTEMPLATED HEREBY.

     Section 10.08. Counterparts; Effectiveness. This Agreement may be signed in any number of counterparts, each of which shall be an original, with the same effect as if the signatures thereto and hereto were upon the same instrument. This Agreement shall become effective when each party hereto shall have received a counterpart hereof signed by all of the other parties hereto. Until and unless each party has received a counterpart hereof signed by the other party hereto, this Agreement shall have no effect and no party shall have any right or obligation hereunder (whether by virtue of any other oral or written agreement or other communication).

     Section 10.09. Entire Agreement. This Agreement, the Key Employee Employment Agreements, the Registration Rights Agreement, the Gardner Non-competition Agreement and the Gardner Assignment Agreement constitutes the entire agreement between the parties with respect to the subject matter of this Agreement and supersedes all prior agreements and understandings, both oral and written, between the parties with respect to the subject matter of this Agreement.

     Section 10.10. Captions. The captions herein are included for convenience of reference only and shall be ignored in the construction or interpretation hereof.

     Section 10.11. Severability. If any term, provision, covenant or restriction of this Agreement is held by a court of competent jurisdiction or other Governmental Authority to be invalid, void or unenforceable, the remainder of the terms, provisions, covenants and restrictions of this Agreement shall remain in full force and effect and shall in no way be affected, impaired or invalidated so long as the economic or legal substance of the transactions contemplated hereby is not affected in any manner materially adverse to any party. Upon such a determination, the parties shall negotiate in good faith to modify this Agreement so as to effect the original intent of the parties as closely as possible in an acceptable manner in order that the transactions contemplated hereby be consummated as originally contemplated to the fullest extent possible.

     Section 10.12. Specific Performance. The parties hereto agree that irreparable damage would occur if any provision of this Agreement were not performed in accordance with the terms hereof and that the parties shall be entitled to an injunction or injunctions to prevent breaches of this Agreement or to

43

enforce specifically the performance of the terms and provisions hereof, in addition to any other remedy to which they are entitled at law or in equity.

44

     IN WITNESS WHEREOF, the parties hereto have caused this Agreement to be duly executed by their respective authorized officers as of the day and year first above written.

SALVADOR IMAGING, INC.
By:	/s/ DAVID GARDNER
	Name:	David Gardner
	Title:	President & CEO
DAVID GARDNER
/s/ DAVID GARDNER
SALVADOR FOUNDATION CHARITABLE REMAINDER UNITRUST
By:	/s/ DAVID GARDNER
	Name:	David Gardner
	Title:	Trustee
JAMES R. LONG
/s/ JAMES R. LONG
PATRICIA LONG
/s/ PATRICIA LONG
KERRY RHEA
/s/ KERRY RHEA
LISA J. RHEA
/s/ LISA J. RHEA

[Signature Page to Agreement and Plan of Merger and Reorganization]

Annex IX-1

PHOTON DYNAMICS, INC.
By:	/s/ JEFFREY A. HAWTHORNE
	Name:	Jeffrey A. Hawthorne
	Title:	President and Chief Executive Officer
SALVADOR ACQUISITION, INC.
By:	/s/ JEFFREY A. HAWTHORNE
	Name:	Jeffrey A. Hawthorne
	Title:	Chief Executive Officer
SALVADOR ACQUISITION, LLC
By:	/s/ JEFFREY A. HAWTHORNE
	Name:	Jeffrey A. Hawthorne
	Title:	Chief Executive Officer

[Signature Page to Agreement and Plan of Merger and Reorganization]

2

EX-21.1

EXHIBIT 21.1

SUBSIDIARIES OF COMPANY

Company
Kabushiki Kaisha Photon Dynamics	Japan	100	%
Photon Dynamics Korea, Inc.	South Korea	100	%
Photon Dynamics Canada, Inc., formerly known as Image Processing Systems, Inc.	Canada	100	%
Intelligent Reasoning Systems, Inc.	United States	100	%
Korea Photon Dynamics	South Korea	100	%
Photon Dynamics Technology (Beijing) Co., Ltd.	China	100	%
Photon Dynamics Nova Scotia Company	Canada	100	%
Salvador Imaging, Inc.	United States	100	%

The subsidiaries listed are all included in the consolidated financial statements of the Company.

