Note 1. Nature of Business and Significant Accounting Policies

Nature of business: The Company operates in one business segment, which includes the design and manufacture of electronic control devices. Sales are to customers located primarily in the upper Midwest, and credit is granted based upon the credit policies of the Company.

A summary of the Company’s significant accounting policies follows:

Use of estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from such estimates and assumptions.

Revenue recognition: In 1999, the staff of the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements.” SAB No. 101 summarizes some of the staff’s interpretations of the application of generally accepted accounting principles to revenue recognition. The Company adopted SAB No. 101 in the fourth quarter of 2000. Management believes the adoption of SAB No. 101 has had no affect on its financial statements. Revenue from product sales is recognized when shipped.

Cash: The Company maintains its cash in bank deposit accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts.

Inventories: Inventories are stated at the lower of cost (first-in, first-out method) or market.

Patents and trademarks: Patents and trademarks are stated at cost and are being amortized using the straight-line method over their economic useful lives.

Depreciation: It is the Company’s policy to include depreciation expense on assets acquired under capital leases with depreciation expense on owned assets. Depreciation is computed using the straight-line method based on the estimated useful lives of the various assets or term of the capital lease, as follows:

Note 1. Nature of Business and Significant Accounting Policies (Continued)

Long-lived assets: The Company reviews its long-lived assets and intangibles periodically to determine potential impairment by comparing the carrying value of the long-lived assets with the estimated future cash flows expected to result from the use of the assets, including cash flows from disposition. Should the sum of the expected future cash flows be less than the carrying value, the Company would recognize an impairment loss. An impairment loss would be measured by comparing the amount by which the carrying value exceeds the fair value of the long-lived assets and intangibles. To date, management has determined that no impairment of long-lived assets exists.

Income taxes: Deferred taxes are provided on an asset and liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards, and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax basis. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

Investment tax credits, research and development credits, and job credits are accounted for by the flow-through method, whereby they reduce income taxes currently payable and the provision for income taxes in the period the assets giving rise to the credits are placed in service. To the extent such credits are not currently utilized on the Company’s tax return, deferred tax assets, subject to considerations about the need for a valuation allowance, are recognized for the carryforward amount.

Fair value of financial instruments: In accordance with the requirements of Statement of Financial Accounting Standards (SFAS) No. 107, Disclosures About Fair Value of Financial Instruments, management estimates that the carrying value of long-term debt approximates fair value, estimated based on interest rates for the same or similar debt offered to the Company having the same or similar remaining maturities and collateral requirements. The carrying value of all other financial instruments approximates fair value due to the short-term nature of the instruments.

Earnings per share: Basic earnings per share is computed by dividing net earnings by the weighted-average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net earnings by the weighted-average number of common shares outstanding during the period, including potentially dilutive shares.

The Company has granted options and warrants to purchase shares of common stock at various amounts per share (see Note 7). For 2000, these options and warrants were not included in the computation of diluted earnings per share because the Company has incurred a loss for the period. The inclusion of potential common shares in the calculation of diluted loss per share would have an antidilutive effect. Therefore, basic and diluted loss per share amounts are the same for 2000.

Research and development expense: The Company expenses research and development costs as incurred. Research and development expenses of $1,045,773 and $835,577 were charged to operations during the years ended December 31, 2000 and 1999, respectively.

Note 2. Inventories

The components of inventories at December 31, 2000 and 1999, are as follows:

Note 3. Financing Arrangement and Long-Term Debt

Financing arrangement: The Company has a $4,500,000 revolving line-of-credit agreement through August 2001. Interest on advances is at the bank’s reference rate (9.5 percent at December 31, 2000) and is due monthly. Advances outstanding on the revolving line-of-credit agreement at December 31, 2000 and 1999, were $3,924,501 and $1,518,501, respectively.

Advances are due on demand, are secured by substantially all assets of the Company, and are subject to a defined borrowing base equal to 80 percent of qualified accounts receivable and 60 percent of eligible inventories plus 25 percent of work in process. In addition, the agreement contains certain reporting and operating covenants. The Company was in violation of certain covenants at December 31, 2000, which were subsequently waived by the bank.

Long-term debt: The following is a summary of long-term debt:

Approximate maturities of long-term debt for years subsequent to December 31, 2000, are as follows:

Note 4. Commitments and Contingencies

Capital leases: The Company is leasing certain equipment under capital leases. The cost and accumulated depreciation of assets acquired under capital leases at December 31, 2000 and 1999, are as follows:

Note 4. Commitments and Contingencies (Continued)

The future minimum lease payments under capital leases and the aggregate present value of the net minimum lease payments at December 31, 2000, are as follow:

Operating leases: The Company leases certain equipment and vehicles under noncancelable operating leases through September 2003. The Company is responsible for all repairs and maintenance, insurance, and other related expenses in connection with these leases.

