APPLIED INNOVATION INC. 10-Q

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)


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

For the quarterly period ended September 30, 2006


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 0-21352

APPLIED INNOVATION INC.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		31-1177192 (I.R.S. Employer Identification No.)

5800 Innovation Drive, Dublin, Ohio (Address of principal executive offices)		43016 (Zip Code)

Registrant’s telephone number, including area code: (614) 798-2000

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 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 o Non-accelerated filerþ

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

As of November 9, 2006, there were 15,266,658 shares of common stock outstanding.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

APPLIED INNOVATION INC.

Consolidated Balance Sheets


	(Unaudited)
	September 30, 2006		December 31, 2005
Assets
Current assets:
Cash and cash equivalents	$	15,316,354	$	9,874,406
Short term investments		6,652,149		10,477,682
Accounts receivable, net of allowance of $106,000 in 2006 and $150,000 in 2005		2,851,424		4,273,406
Inventory, net		3,291,700		2,997,403
Other current assets		354,075		523,554
Deferred income taxes		1,028,000		1,009,000

Total current assets		29,493,702		29,155,451

Property, plant and equipment, net of accumulated depreciation of $9,882,239 in 2006 and $10,405,968 in 2005		5,217,334		5,898,916
Investments		14,212,645		9,740,179
Goodwill		3,525,801		3,525,801
Deferred income taxes		—		808,000
Other assets		1,421,142		1,379,119


	$	53,870,624	$	50,507,466


Liabilities and Stockholders’ Equity

Current liabilities:
Accounts payable	$	966,997	$	1,029,777
Accrued expenses:
Warranty		261,000		336,000
Payroll and related expenses		1,155,762		1,275,036
Restructuring		—		27,695
Income taxes payable		518,245		321,965
Taxes, other than income taxes		310,741		396,484
Other accrued expenses		553,570		628,658
Deferred revenue		1,619,055		1,102,044

Total current liabilities		5,385,370		5,117,659
Deferred income taxes		265,000		—

Total liabilities		5,650,370		5,117,659


Stockholders’ equity:
Preferred stock; $.01 par value; authorized 5,000,000 shares; none issued and outstanding		—		—
Common stock; $.01 par value; authorized 55,000,000 shares; issued and outstanding 15,266,658 shares in 2006 and 15,230,408 in 2005		152,667		152,304
Additional paid-in capital		7,053,859		6,839,219
Retained earnings		40,972,118		38,455,848
Accumulated other comprehensive income (loss), net		41,610		(57,564	)


Total stockholders’ equity		48,220,254		45,389,807


	$	53,870,624	$	50,507,466

See accompanying notes to consolidated financial statements.

- 3 -

APPLIED INNOVATION INC.

Consolidated Statements of Operations (Unaudited)


	Three Months Ended September 30,					Nine Months Ended September 30,
	2006		2005			2006			2005
Sales:
Products	$	6,348,064	$	7,185,987		$	22,112,599		$	19,179,471
Services		1,398,144		1,238,325			3,413,274			4,198,701

Total sales		7,746,208		8,424,312			25,525,873			23,378,172

Cost of sales:
Products		3,116,746		3,316,976			10,899,106			8,849,675
Services		628,341		445,287			1,730,856			1,328,781

Total cost of sales		3,745,087		3,762,263			12,629,962			10,178,456

Gross profit		4,001,121		4,662,049			12,895,911			13,199,716

Operating expenses:
Selling, general and administrative		2,385,125		2,507,903			7,834,083			7,659,553
Research and development		1,040,253		1,209,694			3,134,420			3,305,066
Restructuring charges		—		(10,351	)		—			885,249
Gain on sale of land		—		—			(1,035,937	)		—

Total operating expenses		3,425,378		3,707,246			9,932,566			11,849,868

Income from operations		575,743		954,803			2,963,345			1,349,848

Interest and other income, net		372,395		190,601			999,925			523,553


Income before income taxes		948,138		1,145,404			3,963,270			1,873,401

Income tax expense		400,000		319,000			1,447,000			588,000


Net income	$	548,138	$	826,404		$	2,516,270		$	1,285,401


Basic earnings per share	$	0.04	$	0.05		$	0.16		$	0.08

Diluted earnings per share	$	0.04	$	0.05		$	0.16		$	0.08


Weighted-average shares outstanding for basic earnings per share		15,262,140		15,210,282			15,253,244			15,176,421


Weighted-average shares outstanding for diluted earnings per share		15,265,446		15,273,509			15,264,001			15,233,391

See accompanying notes to consolidated financial statements.

- 4 -

APPLIED INNOVATION INC.

Consolidated Statements of Cash Flows (Unaudited)


	Nine Months Ended September 30,
	2006			2005
Cash flows from operating activities:
Net income	$	2,516,270		$	1,285,401
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		371,273			551,404
Gain on disposal of assets		(1,026,859	)		(21,555	)
Deferred income tax		999,000			529,000
Non-cash stock compensation		96,779			—
Stock issued to non-employees		—			8,000
Tax benefit of options exercised		—			25,350
Effects of changes in operating assets and liabilities:
Accounts receivable		1,421,982			1,321,317
Inventory		(294,297	)		(78,552	)
Other current assets		169,479			204,693
Other assets		(42,023	)		(30,034	)
Accounts payable		(62,780	)		183,831
Income taxes		196,280			(52,972	)
Accrued expenses		(379,724	)		166,980
Deferred revenue		517,011			360,746

Net cash provided by operating activities		4,482,391			4,453,609


Cash flows from investing activities:
Purchases of property, plant and equipment		(61,824	)		(59,425	)
Proceeds from sales of property, plant and equipment		1,395,916			21,618
Purchases of investments		(9,028,876	)		(12,815,974	)
Proceeds from maturities of investments		8,381,857			6,726,635
Proceeds from sales of investments		154,260			759,886

Net cash provided by (used in) investing activities		841,333			(5,367,260	)


Cash flows from financing activities:
Tax benefit of options exercised		3,985			—
Proceeds from issuance of common stock		114,239			343,731

Net cash provided by financing activities		118,224			343,731


Increase (decrease) in cash and cash equivalents		5,441,948			(569,920	)
Cash and cash equivalents — beginning of period		9,874,406			9,773,586


Cash and cash equivalents — end of period	$	15,316,354		$	9,203,666

See accompanying notes to consolidated financial statements.

- 5 -

APPLIED INNOVATION INC.

Notes to Consolidated Financial Statements

(Unaudited)

1. BASIS OF PRESENTATION

The consolidated balance sheet as of September 30, 2006, the consolidated statements of operations for the three and nine months ended September 30, 2006 and 2005, and the consolidated statements of cash flows for the nine months ended September 30, 2006 and 2005 have been prepared by the Company without audit. In the opinion of management, all adjustments necessary to present fairly, in accordance with U.S. generally accepted accounting principles, the financial position, results of operations and cash flows for all periods presented have been made.

Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted. These consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s December 31, 2005 Annual Report on Form 10-K. The results of operations for the periods ended September 30, 2006 are not necessarily indicative of the results for the full year.

2. STOCK-BASED COMPENSATION

Adoption of SFAS 123(R)

On January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (“SFAS”) (revised 2004), Share-Based Payment (“SFAS 123(R)”), which requires the measurement of stock-based compensation expense for all share-based payment awards made to employees for services. In January 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which provided supplemental implementation guidance for SFAS 123(R). Prior to January 1, 2006, the Company accounted for its share-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Accordingly, no compensation cost had been recognized in the consolidated financial statements for stock option grants or for shares purchased under the employee stock purchase plan.

The Company has elected to adopt the modified-prospective transition method permitted by SFAS 123(R) and accordingly prior periods have not been restated to reflect the impact of SFAS 123(R). The modified prospective transition method requires that stock-based compensation expense be recorded for (a) any share-based payments granted through, but not vested as of, December 31, 2005, based on the grant-date fair value estimated in accordance with the pro forma provisions of SFAS No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), and (b) any share-based payments granted subsequent to December 31, 2005, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123(R).

- 6 -

Stock-based compensation expense recognized under SFAS 123(R) for the three and nine months ended September 30, 2006 was $35,201 and $96,779, respectively. Prior to the adoption of SFAS 123(R), the Company reported amounts attributable to the benefits of tax deductions in excess of recognized compensation in the financial statements in the statement of cash flows as operating activities. SFAS 123(R) requires the cash flows resulting from excess tax benefits to be classified as financing cash flows. For the three and nine months ended September 30, 2006, $580 and $3,985, respectively, in excess tax benefits were included in cash flows from financing activities. For the three and nine months ended September 30, 2005, $13,791 and $25,350, respectively, in excess tax benefits were included in cash flows from operating activities.

The Company estimates the fair value of stock options using a Black-Scholes option-pricing model to determine the fair value of stock-based awards under SFAS 123(R), and consistent with that used for pro forma disclosures under SFAS 123, prior to the adoption of SFAS 123(R). 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, the Black-Scholes option-pricing model incorporates various and highly subjective assumptions including expected volatility, expected term and interest rates. The expected volatility is based on historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected term of the Company’s stock options. The expected term of the Company’s stock options are based on historical experience. The risk free interest rate was based on current market yields on 5-year US treasury securities. The expected forfeiture rate is based on historical experience, and was 45% for the three and nine months ended September 30, 2006.

The assumptions used to estimate the fair value of stock options granted and stock purchase rights granted under our Employee Stock Purchase Plan for the three and nine months ended September 30, 2006 and 2005 are as follows:


	Three months ended						Nine months ended
	September 30,			September 30,			September 30,			September 30,
	2006			2005			2006			2005
Weighted-average fair value of options granted during the period using a Black-Scholes option valuation model	$	—		$	2.86		$	1.99		$	2.52
Weighted-average assumptions used for grants:
Expected volatility		57	%		82	%		59	%		83	%
Expected term (years)		4.46			5.55			4.81			5.54
Risk free interest rate		4.84	%		4.04	%		4.79	%		3.93	%
Expected dividend yield		0	%		0	%		0	%		0	%

- 7 -

The following table shows the impact of adopting SFAS 123(R) for the three and nine months ended September 30, 2006:


	Three Months Ended			Nine Months Ended
	September 30, 2006			September 30, 2006
Income from operations:
Before stock-based compensation	$	610,944		$	3,060,124
Less: Stock-based compensation recorded under SFAS 123(R)		(35,201	)		(96,779	)

As reported	$	575,743		$	2,963,345


Income before income taxes:
Before stock-based compensation	$	983,339		$	4,060,049
Less: Stock-based compensation recorded under SFAS 123(R)		(35,201	)		(96,779	)

As reported	$	948,138		$	3,963,270


Net income:
Before stock-based compensation	$	568,555		$	2,577,241
Less: Stock-based compensation recorded under SFAS 123(R)		(20,417	)		(60,971	)

As reported	$	548,138		$	2,516,270


Net income per share, basic and diluted
Before stock-based compensation	$	0.04		$	0.17
Less: Stock-based compensation recorded under SFAS 123(R)	$	—		$	(0.01	)

As reported	$	0.04		$	0.16

The following table illustrates the effect on net income and net income per share for the three and nine months ended September 30, 2005 if the Company had applied the fair value recognition provisions of SFAS 123(R) to stock-based employee compensation using the Black-Scholes model:


	Three Months Ended			Nine Months Ended
	September 30, 2005			September 30, 2005
Net income, as reported	$	826,404		$	1,285,401
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(177,031	)		(580,841	)

Pro forma net income	$	649,373		$	704,560


Net income per share:
Basic and diluted — as reported	$	0.05		$	0.08
Basic and diluted — pro forma	$	0.04		$	0.05

As of September 30, 2006, $376,211 of unrecognized compensation expense related to unvested stock options is expected to be recognized over a weighted average period of approximately 2.17 years.

- 8 -

The Company’s 2001 Stock Incentive Plan (“the 2001 Plan”) was adopted by the Board of Directors on February 27, 2001, and approved by the stockholders of the Company as of April 26, 2001, with 2,000,000 shares of common stock reserved for issuance under the 2001 Plan. Options granted under the 2001 Plan may be either incentive stock options or nonstatutory stock options, with maximum terms of ten years. The exercise price of each incentive stock option must be at least 100% of the fair market value per share of the Company’s common stock as determined by the Stock Option and Compensation Committee on the date of grant. Except for options granted to the Board of Directors which generally vest immediately and become exercisable one year from issuance, options granted under the 2001 Plan generally vest over five years. The shares subject to Options and Restricted Stock grants under the Plan are the shares of common stock, $.01 par value, of the Company (the “Shares”). The Shares issued under the Plan may be authorized and unissued Shares, Shares purchased on the open market or in a private transaction, or Shares held as treasury stock.

Previously, the Company had adopted the 1996 Stock Option Plan (“the 1996 Plan”) with 2,000,000 shares of common stock reserved for issuance under the 1996 Plan. Options granted under the 1996 Plan have maximum terms of ten years. The exercise price of each incentive stock option must be at least 100% of the fair market value per share of the Company’s common stock as determined by the Stock Option and Compensation Committee on the date of grant. Except for options granted to the Board of Directors which generally vest immediately and become exercisable one year from issuance, options granted under the 1996 Plan generally vest over five years.

The following table summarizes stock option activity for the three and nine months ended September 30, 2006:


						Weighted average
	Number of			Weighted average		remaining contractual		Aggregate
	options			exercise price		life (in years)		intrinsic value
Balance at December 31, 2005		1,192,400		$	6.38
Granted		325,000		$	3.68
Exercised		(10,000	)	$	3.14
Forfeited		(312,800	)	$	3.70
Expired		(48,500	)	$	7.26
Balance at March 31, 2006		1,146,100		$	6.28		6.53	$	376,858

Granted		241,250		$	4.13
Exercised		(1,900	)	$	3.03
Forfeited		—		$	—
Expired		—		$	—
Balance at June 30, 2006		1,385,450		$	5.91		6.89	$	171,780

Granted		—		$	—
Exercised		(12,000	)	$	3.03
Forfeited		(93,400	)	$	4.03
Expired		(68,100	)	$	5.13
Balance at September 30, 2006		1,211,950		$	6.13		6.52	$	32,933

- 9 -

The aggregate intrinsic value in the preceding table represents the total pretax intrinsic value, based on the Company’s closing stock price of $3.15 as of September 30, 2006, which would have been received by the option holders had all option holders exercised as of that date. The total intrinsic value of stock options exercised during the three months ended September 30, 2006 and September 30, 2005 was $1,910 and $40,614, respectively, and $11,975 and $77,914 for the nine months ended September 30, 2006 and 2005, respectively. The total fair value of options which vested during the three months ended September 30, 2006 and September 30, 2005 was $870 and $3,156, respectively, and $31,456 and $27,609 for the nine months ended September 30, 2006 and 2005, respectively.

A summary of nonvested options for the three and nine months ended September 30, 2006, and changes during the quarters are as follows:


				Weighted average
	Number of			grant date
	options			fair value
Nonvested at December 31, 2005		247,650		$	3.22
Granted		325,000		$	1.09
Vested		(36,950	)	$	2.76
Forfeited		(312,800	)	$	1.15

Nonvested at March 31, 2006		222,900		$	3.12
Granted		241,250		$	2.00
Vested		(11,400	)	$	3.58
Forfeited		—		$	—

Nonvested at June 30, 2006		452,750		$	3.77
Granted		—		$	—
Vested		(10,100	)	$	2.60
Forfeited		(93,400	)	$	2.45

Nonvested at September 30, 2006		349,250		$	4.81

The following table summarizes information about stock options outstanding at September 30, 2006:


			OPTIONS OUTSTANDING						OPTIONS EXERCISABLE
					Weighted Average
					Remaining		Weighted				Weighted
Range of			Number		Contractual		Average		Number		Average
Exercise Prices			Outstanding		Life (Years)		Exercise Price		Exercisable		Exercise Price
$2.9600	$	3.0000		16,500		7.81	$	2.9636		6,900	$	2.9652
$3.0300	$	3.0300		126,650		6.26	$	3.0300		91,150	$	3.0300
$3.0600	$	3.6200		123,700		7.83	$	3.3952		89,200	$	3.3820
$3.6400	$	4.1100		56,000		9.07	$	3.7630		4,600	$	3.9226
$4.1400	$	4.1400		187,750		9.53	$	4.1400		0	$	0.0000
$4.2500	$	5.0000		29,500		7.56	$	4.6797		11,000	$	4.6632
$5.1500	$	5.1500		161,750		5.32	$	5.1500		158,750	$	5.1500
$5.2000	$	6.0300		11,250		6.36	$	5.6758		11,250	$	5.6758
$6.7300	$	6.7300		163,000		7.26	$	6.7300		154,000	$	6.7300
$6.8750	$	17.3750		335,850		4.11	$	10.2944		335,850	$	10.2944

$2.9600	$	17.3750		1,211,950		6.52	$	6.1306		862,700	$	7.0046

- 10 -

On December 15, 2005 the Company’s Board of Directors approved a plan to accelerate the vesting of all unvested employee stock options with an exercise price greater than $5.00, other than those options awarded to officers of the Company. These options were all out-of-the-money. The Board took this action with the belief that it is in the best interest of stockholders, as it will reduce the Company’s reported compensation expense associated with those stock options in future periods by approximately $448,000.

Tax benefits realized by the Company for deductions in excess of compensation expense under these plans are credited to additional paid-in capital.

The Company accounts for stock grants to non-employees in accordance with Emerging Issues Task Force Issue No. 96-18, Accounting for Equity Instruments That are Issued to Other Than Employees for Acquiring, or in Conjunction With Selling, Goods or Services. The Company recognized no expense for stock grants to non-employees for the three months ended September 30, 2006 and 2005, and $0 and $8,000 of expense was recognized for the nine months ended September 30, 2006 and 2005, respectively.

3. INVENTORY

Inventory is stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out method, net of allowances for estimated obsolescence. Major classes of inventory at September 30, 2006 and December 31, 2005 are summarized below:


	September 30, 2006			December 31, 2005
Raw materials	$	2,742,502		$	2,237,102
Work-in-process		80,496			136,882
Finished goods		748,702			910,419

		3,571,700			3,284,403
Reserve for obsolescence		(280,000	)		(287,000	)

	$	3,291,700		$	2,997,403

4. WARRANTY

The Company’s warranty activity for the three and nine months ended September 30, 2006 and 2005 is summarized below:


	Three months ended September 30,						Nine months ended September 30,
	2006			2005			2006			2005
Beginning balance	$	275,000		$	365,000		$	336,000		$	425,000
Warranty provision		70,447			47,244			203,596			155,242
Warranty costs incurred		(84,447	)		(81,268	)		(278,596	)		(249,266	)

Ending balance	$	261,000		$	330,976		$	261,000		$	330,976

- 11 -

5. INCOME TAXES

The Company has recorded its interim income tax provision based on estimates of the Company’s effective tax rate and income tax credits expected to be applicable for the full fiscal year. Estimated taxes and credits recorded during interim periods may be periodically revised, if necessary, to reflect revised estimates for the full fiscal year. The Company has recorded the impact of any changes in measurement of certain tax positions entirely in the interim period in which the change occurred.

During the first half of 2006, the Company utilized a research and experimentation (R&E) credit to calculate the annualized income tax rate. Because the authority for this credit ended at December 31, 2005, this credit should not have been utilized in the first half of 2006. The Company concluded that the correction was not material to the first and second quarters of 2006 and as a result the $122,000 adjustment is included in the nine-month period ended September 30, 2006. There is currently a proposal before Congress to reinstate the R&E credit with an effective date of January 1, 2006. If this law is enacted the Company will likely be required to utilize the R&E credit entirely in the quarter ended December 31, 2006.

6. COMPREHENSIVE INCOME

Comprehensive income for the three and nine months ended September 30, 2006 was $693,557 and $2,615,444, respectively. The sole adjustment necessary to reconcile net income with comprehensive income is the net unrealized gain, net of taxes, on available-for-sale securities, which was $145,419 for the three months ended September 30, 2006 and $99,174 for the nine months ended September 30, 2006.

Comprehensive income for the three and nine months ended September 30, 2005 was $786,606 and $1,230,200, respectively. The sole adjustment necessary to reconcile net income with comprehensive income is the net unrealized loss, net of taxes, on available-for-sale securities, which was $39,798 for the three months ended September 30, 2005 and $55,201 for the nine months ended September 30, 2005.

7. INCOME PER SHARE

Basic income per share is calculated using the weighted-average number of common shares outstanding during the periods. Diluted income per share is calculated using the weighted-average number of common and common equivalent shares outstanding during the periods. Stock options which were out-of-the money and, therefore, anti-dilutive under the treasury stock method have also been excluded from the calculation of diluted income per share. The Company’s weighted-average number of stock options outstanding which were excluded because they were out-of-the-money for the nine months ended September 30, 2006 and 2005 were 1,136,950 and 1,008,800, respectively.

- 12 -

Shares of common stock used in calculating income per share differed from outstanding shares reported in the consolidated financial statements as follows:


	Three months ended						Three months ended
	September 30, 2006						September 30, 2005
	Basic earnings			Diluted earnings			Basic earnings			Diluted earnings
	per share			per share			per share			per share
Outstanding shares		15,266,658			15,266,658			15,218,408			15,218,408
Effect of weighting changes in outstanding shares		(4,518	)		(4,518	)		(8,126	)		(8,126	)
Dilutive effect of stock options		—			3,306			—			63,227

Adjusted shares		15,262,140			15,265,446			15,210,282			15,273,509


	Nine months ended						Nine months ended
	September 30, 2006						September 30, 2005
	Basic earnings			Diluted earnings			Basic earnings			Diluted earnings
	per share			per share			per share			per share
Outstanding shares		15,266,658			15,266,658			15,218,408			15,218,408
Effect of weighting changes in outstanding shares		(13,414	)		(13,414	)		(41,987	)		(41,987	)
Dilutive effect of stock options		—			10,757			—			56,970

Adjusted shares		15,253,244			15,264,001			15,176,421			15,233,391

8. RESTRUCTURING COSTS

No restructuring charges were recorded for the nine months ended September 30, 2006. During the quarter ended March 31, 2005, the Company enacted two restructuring events. The actions were taken primarily to reduce operating costs and improve profitability. In January 2005, the Company announced management changes resulting in the election of William H. Largent as President and Chief Executive Officer. Former President and Chief Executive Officer, Gerard B. Moersdorf, Jr. resigned those positions while retaining his position as Chairman of the Board of Directors. At the same time, Michael P. Keegan resigned his position as Executive Vice President and Chief Operating Officer. In February 2005, the Company enacted a restructuring event affecting employees in sales, engineering, operations, services and administration. As a result of these actions, the Company incurred restructuring charges of $965,481 during the first quarter of 2005, consisting of severance and other benefit costs.

During the three and nine months ended September 30, 2005, the Company reduced the restructuring accrual by $10,351 and $80,232, respectively, to adjust for certain benefit costs that were less than originally estimated, as well as certain sublease receipts that were higher than originally estimated. The charges and adjustments are aggregated as a separate line item on the consolidated statements of operations.

As of September 30, 2006 and 2005, the remaining restructuring accrual was $0 and $130,013, respectively.

- 13 -

Activity in the restructuring accrual for the nine months ended September 30, 2006 is summarized below:


	Employee
	separations
Restructuring accrual — December 31, 2005	$	27,695
Cash deductions		(27,695	)

Restructuring accrual — September 30, 2006	$	—

9. MAJOR CUSTOMERS AND GEOGRAPHIC DATA

Because of the Company’s concentration of sales to a limited customer base, a small number of customers typically represent substantial portions of total sales. For the first nine months of 2006, sales to three companies comprised 84% of total sales. Each of the three customers contributed between 20% and 43% of total sales. For the first nine months of 2005, sales to four companies comprised 82% of total sales. Each of the four customers contributed between 12% and 29% of total sales.

The Company’s sales by geographic areas for the three and nine months ended September 30, 2006 and 2005 are summarized below:


	Three months ended September 30,				Nine months ended September 30,
	2006		2005		2006		2005
United States	$	6,803,383	$	6,363,779	$	23,624,641	$	20,175,484
International		942,825		2,060,533		1,901,232		3,202,688

	$	7,746,208	$	8,424,312	$	25,525,873	$	23,378,172

10. EMPLOYEE STOCK PURCHASE PLAN

The Applied Innovation Inc. Employee Stock Purchase Plan (“ESPP”), approved and adopted by the stockholders on April 25, 2002, authorizes the Company to issue up to 500,000 shares of common stock to eligible employees, as defined. The ESPP has semi-annual offering periods commencing January 1 and July 1 during which eligible employees may purchase shares at a price equal to 90% of fair market value on the first or last business day of the offering period, whichever is lower.

On January 4, 2006, the Company issued 7,591 shares of common stock at a price of $2.98 per share based on employee payroll deductions for the six month offering period ended December 31, 2005. On July 5, 2006, the Company issued 4,759 shares of common stock at a price of $2.98 per share based on employee payroll deductions for the six month offering period ended June 30, 2006. Since the inception of the ESPP, 111,379 shares have been issued to eligible employees.

- 14 -

11. CORRECTION OF ERROR

In the quarter ended September 30, 2006, the Company corrected an immaterial error related to income taxes. During the first and second quarters of 2006, the Company’s 2006 estimated effective income tax rate reflected the benefit of a research and experimentation (R&E) credit. Because the legislative authority for this credit ended at December 31, 2005, this credit should not have been utilized in 2006. There is currently a proposal before Congress to reinstate the R&E credit with an effective date of January 1, 2006. If this law is enacted, the Company will likely utilize the R&E credit entirely in the quarter ended December 31, 2006. The error resulted in a $73,000 and $49,000 understatement of income tax expense and income taxes payable for each of the quarters ended March 31, 2006 and June 30, 2006, respectively. The error had no effect on EPS for the quarters ended March 31, 2006 and June 30, 2006. The Company concluded that the correction was not material to the first and second quarters of 2006, estimated income for 2006, or to the trend of earnings.

As a result of this correction of error, the Company’s financial results for the three months ended March 31, 2006 have been adjusted as follows:


	Three months ended
	March 31, 2006					March 31, 2006
	(as previously reported)		Adjustments			(adjusted)

Balance sheet:

Income taxes payable	$	72,390	$	73,000		$	145,390
Retained earnings	$	39,718,478	$	(73,000	)	$	39,645,478

Statement of Operations:

Income tax expense	$	541,000	$	73,000		$	614,000
Net income	$	1,262,630	$	(73,000	)	$	1,189,630
Diluted income per share	$	0.08	$	—		$	0.08

As a result of this correction of error, the Company’s financial results for the three months ended June 30, 2006 have been adjusted as follows:


	Three months ended
	June 30, 2006					June 30, 2006
	(as previously reported)		Adjustments			(adjusted)

Balance sheet:

Income taxes payable	$	335,060	$	122,000		$	457,060
Retained earnings	$	40,545,979	$	(122,000	)	$	40,423,979

Statement of operations:

Income tax expense	$	384,000	$	49,000		$	433,000
Net income	$	827,501	$	(49,000	)	$	778,501
Diluted income per share	$	0.05	$	—		$	0.05

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

Applied Innovation Inc. (Applied Innovation, AI, and the Company) is a network management solutions company that simplifies and enhances the operation of complex, distributed voice and data networks. Building on a deep knowledge of network architecture, elements and management, AI delivers unique hardware, software and service solutions that provide greater connectivity, visibility and control of network elements and the systems that support them. By providing solutions in the areas of network mediation, aggregation and adaptation, the Company enables its customers to more effectively and efficiently manage their large, complex networks.

Applied Innovation’s products and services help its customers to improve network visibility thereby enabling better quality and uptime and, at the same time, reduce network maintenance and repair costs. By leveraging its extensive knowledge of network infrastructure, its vendor-neutral methodology and its customer-centric approach, AI provides solutions which help customers better manage and control both their capital expenditures and their operating expenditures. The Company’s solutions are targeted to global service providers that serve both wireline and wireless telecommunications services, as well as other providers of critical infrastructure.

During the third quarter of 2006, the Company sales declined 8% over the comparable period of the prior year. The third quarter 2006 decline was primarily due to declines in wireline and international sales, partially offset by increased wireless sales. The Company expects total year sales for 2006 to be similar to total year 2005 sales. The Company will continue to focus on market diversification efforts and to strengthen its business in global markets. These activities will continue to be through the Company’s direct sales force, as well as through added partners. Increased demand in the wireline market during the first nine months of 2006 was largely attributable to accelerated demand for products associated with next generation fiber initiatives at the Company’s largest wireline customers. This included a mix of both traditional products and new products focused on IP networking and network security.

- 15 -

Continued efforts to strengthen the Company’s presence in the wireless marketplace will be critical to maintaining the expected sales growth. Further, the Company expects to continue to see gross margin pressure as lower margin third party products and wireless sales increase as a percentage of total sales.

RESULTS OF THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2006 COMPARED TO THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005

Total Sales and Gross Profit

Sales for the third quarter of 2006 were $7,746,000, an 8% decrease from sales of $8,424,000 during the third quarter of 2005. The decrease in quarterly sales in 2006 resulted primarily due to declines in wireline and international sales, partially offset by increased wireless sales.

Year-to-date sales in 2006 increased 9% to $25,526,000 from $23,378,000 in the same period in 2005. The increase in year-to-date sales in 2006 was attributable to increased demand from the Company’s domestic wireline and wireless customers, partially offset by declines in sales to the Company’s international and government customers.

Gross profit as a percentage of total sales was 52% for the third quarter of 2006 comparable to 55% during the same period in 2005. Year-to-date gross profit margins were 51% and 56% for 2006 and 2005, respectively. The decrease in gross profit was primarily due to lower gross profit from services and increases in the resale of lower margin third party products during 2006 as compared to 2005.

The following table summarizes sales and gross profit for products and services:


	For the Quarter Ended September 30, 2006									For the Quarter Ended September 30, 2005
	Products			Services			Total			Products			Services			Total
Sales	$	6,348,000		$	1,398,000		$	7,746,000		$	7,186,000		$	1,238,000		$	8,424,000
Gross Profit		3,231,000			770,000			4,001,000			3,869,000			793,000			4,662,000
Gross Profit %		51	%		55	%		52	%		54	%		64	%		55	%


	For the Nine Months Ended									For the Nine Months Ended
	September 30, 2006									September 30, 2005
	Products			Services			Total			Products			Services			Total
Sales	$	22,113,000		$	3,413,000		$	25,526,000		$	19,179,000		$	4,199,000		$	23,378,000
Gross Profit		11,214,000			1,682,000			12,896,000			10,330,000			2,870,000			13,200,000
Gross Profit %		51	%		49	%		51	%		54	%		68	%		56	%

- 16 -

Product Sales and Gross Profit

Product sales of $6,348,000 were 82% of 2006 third quarter sales, versus product sales of $7,186,000, which were 85% of 2005 third quarter sales. This represented a 12% decrease in product sales from the comparable quarter in the prior year. Year-to-date product sales of $22,113,000 were 87% of total sales in 2006, versus product sales of $19,179,000, which were 82% of total sales in 2005. This represented a 15% increase in product sales from the previous year. Year-to-date demand in the domestic wireline market was particularly strong, as the Company’s two largest wireline customers purchased product for their next generation fiber initiatives, primarily during the first half of the year.

Product sales include revenues from the sales of the Company’s hardware products, as well as third-party hardware and software licensing revenues.

Gross profit on product sales was 51% of total product sales for the third quarter and year-to-date of 2006, compared with 54% of total product sales for the same periods last year. The decrease in gross profit over the prior year period was primarily due to increased sale of lower margin third party products.

Services Sales and Gross Profit

Services sales of $1,398,000 were 18% of 2006 third quarter sales, versus services sales of $1,238,000, or 15% of 2005 third quarter sales. The 13% increase in service sales during the three months ended September 30, 2006 compared to the same period last year was primarily a result of increased installation projects during this period. Year to date services sales of $3,413,000 were 13% of total sales in 2006, compared to $4,199,000, or 18% of total sales in 2005. The 19% decrease in services sales in the year to date 2006 compared to the same period last year was primarily a result of fewer installation projects year-to-date and lower pricing in these projects.

Services sales consist primarily of network planning and design, installation services, project management, engineering services, training and maintenance.

Services gross profit for the quarter ended September 30, 2006 was 55% of services sales, versus 64% of services sales for the comparable quarter a year ago. Gross profit decreased primarily due to lower average margins in the current mix of service projects. Services gross profit for the nine months ended September 30, 2006 was 49% of services sales, versus 68% of services sales for the comparable period a year ago. Gross profit decreased primarily due to lower average margins in the current mix of service projects. We expect the service gross margins to continue at this lower rate.

- 17 -

Selling, General and Administrative Expenses

Selling, general and administrative (“SG&A”) expenses decreased to $2,385,000 for the third quarter of 2006, from $2,508,000 in the third quarter of 2005. As a percentage of total quarterly sales, this represented 31% in 2006 and 30% in 2005. Year-to-date SG&A expenses were $7,834,000 in 2006 and $7,660,000 in 2005. As a percentage of total year-to-date sales, this represented 31% in 2006 and 33% in 2005. SG&A expenses included $35,000 and $97,000 in stock option and Employee Stock Purchase Plan expense required by the implementation of Statement of Financial Accounting Standards No. 123(R) Share Based Payment (“SFAS 123(R)”) for the three and nine months ended September 30, 2006, respectively. For the fourth quarter of 2006, SG&A expenses are expected to be comparable to the quarter ended September 30, 2006.

Research and Development Expenses

Research and development (“R&D”) expenses decreased to $1,040,000 for the third quarter of 2006, versus $1,210,000 for the same period in 2005. As a percentage of total quarterly sales, this represented 13% in 2006 and 14% in 2005. Year-to-date R&D expenses were $3,134,000 for 2006 and $3,305,000 for 2005. As a percentage of total year-to-date sales, this represented 12% in 2006 and 14% in 2005. The decrease in year-to-date R&D expenses was primarily due to reductions in compliance testing costs, depreciation, consulting, and hardware materials & parts, offset by increased wages and benefits. For the remaining quarter in 2006, R&D expenses are expected to be generally consistent with the third quarter of 2006.

Restructuring Charges

During the quarter ended March 31, 2005, the Company enacted two restructuring events. The actions were taken primarily to reduce operating costs and improve profitability. In January 2005, the Company announced management changes resulting in the election of William H. Largent as President and Chief Executive Officer. Former President and Chief Executive Officer, Gerard B. Moersdorf, Jr. resigned those positions while retaining his position as Chairman of the Board of Directors. At the same time, Michael P. Keegan resigned his position as Executive Vice President and Chief Operating Officer. In February 2005, the Company enacted a restructuring event affecting employees in sales, engineering, operations, services and administration. As a result of these actions, the Company incurred restructuring charges of $965,000 during the first quarter of 2005, consisting of severance and other benefit costs.

As of September 30, 2006 and 2005, the remaining restructuring accrual was $0 and $130,013, respectively.

- 18 -

Gain on Sale of Land

During the quarter ended March 31, 2006, the Company completed the sale of 8.6 acres of land located adjacent to its corporate headquarters, and recorded a gain on the sale of $1,036,000. The Company continues to list for sale an additional 16.3 acres of adjoining land.

Interest and Other Income, Net

Interest and other income, net increased to $372,000 in the third quarter of 2006 from $191,000 in the comparable quarter last year. Year-to-date interest and other income, net increased to $1,000,000 in 2006 from $524,000 in the prior year. The quarterly and year-to-date increases in interest and other income, net in 2006 as compared to 2005 are primarily attributable to higher interest income due to higher cash and investment balances, and higher interest rates.

Income Taxes

The Company’s effective income tax rate was 42% for the three months ended September 30, 2006, compared to an effective rate of 28% for the same period in 2005. The Company’s effective income tax rate was 37% for the nine months ended September 30, 2006, compared to an effective rate of 31% for the same period in 2005.

In the quarter ended September 30, 2006, the Company corrected an immaterial error related to income taxes. During the first and second quarters of 2006, the Company’s 2006 estimated effective income tax rate reflected the benefit of a research and experimentation (R&E) credit. Because the legislative authority for this credit ended at December 31, 2005, this credit should not have been utilized in 2006. There is currently a proposal before Congress to reinstate the R&E credit with an effective date of January 1, 2006. If this law is enacted, the Company will likely utilize the R&E credit entirely in the quarter ended December 31, 2006. The error resulted in a $73,000 and $49,000 understatement of income tax expense and income taxes payable for each of the quarters ended March 31, 2006 and June 30, 2006, respectively. The Company concluded that the correction was not material to the first and second quarters of 2006, estimated income for 2006, or to the trend of earnings.

Net Income and Net Income Per Share

As a result of the above factors, the Company recorded net income of $548,000, or $0.04 per share, in the third quarter of 2006, versus net income of $826,000, or $0.05 per share, in the third quarter of 2005. Year-to-date net income was $2,516,000, or $0.16 per share, in 2006, versus net income of $1,285,000, or $0.08 per share, in 2005.

LIQUIDITY AND CAPITAL RESOURCES

Net working capital was $24,108,000 at September 30, 2006, compared to $24,038,000 at December 31, 2005. At September 30, 2006, the current ratio was 5.5:1 and the Company had no debt outstanding.

- 19 -

The Company had $36,181,000 of cash and cash equivalents and short and long term investments at September 30, 2006, an increase of $6,089,000 from the December 31, 2005 balance of $30,092,000.

Operating Activities

For the nine months ended September 30, 2006, operating activities provided cash of $4,482,000. Significant components of cash flows from operations included: gain on sale of land of $1,036,000; decreased accounts receivable of $1,422,000, primarily due to decreased sales; and decreased deferred income tax of $999,000.

Investing Activities

During the nine months ended September 30, 2006, investing activities provided cash totaling $841,000. Proceeds from the sale of land provided $1,393,000; purchases of property, plant and equipment used $62,000; and maturities and sales of investments, net of investment purchases, used $493,000.

Financing Activities

Common stock issued for stock option exercises and purchases under the Employee Stock Purchase Plan provided cash of $118,000 during the first nine months of 2006.

The Company believes that its existing cash, cash equivalents, investments and cash to be generated from future operations will provide sufficient capital to meet the business needs of the Company for the next twelve months. In addition, the Company believes it could generate additional funding through issuance of debt or equity or through the sale of land if the Company’s working capital needs significantly increase due to circumstances such as sustained weakness in the telecommunications industry resulting in decreased demand for the Company’s products and services and operating losses; faster than expected growth resulting in increased accounts receivable and inventory; additional investment or acquisition activity; or significant research and development efforts. However, there can be no assurance that additional financing will be available on terms favorable to the Company or at all.

FACTORS THAT COULD AFFECT FUTURE RESULTS-Impairment of Goodwill Could Impact Net Income

We account for goodwill and other intangible assets under Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets.” Under this Statement, goodwill is tested for impairment annually or more frequently if certain events or changes in circumstances indicate that the carrying amount of goodwill exceeds its implied fair value. As of September 30, 2006, we performed our annual review of goodwill and determined there to be no impairment. Due to current low stock prices for the Company’s stock, the Company has determined that interim testing for goodwill impairment will be necessary for the

- 20 -

quarter ending December 31, 2006. If the review determines that such goodwill is impaired, we will be required to recognize an impairment charge necessary to reduce the carrying value of the goodwill to its net realizable value. Should events occur that would give rise to such an impairment charge, we would recognize decreased profitability to the extent of such adjustment. Cash flows would not be directly affected by the impairment charge, but cash flows may be adversely affected as a result of the facts and circumstances that created the impairment charge.

Recent Accounting Pronouncements

In September 2006, the SEC staff issued Staff Accounting Bulletin (“SAB”) 108 “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108). SAB 108 requires that public companies utilize a “dual-approach” to assessing the quantitative effects of financial misstatements. This dual approach includes both an income statement focused assessment and a balance sheet focused assessment. The guidance in SAB 108 must be applied to annual financial statements for fiscal years ending after November 15, 2006. The Company is currently assessing the impact of adopting SAB 108 but does not expect that it will have a material effect on our consolidated financial position or results of operations.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS No. 157). SFAS No. 157 establishes a common definition for fair value to be applied to U.S. generally accepted accounting principles guidance requiring use of fair value, establishes a framework for measuring fair value, and expands disclosure about such fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact of SFAS No. 157 on its consolidated financial position and results of operations.

In June 2006, the FASB issued FASB Interpretation (“FIN”) 48, “Accounting for Uncertainty in Income Taxes.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” This Interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the effect that the adoption of FIN 48 will have on its financial position and results of operations.

In May 2005, the Financial Accounting Standards Board issued Statement No. 154, “Accounting Changes and Error Corrections – a Replacement of APB Opinion No. 20 and FASB Statement No. 3.” Statement No. 154 requires retrospective application to prior periods’ financial statements for changes in accounting principle, unless determination of either the period specific effects or the cumulative effect of the change is impracticable. The provisions of this Statement became effective January 1, 2006. The adoption of Statement No. 154 did not have a material impact on the Company’s financial position, results of operations or cash flows.

In December 2004, the FASB issued Statement No. 153, “Exchanges of Non-monetary Assets – an Amendment of APB Opinion No. 29.” Statement No. 153 eliminates the exception for non-monetary exchanges of similar productive assets and replaces it with a general exception for exchanges of non-monetary assets that do not have commercial substance. A non-monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. Statement No. 153 became effective January 1,

- 21 -

2006. The adoption of Statement No. 153 did not have a material impact on the Company’s financial position, results of operations or cash flows.

In November 2004, the FASB issued Statement No. 151, “Inventory Costs.” Statement No. 151 amends the guidance in Accounting Research Bulletin No. 43 to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). This Statement requires that the allocation of fixed production overhead to the costs of conversion be based on the normal capacity of the production facilities. This Statement became effective January 1, 2006. The adoption of Statement No. 151 did not have a material impact on the Company’s financial position, results of operations or cash flows.

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

The foregoing Management’s Discussion and Analysis of Financial Condition and Results of Operations contains certain forward looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. These forward-looking statements include, but may not be limited to, all statements regarding intent, beliefs, expectations, projections, forecasts, and plans of the Company and its management. These forward looking statements involve numerous risks and uncertainties, including, without limitation, fluctuations in demand for the Company’s products and services, the impact of competitive products and services, general economic and business conditions, the Company’s ability to develop new products as planned and on budget, the fact that the Company may decide to substantially increase R&D expenditures to meet the needs of its business and customers, currently unforeseen circumstances that could require the use of capital resources, current and future mergers of key customers and the various risks inherent in the Company’s business and other risks and uncertainties detailed from time to time in the Company’s periodic reports filed with the Securities and Exchange Commission, including the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005. One or more of these factors have affected, and could in the future affect the Company’s business and financial results and could cause actual results to differ materially from plans and projections. Therefore, there can be no assurance that the forward looking statements included in this Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in the forward looking statements included herein, the inclusion of such information should not be regarded as a representation by the Company, or any other person, that the objectives and plans of the Company will be achieved. All forward looking statements are based on information presently available to the management of the Company. The Company assumes no obligation to update any forward looking statements.

- 22 -

Item 3. Quantitative and Qualitative Disclosure about Market Risk

The Company does not have any material exposure to interest rate changes, commodity price changes, foreign currency fluctuations, or similar market risks. The Company invests in various debt obligations, primarily U.S. government and agency obligations and high quality commercial paper, with maturities generally less than three years. Although the yields on such investments are subject to changes in interest rates, the potential impact to the Company and its future earnings as a result of customary interest rate fluctuations is immaterial. Furthermore, the Company has not entered into any derivative contracts.

Item 4. Controls and Procedures

As of the end of the period covered by this report, the Company’s management carried out an evaluation, with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934). Based upon that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report. It should be noted that the design of any system of controls is based in part upon 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, regardless of how remote.

There were no changes in the Company’s internal controls over financial reporting that occurred during the Company’s most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

- 23 -

PART II. OTHER INFORMATION

Item 1A. Risk Factors

Item 1A. of Part 1 of our Annual Report on Form 10-K for the year ended December 31, 2005, includes a detailed discussion of our risk factors. The information presented below updates and should be read in conjunction with the risk factors and information disclosed in our Form 10-K.

Based on our stock price, we will be required to implement interim testing for goodwill impairment for our fourth quarter ended December 31, 2006, and if such review determines that our goodwill is impaired, we will be required to recognize an impairment charge.

We account for goodwill and other intangible assets under SFAS No. 142, “Goodwill and Other Intangible Assets.” Under this standard, goodwill is tested for impairment annually or more frequently if certain events or changes in circumstances indicate that the carrying amount of goodwill exceeds its implied fair value. As of September 30, 2006, we performed our annual review of goodwill and determined there to be no impairment. Due to current low stock prices for the Company’s stock, the Company has determined that interim testing for goodwill impairment will be necessary for the quarter ending December 31, 2006. If the review determines that such goodwill is impaired, we will be required to recognize an impairment charge necessary to reduce the carrying value of the goodwill to its net realizable value. Should events occur that would give rise to such an impairment charge, we would recognize decreased profitability to the extent of such adjustment. Cash flows would not be directly affected by the impairment charge, but cash flows may be adversely affected as a result of the facts and circumstances that created the impairment charge.

Item 6. Exhibits

Exhibit 31.1 – Rule 13a-14(a) Certification of Principal Executive Officer

Exhibit 31.2 – Rule 13a-14(a) Certification of Principal Financial Officer

Exhibit 32.1 – Section 1350 Certification of Principal Executive Officer

Exhibit 32.2 – Section 1350 Certification of Principal Financial Officer

- 24 -


	Page
Facing Page		1
Table of Contents		2
Part I. Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005		3
Consolidated Statements of Operations for the three and nine month periods ended September 30, 2006 and 2005 (unaudited)		4
Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2006 and 2005 (unaudited)		5
Notes to Consolidated Financial Statements (unaudited)		6-15
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		15-22
Item 3. Quantitative and Qualitative Disclosure About Market Risk		23
Item 4. Controls and Procedures		23

Part II. Other Information
Item 1A. Risk Factors		24
Item 6. Exhibits		24
Signatures		25
EX-31.1
EX-31.2
EX-32.1
EX-32.2


		APPLIED INNOVATION INC.
		(Registrant)

November 13, 2006 Date		/s/ William H. Largent William H. Largent
		President and Chief Executive Officer
		(Principal Executive Officer)

November 13, 2006 Date		/s/ Julia A. Fratianne Julia A. Fratianne
		Vice President, Chief Financial Officer and Treasurer*
		(Principal Financial Officer and Principal Accounting Officer)


*		In her capacity as Vice President, Chief Financial Officer, and Treasurer, Ms. Fratianne is duly authorized to sign this report on behalf of the Registrant.