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

We consent to the incorporation by reference in the following Registration Statements:

(1)	Registration Statement (Form S-8 No. 33-99582) pertaining to the Photon Dynamics, Inc. 1995 Employee Stock Purchase Plan;
(2)	Registration Statement (Form S-8 No. 333-05283) pertaining to the Photon Dynamics, Inc. 1987 Stock Option Plan and 1995 Stock Option Plan;
(3)	Registration Statement (Form S-8 No. 333-51413) pertaining to the Photon Dynamics, Inc. 1995 Stock Option Plan and 1995 Employee Stock Purchase Plan;
(4)	Registration Statement (Form S-8 No. 333-72761) pertaining to the Photon Dynamics, Inc. 1995 Stock Option Plan and 1995 Employee Stock Purchase Plan;
(5)	Registration Statement (Form S-8 No. 333-95479) pertaining to the Photon Dynamics, Inc. 1995 Stock Option Plan, 1995 Employee Stock Purchase Plan, the CR Technology, Inc. 1983 Stock Option Plan and 1991 Stock Option Plan;
(6)	Registration Statement (Form S-8 No. 333-54254) pertaining to the Photon Dynamics, Inc. 1995 Stock Option Plan, 1995 Employee Stock Purchase Plan, 2001 Equity Incentive Plan and Image Processing Systems Inc. Share Incentive Plan;
(7)	Registration Statement (Form S-8 No. 333-90332) pertaining to the Photon Dynamics, Inc. 1995 Stock Option Plan and 1995 Employee Stock Purchase Plan;
(8)	Registration Statement (Form S-8 No. 333-97037) pertaining to the Photon Dynamics, Inc. 2001 Equity Incentive Plan;
(9)	Registration Statement (Form S-8 No. 333-104809) pertaining to the Photon Dynamics, Inc. 1995 Amended and Restated Stock Option Plan and 1995 Employee Stock Purchase Plan;
(10)	Registration Statement (Form S-8 No. 333-117021) pertaining to the Photon Dynamics, Inc. 1995 Amended and Restated Stock Option Plan and 1995 Employee Stock Purchase Plan; and
(11)	Registration Statement (Form S-8 No. 333-127448) pertaining to the Photon Dynamics, Inc. 2005 Employee Stock Purchase Plan, 2005 Equity Incentive Plan and 2005 Non-Employee Directors Stock Option Plan
(*12)	Registration Statement (Form S-8 No. 333-141811) pertaining to the Photon Dynamics, Inc. 2005 Equity Incentive Plan, as amended, and 2006 Non-Employee Directors’ Stock Incentive Plan

of our reports dated January 21, 2008 with respect to the consolidated financial statements and schedule of Photon Dynamics, Inc. and the effectiveness of internal control over financial reporting of Photon Dynamics, Inc., included in this Annual Report (Form 10-K) for the year ended September 30, 2007.

/s/ Ernst & Young LLP

Palo Alto, California
January 21, 2008

EX-31.1

Exhibit 31.1

CERTIFICATION

I, Jeffrey A. Hawthorne, certify that:

1.	I have reviewed this Annual Report on Form 10-K of Photon Dynamics, Inc.;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a.	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b.	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c.	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d.	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a.	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b.	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

/s/ Jeffrey A. Hawthorne  

Jeffrey A. Hawthorne 

President and Chief Executive Officer 

Date: January 23, 2008

EX-31.2

Exhibit 31.2

CERTIFICATION

I, Michael Schradle, certify that:

1.	I have reviewed this Annual Report on Form 10-K of Photon Dynamics, Inc.;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a.	Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b.	Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;
c.	Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d.	Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a.	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b.	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

/s/ Michael Schradle  

Michael Schradle 

Chief Financial Officer 

Date: January 23, 2008

EX-32.1

Exhibit 32.1

PHOTON DYNAMICS, INC.
CERTIFICATIONS PURSUANT TO
18 U.S.C. §1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report on Form 10-K of Photon Dynamics, Inc. (the “Company”) for the fiscal year ended September 30, 2007, as filed with the Securities and Exchange Commission on the date hereof and to which this Certification is attached as Exhibit 32.1 (the “Report”), and pursuant to the requirement set forth in Rule 13a-14(b) of the Securities Exchange Act of 1934, and Section 1350 of Chapter 63 of Title 18 of the United States Code (18 U.S.C. §1350), Jeffrey A. Hawthorne, President and Chief Executive Officer of the Company, and Michael Schradle, Chief Financial Officer of the Company, each hereby certifies, to the best of his knowledge, respectively, that:

(1)	The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2)	The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated: January 23, 2008

/s/ Jeffrey A. Hawthorne Jeffrey A. Hawthorne	/s/ Michael Schradle Michael Schradle
President and Chief Executive Officer	Chief Financial Officer

This certification accompanies the Form 10-K to which it relates, is not deemed filed with the Securities and Exchange Commission and is not to be incorporated by reference into any filing of the Company under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934 (whether made before or after the date of the Form 10-K), irrespective of any general incorporation language contained in such filing.