Rental and other related expenses for the above leases for the years ended December 31, 2000 and 1999, were approximately $150,000 and $126,000, respectively.

Approximate minimum future annual lease payments under these leases as of December 31, 2000, are as follows:

Note 5. Deferred Revenue

During 1994, the Company and the city of Mankato entered into a tax increment financing agreement for the construction of the Company’s operating facility. In connection with this agreement, the city donated land improvements with a fair value of $270,009. The fair value of land improvements donated was accounted for as deferred revenue and is being amortized over 39 years, which is the life of the building.

Note 6. Income Taxes

Components of the provision for income taxes are as follows:

The statutory income tax rate reconciliation to effective rate is as follows:

Net deferred taxes consist of the following components as of December 31, 2000 and 1999:

Note 6. Income Taxes (Continued)

The components giving rise to the net deferred tax assets and liabilities described above have been included in the accompanying balance sheets at December 31, 2000 and 1999, as follows:

At December 31, 2000, the Company has state net operating loss carryforwards of approximately $307,000. These carryforwards expire in 2016. In addition, the Company has approximately $57,000 of tax credits that expire in 2021.

Note 7. Stock-Based Compensation Plans

Stock option plan: The Company has reserved 750,000 common shares for issuance under qualified and nonqualified stock options for its key employees and directors. Option prices are the market value of the stock at the time the option was granted. Options become exercisable as determined at the date of grant by a committee of the Board of Directors. Options expire over the terms of the options, generally five years after the date of grant, unless an earlier expiration date is set at the time of grant.

The Company has adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. Accordingly, no compensation cost has been recognized for the stock option plan. Had compensation cost for the Company’s stock option plan been determined based on the fair value at the grant date for awards consistent with the provisions of SFAS No. 123, the Company’s earnings and earnings per share would have changed to the pro forma amounts indicated below:

Note 7. Stock-Based Compensation Plans (Continued)

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 2000 and 1999:

The pro forma effect on earnings in 2000 and 1999 is not representative of the pro forma effect in future years because it does not take into consideration pro forma compensation expense related to grants made prior to 1995.

Additional information relating to all outstanding options as of December 31, 2000 and 1999, is as follows:

Options exercised in 2000 were done on a cashless basis resulting in the issuance of only 13,955 shares of common stock.

Note 7. Stock-Based Compensation Plans (Continued)

The following table summarizes information about stock options and warrants outstanding at December 31, 2000:

At December 31, 1999, there were 286,500 options exercisable at a weighted-average exercise price of $2.02.

At December 31, 1999, the Company also had outstanding warrants to purchase 37,000 shares of common stock. In 2000, 28,212 warrants were exercised at $2.20 per share, and 8,788 warrants expired.

Note 8. Employee Benefit Plans

Pension plan: The Company has a qualified defined contribution 401(k) profit-sharing plan for its employees who meet certain age and service requirements. Employees are allowed to make contributions up to 15 percent of their eligible compensation. The plan also provides for a company-sponsored match to be determined each year by the Board of Directors. The Company contributed approximately $79,400 and $76,000 to the plan for the years ended December 31, 2000 and 1999, respectively. In addition, the Company may make additional discretionary contributions to the plan to the extent authorized by the Board of Directors. There were no discretionary contributions to the plan for the years ended December 31, 2000 and 1999.

Stock purchase plan: The Company has adopted an employee stock purchase plan to provide substantially all employees an opportunity to purchase shares of its common stock through payroll deductions, up to 15 percent of eligible compensation. The plan is carried out in two annual six-month phases beginning January 1 and July 1, the grant dates. On June 30 and December 31, the exercise dates, participant account balances are used to purchase shares of stock at the lesser of 85 percent of the fair value of shares on the grant date or the exercise date. The employee stock purchase plan expires December 31, 2002. A total of 100,000 shares were originally available for purchase under the plan. There were 8,526 and 5,834 shares purchased under the plan for the years ended December 31, 2000 and 1999, respectively.

Note 9. Major Customers, International Sales, and Enterprisewide Disclosures

Major customers: The Company has customers which accounted for more than 10 percent of net sales for the years ended December 31, 2000 and 1999, as follows:

International sales: Export sales to international customers for 2000 and 1999 were approximately $256,000 and $613,000, respectively. Accounts receivable from international customers were approximately $20,000 and $50,000 at December 31, 2000 and 1999, respectively.

Enterprisewide disclosures: The following table presents revenue from external customers for each of the Company’s groups of products and services: